Process: 273/2016-T

Date: January 26, 2017

Tax Type: IRC

Source: Original CAAD Decision

Summary

CAAD Process 273/2016-T examines the deductibility of financial charges under Article 23 of the CIRC, focusing on the 'indispensability' requirement for IRC purposes. Company A, SA challenged an additional IRC assessment for 2012 totaling €503,966.72, disputing two main corrections: (1) the Tax Authority's disallowance of €1,536,776.57 in financial charges related to a €125.5 million loan from a financial institution, where the company provided interest-free financing of €36.9 million to its shareholder and related entities; and (2) the rejection of €60,000 in consulting invoices from a Dutch company lacking proper tax identification and VAT details. The Tax Authority calculated that 4.17% of the company's effective financing costs attributed to interest-free loans granted to related parties should be non-deductible, arguing these expenses were not indispensable for generating taxable income. The arbitral tribunal, constituted under the LRAT, examined whether financial charges on borrowed funds subsequently lent without interest to group companies meet the indispensability test under Article 23 CIRC. This case illustrates key principles for expense deductibility: expenses must demonstrate a direct connection to income-generating activities, and the provision of interest-free loans to related parties using borrowed funds raises questions about business purpose and tax deductibility of associated financing costs.

Full Decision

ARBITRAL DECISION

The arbitrators, Counsellor José Baeta de Queiroz (arbitrator-president), Dr. Paulo Lourenço and Professor Doctor Luísa Anacoreta (arbitrator-members), appointed by the Ethics Council of the Centre for Administrative Arbitration to form the Arbitral Tribunal, agree as follows:

1. Report

A…, SA, legal entity number…, with registered office at Building…, …, number…, …, in Lisbon, filed a request for the constitution of a collective arbitral tribunal, pursuant to the combined provisions of Articles 2 and 10 of Decree-Law No. 10/2011, of 20 January (Legal Regime for Arbitration in Tax Matters, hereinafter referred to only as LRAT), in which the TAX AUTHORITY AND CUSTOMS SERVICE is the respondent, with a view to a declaration of illegality of the act of additional corporate income tax assessment for the year 2012 (assessment No. 2015…), as well as the respective compensatory interest (assessments No. 2015… and 2015…, both of 22 December 2015).

The request for the constitution of the arbitral tribunal was accepted by the President of CAAD and automatically notified to the Tax Authority and Customs Service on 20 May 2016.

Pursuant to the provisions of Article 6(2)(a) and Article 11(1)(b) of the LRAT, in the wording introduced by Article 228 of Law No. 66-B/2012, of 31 December, the Ethics Council appointed as arbitrators of the collective arbitral tribunal Counsellor José Baeta de Queiroz, Dr. Paulo Lourenço and Professor Doctor Luísa Anacoreta, who communicated their acceptance of the appointment within the applicable time limit.

On 8 July 2016, the parties were duly notified of this appointment, and did not express any wish to object, in accordance with the combined provisions of Article 11(1)(a) and (b) of the LRAT and Articles 6 and 7 of the Code of Ethics.

Thus, in accordance with the provisions of Article 11(1)(c) of the LRAT, in the wording introduced by Article 228 of Law No. 66-B/2012, of 31 December, the collective arbitral tribunal was constituted on 25 July 2016.

The Tax Authority and Customs Service responded, arguing that the request should be dismissed.

By order of 2 October 2016, the applicant was notified to identify the facts alleged for which it intended to hear the witness listed, given that the utility of the examination was contested by the respondent, having informed, through a request submitted on 13 October 2016, that it waived the witness testimony.

In view of this, the tribunal, finding no justified reason for the hearing referred to in Article 18 of the LRAT, determined, by order of 13 October 2016, its exemption and invited the parties to submit written arguments, if they wished, within a successive period of ten days.

The applicant and the respondent submitted their arguments on 25 October 2016 and 4 November 2016, respectively.

2. Procedural Issues

The arbitral tribunal was regularly constituted and is materially competent, in accordance with the provisions of Articles 2(1)(a) and 30(1) of Decree-Law No. 10/2011, of 20 January.

The parties have legal personality and capacity, are legitimately parties and are represented (Articles 4 and 10(2) of the same decree-law and Article 1 of Order No. 112-A/2011, of 22 March).

