Deduction of Property Maintenance Expenses Under IRS Article 41 – Proportionality Rule for Rental Days | CAAD 264/2017-T

Arbitral Decision

I. REPORT

1. On 13 April 2017, the taxpayers A… and B…, non-residents in Portugal for tax purposes, with tax identification numbers … and …, respectively, with tax address at Street …, no. …, …-… …, hereinafter designated as the Claimants, requested the constitution of an Arbitral Tribunal and submitted a request for arbitral decision, in accordance with paragraph a) of article 2(1) and paragraph a) of article 10(1) of Decree-Law no. 10/2011, of 20 January (Legal Framework for Arbitration in Tax Matters, hereinafter referred to only as LFATM), in which the Tax and Customs Authority (hereinafter designated as TCA) is the Respondent.

2. The Claimants are represented, in the present proceedings, by their attorney, Dr. E…, and the Respondent is represented by the legal counsels, Dr. C… and Dr. D….

3. The request for constitution of the Arbitral Tribunal was accepted by the Esteemed President of CAAD and was notified to the Respondent on 17 April 2017.

4. By means of the request for constitution of the Arbitral Tribunal and for arbitral decision, the Claimants seek a declaration of illegality of the decision of partial acceptance of the administrative complaint no. …2016…, and consequently, annulment of the tax acts of assessment of Personal Income Tax (IRS) and compensatory interest, for the years 2012, 2013 and 2014 and, consequently, the restitution of the total amount of € 9,206.91 (nine thousand, two hundred and six euros and ninety-one cents).

5. Having verified the formal regularity of the request presented, in accordance with paragraph a) of article 6(2) of the LFATM, the undersigned was designated as arbitrator by the President of the Deontological Council of CAAD.

6. The Arbitrator accepted the designation made, and the Arbitral Tribunal was constituted on 28 June 2017, at the headquarters of CAAD, located at Avenida Duque de Loulé, no. 72-A, in Lisbon, as per the minutes of constitution of the Arbitral Tribunal which were drawn up and are attached to the present proceedings.

7. After being notified for that purpose, the Respondent submitted its reply on 18 September 2017.

8. By order of 09 October 2017, given that there was no need for the production of additional evidence beyond that which is already incorporated in the proceedings in documentary form, and given that there appeared to be no need for the parties to correct their respective procedural submissions, with the proceedings containing all the necessary elements for the issuance of the decision, for reasons of procedural efficiency and celerity and prohibition of useless acts, the Tribunal considered it appropriate to waive the holding of the meeting referred to in article 18 of the LFATM, and should likewise waive the submission of arguments, provided the parties did not object. In light of the parties' silence, the aforementioned meeting was waived, as well as the mentioned arguments.

9. The Tribunal, in compliance with article 18(2) of the LFATM, designated 28 December 2017 as the date for issuance of the arbitral decision, and warned the Claimants, in the order of 09 October 2017, that they should proceed with payment of the subsequent arbitral fee, in accordance with article 4(3) of the Regulation on Costs in Tax Arbitration Proceedings, and communicate such payment to CAAD.

II. The Claimants Support Their Request, in Summary, as Follows:

The Claimants support their request for annulment of the partial acceptance of the administrative complaint no. …2016… and of the IRS assessments relating to the years 2012, 2013 and 2014, embodied by (i.) the IRS assessment statement no. 2016…, of 18 April 2016, compensatory interest statement no. 2016…, as well as the respective account adjustment statement no. 2016…, these two of 3 May 2016, (ii.) the IRS assessment statement no. 2016…, of 18 April 2016, compensatory interest statement no. 2016…, as well as the respective account adjustment statement no. 2016…, both of 2 May 2016, and (iii.) the IRS assessment statement no. 2016…, of 7 April 2016, compensatory interest statement no. 2016…, as well as the respective account adjustment statement no. 2016…, both of 11 April 2016, in the total amount of € 10,220.33 (ten thousand, two hundred and twenty euros and thirty-three cents), in which, following the said final decision of partial acceptance of the Administrative Complaint submitted by the Claimants, they received reimbursements of € 446.24 (four hundred and forty-six euros and twenty-four cents) and € 567.18 (five hundred and sixty-seven euros and eighteen cents), relating to tax paid in excess for the tax years 2013 and 2014 to which they were subject, on the grounds of the following defects:

a) The Claimants were subject to an internal tax inspection action, relating to the tax years 2012, 2013 and 2014, under Service Orders no. OI2015…/…/…, of 17 September 2015.

