Deduction of Financial Charges and Transfer Pricing in IRC: CAAD Arbitral Decision 267/2016-T

ARBITRAL DECISION

I – REPORT

A…, S.A., with Tax Identification Number … and registered office in Porto, and B…, S.G.P.S., with Tax Identification Number …, and registered office in the same city, came on 13 May 2016 to request the establishment of an arbitral tribunal, with a view to declaring the illegality of the hierarchical appeal decision made following the Personal Income Tax (IRS) assessment that they named and shall hereinafter be identified, as well as of the contested assessment act.

Since they stated that they did not intend to appoint an arbitrator, the undersigned signatories were appointed by the Deontological Council, an appointment which they accepted and against which no party objected, leaving the tribunal constituted on 25 July 2016.

The Tax Authority (AT) responded, within the legal deadline, defending itself by filing objections and attaching a copy of the administrative file.

The meeting referred to in article 18 of the Legal Regime of Tax Arbitration (RJAT) was dispensed with, as it was considered unnecessary in this case. The tribunal announced that it would render a decision by 15 December 2016 and invited the parties to submit written submissions, which they did.

II – PRELIMINARY MATTERS

The tribunal is competent, the parties are legitimate, possessed of legal personality and capacity, and are duly represented, with the coalition being lawful, in accordance with article 3, paragraph 1 of the RJAT.

There are no nullities, exceptions, or preliminary questions that prevent knowledge of the claim.

III – FACTUAL MATTERS

1) PROVEN FACTS

a) The Claimant A…, S.A., is a joint-stock company integrated into the C… Group since December 2005, a business group with significant market presence in European clinical analysis services. The process of the Claimant's integration into the C… Group underwent different stages resulting from the degree of the Group's implementation in the Portuguese market.

b) Prior to December 2005, the social shares of the Claimant were directly held 85% by the company B… and 15% by the Family D…. In December 2005, the C… Group entered the Portuguese market through the acquisition of B…'s social shares from A….

c) On that date, the "Portuguese arm" of the Group presented the following structure:

i. At the top of the Group was the Swiss company "E…, S.A.".

ii. E…, S.A. held 100% of the social shares in the Dutch law company "F…, BV".

iii. F… held 100% of the social shares of B….

iv. B… held 85% of the social shares of G… and 85% of the social shares of the company H…, S.A.

d) In late 2007, the Group carried out a restructuring which began with the establishment of I…, held 100% by F…. Subsequently, F… sold to I… all the social shares it held in Portugal (among which were the social shares in B…), in the total value of €52,409,640.00.

e) The acquisition of those social shares by I… was initially financed by F…, effected through an intra-group loan.

f) Already in 2008, non-resident companies of the C… Group financed themselves with J… to meet the needs of various subsidiaries, including I…. Consequently, such financing enabled I… to pay F… almost all outstanding amounts, while also allowing the injection of liquidity into B…, through accessory contributions.

g) In July 2008, B… acquired from Family D…, for the total value of €5,600,000.00, 15% of the social shares in G… and 15% of the social shares in H…, thus coming to hold all the social shares of both companies.

h) On the other hand, in September 2008, non-resident companies of the C… Group carried out a refinancing with a consortium led by K…, including the amounts from which I… benefited.

i) At the end of 2008, the Portuguese arm of the C… Group underwent another restructuring aimed at strengthening its competitiveness, seeking to concentrate structures and rationalize expenses, improve the definition of development and management policies, maximize resources, and concentrate the financing of operations in a single entity. In this context, group management understood that operations in Portugal, then comprised of several companies in the clinical analysis business, should be headed by G…, taking into account, in particular, the prestige and reputation it enjoyed in the Portuguese market.

j) This operation aimed to prepare the Portuguese arm of the C… Group for the new challenges of the clinical analysis market, where it proved of paramount importance to reduce structures and redefine decision-making centers. Thus, by contract signed on 5 December 2008, B… sold to F… 100% of the social shares held in G….

k) Subsequently, the capital of G… was increased to €200,000.00 through a contribution in kind corresponding to the entire capital of I…. Finally, on 29 December 2008, G… merged with I… through the absorption of I… into G…, an operation which was effected under the tax neutrality regime provided for in the Corporate Income Tax Code.

l) The financial charges which until the date of legal effect of the merger were borne in the sphere of I…, passed, as a result of the merger operation, to be borne by G….

m) B… was subject to a partial tax inspection, accredited by Service Order OI2012…, directed at analyzing Corporate Income Tax (IRC) for the years 2009 and 2010, and subsequently extended to the year 2011, motivated by the "need to assess the non-accounting of interest on credits held against a non-resident related entity in light of the transfer pricing regime, established in article 63 of the Corporate Income Tax Code".

n) The inspection activity took place between 13 September 2012 and 12 September 2013, with the inspection procedure deadline being extended by two additional periods of three months, pursuant to article 36, paragraph 3, subsection a) of the Supplementary Rules of the Tax Inspection Procedure ("RCPIT"), in accordance with orders of 11 February 2012 and 20 May 2013.

o) B… is part of the C… Group which, for what is relevant in the present case, presented the following structure on 5 December 2008:

[Structure diagram referenced]

p) B…, as a Management Company Holding Social Shares ("SGPS"), was the holder of all social shares in G….

q) On 5 December 2008, B… concluded a purchase and sale contract with the company F… BV, resident in the Netherlands ("F…"), through which it sold all social shares held in G… for the value of €29,862,000.00.

r) According to the terms established in the contract, payment of the price was to be effected on the following basis:

(i) €20,500,000.00 would be paid by the end of 2009 and

(ii) €9,362,000.00 would be paid by the end of 2010.

s) The Tax and Customs Authority did not contest the selling price of all social shares in G… for the price of €29,862,000.00 established in the contract. The Tax and Customs Authority considered, however, that the "deferral" of payment agreed in the contract constituted a gratuitous financing capable of being corrected in light of the transfer pricing rules, contained in article 63 of the Corporate Income Tax Code, in Regulation No. 1446-C/2001, of 21 December ("Regulation"), and in article 9 of the Conventions to Avoid Double Taxation concluded between Portugal and the Netherlands and between Portugal and Switzerland ("CDT").

t) The Tax and Customs Authority applied the comparable market price method, having identified as comparable transaction financing contracts concluded between entities of the Group and a syndicate of various international banks.

u) The said comparable transaction presented an interest rate indexed to the 3-month Euribor rate until April 2010 and subsequently to the 1-month Euribor rate and a weighted average spread of 2.977%.

v) By applying the financing conditions of Group entities with an international banking syndicate to the purchase and sale transaction in question, the Tax and Customs Authority proceeded, under article 63 of the Corporate Income Tax Code, to correct the taxable matter of B…, relating to the year 2011, in the amount of €1,256,166.60.