The proceedings are not affected by any nullities and no exceptions were raised.

Accordingly, there is no obstacle to the examination of the merits of the case.

3. Factual Matters

3.1. Proven Facts

The following facts are considered proven and of interest for the proper decision of the case:

A) The applicant is a commercial company whose corporate purpose consists of managing its own real estate and, subsidiarily, in the purchase of buildings or land and the development of their urbanization projects.

B) The applicant's activity concentrates, essentially, on the exploitation of a building containing shops, offices and automatic parking «…».

C) In the execution of the project «…» the applicant resorted several times to external capital, namely from financial institutions.

D) On 20 August 2007, it entered into a loan agreement with financial institution B…, in a maximum amount of €125,500,000.00, with a view to, pursuant to the terms of the respective contract, the refinancing of the investment made in the building «…».

E) The loaned amount was used for various purposes, including the settlement or repayment of loans previously contracted with various banking entities.

F) As of 31 December 2012, the accumulated debt was €123,657,774.16.

G) The applicant's financial statements include financing provided to the shareholder - €32,500,000.00 - and to group and related companies - €4,479,993.05 -, which bear no interest and have no defined repayment schedule.

H) In the year 2012, the applicant incurred financial charges in the amount of €5,151,456.06.

I) The applicant was subject to an inspection for the year 2012;

J) Following the inspection, the Tax Authority made a correction to the applicant's taxable profit in the amount of €1,536,776.57, considering this portion of the financial charges incurred in the year 2012 to be non-deductible for tax purposes;

K) The criterion used by the Tax Authority consisted in calculating the average annual financing balance of the applicant - €36,853,269.43 - determining the rate of effective financing costs - 4.17% - applying this rate to the value of the loans to the companies referred to in G), and disregarding as a tax cost the value obtained - €1,536,776.57.

L) The Tax Authority did not consider the seven invoices recorded by the applicant, issued by C…, with registered office in the Netherlands, between March and December 2012, numbered 2012001 to 2012007, in the total amount of €60,000.00, relating to the provision of consulting services.

M) Although not mentioned in the said invoices, the tax identification number of C… is 850 849 263, as evidenced by a document issued by the Dutch tax authorities.

N) The disallowance as a tax deduction was based, furthermore, on these invoices not showing the tax identification number (NIF) of either the issuer or the applicant, not breaking down VAT or mentioning the type of VAT taxation or exemption, and the fact that the issuer had no registration of NIF in the VIES register (VAT Information Exchange System), with the respective services not having been declared by C….

O) The corrections mentioned resulted in additional assessment No. 2015…, of 18 December 2015, the assessment of compensatory interest No. 2015… and No. 2015…, of 22 December 2015, and also the assessment of default interest No. 2015…, of 22 December 2015, all in a total amount of €503,966.72, which the applicant paid on 8 April 2016.

3.2. Unproven Facts

There are no facts relevant to the examination of the merits of the case that have not been proven.

3.3. Basis for the Establishment of Factual Matters

The proven facts are based on the documents attached to the proceedings, which are hereby considered reproduced, and on the agreement of the parties.

4. Legal Matters

There are two issues to be decided in the present proceedings:

  • whether the financial charges incurred by the applicant in relation to the financing referred to in G) of the factual matters should be considered as expenses for the period for tax purposes;

  • whether the invoices referred to in L) of the factual matters should be considered for tax purposes.

4.1. The Applicant's Arguments

The applicant argues that the financing obtained from B… was used to pay liabilities to D…, E… and F…, as well as to make payments of commissions and other charges, including those of a tax nature.

In fact, obtaining external financing to use in the scope of the activity and considering as expenses the financial charges incurred with such financing does not, as a rule, raise any tax-related issue. However, making available to other group entities financial resources, whether own or borrowed, without charging interest does not generate any taxable income, meaning that the balance rule that should exist, from a tax perspective, between expenses and income is broken.

Accordingly, it is important to bring to bear Article 23 of the Corporate Income Tax Code, with a view to answering the question of whether the charges incurred with financing that would not have been necessary to obtain if other group entities had not been granted financial resources without any remuneration should be considered as expenses.