b) Following the mentioned inspection action, the TCA services deemed it appropriate to make arithmetic corrections, which resulted in additional IRS assessments and respective compensatory interest assessments, relating to the tax years 2012, 2013 and 2014, requiring the Claimants to lodge an administrative complaint, which resulted in a final decision of partial acceptance, with the TCA accepting: "the tax deductibility of all expenses that the Claimant had complained about for the tax years 2012, 2013 and 2014, with the exception of the following expenses in the year 2014: Internet equipment installation - € 92.25; Internet router materials - € 79.95; Joint relief/housing - € 30.75 and IPTV box installation - € 119.98."

c) In effect, "although the Claimant presented documentary support for all these expenses that were not accepted at this stage, as shown in the documents attached to the Administrative Complaint, the said expenses were not accepted for tax purposes as they were considered current expenses and not maintenance and conservation expenses."

d) Additionally, "the TCA maintained the application of a proportionality coefficient for expenses based on the number of days the property was leased."

e) However, "the Inspection Report refrains from indicating which expenses are specifically non-deductible when the description does not allow the classification of the asset/service provided, those that are non-deductible because they are 'current expenses' or other non-deductible expenses."

f) Furthermore, the alleged proportionality that should exist between the expenses incurred and the periods in which the Claimants' properties generate income, set out in the Inspection Report and in the order of partial acceptance of the Administrative Complaint, is not legitimized by law.

g) In these terms, "considering the TCA's failure to comply with the special duty of substantiation to which the law obliges it, all the assessment statements now complained about should be considered unsubstantiated, pursuant to article 153(2) of the Code of Administrative Procedure (CAP) – applicable by virtue of paragraph d) of article 2 of the CTCP – as well as the above-cited articles, and consequently, due to a defect of form, should be annulled."

h) Nevertheless, even if the acts "are not annulled due to defect of form for lack of substantiation, they should be so due to error regarding the factual and legal presuppositions."

i) On the one hand, "it appears to be the settled position of legal doctrine that defends that the ratio underlying the concept of 'conservation expenses' consists of accepting for purposes of deductibility under article 41 of the IRS Code, all conservation expenses, whether ordinary or extraordinary."

j) Thus, "all expenses necessary for the maintenance of the properties and their economic activity should be considered 'maintenance expenses', such as those related to the internet functioning of the property, which is leased with that same functionality."

k) On the other hand, "By arguing that the application of a proportionality coefficient for maintenance and conservation expenses versus income should be applied to the Claimant, the TCA demonstrates a certain detachment from reality and the law."

l) In view of the above, the Claimants understand that they "request the annulment in its entirety of the corrections concerning Corporate Income Tax allegedly owed due to non-deductible expenses under the mentioned article 41 of the IRS Code", as well as "due to the application of a proportionality coefficient and, consequently, of the assessment acts and the final decision of partial acceptance of the Administrative Complaint that are associated with them."

m) Furthermore, "it must be concluded that there is an absence of substantiation of the assessment of compensatory interest, in particular with respect to the Claimant's fault in the supposed delay in the tax assessment, which violates the provisions of article 35(1) and articles 77(1) and 77(2), both of the GTL, as well as the provisions of article 268(3) of the CRP."

n) Therefore, they request that the Arbitral Tribunal declare: (i.) the illegality of the acts of additional assessment of IRS for the tax years 2012, 2013 and 2014; (ii.) the illegality of the act of partial acceptance of the Administrative Complaint relating to the tax years 2012, 2013 and 2014; (iii.) the reimbursement of the amount of € 9,206.91 paid unduly in excess; (iv.) the payment of indemnity interest calculated on the amount paid unduly.