2) SUBSTANTIATION OF FACTUAL MATTERS

The tribunal's conviction rested on the examination of documents attached to the file and on statements by one party not contradicted by the other party.

3) UNPROVEN FACTS

Of those alleged, which are relevant to the decision, none remained unproven.

IV – POSITION OF THE PARTIES

The case under review refers to two operations which shall herein be referred to as "Adjustment to the Taxable Income of G…" and "Corrections to the Taxable Matter of B…"

A) ADJUSTMENT TO THE TAXABLE INCOME OF G…

IV - 1.1. Position of the Claimant

The Inspection Report (RIT) of G… proceeded to correct the taxable income of G…, namely for the year 2011 under review, such correction resulting from the disqualification of the tax deductibility of interest relating to financing incurred by the company I…, S.A. ("I…"), subsequently absorbed by merger into G…, for the acquisition of a set of social shares, among which the social shares of the company B…, SGPS, S.A. ("B…").

The principal legal question raised in the present action is to determine whether the deductibility of charges from a given financing obtained in the past should be assessed:

(i) by reference to the moment when the economic agent incurred the financing (position defended by the Claimant); or

(ii) by reference to the moment when the financial charges are deducted, taking into account in particular changes in the group's corporate structure subsequent to the moment of financing.

There are already two arbitral decisions which have become final that ruled on the same legal question, in the context of the same financing at issue here, differing only in the year under review.

From those arbitral decisions it is clear that the relevant moment to consider in assessing the deductibility of financial charges is the moment when the economic agent acted (i.e., at the moment the financing contract was concluded), and the occurrence of a merger subsequent to obtaining the financing cannot call into question this understanding.

The claimant refers to Arbitral Decision No. 101/2013-T2, of the Administrative Arbitration Center ("CAAD"): which concerned the official assessment of Corporate Income Tax relating to the same financing contract, but for the year 2008 of the Claimant. In this case, the Arbitral Tribunal considered that the tax deductibility of charges relating to given financing will depend on ascertaining whether, on the date when the financing was incurred, it was potentially suitable to provide profits or gains, regardless of the success or failure it actually provided: "the appropriate perspective for assessing the indispensability of expenses for obtaining profits is that of the economic agent at the moment he acted, when there is only the possibility of the business options to be taken coming to produce profits and not that of tax inspection, acting in the presence of results obtained, assessing the relevance that expenses actually had in achieving them" (emphasis ours).

Additionally, the claimant emphasizes Arbitral Decision No. 281/2015-T3, of the CAAD: which concerned the official assessment of Corporate Income Tax relating to the same factual situation, but for the year 2010 of the Claimant. Furthermore, the assessment in question in this arbitral proceeding originated from the same Tax Inspection Report which determined the corrections to the taxable income of the Claimant in the present action. The Arbitral Tribunal decided that "it follows from this provision that for financial charges to be considered as costs, it is sufficient that they are in the abstract suitable to ensure the realization of income or to ensure the maintenance of its productive source. There is therefore nothing preventing charges relating to the acquisition of social shares prior to a merger from being considered deductible". Expressly adhering to the Court Decisions of the CAAD Nos. 29/2012-T and 101/2013-T, the Tribunal decided that the relevant moment for assessing the indispensability of the expense is the moment when the financing is incurred, considering that both the legal nature of the merger and the principle of tax neutrality prevent the correction to taxable income as made.

The Claimant understands that, similarly to what was decided in Arbitral Decisions Nos. 101/2013-T and 281/2015-T and the case law of the Supreme Administrative Court, relating to the interpretation of article 23 of the Corporate Income Tax Code (cf. Decision of 24 September 2014, case No. 0779/12), the relevant moment to be considered for the purposes of deductibility of financial charges is the moment when the financing associated with them was incurred, because only with reference to this can the profit-generating potential, that is, the business purpose of the obtained financing, be assessed.

The claimant notes, in the first place, that at no time is the tax deductibility of financial charges supported by I… put into question, before the merger occurred. Consequently, the tax indispensability of the charges in question must be accepted when they occurred in the sphere of I….

Since the allocation of the financing was not altered—which is accepted by the Respondent (regardless of the discussion of whether it is allocated to the acquisition of social shares in G… or in B…, SGPS)—the moment to be referred to for assessing the deductibility of financial charges associated with said financing is the moment when such financing occurred.

Thus, since the act that generates the cost has a business purpose (i.e., since the financing has the potential to generate profit), the financial expenses associated with it will also have this purpose, which implies the tax admission of their deduction.

The claimant emphasizes the position of Rui Morais and Gustavo Lopes Courinha in the Legal Opinion which it attached, in which it is written:

"Indeed, only at the moment when a given expense is legally assumed does it become payable to the taxpayer; and it is at that moment, and only at that moment, that the judgment about its indispensability can be assessed: it was then that the board of directors, with greater or lesser accuracy, decided to bind the company to the assumption of the legal obligation".

If, at the moment when the financing occurred, the financial charges associated with it were tax deductible, such financial charges should also be deductible in the sphere of the company resulting from the merger (G…), especially in a context where such merger occurred under the tax neutrality regime.

Thus, constituting the merger a form of corporate transformation (theory of the modifying act) in which there is continuity of the merged company in the company resulting from the merger, it would not be comprehensible that, at the moment prior to the merger, a given expense would be tax deductible and that, as a result of that same merger, such expense would cease to be tax disqualified.

From a legal standpoint, the merger implies the continuity of I… in G…. It is, therefore, entirely incongruous, for the claimant, with the nature of the merger to say that an expense tax deductible in the merged company ceases to be in the company resulting from the merger (in this case, in G…).

