Process: 289/2016-T

Date: January 4, 2017

Tax Type: IRC

Source: Original CAAD Decision

Summary

CAAD arbitration decision 289/2016-T addresses the IRC (Corporate Income Tax) deductibility of a €7,072,867.71 indemnity paid for early termination of a commercial agency contract. The taxpayer company unilaterally rescinded a renewable commercial contract in June 2010, four years before its scheduled expiration in March 2015, paying compensation calculated based on projected commissions (3% of estimated future sales). The company deducted the entire amount in the 2010 tax year. Following an IRC inspection, the Tax Administration disallowed €6,039,506.67 of the deduction, applying the accrual principle under Articles 17(3)(a) and 18(1) of the IRC Code. The Tax Authority argued that since the indemnity related to future economic benefits (commissions on sales through March 2015), only the portion proportional to actual 2010 sales (€1,033,370) qualified as a deductible expense in that year. After filing a gracious complaint with partial allowance, the taxpayer challenged the assessment through CAAD arbitration. The case illustrates critical issues in Portuguese corporate tax law regarding the temporal recognition of contract termination costs, the application of accrual accounting principles to indemnities calculated on projected revenues, and the proper matching of expenses with the periods generating corresponding benefits. It demonstrates the procedural path from IRC assessment through administrative complaint to tax arbitration for resolving disputes over expense deductibility.

Full Decision

ARBITRAL DECISION

I – REPORT

A…, LDA., with NIF … and registered office in …, requested the constitution of an arbitral tribunal, with a view to the declaration of illegality of the decision of the gracious complaint filed as a result of the additional assessment of Corporate Income Tax (IRC) which shall be identified hereinafter, as well as of the assessment act complained against.

As nothing was said concerning any intention to designate an arbitrator, the signatories were appointed by the Deontological Council, an appointment which they accepted and which met with no opposition from any of the parties, with the tribunal being constituted on August 4, 2016.

The Tax Administration (AT) replied, within the legal deadline, defending itself by impugnation 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 January 4, 2016 and invited the parties to produce written submissions, which they did, maintaining, in essence, the positions previously expressed.

II – STANDING AND ADMISSIBILITY

The tribunal is competent, the parties are legitimate, endowed with legal standing and capacity, and are duly represented. There are no nullities, exceptions or preliminary objections that prevent the examination of the claim.

III – FACTUAL MATTERS

  1. ESTABLISHED FACTS

a) The Claimant A…, LDA., is a company constituted in 1991 resulting from a joint venture between Group B… and Group C…, whose capital was held, until July 20, 2010, in 50% by each of those groups.

b) On this last date, Group B… came to hold the totality of the capital of the Claimant.

c) The Claimant operates an industrial unit in Tondela, dedicated to the production of key systems, safety and immobilization systems for automobiles.

d) On March 6, 1995, the Claimant and D…, SA concluded a contract, valid for five years, renewable unless one year's notice, whereby the latter undertook to promote the commercialization of the production of the former, by means of a commission of 3% of the value of sales.

e) The contract had a validity of 5 years, renewable for equal periods whenever, with one year's notice prior to the end of that period, neither of the parties opted for rescission.

f) Thus, in June 2010, with the contract in a period of validity whose term would be on March 6, 2015, the Claimant unilaterally and immediately rescinded the same contract, for reasons relating to the reorientation of the company's business, its commercialization strategy, namely, the acquisition of new markets and new customers.

g) Since the initial contract provided that its non-performance or rescission would imply a negotiation of settlement, without making reference to the method of calculation or the value that should assume the contractual penalty resulting from unilateral rescission, the contracting parties agreed that the Claimant would pay to D…, SA the sum of € 7,072,867.71, payment which occurred in 2010 and was disclosed in the sub-account "#… – Other contractual penalties", influencing in its entirety the net result of the 2010 financial year and the corresponding taxable profit.

h) To arrive at the said amount, the parties estimated that, between January 2010 and March 6, 2014, D…, SA would earn commissions in the amount of € 7,000,000.00.

i) Thus, the criterion that governed the calculation of the compensatory amount ascertained in the context of rescission was to consider the commissions that D…, SA would be entitled to if the contract were performed for the intended period.

j) The Claimant was the subject of an inspection action relating to the 2010 financial year.

k) During this inspection action, the Claimant had a transfer pricing file, to which the Respondent made no objection, nor questioned the tax deductibility of that penalty.

l) It appears from the inspection report that "(…) the payment of the indemnity of €7,072,876 is associated with future economic benefits, so only the portion proportional to the gains generated could be considered as an expense in 2010, because, notwithstanding the fact that there was the "expense" in the 2010 financial year, it would not represent an "expense" in its entirety in that year".