III. In Its Reply the Respondent Invoked, in Summary, the Following:

For its part, the TCA comes forward in its reply to defend itself by means of the following objections:

a) The Respondent submits that: "Regarding the lack of substantiation, it must be stated that, with due respect for any different understanding, the Claimant's thesis regarding the lack of substantiation of the tax act has no foundation whatsoever."

b) In effect, "to achieve that objective it is sufficient to have a concise substantiation, but one that is clear, concrete, congruent and contextual, with the substantiation of the administrative-tax act being sufficient if, in the context in which it was adopted, and considering the factual and legal reasons expressly stated therein, it is capable, apt and sufficient to allow a normal recipient to comprehend the cognitive and evaluative path of the decision."

c) In the concrete case, "it is inescapable that the substantiation is sufficiently clear and unequivocal, all the more so because the Claimants through the present request for arbitral decision and in view of the arguments they have put forward throughout their pleading, demonstrate that they have fully understood the factual and legal framework on which the Respondent's decision was based, since they attempt to rebut, point by point, its entire action."

d) Therefore, "even if the act at issue suffered from deficiencies in the level of substantiating discourse – which is only admitted as a mere academic hypothesis – such deficiencies would be degraded into merely non-essential irregularities."

e) However, "even if it were understood that the act suffered from any omission of substantiation, which is not conceded, the Claimant would always have at its disposal the procedure provided for in article 37 of the CTCP."

f) As to the alleged error of law in the corrections made, and consequently in the assessments issued, that is, the defect of violation of law, particularly article 41 of the IRS Code, in the version applicable at the time of the facts, "the Claimant's position has no merit, as is amply demonstrated in the information that substantiated the decision of the proposed correction and, as well, of the rejection of the Administrative Complaint to which we refer and which is hereby given as entirely reproduced for all legal purposes."

g) According to the Respondent, "Once the taxable income is determined for purposes of taxation under Category F of the IRS Code, regard is paid to the net income obtained, i.e., the rents received minus the expenses and charges incurred to produce the rental income encompassed and to maintain intact the respective income-generating source, that is, the leased properties, it appears that such expenses should be proportionally considered based on the number of months the property was leased."

h) Now, "In the periods in which the property was not occupied and, for that reason, did not produce any rental income, there being no gross income against which any expense incurred could be deducted, in such a circumstance, it will not be possible to determine a net income subject to taxation under category F of the IRS Code."

i) Continuing its thesis, the Respondent expresses the understanding that "any other interpretation that does not support the position set forth in the IR, and which is the TCA's interpretation, frontally violates Constitutional provisions, namely the principle of equality (article 13 CRP) and, as well, that of contributory capacity (article 104 CRP), by discriminating between those who lease a property for only a few days, deducting all and any expenses provided for in article 41 without any limit, and those who, constantly using and throughout the entire tax year the property for leasing, find themselves in the contingency of being placed on the same level of contributory capacity (which is by no means equal) as those others."

j) Therefore, "it is evident that the tax act that is the subject of the present arbitral request is legally compliant.", with "the possibility of recognition of the right to indemnity interest ruled out, pursuant to articles 43(1) and 43(2) of the GTL."

IV. Procedural Matters

The Tribunal is competent and is regularly constituted, in accordance with paragraph a) of article 2(1) and articles 5 and 6, all of the LFATM.

Having regard to the appreciation of the same circumstances of fact and the interpretation and application of the same principles and rules of law, the present accumulation of requests is admissible, in accordance with article 3(1) of the LFATM.

The parties have legal personality and capacity, show themselves to be interested parties, are regularly represented and the proceedings do not suffer from any nullities.