This consideration is further reinforced because what is at stake is a merger operation under the neutrality regime, because if such neutrality is not contested, given that there were valid commercial reasons for carrying out the merger operation in question, it is not possible to place a tax burden on such operation in violation of the objectives of continuity and deferral of that same neutrality regime.

The claimant further states that the current article 75-A, paragraph 2 of the Corporate Income Tax Code expressly establishes (what should be understood as an interpretative rule) that "the net financing costs of companies merged by these not deducted […] may be considered in determining the taxable income of the beneficiary company in a merger operation to which the special regime provided for in article 74 applies"

That is, it is the legislator itself who assumes that the tax neutrality regime of the merger is not compatible with the consequence that, after the merger, interest previously deductible ceases to be.

There are no legal grounds to support that the indispensability of an expense, in light of article 23 of the Corporate Income Tax Code, can consider factuality subsequent to the moment when the expense occurred. Indeed, subsequent factuality is the relevant criterion for determining the application of article 38, paragraph 2 of the General Tax Law which, in this case, did not occur, nor could it have occurred.

Indeed, shielding itself in the supposed use of the tracing approach method—which in its proper meaning does not lead to the result sought by the Respondent—the Tax and Customs Authority fully mimics within the scope of application of article 23 of the Corporate Income Tax Code the method intended to combat elusive practices contained in article 38, paragraph 2 of the General Tax Law, which cannot happen.

IV-1.2. POSITION OF THE AT

The AT points out that the acquisition, on 21 July 2008, by B… SGPS, subsidiary of I… S.A., of 15% of the capital stock of the 1st Claimant and of 15% of the capital stock of H… (which were still in the possession of shareholders 'Family D…') for the values of €5,546,000.00 and €54,000.00, respectively, in the total amount of €5,600,000.00, an operation that was initially financed by F… BV.

As a result of the merger that occurred in 2008, the 1st Claimant accounted for, in the year 2011, an expense relating to interest on said loans in the amount of €2,543,972.76, which had significant weight with respect to income recorded in the year 2011.

For the AT, doubts remain as to whether the expense accounted for in the year 2011 in the amount of €2,543,972.76 constituted a charge relating to loans initially incurred by I… S.A. and which, through the merger of the 1st Claimant with that company, became the responsibility of the 1st Claimant.

Thus, it was concluded that the expenses accounted for by the 1st Claimant with the loans incurred for the acquisition of social shares and which, through the merger, became its responsibility, relating to interest, amounted in the year 2011 to €2,543,972.76. In sum, the 1st Claimant has been bearing, since 1 January 2008, financial charges relating to a bank loan obtained by I…, S.A. intended for:

a) The acquisition of all the capital stock of the company B… SGPS, S.A., which in turn held 85% of the capital stock of the 1st Claimant and 85% of the capital stock of H…, S.A.

b) To make accessory contributions in B… SGPS, which were used by it to acquire the remaining 15% of the capital of the 1st Claimant and 15% of the capital of H…, S.A.

From the foregoing it results that the 1st Claimant is bearing financial charges relating to a loan which "ultimately" was intended to finance its own acquisition, since the obtaining of that loan had as its main objective allowing the acquisition of the 1st Claimant, even if through B… SGPS.

The AT further states that the corporate purpose of the 1st Claimant corresponds to the provision of clinical analysis services, and does not have as activity the management of social shares, whereby the expenses/income are not mutually related with the activity of the 1st Claimant. Nor is any income identified that could accrue to it directly through said expenses.

The expenses relating to the acquisition of the 1st Claimant, even if effected through B… SGPS, cannot be considered tax deductible, because they manifestly are not essential to obtaining its profits or for maintaining the productive source.

It should be noted that the determination of income corresponding to the activity of the 1st Claimant was affected by the charges arising from loans incurred by I…, S.A. to effect the acquisition of the 1st Claimant itself.

For the reasons listed above, the amount of €1,444,938.68, relating to financial charges attributable to the acquisition of the capital stock of the 1st Claimant itself, are not accepted tax-wise under article 23 of the IRC. Whereby that amount should be added for the purpose of determining the taxable income for the year 2011.

Furthermore, in the scope of case No. 87/2014-T1, which was processed before the Administrative Arbitration Center, an arbitral decision was rendered, relating to the same matter and the same Claimant, but relating to the year 2009 (after the merger date), which found the request for arbitral pronouncement groundless.

The learned arbitral decision states that "It should be noted, then, that in a summary often reiterated, the Supreme Administrative Court declared as to the meaning and functioning of the requirement of indispensability of costs for tax purposes that: 'the requirement of indispensability of a cost must be interpreted as an indeterminate concept requiring case-by-case fulfillment, as a result of an analysis of business economic perspective, in the perception of a relationship of economic causality between the assumption of a cost and its realization in the interest of the company, given the corporate object of the commercial entity in question.' (cf. for example, the decisions of the STA of 15.6.2011, case No. 049/11. No. III and of 29.3.2006, case No. 01236/05. No. 3,4; see also recently the decision of the TCA South of 16.10.2014).

Well then, in attention to the object of these proceedings, it is important to stress the necessity, for the judgment of indispensability of costs, of the 'perception of a relationship of economic causality between the assumption of a cost and its realization in the interest of the company' to have to be concretized in relation to the 'commercial entity in question'. Indeed, in the relationship of economic causality of the cost with the interest of the company, the business interest that is assessed is that of the company itself that deducts the cost tax-wise.

Having the Arbitral Tribunal concluded that: "17- This means that the financial charges borne in the year 2009 attributable to the acquisition of the capital of Laboratory A… do not find nexus of economic causality with the interest and activity of the Claimant itself, having no potential for the generation of profits in its legal sphere."

The tax deductibility of interest borne depends on a judgment as to its indispensability for the realization of profits or gains subject to tax or for maintaining the productive source, with subsection c) of paragraph 1 of article 31 of the IRC clarifying that such interest on alien capital is "applied in operations".

The tax deductibility of the expense should depend only on a justified relationship with the company's productive activity, with the indispensability of the cost in obtaining profits being verified when, by operation of the theory of specialty of legal persons, corporate operations are inserted in their capacity by subsumption to their respective corporate scope, provided they are connected with profit-making through the activity carried out.