According to Article 23 of the Corporate Income Tax Code, in the version applicable to the date of the facts, "…expenses are those that are demonstrably indispensable for the realization of income subject to taxation or for the maintenance of the income-producing source…".

An analysis of the said rule allows us to conclude that, if the reasonableness of the expense incurred is demonstrated, as well as its causal nexus with the realization of income subject to taxation or with the maintenance of the income-producing source, its deductibility and inclusion under Article 23 of the Corporate Income Tax Code are accepted.

According to the understanding of the Central Administrative Court South "…the legal notion of indispensability is therefore delimited from an economic-business perspective, by direct or indirect fulfillment of the ultimate motivation for the achievement of profit" (Decision of the Central Administrative Court South, of 27 March 2012, Case No. 05312/12).

The aforementioned decision further adds that "…the deductibility of a cost depends only on a causal and justified relationship with the company's activity. And outside the concept of indispensability will be only acts that are contrary to the social purpose, those that do not serve the interest of the company, especially because they do not aim at profit".

In this sense, as the applicant states, once the direction of expenses towards the pursuit of the company's activity and, consequently, towards the achievement of profit is proven, it is understood that the criterion of indispensability is met, being outside the scope of the Tax Authority to make value judgments on the propriety of the business management pursued by the applicant.

This understanding is, moreover, what has been followed by the arbitral tribunals of CAAD.

In fact, according to decision 444/2015T, "from a general point of view, the essential features of the path established by national doctrine and jurisprudence on the matter of the indispensability of expenses can be summarized as follows":

  • the assessment of the indispensability of expenses incurred implies that their contribution to the achievement of income or gains subject to taxation or to the maintenance of the income-producing source is verified, whereby "The legal notion of indispensability is therefore delimited from an economic-business perspective, by direct or indirect fulfillment of the ultimate motivation for the achievement of profit" and "the tax deductibility of a cost depends only on a causal and justified relationship with the company's activity." (Decision of the Supreme Administrative Court, issued on 30-11-2011, in case No. 0107/11[1]);

  • "the costs (...) must, from the outset, relate to the contributing company itself. That is to say, in order for a certain amount to be considered a cost of that company, it is necessary that the respective activity be developed by it itself, and not by other companies." (Decision of the Supreme Administrative Court, issued on 30-05-2012, in case No. 0171/11);

  • "a concept of indispensability which, definitely moving away from the idea of causality between expenses and income, places emphasis on the relationship of expenses with the activity pursued by the taxpayer, that is, considering that the said concept of indispensability is met whenever expenses are incurred in the interest of the company, in the pursuit of its respective activities." (Decision of the Supreme Administrative Court, issued on 04-09-2013, in case No. 0164/12);

  • the concept of indispensability is matter of case-by-case analysis and the nexus of economic causality cannot be detached from the factual circumstances of the specific case, namely that "the Tax Authority cannot assess the indispensability of costs in light of criteria relating to the opportunity and merit of the expense. A cost is indispensable when it relates to the company's activity, with costs unrelated to the company's activity being only those where it is not possible to discern any causal nexus with the income or gains (or with the income, in the current wording of the code - see art. 23, no. 1, of the CIRC), explained in terms of normality, necessity, congruence and economic rationality." (Decision of the Administrative Court South, issued on 16-10-2014, case No. 06754/13);

  • "The indispensability of a cost must result simply from its connection to the business activity. If the cost is not unrelated to the company's activity, that is, if it relates to the company's normal activity (regardless of the degree of intensity or proximity), and if its existence is accepted (it is not an apparent or simulated cost), the cost is indispensable." (Decision of the Administrative Court North, issued on 20-12-2011, case No. 01747/06.3BEVIS);