V. Statement of Facts

With relevance for the decision, the following facts are established as proven:

A. The Claimants are owners of the urban property registered in the property register under item no. …, of the parish of …, of the municipality of Loulé, located at … – Urbanization … (cf. document no. 2 attached to the Arbitral Petition);

B. The rental income of category F declared by the Claimants, as well as the related expenses and charges incurred and declared were as follows (cf. annexes 7 to 9 attached to the Initial Petition):

C. Within the scope of Service Orders no. OI2015…/…/…, of 17 September 2015, the Tax and Customs Authority carried out an internal inspection action against the Claimants, relating to the tax years 2012, 2013 and 2014, with partial scope, relating to the procedures adopted in determining the IRS (cf. annex 2 attached to the arbitral petition);

D. In the course of the mentioned inspection action, the tax inspection services deemed it appropriate to make the following corrections (cf. annex 2 attached to the Initial Petition):

E. Following this, the Claimants were notified of the following tax acts relating to the tax years 2012, 2013 and 2014:

· IRS assessment statement no. 2016…, of 18 April 2016, compensatory interest statement no. 2016…, as well as the respective account adjustment statement no. 2016…, these two of 3 May 2016;

· IRS assessment statement no. 2016…, of 18 April 2016, compensatory interest statement no. 2016…, as well as the respective account adjustment statement no. 2016…, both of 2 May 2016;

· IRS assessment statement no. 2016…, of 7 April 2016, compensatory interest statement no. 2016…, as well as the respective account adjustment statement no. 2016…, both of 11 April 2016; (cf. copies of assessment notices attached to the administrative complaints – cf. pages 73 to 75, 78 to 80, 83 to 85, all of the administrative file).

F. The Claimants proceeded with payment of the assessment acts underlying the arbitral petition on 18 May 2016 (cf. pages 76, 81 and 86 of the administrative file).

G. Given that they did not agree with the correction carried out by the Tax Inspectors, within the scope of the mentioned inspection action, the Claimants submitted, on 29 July 2016, an administrative complaint relating to the tax years 2012, 2013 and 2014 (cf. document no. 1 attached to the arbitral petition).

H. On 13 January 2017, the Claimants were notified of the final decision of partial acceptance of the mentioned administrative complaint (cf. document no. 2 attached to the arbitral petition).

I. Following the mentioned final decision of partial acceptance of the administrative complaint submitted by the Claimants, they received reimbursements in the amount of € 446.24 and € 567.18 relating to tax paid in excess for the tax years 2013 and 2014 (cf. documents no. 3 and 4 attached to the arbitral petition).

VI. Facts Not Established as Proven

There are no facts established as not proven, because all facts relevant to the assessment of the request were established as proven.

VII. Reasoning Regarding the Facts Established as Proven

For the conviction of the Arbitral Tribunal, regarding the established facts, the documents attached to the proceedings were relevant, as well as the administrative file, all analysed and considered together with the pleadings, from which results agreement regarding the factual circumstances presented by the Claimants in the request for arbitral decision.

VIII. Issue to Be Decided

1. In view of what has been set out in the preceding paragraphs, the main issue to be decided is as follows:

− Are the tax acts of assessment of IRS, relating to the tax years 2012, 2013 and 2014, illegal, insofar as they resulted from the non-consideration of expenses declared by the Claimants, for purposes of deduction from the income of category F of the IRS, in compliance with article 41 of the IRS Code.

IX. Legal Grounds

1. We shall now determine the law applicable to the underlying facts, in accordance with the issue already stated (see above, no. 10).

2. In the context of IRS and in accordance with article 13(2) of the IRS Code, the passive subjects of IRS are "(…) natural persons who reside in Portuguese territory and those who, not residing therein, obtain income there.", with IRS applying to "the annual value of income of the following categories, even when derived from unlawful acts, after the corresponding deductions and relief have been made." (cf. article 1(1) of the IRS Code).

The amounts received by the Claimants as rents are considered real estate income – category F (cf. article 8 of the IRS Code).

On the other hand, the expenses susceptible to being deductible from real estate income are provided for in article 41 of the IRS Code.

Having regard to the version applicable at the time of the facts, article 41 of the IRS Code in force in the year 2012 provided that "from the gross income referred to in article 8, there are deducted the maintenance and conservation expenses incumbent upon the taxpayer, borne by him and documented, as well as property tax and stamp tax levied on the value of the properties (…) whose income has been included." For the years 2013 and 2014 it provided that "from the gross income referred to in article 8, there are deducted the maintenance and conservation expenses incumbent upon the taxpayer, borne by him and documented, as well as property tax and stamp tax levied on the value of the properties (…) whose income is subject to taxation in the tax year."