The tax relevance of a cost depends, thus, on proof of its necessity, adequacy, normality, or the production of the result, whereby the lack of these characteristics may generate doubts as to whether the cause is or is not business-related. The expense/cost is an expenditure with a business purpose which does not mean that it immediately has a directly profitable purpose, but that it has, in its origin and in its cause, a business purpose, granting the law to the AT sufficient powers to refuse acceptance as a tax cost of expenses that cannot be considered compatible with the objectives to be pursued by the company.

The Arbitral Decision of 4 January 2013, case No. 14/2011-T, also states that: "On another aspect, it is equally duly explicit that it is a presupposition in the application of art. 23 of the IRC 'the individualized consideration of each company or institution whereby reasoning based on criteria of management of the 'group' or even of financing—even if gratuitous—from its partners or even the will of these, which in this matter is irrelevant, cannot interfere here, since it is a legal criterion, with only the legal person whose costs are under review being relevant".

And furthermore: "We have, then, that the costs incurred with the loan under review are not applied in the operations of the Claimant itself, in its business activity, nor serve the maintenance of the productive source of income. Such costs, although entered in the Claimant's accounting, do not benefit its activity nor its respective business interest...".

The AT stresses a difference in positions regarding the analysis of the indispensability of the cost: if in the Arbitral Decision relating to Case No. 101/2013-T the analysis of indispensability of financial charges is carried out in light of the corporate object and interests of the company that incurred the loan (in this concrete case the incorporated company),

In the Arbitral Decision relating to Case No. 14/2011-T it is argued that, through a methodology of ascertainment and tracing of the use and destination of the financing, said analysis should be carried out in the sphere of the company that came to actually bear those costs (i.e. the incorporating company).

In fact, said difference in case law is well evident in the present proceedings, given that the Tax Inspection Services carried out the analysis of the tax deductibility of the charges in the sphere of the incorporating company, in conformity with the methodology indicated in Case No. 14/2011-T,

Having concluded that, insofar as the financial charges are not indispensable to the activity of the 1st Claimant, said expenses will not be tax deductible. The indispensability required by article 23 of the IRC was not demonstrated.

The determination of the indispensability of financial charges relating to financing incurred, an essential condition for assessing their tax deductibility, must necessarily be based on the analysis of the purpose and destination of such financings.

The purpose underlying the obtaining of the loan here at issue must be understood by relativizing the mere direct application of the financings and the complex of operations that followed, namely the merger operation between the 1st Claimant and I… S.A., in light of the final result arising from those operations.

With regard to the tax neutrality regime applicable to mergers, paragraph 1 of article 68 of the IRC stipulates that "In determining the taxable income of the merged companies (…) no result derived from the transfer of assets as a consequence of the merger is considered. It so happens that the neutrality regime is directed only at the elimination of any result obtained as a consequence of that transfer and never at the definition of costs and income with tax acceptance.

The tax neutrality regime in the scope of mergers does not cover the issue of costs/expenses that are indispensable for the realization of income, as provided in article 23 of the IRC. That regime does not contain any rule which, by virtue of any merger, eliminates the need to ascertain the character of indispensability of costs in the sphere of the beneficiary company. The "theory of the modifying act", invoked by the 1st Claimant, has no application here, in the terms in which it does so.

B) CORRECTIONS TO THE TAXABLE MATTER OF B…

IV-2. Position of the Parties

2.1 Position of the Claimant

It so happens that the legal question under analysis has already been decided twice before arbitral tribunals functioning under the CAAD:

Arbitral Decision No. 101/2014-T10, of the CAAD: which concerned the official assessment of Corporate Income Tax relating to the same factual situation, but for the year 2009 of B…. The judgment of the Arbitral Tribunal was clear in considering that the Tax and Customs Authority could not proceed to modify the legal form of operations through transfer pricing rules (especially article 63 of the Corporate Income Tax Code), which determined the annulment of the issued assessment:

"It is true that, in the domain of the purchase and sale contract, there is a series of operations and inherent obligations, and it is possible to identify specifically the deferrals relating to payment of the price. However, these are an integral part of a contract that, as is recognized by the parties, is a single one and includes all dimensions […] it is not possible, therefore, to fragment the purchase and sale contract to apply transfer pricing to one of the elements composing it […] thus, despite there being clauses of the contract and amendments to it that result in a deferral of payment and consequently have the effects of a loan contract, these clauses are integrated in the contract understood as a whole, not being able to be abstracted from it to gain autonomous life […] having not been initiated the only procedure that would allow a requalification of the financial operation performed in tax terms, which would only be possible with the framework in art. 63 of the CPPT and art. 38, para. 2, of the LGT..."

In the present case, what is essentially at issue is the sale of social shares in G…, held by B…, to F…. Indeed, the parties in the contract established a price and the payment and delivery conditions of said social shares.

It was determined that the price would be paid in installments as follows:

(i) €20,500,000.00 would be paid by the end of 2009 and

(ii) €9,362,000.00 would be paid by the end of 2010.

Thus, on the day the contract was concluded - 5 December 2008 - the social shares of G… came to belong to F…, which in turn became indebted to B… in the total amount of €29,862,000.00, to be paid on the stated terms.

There was not, therefore, and as it is evident, any financing operation and, much less, a loan: B… and F… concluded a purchase and sale contract with determined payment conditions. Consequently, the application of transfer pricing rules in the present case could only have reference to the price and conditions practiced.

If, in light of the agreed payment conditions, the Tax and Customs Authority considered that the price fixed by the parties did not reflect an arm's length price, it was for it to correct that price, provided the legal requirements were met (which, as will be demonstrated, were not satisfied).

What the Law does not permit is that the Tax and Customs Authority use the Portuguese transfer pricing regime, established in article 63 of the Corporate Income Tax Code, without more, to proceed to alter the legal form of a given operation and consequently correct the value of the operation it fictioned.