  • "from the legal notion of cost provided by Article 23 of the CIRC, it does not follow that the Tax Authority may call into question the principle of freedom of management, scrutinizing the propriety and opportunity of the economic decisions of company management and considering that only those from which directly result profits for the company or which prove convenient for the company can be fiscally assumed. The indispensability referred to in Article 23 of the CIRC as a condition for a cost to be deductible does not refer to necessity (the expense as a sine qua non condition for income), nor even to convenience (the expense as convenient for the business organization), under penalty of intolerable interference of the Tax Authority in the autonomy and freedom of management of the taxpayer, but requires merely a relationship of economic causality, in the sense that it suffices that the cost be incurred in the interest of the company, directly or indirectly, for the achievement of profits. The legal notion of indispensability is therefore delimited from an economic-business perspective, by direct or indirect fulfillment of the ultimate motivation for the achievement of profit. Essential costs are equivalent to expenses incurred in the interest of the company or, in other words, to all acts abstractly subsumable within a profit-making profile. This objective purposefully brings together economic and tax categories through a primarily logical and economic interpretation of legal causality. The essential expense is equivalent to every cost incurred in order to obtain income and which represents an economic decline for the company. As a rule, therefore, the tax deductibility of a cost depends only on a causal and justified relationship with the company's activity. And outside the concept of indispensability will be only acts contrary to the social purpose, those that do not serve the interest of the company, especially because they do not aim at profit." (Decision of the Supreme Administrative Court, issued on 30-11-2011, case No. 0107/11);

  • "The rule is that correctly recorded expenses are tax costs; the criterion of indispensability was created by the legislator, not to allow the Administration to interfere in company management, dictating how it should apply its resources, but to prevent the fiscal consideration of expenses which, although recorded as costs, do not fall within the scope of the company's activity, were incurred not for its pursuit but for other alien interests. Strictly speaking, these are not true company costs, but expenses which, given their object, were abusively recorded as such. Without the Administration being able to assess the indispensability of costs in light of criteria relating to their opportunity and merit. The concept of indispensability not only cannot be equated to a strict judgment of imperious necessity, as has been said, but also cannot be based on a judgment about the convenience of the expense, made necessarily a posteriori. For example, expenses incurred on an advertising campaign that proved unsuccessful cannot, solely on the basis of that result, be deemed dispensable. The assessment of the opportunity and convenience of expenses is the exclusive prerogative of the businessman. If he decides to incur expenses in order to pursue the company's object but is unsuccessful and those expenses prove, in the end, unproductive, they remain tax costs. But any expense that is recorded as a cost and is shown to be unrelated to the company's purpose is not a tax cost, because it is not indispensable. We understand (...) that, under penalty of violation of the principle of tax capacity, the Administration can only exclude expenses not directly excluded by law based on strong motivation that convinces that they were incurred beyond the social objective, that is, in the pursuit of another interest than the business one or, at least, with clear excess, deviating, in light of the objective needs and capacities of the company." (Decision of the Supreme Administrative Court, issued on 29-03-2006, case No. 01236/05).

Having thus established the criteria for assessing the indispensability of expenses in light of Article 23 of the CIRC, it remains to apply such criteria to the present case.

All things considered, taking into account the jurisprudential approach mentioned above and the arguments presented by the applicant and the respondent, it can therefore be concluded that, in an isolated analysis, the financial charges incurred in obtaining financing intended for use in the scope of the activity should be considered as expenses for tax purposes.

However, in the present case, the applicant only needs to bear part of such charges because, freely, voluntarily and in compliance with management criteria that are its sole responsibility, it made available to other entities some financial resources, whether own or borrowed, which it could have used for its activity.

Moreover, making available to other entities such financial resources was done, as previously mentioned, without any charge of interest or any other remuneration, a situation that gave rise to an emphasis being placed on the statutory certification of accounts.

Indeed, it is clear that it is outside the corporate purpose of the company to make available to other entities financial resources, bearing in mind in particular what is provided for in Article 6 of the Commercial Companies Code.

It is not, in fact, in the interest of the applicant to make available financial resources to other entities without charging interest, while at the same time there is a need, even if partial, to request financing, having to bear the resulting financial charges.

The amounts loaned, without any remuneration, could always have prevented part of the financial charges from having to be borne.

In this context, it is considered that the position of the Tax Authority in not considering as business expenses the financial charges incurred and directly related to the financial resources that the applicant made available to other group entities and which could have been used in the scope of the activity, preventing part of the charges from having to be borne, merits no censure.