1. Having regard to the above, this article provides for the following legal requirements for consideration of expenses and charges incurred: i. Maintenance and conservation expenses incumbent upon the taxpayer; ii. Expenses effectively borne and documented; iii. IMI levied on the value of the leased property, whose income is subject to taxation in the tax year, that is, paid in the year of the income subject to taxation for IRS purposes.

2. However, the IRS Code does not define what is meant by "maintenance and conservation expenses", so the interpretation of that concept should be carried out having as reference article 11 of the GTL.

Having regard to the civil law notion contained in the Urban Lease Regime (ULR), as this was the statute that defined the rules of urban leasing and defined which works were incumbent upon the landlord, although there is no terminological correspondence between "maintenance and conservation expenses", provided for in article 41 of the IRS Code, and the ULR, which distinguishes between "ordinary conservation works", "extraordinary conservation works" and "improvement works", article 11 provided that:

1 - In urban properties, and for purposes of this statute, there may be ordinary conservation works, extraordinary conservation works and improvement works.

2 - Ordinary conservation works are:

a) The repair and general cleaning of the property and its dependencies;

b) Works imposed by the Public Administration, in accordance with applicable general or local law, and which aim to give the property the characteristics it presented when the building permit was granted;

c) In general, works intended to keep the property in the conditions required by the purpose of the contract and existing at the time of its execution.

3 - Extraordinary conservation works are those occasioned by a defect in the construction of the property or by fortuitous event or force majeure, and, in general, those which, not being attributable to unlawful actions or omissions perpetrated by the landlord, exceed, in the year in which they become necessary, two-thirds of the net income of that same year.

4 - Improvement works are all those not covered in the two preceding paragraphs."

See, in this regard, the Judgment of the Supreme Administrative Court of 06.07.2016, delivered in case no. 088/16, where, among other things, the following may be read: "Maintenance and conservation expenses will be expenses that are necessary for the conservation and maintenance of properties that are income-generating. They may be, as previously defined in the Urban Lease Regime, article 11, expenses incurred with ordinary conservation works - repair and general cleaning of the property, works imposed by the Public Administration, and, in general, those intended to keep the property in the conditions required by the purpose of the contract and existing at the time of its execution; extraordinary conservation works – for repair of construction defects of the property or supervening; or even improvement of the property, but always with repercussions on the property and on its ability to generate income."

1. Thus, maintenance and conservation expenses will be expenses that are necessary for the conservation and maintenance of income-generating properties. They may be expenses incurred with ordinary conservation works, repair and general cleaning of the property, works imposed by the Public Administration, and, in general, all those intended to keep the property in the conditions required by the purpose of the contract and existing at the time of its execution; extraordinary conservation works, repair of construction defects of the property or supervening defects, or even improvement of the property, but always with repercussions on the same and on its ability to generate income. It being understood that only ordinary conservation works are at the charge of the landlord. Conversely, extraordinary conservation works and improvement works are only at the charge of the landlord when their execution is ordered by the competent municipal authority or when there is written agreement of the parties to their implementation, with specification of the works to be carried out.

2. In the concrete case, according to the Claimants and the final decision of partial acceptance of the administrative complaint, in terms of article 41 of the IRS Code, the expenses relating to internet equipment installation, in the amount of € 92.25, internet router materials, in the amount of € 79.95, joint relief/housing, in the amount of € 30.75, and IPTV box installation, in the amount of € 113.98, there is no doubt that they are capable of constituting maintenance expenses and, consequently, considered as falling within the scope of article 41 of the IRS Code, since they are necessary for the maintenance of the property and the generation of income, being duly proven and borne by the Claimants.

The Respondent itself did not challenge the existence of such expenses and charges, nor the requirement for their payment by the hired companies, but, due to the fact that they were considered current expenses, which, as we have seen, has no support in the letter of the law.

1. As to the argument that the Claimants should have applied a proportionality coefficient to the deductible expenses in terms of article 41 of the IRS Code, based on the number of days the property was leased, we also understand that such procedure cannot be accepted, since all expenses incurred, such as cleaning of the properties and swimming pool and their health treatment, water, electricity, insurance, IMI and others, will always have to be borne, regardless of the number of days the property is leased.