Thus, the Tax and Customs Authority could, according to the claimant, consider two alternatives:

i. It accepted that what was at issue was a purchase and sale and contested the transaction price, taking into account the payment conditions, using, for that purpose, the transfer pricing rules;

ii. It considered that what was at issue was an abuse of legal forms, using, for that purpose the general anti-abuse rule provided for in article 38, paragraph 2 of the General Tax Law and subsequently the transfer pricing rules to determine the market value at which the fictioned loan would have occurred.

The Tax and Customs Authority confuses, in the claimant's view, the adjustment of the terms and conditions of a determined operation (with direct impact on the sale price) with the "adjustment" of the operation itself. Symptomatic of this confusion is the statement that "the deferrals" of payment of the price "are unjustifiable under the ALP, constituting gratuitous financing of related companies F… BV and subsequently E… SA. Thus, in light of the Transfer Pricing Regime, adjustments to be made should be determined, namely by the consideration of interest as consideration for the obtained financing".

However, the operation, as conceived and structured by B… and F…, is a purchase and sale operation of social shares, with no financing existing. The Tax and Customs Authority could never have used the transfer pricing rules to fiction the existence of a financing and subsequently to proceed to determine the remuneration associated with it.

On the contrary, the literal element of the rule, with particular emphasis on paragraph 3 of article 63 of the Corporate Income Tax Code, in fixing the methods capable of being used for determination of the terms and conditions of the operations in question, clearly imposes that adjustments have a solely quantitative character:

See, in this regard, the claimant states, in addition to the arbitral decisions already mentioned, which are based on the RIT B…, the arbitral decision rendered by the CAAD in Case No. 76/2012-T, which holds:

"In the application of the rule on transfer pricing, the Tax Authority must attend to the operation actually practiced, to the 'legal form' used by the taxpayer in its commercial or financial operation, being able to alter, for tax purposes, its terms or conditions when it considers them different from those which would be contracted accepted and practiced between independent entities in comparable operations. It is those operations effectively performed that are fictioned, for tax purposes, to have been performed in other terms or conditions. Different from these situations and outside the transfer pricing regime are situations in which the Tax Authority concludes that, instead of the commercial or financial operations actually performed, independent people would perform other operations, of different types, with other 'legal forms'. In these cases, the requirements for ceasing to consider effective, for tax purposes, the operations actually performed are not those provided for in art. 58 of the IRC, but rather those provided for in art. 38, para. 2 of the General Tax Law and in art. 63 of the CPPT".

For the Tax and Customs Authority to be able to proceed to corrections to the taxable matter and consequent additional assessment, under transfer pricing rules, it would have been necessary that it verify and prove the following prerequisites:

(i) Existence of special relationships;

(ii) The related entities had established conditions different from those which would normally be agreed between independent persons;

(iii) The different conditions had led to the ascertainment of a profit different from what would be ascertained in their absence;

(iv) The special relationships were an adequate cause for the "different conditions" agreed.

However, in the present case, only the requirement mentioned in (i) was met.

Apart from what has already been referred to regarding alteration of legal form, the related operation and the comparable operation present a distinct nature, because while in the related operation one starts from fractional payment of the price to conclude the existence of financing, in the case of the comparable operation, financing occurs through a loan contract.

Thirdly, the maturity of the financings is totally distinct. In the case of comparable operations, maturities of 7, 8 and 9 years are at issue, whereas in the fictioned related operation, at most, a maturity of 2 years could be admitted.

Fourthly, the risk to be considered is distinct in the related operation and in the comparable operations. Indeed, the sale of social shares has a much lower risk than the loan contracts of the comparable operations, not only because of the different nature of the operations but also because of the knowledge that each entity has of the respective counterparties.

2.2. Position of the AT

Given that the purchase and sale operation was carried out between related entities, the question remains of assessing whether the conditions defined in this related operation respect the Arm's Length Principle.

From the Inspection Report, it contains the description of the justification presented by the 2nd Claimant of the conformity of the terms and conditions practiced in the related operation with the Arm's Length Principle, which is given as entirely reproduced.

From that justification, it is extracted, in summary, that the 2nd Claimant opted for the application of "Another Method" to the operation under analysis, having concluded that the deferral of payment of the price, as well as the non-requirement of interest complies with the Arm's Length Principle, by the "expectation that the value of positive valuation could suffer a decrease resulting from an estimate of decrease in business volume of the target company, following the expectations of deterioration of macroeconomic conditions at the end of 2008."

The Tax Inspection Services properly assessed the method used by the 2nd Claimant, as well as the selling price and the deferral of its payment, as described in the Inspection Report.

As for the deferral of payment of the price (whether stipulated initially or granted subsequently), it became necessary to verify whether the conditions practiced in the related operation assume a character of normality by comparing with the terms and conditions practiced in other acquisitions carried out by the Claimant or by other companies in the group:

In the acquisition of social shares effected in late 2007 by I… SA to F… BV (entities belonging to the same group and related to each other), for the amount of €52,409,640.00, the price was not paid on the date of the contract, with the value remaining outstanding to accrue interest at a rate equivalent to 3-month LIBOR plus a spread of 2%.

Now, neither in the initial contract nor in said amendment is there any compensation provided for the 2nd Claimant as consideration for not receiving the price on the agreed dates, nor any penalty for possible breach of contract.

Given the foregoing, there are no doubts for the AT that the deferrals of payment of the price (the initial and the subsequently granted) and the non-requirement of payment of the respective interest are unjustifiable under the Arm's Length Principle, constituting gratuitous financing of related companies F… BV and, subsequently, E… SA.

It is demonstrated, for the AT, that F… BV or E… SA could not obtain the contractual conditions stated above if they carried out that purchase and sale with an independent entity.

Whereas the 2nd Claimant would obtain, in normal conditions, interest so as to remunerate itself for the terms and conditions it accepted to contract. It is easily concluded that the 2nd Claimant would not assume this burden if this operation had been carried out, in normal market conditions, with an independent entity.

There are no doubts that the related operation integrates a form of gratuitous financing effected by a resident company to its non-resident related entity.

Indeed, apart from not accepting to receive the price on the date of the contract, having, nevertheless, delivered the titles representing the capital stock of A…, it accepted not to charge payment of any type of interest or penalty for breach of the established payment dates.