This has nothing to do with the documentation of the charges, which the Tax Authority did not question, nor with the presumption of truthfulness of taxpayers' statements, which was also not affected, nor with the regularity of the applicant's accounting, which the Tax Authority did not challenge, nor with a presumption that the bank financing was intended, directly and immediately, for the granting of loans to third parties, which the Tax Authority also did not affirm, nor with the freedom that businessmen have to manage their companies according to criteria which it is not for the Tax Authority to replace with others.

What is being said is that the granting of free loans to third parties, using the applicant's financial resources – which, naturally, result from the financing obtained and income derived from its activity – does not meet the said criterion of indispensability.

Furthermore, the Tax Authority, to reach the result it did, used an appropriate criterion, described in section K) of the factual matters, and the applicant does not criticize it or propose another, only saying that there is no direct allocation between the financing obtained and the loans granted – which is true and, it is repeated, the Tax Authority did not affirm.

What exists is an economic reality that translates to the following: if the applicant had not granted the said free loans, it would not have needed to resort to credit to the extent that it did.

Therefore, the charges with this resort to credit are not, in their entirety, indispensable expenses.

4.2. The Invoices from C…

Let us now examine the seven invoices recorded by the applicant and issued by C…, with registered office in the Netherlands, in the amount of €60,000.00, relating to the provision of consulting services, which the Tax Authority did not consider as deductible, namely because these invoices did not indicate the tax identification number (NIF) of either the issuer or the applicant, did not break down VAT or mention the type of VAT taxation or exemption, and the issuer had no registration of NIF in the VIES register (VAT Information Exchange System), with the respective services not having been declared by C….

The Tax Authority based its position of non-acceptance of these expenses as a tax deduction on the provisions of sections b) and g) of Article 45(1) of the Corporate Income Tax Code, as amended, according to which "The following charges are not deductible for the purpose of determining taxable profit, even if recorded as expenses for the tax period:

(…)

b) Charges shown in documents issued by taxpayers with a non-existent or invalid tax identification number (…);

g) Charges not properly documented".

Here it is not a matter of calling into question the correctness of the applicant's accounting, or the truthfulness of the documents on which it is based, or even of questioning whether the costs were actually incurred.

What is in question is whether or not they are to be considered deductible for the determination of taxable profit.

The invoices in question were issued by an entity that has a tax number, so the requirement demanded by section b) of Article 45(1) of the aforementioned Corporate Income Tax Code is considered to be met.

On the other hand, the invoices make no reference to the VAT treatment of the service provider, nor do they indicate the tax identification number of the respective recipient.

Now, according to decision 2390 of the Supreme Administrative Court of 14 July 2014 "in the context of corporate income tax, the document proving and justifying costs for the purposes of Articles 23(1) and 42(1)(g) of the CIRC does not have to assume the essential formalities required for invoices for VAT purposes. The requirement for documentary evidence is not confused with nor exhausted in the requirement for an invoice, it being sufficient, according to some authors, to have a written document, in principle external and mentioning the fundamental characteristics of the transaction. With respect to the jurisprudence of this Supreme Court, it was established in the Decision of 8/7/1999, case No. 23535, that "The requirements for invoices, contained in Article 35(5) of the VAT Code, are not requirements of formal validity of invoices for corporate income tax purposes, but only for the purposes of VAT deduction, pursuant to Article 19(2) of the VAT Code".

In fact, the requirement for the tax identification number of the resident purchaser did not apply at the date of the facts, appearing only with the corporate income tax reform in 2014, in the wording of Article 23(4) of the Corporate Income Tax Code.

It is therefore concluded that the non-acceptance as an expense of the costs documented in the invoices from C… has no basis in sections b) and g) of Article 45(1) of the then Corporate Income Tax Code.

5. Decision

In light of the above, the panel of arbitrators of the Arbitral Tribunal agrees to partially dismiss the request for an arbitral ruling, and therefore decides:

a) To maintain the additional corporate income tax assessment for the year 2012 (assessment No. 2015…) insofar as it concerns the non-acceptance as a tax deduction of the financial charges in the amount of €1,536,776.57,

b) To maintain the respective compensatory interest (assessments No. 2015… and 2015 …, both of 22 December 2015).

c) To annul the additional corporate income tax assessment relating to the non-acceptance as a tax deduction of invoices issued by C… (assessment No. 2015…) in the amount of €60,000.

d) To annul the respective compensatory interest (assessments No. 2015 … and 2015…, both of 22 December 2015).