On the one hand, the basis of IRS "applies to the annual value of the income of the categories (…), after the corresponding deductions and relief have been made", and therefore it is with regard to each calendar year that the elements permitting determination of the tax base must be considered, namely, gross income, deductions and relief. On the other hand, all expenses meet the cumulative conditions provided for in article 41 of the IRS Code (i. expenses incumbent upon the taxpayer; ii. expenses effectively borne by the taxpayer; and, iii. such expenses being documented).

1. In this sense, at least, the decisions of CAAD in cases no. 201/2015-T, 294/2015-T, 434/2016-T, 42/2017-T and 103/2017-T have already pronounced.

2. Thus, all expenses borne and documented by the Claimants should be considered maintenance expenses, since they are necessary for the maintenance of the property and its economic activity, i.e. susceptible to generating income, and therefore the IRS assessments impugned herein are illegal, both those relating to the supposedly owing tax and those relating to compensatory interest, and the taxes paid should be reimbursed to the Claimants.

3. With regard to the alleged defects of unconstitutionality due to violation of the principles of (i) lack of substantiation, (ii) contributory capacity, (iii) legality, and (iv) equality, set forth in the Constitution of the Portuguese Republic, the knowledge of such issues is precluded by the declaration of illegality of the IRS assessments in question, due to substantive defect which prevents their re-enactment or renewal.

As stated in the Commentary to the Code of Procedure in Administrative Courts, Almedina, 2005, by Mário Aroso de Almeida and Carlos Cadilha, in annotation to article 95 of that statute, p. 483 (applicable by referral from paragraph c) of article 2 of the CTCP and from article 29(1), paragraphs a) and c) of the LFATM) "If the Court upheld the principal request, the judicial power is barred as to a subsidiary or alternative request; and in the same terms, if the ruling adopted regarding one issue consumes or leaves precluded other aspects of the case that correlate with it."

In these terms, in view of the material interpretation recommended, the knowledge and appreciation of the remaining defects imputed to the impugned assessment acts is precluded.

1. Finally, in accordance with article 43(1) of the GTL, indemnity interest is owed when it is determined, in administrative complaint or judicial impugnation, that there has been error attributable to the TCA services from which results payment of the tax debt in an amount exceeding that legally due.

The right to indemnity interest referred to in the mentioned provision of the GTL presupposes that tax has been paid in an amount exceeding that due and that such results from error, of fact or of law, attributable to the TCA services (cf. Judgment of the Supreme Administrative Court, case no. 01215/12, of 10.04.2013).

1. In the present case, both conditions are met, thereby constituting the obligation of indemnity interest in favor of the Claimants, which is hereby declared.

X. DECISION

In accordance with the foregoing, it is decided:

• To uphold the request filed by the Claimants in the present tax arbitral proceedings, regarding the illegality of the decision of partial acceptance of the administrative complaint no. …2016…, and consequently annulment of the tax acts of assessment of IRS, for the years 2012 to 2014, in the total amount of € 9,206.91 (nine thousand, two hundred and six euros and ninety-one cents).

• To uphold the request for condemnation of the Tax and Customs Authority to reimburse the Claimants the amount of tax paid, plus indemnity interest in accordance with legal terms, from the date such payment was made until the date of full reimbursement thereof.

XI. Case Value

The case value is set at € 9,206.91, in accordance with article 97-A(1), a), of the Code of Tax Procedure and Process, applicable by virtue of paragraphs a) and b) of article 29(1) of the LFATM and article 3(2) of the Regulation on Costs in Tax Arbitration Proceedings.

The amount of costs is set at € 918.00, in accordance with Table I of the Regulation on Costs in Tax Arbitration Proceedings, to be paid by the Tax and Customs Authority, since the request was wholly upheld, in accordance with articles 12(2) and 22(4), both of the LFATM, and article 4(4) of the cited Regulation.

Notify the parties accordingly.

Lisbon, 27 December 2017

The Arbitrator,

(Jorge Carita)