Contrary to the argument used by the 2nd Claimant, the risks and functions assumed by the parties in a loan/refinancing contract or in the contract in question end up being similar. Whether in one situation or the other, one of the parties assumes the obligation to remunerate the deferral of payment of the price.

In contractual terms there is a similitude between the purposes.

Notwithstanding this matter being duly substantiated in fact and law in the Inspection Report, it is to be stated that, contrary to what the 2nd Claimant alleges throughout the, moreover, learned, Reply, the Tax Inspection Services never altered the legal qualification of the purchase and sale contract of social shares that is under review.

The Tax Inspection Services had as reference the related operation as conceived by the 2nd Claimant, that is, as a purchase and sale contract of social shares. The Tax Inspection Services never altered the legal form of the contract in question.

It is precisely because that legal form is attended to, to the purchase and sale contract of social shares, that the AT considers that before the conclusion of such a type of contract between independent entities, conditions and terms distinct from those contracted would always be concluded.

The arbitral decision rendered in case No. 101/2014-T made an incorrect assessment of the factual matter on this point, as it considered that the Respondent had altered the legal form of the contract in question.

Nor does the application of the arm's length principle aim to recharacterize operations performed, nor a qualification of them as abusive, but it should be stressed, and attending to the basic premises of substance over form, the legal instrument cannot prevent the taxable income of the taxpayer from being subject to a tax adjustment when this results from the application of the arm's length principle in the ascertainment of taxable income of the taxpayer.

Hence, only the extraction of the tax consequences takes place on the basis of the result that would be achieved if the parties had adopted a conduct in accordance with normal market conditions, that is, if they had had an "arm's length behaviour".

V - ANALYSIS

3.1. Regarding the Adjustment to Taxable Income of G…

It is not necessary to enter into lengthy considerations to conclude that, presently, after being widely elucidated by doctrine and case law, the concept of "indispensable expenses"—contained in article 23 of the IRC in the wording in force at the time of the facts—has been interpreted as meaning that expenses must evidence a relationship with the activity or interest of the entity bearing them.

Thus, in the case at hand, the central question comes down to inquiring whether the indebtedness and, more specifically, the financial charges derived from it, borne by the claimant after the merger operation should be non-deductible because they do not evidence a relationship with its activity, or whether, evidencing such a relationship, they will be deductible.

Now this tribunal understands that, regarding the concrete case, the AT is not right, for several reasons. Let us see.

In the first place, the financing allocated to the claimant by virtue of the merger will necessarily reflect the existence of assets which, in the post-merger balance sheet, are supported by such financing. Not the assets originally financed (the investment interest of I… in the claimant), obviously, but other assets, which may be financial, tangible, credits against third parties, monetary availability, etc., which the merger causes to flow into the patrimony of the incorporating company, here claimant.

Indeed, the merger contract corresponds to a patrimonial reality in which the incorporating company (claimant) absorbs rights (assets) and obligations (liabilities) of the incorporated company. Now from the well-known relationship Asset = Equity + Liability, it is deduced that in the incorporating company converge liabilities (among which the debt from which the interest at issue in the Case results) and also the assets coming from the incorporated entity.

The diagram II contained in the "Merger Plan", which is reproduced below, shows the claimant (G…) as the "head" of a patrimonial, operational, and financial ensemble which necessarily would have to be sustained by debt and equity; that is, by sources of financing which would also include those arising from the merger.

This means that the loan originally obtained for one purpose—and which, during that period, generated tax-deductible interest in I…—passes into the sphere of the claimant as one (among many) sources of financing sustaining the assets which the claimant comes to hold in the post-merger period.

And here, thus it is judged, lies the essential reason for considering that the loan has a relationship, after the merger, with the claimant's activity, because it comes to finance, not in the logic of a specific asset, but rather in a sense of overall financing, the assets of the new entity.

Understanding the activity of an entity as consisting in the use that its administration makes of its assets, with a view to developing its economic purpose, which may or may not prove to be profitable, then the sources of financing sustaining such assets are devoted to its activity.

In other words, stating it differently, the fact that the financing and the interest in question had, in the past, an allocation to financing the acquisition of the claimant, does not prevent such financing from coming, through the merger, to perform, together with other financial resources, a general function of supporting, financing, or constituting a source of funds sustaining the global assets of the post-merger entity.

Without entering at this point into the question of what should be the relevant moment for assessing the deductibility of financial charges, the fact is that in the year 2011 the financing originally obtained for one purpose was performing a new role or evidencing a new purpose. However, that new purpose—the general financing of the assets of the new entity resulting from the merger—is not alien to its interest. And that would suffice to deny the AT's position.

(The tribunal notes that it did not find, presented by either of the parties, in the documentation attached to the file, as would be useful, the pre- and post-merger balance sheets, which would allow a more detailed analysis on this point. However, from the simple fundamental relationship of the balance sheet, if an incorporating entity absorbs an obligation (liability), it will absorb rights or resources (assets) which come to be, in a general sense, financed by the set of own and alien means that the new balance sheet will evidence).

In conclusion, and on this first point on which the tribunal understands that the AT is not right, if in the sphere of I… the debt and interest had a specific connection to a certain management decision, when that debt and those interests pass into the sphere of the new entity, they come to have a general relationship with the assets of the new company and, therefore, with its activity.

Doctrine and case law have long departed from interpreting the condition of "indispensability of expenses" as requiring an obligatory nexus of causality between an expense and the income derived from it, or a micro-analytical nexus between a certain expense and a specific income.

The debt in question, from which interest emerges, is devoted to the financing of business assets (and, after the merger, cannot cease to be so in the sphere of the incorporating company which received operational and financial activity from the companies that converged in it). It is those assets that enable the new entity to develop its activity or pursue its interest. Then the expenses pass the indispensability test, as is judged to happen in the case at hand.

On the other hand, and in the second place, the mechanism of the tracing approach, to which the AT resorts, is judged here to be inappropriate. For two reasons, one of which is pointed out in an opinion attached to the file, authored by Professors Rui Morais and Gustavo Courinha.

In the words of the authors, to which the tribunal adheres: "What the AT.... designates by 'tracing approach'—is nothing more than the transposition to the scope of article 23 of the Corporate Income Tax Code of the step-by-step analysis methodology, characteristic of anti-elusive reasoning and anti-abuse open clauses, especially of the CGAA; and does it, obviously, to the detriment of the scope and application of these latter. The passages are, moreover, evident in which this occurs in the inspection report, in terms that leave no doubt about the assumed anti-elusive methodology adopted."