Based on the proportionality calculations made by the Tribunal, the additional corporate income tax assessment in the amount of €484,999.44, including compensatory interest, corresponding to 96.2% of the total amount, is thus maintained.

6. Value of the Proceedings

In accordance with Article 315(2) of the Code of Civil Procedure and Article 97-A(1)(a) of the Code of Tax Procedure and Article 3(2) of the Regulation on Costs in Tax Arbitration Proceedings, the value of the proceedings is fixed at €503,966.72 (five hundred and three thousand nine hundred and sixty-six euros and seventy-two cents).

7. Costs

Pursuant to Article 22(4) of the LRAT, the amount of costs is fixed at €7,956.00 in accordance with Table I attached to the Regulation on Costs in Tax Arbitration Proceedings, with the applicant bearing €7,363.00 and the remainder being borne by the respondent.

Lisbon, 26 January 2017

The Arbitrators

José Baeta de Queiroz

Paulo Lourenço

Luísa Anacoreta

[1] Available at www.dgsi.pt, as well as the remaining jurisprudence cited without indication of source.

Frequently Asked Questions

Automatically Created

What does Article 23 of the CIRC establish regarding the deductibility of business expenses for IRC purposes?
Article 23 of the CIRC establishes that business expenses are deductible for IRC purposes when they are indispensable (indispensáveis) for obtaining or maintaining taxable income. This requires demonstrating a direct connection between the expense and the company's income-generating activity. The Tax Authority may disallow expenses that lack this essential link, as illustrated in Process 273/2016-T where financial charges on loans subsequently provided interest-free to related parties were questioned.
How does the CAAD assess the indispensability requirement for corporate tax expense deductions?
CAAD assesses the indispensability requirement by examining the causal connection between the expense and the generation of taxable income or maintenance of the income source. In Process 273/2016-T, the tribunal analyzed whether financial charges of €5,151,456.06 were indispensable when the company provided €36.9 million in interest-free loans to shareholders and related entities. The Tax Authority applied a proportional approach, calculating the effective financing rate (4.17%) and disallowing the portion of financial charges attributable to non-income-generating use of borrowed funds, totaling €1,536,776.57.
What was the outcome of the additional IRC assessment challenged in CAAD process 273/2016-T?
The text excerpt provided does not include the final decision of the arbitral tribunal in Process 273/2016-T. The case proceeded through proper constitution of the arbitral tribunal on 25 July 2016, with both parties submitting their arguments by November 2016. The tribunal was examining whether €1,536,776.57 in financial charges and €60,000 in consulting invoices should be tax-deductible. The total amount under dispute was €503,966.72 in additional IRC assessment and compensatory interest for the 2012 tax year.
Can a company challenge an additional IRC tax assessment and compensatory interest through tax arbitration at CAAD?
Yes, companies can challenge additional IRC tax assessments and compensatory interest through tax arbitration at CAAD. Process 273/2016-T demonstrates this right under Articles 2 and 10 of Decree-Law No. 10/2011 (LRAT - Legal Regime for Arbitration in Tax Matters). Company A, SA successfully initiated arbitration against assessment No. 2015... and related compensatory interest assessments. The arbitral tribunal was constituted with three arbitrators appointed by the CAAD Ethics Council, providing an alternative dispute resolution mechanism to administrative and judicial courts for resolving corporate tax disputes.
What criteria must business expenses meet to be considered indispensable and deductible under Portuguese corporate income tax law?
Under Portuguese corporate income tax law, particularly Article 23 of the CIRC, business expenses must meet the 'indispensability' criterion to be deductible. This requires: (1) a direct causal connection between the expense and obtaining or maintaining taxable income; (2) the expense must serve a legitimate business purpose related to the company's income-generating activity; (3) proper documentation and compliance with formal requirements (tax identification numbers, VAT details); and (4) the expense cannot primarily benefit related parties without corresponding income generation. Process 273/2016-T illustrates that financial charges on borrowed funds used for interest-free loans to related parties may fail this test, as they lack the necessary connection to income generation.