Additionally, still on this second reason, it should be noted that the tracing approach, applied in the context of article 23 of the IRC, can lead to inconsistent results. Let us see. Suppose that at moment 1, a certain company A acquires a machine for one million euros and incurs debt in that amount, with no doubts about the micro relationship between debt (liability) and the machine (asset). At moment 2 the company sells such machine and receives, let us assume, 900,000 euros, which it maintains in a deposit account, without earning interest. It opts not to repay 800,000 euros which, let us assume, it still owes from the initial loan of 1 million.

At moment 3, A is absorbed by B in a merger process, with the debt, originally incurred by A for the acquisition of the machine, and the liquid resources which formed part of A's assets then passing into the sphere of B.

On the basis that the machine is no longer in the sphere of the new entity and the loan no longer finances the originally acquired asset and the financial resources obtained do not generate income, should the interest on the still outstanding (of 800,000 euros) be non-deductible? It is judged that it should not.

The original loan is now, as in the case at hand, sustaining or serving as a source of funds supporting assets in B. Now in a general sense, and not in a micro and specific relationship, as in company A. Those assets are the means with which the new entity develops its activity. Thus the interest has a relationship with such activity and will be deductible.

That is, the tracing approach would lead to the argument that, in this example, the debt appearing in B's balance sheet, from the merger, was originally obtained to acquire an asset that is no longer in the sphere of the entity. But, as has been seen, that debt corresponds to other assets (e.g., the liquidity obtained from the sale), which can be used by the new company in its activity. And, in this measure, the interest should continue to be deductible.

Of course, the situation is not coincident with that of the present case. However, it well illustrates that the tracing approach, used in the scope of the application of article 23 of the IRC, can lead to economic and legally unacceptable results. And this results from not taking into account that a liability, originally devoted to a given asset, may, by virtue of legal-economic operations (e.g., merger, division), entirely legal, come to perform a role of financing other assets, in light of the patrimonial mutations that such operations imply. For such mutations and their effects (e.g., disqualification of interest) to be disregarded, it is not article 23 of the IRC that is the appropriate rule.

A third reason also leads to denying the AT's position, being well expressed in the opinion to which we have already alluded.

The authors state: [text as referenced]

Indeed, article 23 of the IRC should not function as an anti-abuse clause. Moreover, in the case of mergers, the AT need not resort to the CGAA. Article 73, paragraph 10 of the IRC established, at the time:

"10 — The special regime established does not apply, in whole or in part, when it is concluded that the operations covered by it had as their main objective or as one of their main objectives tax evasion, which may be considered verified, namely, in cases where the companies involved do not have the totality of their income subject to the same tax regime in IRC or when the operations were not carried out for valid economic reasons, such as the restructuring or rationalization of the activities of the companies participating in them, in which case, if applicable, the corresponding additional tax assessments are made."

Now, without the AT putting into question that the merger carried out did not have tax evasion as its essential purpose, does not disqualify the operation. By not disqualifying the operation, then the expenses resulting from it, such as the interest in the sphere of the claimant, cannot be disqualified by understanding that, with the merger, they cease to be indispensable in the sphere of the claimant.

As has already been shown, even if the AT seeks to go directly to the expense (interest) without passing through the questioning of the operation (merger) through an anti-elusive rule, such a procedure presupposes that the debt, now in the sphere of the claimant, ceases, because of the merger, and only because of it, to have a business motivation, given that, before the merger, it was never questioned.

Now the debt, in the sphere of the claimant, is, by the simple logic of the fundamental balance sheet equation, financing assets of this and related, therefore, with its activity. Unless the AT, on the basis of pre- and post-merger balance sheets, proved that this is not so, which is not found in the file.

The arbitral claim therefore proceeds on this point.

3.2. Regarding the Corrections to the Taxable Matter of B…

Application of Transfer Pricing to Deferrals of Payment of Price

One of the questions which it is important to decide is whether the deferrals of payment of the price constitute gratuitous financings and, in that measure, transfer pricing can be applied to them.

As a matter of framing, it is important to state that the AT, both in the inspection report and in the reply, considers that the operation at issue is a purchase and sale contract and that no alteration of the legal qualification thereof was made (article 223 of the reply). This is without prejudice, however, to understanding that the purchase and sale contract raises two distinct questions: one as to the selling price of the totality of the laboratory capital and another as to the deferral of the price.

The parties agree that a purchase and sale contract was concluded comprising several elements. There is disagreement, however, regarding the question of whether transfer pricing can be applied to the deferrals of payment of the price, which in the AT's view constitute gratuitous financings to be corrected.

This tribunal understands that there are inherent to the purchase and sale contract a series of operations, and it is therefore possible, from an economic standpoint, to identify deferrals relating to payment of the price which, in terms of substance, may imply gratuitous financing. However, as is admitted by both parties, those deferrals are an integral part of the purchase and sale contract which is unitary. That is, the operation which gave rise to the application of transfer pricing was the purchase and sale and not financing as an independent operation, as indeed results from the expressed position by the AT.

It follows from the letter of article 63 of the IRC that this applies to operations as a whole, although naturally the terms and conditions thereof are taken into account. The correction which flows from the application of transfer pricing therefore concerns the operation as a whole and not solely one of its terms or conditions. In this concrete case it is crystal clear that the operation to be considered is the purchase and sale and not a possible financing.

Apart from the literal element of article 63 which refers unequivocally to operations, it is relevant to attend to the Principles applicable regarding transfer pricing intended for multinational enterprises and Tax Administrations, despite their nature of soft law and having to be duly received by the various legal systems, or at least not shock the provisions that obtain in each of them. This instrument can be an important interpretative resource both because of its historical connection to the creation of the various transfer pricing rules and because it is of great value as regards the delimitation of the teleological element of those provisions.

In point 1.64 of that instrument it is stated that "the verification by the Tax Administration of a related operation must be based on the operation actually occurring between the parties and on the manner in which it was structured by them. Except in exceptional cases, the Tax Administration should not abstract from the actual operations, nor substitute them for other operations". In that same document, in point 1.65, it is admitted, however, that "there are two specific cases in which, exceptionally, tax authorities may have justification for not attending to the structure adopted by a taxpayer to perform the related operation. The first case arises whenever there is a disagreement between the form of the operation and its economic substance. The tax authorities may then ignore the qualification made by the parties and requalify it based on their respective substance […]. The second case occurs when, in the absence of divergences between the form and substance of the operation, the terms of the operation, viewed in their entirety[1], are different from those that would be adopted by independent enterprises, acting in a commercially rational manner, which in practice, the effective structure prevents the Tax Administration from determining an appropriate transfer price […]. Accordingly, in the case set out above the Tax Administration may have justifications, for example, to modify the terms[2] of the agreement in a commercially rational perspective, configuring them as an ongoing investigation agreement".

Regarding the first situation, it is verified that, in the case under analysis, the AT clearly assumes that it did not make any option for a requalification, with the possibility of requalifying the purchase and sale, transforming it into a financing contract, being ruled out.

As regards the second exceptional case we understand that it also does not provide cover to the situation sub judice. That case is very specific and concerns the sale of an unlimited right to intellectual property rights which, moreover, is already addressed in paragraph 1.11 of the instrument to which we refer, whereby it would hardly be possible to relate it to the situation under analysis. However, even if the concrete example used to illustrate that situation were disregarded, it is still clear to this tribunal that the second case diverges greatly from the situation we are dealing with. Let us see.

In those situations the structure adopted by the taxpayer is no longer attended to because the terms of the operation viewed in its entirety are different from those which would be adopted by independent enterprises. In the concrete case precisely the opposite is happening, given that the AT instead of attending to the purchase and sale contract in its entirety, centers itself on a specific term. That is, instead of looking at the operation as a whole and possibly modifying the terms of the agreement [note that the use of the words entirety and terms (in the plural) is certainly not despicable], it centers itself on the financing and on the term which supposedly serves as its basis, disregarding the sales contract in its entirety. In fact, it fragments it to center itself on one of the only conditions or terms that compose it and not on several of them as the word terms suggests.

It is understood, therefore, without prejudice to considering that there would even be scope for the AT to disregard the qualification made by the parties under the first exceptional case (having complied with the procedure arising from domestic law, naturally), decided, at least from the formal standpoint, not to do so. That is, despite recognizing that the amendment to the purchase and sale contract has, in terms of substance, the nature of a refinancing, decided not to make that requalification, saying, clearly and duly highlighted in the reply (article 223), that the legal qualification of the purchase and sale contract was never altered. Thus, despite it being recognized by the AT that there are clauses of the contract and amendments to it which result in a deferral of payment and which have the effects of a loan contract, it did not call into question that those clauses were integrated in the purchase and sale contract as a whole. Consequently, it cannot, in a context in which it denies that it made any requalification, come, in practice, to treat that financing autonomously as if it had disregarded the remaining elements of the contract.

It is verified, inversely, that the AT, in the concrete case, despite asserting that the operation it seeks to correct is the purchase and sale and that it never made any requalification, centers itself on what it considers to be a financing operation, making a comparison with others similar. This without resorting to the procedure that would allow the requalification of the financial operation: specifically, the application of article 38, paragraph 2 to the amendment to the purchase and sale contract—the only way to justify placing the emphasis on the gratuitous financing.

Now, if the operation at issue is the purchase and sale and what is corrected is only one of its terms and conditions, it is incumbent that the correction made under article 63 of the IRC has effects on the operation as a whole and not solely on the refinancing operation which, despite being implicit in the main operation and even being one of its most relevant terms or conditions, obviously does not exhaust it.

The purchase and sale operation should, therefore, be corrected as a whole and not solely as regards the financing conditions which are only one of its terms or conditions. It should be highlighted, among other relevant conditions, in particular and in a special manner, the selling price.

It is concluded, therefore, that article 63 of the IRC, in a context in which the purchase and sale contract was considered unitary and as encompassing the possible financing, as is moreover assumed by the AT, cannot be applied exclusively to the financing inherent in that contract, but solely and uniquely to the contract as a whole. The comparison to be made should be with other purchase and sale contracts and not with financing operations. Unless, obviously, as we have already indicated, the operation to be corrected were the financing. Only in that case could article 63 of the IRC be applied directly. The context in which transfer pricing is applied was not, however, that one, given that neither of the parties, and especially the AT, disregarded the main operation, that is, the purchase and sale operation.

One cannot, therefore, correct the price of a purchase and sale contract by applying the comparable market price method solely to one of its conditions or terms as if the contract were limited to that aspect. The comparison should, in the first place, be made with other similar purchase and sale contracts, resorting, if it is impossible to find them, to another method of determining transfer prices more consistent with a complex operation such as the one at issue.

The arbitral claim therefore proceeds on this point as well.

VI. DECISION

In view of the foregoing, it is decided:

• To judge the arbitral claim as meritorious, and consequently to annul the decision of the gracious appeal, as well as the assessment act which preceded it;

• To condemn the Tax Authority in the request for restitution of the amount assessed, including compensatory interest;

• To condemn the Tax Authority in the request for payment of indemnificatory interest on the amount paid from the date of payment until full restitution;

• To condemn the Tax Authority in the costs of the proceedings.

VII. VALUE OF THE CASE

The value of the case is fixed at €779,880.49.

VIII – VALUE OF COSTS

The costs are computed in the amount of €11,322.00, pursuant to Table I annexed to the Regulation of Costs in Tax Arbitration Proceedings.

Let it be notified.

Lisbon, 24 November 2016.

The arbitrators

(José Baeta de Queiroz)

(João Sérgio Ribeiro)

(António Martins)

(Text prepared by computer, pursuant to article 138, paragraph 5 of the Code of Civil Procedure, applicable by reference of article 29, paragraph 1, subsection e), of the Legal Regime of Tax Arbitration, with blank verses and reviewed by us. The text adopts the orthography resulting from the Orthographic Agreement, except as to citations and transcriptions, in which the orthography of the originals was respected.)

[1] The underlining is ours.

[2] The underlining is ours.