m) The Respondent concluded that the expense to be considered in the 2010 financial year would be the result of the product between the percentage of 3% (the value fixed in the contract for the commission) and the value of sales carried out in the period after rescission, which amounted to € 34,445,668.00, that is, € 1,033,370.00, correcting the taxable profit upwards by € 6,039,506.67.

n) This correction to the taxable profit ascertained by the Claimant and other corrections to the taxable profit and the calculation of tax made by the Respondent in the context of the same inspection action gave rise to the IRC assessment statement No. 2015-…, the interest assessment statement Nos. 2015-…, 2015-… and 2015-…, and the corresponding account adjustment statement No. 2015-….

o) In disagreement with the aforementioned correction to the taxable profit and the correction to the calculation of tax, on September 15, 2015, the Claimant filed a gracious complaint.

p) On May 2, 2016, the Claimant was notified of the decision of partial allowance of the aforementioned gracious complaint, with the Respondent maintaining the understanding that, from the total amount of indemnity paid of € 7,072,876.00, only the amount of € 1,033,370.00 could contribute to the taxable profit of the 2010 financial year.

  1. SUBSTANTIATION OF FACTUAL MATTERS

The tribunal's conviction was based on the examination of the documents attached to the case, which are reproduced here, and on statements of a party not contradicted by the counterparty.

  1. UNESTABLISHED FACTS

Among those alleged, relevant to the decision, none remained unproven.

IV – SUBSUMPTION OF FACTS TO LAW

The Respondent considers that "given the economic substance (No. 3 of article 11 of the General Tax Law) of the operation, namely the method of calculation of the value of the indemnity (commissions projected based on scenarios of evolution of sales of A…) and the reasons that led to the choice of payment and assumption of the charge to Group C… (reorientation of the company's business, namely in terms of access to new markets and channels, an optimization of its value chain and optimization in strategic terms), we verify that the payment of the amount of the indemnity of €7,072,876.71 is associated with future economic benefits, so only the portion proportional to the gains generated could be considered as an expense of 2010, because notwithstanding the fact that there was the "expense" in the 2010 financial year, it does not represent an "expense" in its entirety in that year. Thus by application of item a) of No. 3 of article 17 of the IRC Code, which mentions that accounting should be organized in accordance with accounting normalization and of No. 1 of article 18 of the IRC Code, income or expenses are attributable to the taxation period in which they are obtained or incurred, regardless of their receipt or payment".

The Respondent concludes that "Therefore, and in obedience to the legal provisions aforementioned, as to the amount incurred with the rescission of the contract, in the 2010 financial year, the expense to be considered will be the result of the product between the percentage of 3% (the value fixed in the contract for the commission) and the value of sales carried out in the period after rescission, which as shown on page 74 of the DPT, from July to December 2010 amounted to 34,445,668.00, given that the value of the commissions would be associated with the amount of sales. Thus the expense to be considered in the 2010 financial year is 1,033,370.00 (…)".

The Claimant argues succinctly that the indemnity is not associated with future economic benefits and, consequently, the expense attributable to the 2010 financial year should correspond to the total amount of the indemnity.

Thus, the main issue submitted to the appreciation of the Arbitral Tribunal is to assess whether the Claimant has the right to deduct, for purposes of the calculation of the taxable profit of the 2010 financial year, the total amount of € 7,072,876.00 relating to the indemnity paid by the Claimant to D…, SA or only to proceed with the deduction of the portion proportional to the gains generated, corresponding to 3% of the value of sales carried out in the period from July to December 2010, in the amount of € 1,033,370.00.

It is necessary, therefore, to decide on the merits of the petition for arbitral decision of the IRC assessment sub judice and the act of partial dismissal of the gracious complaint which had sought the annulment of that assessment act.

Pursuant to the provisions of No. 1 of article 17 of the IRC Code, the taxable profit of legal persons is constituted by the algebraic sum of the net result of the period and of the positive and negative variations in equity verified in the same period and not reflected in that result, determined on the basis of accounting and possibly corrected in accordance with the same Code. No. 3 of the same article provides that accounting should be organized in accordance with accounting normalization and other legal provisions in force for the respective sector of activity, without prejudice to the observance of the provisions provided for in the IRC Code and should reflect all operations carried out by the taxpayer and be organized in such a way that the results of operations and variations in equity subject to the general regime of the IRC can clearly be distinguished from those of the remaining ones.

These rules thus establish the model of partial dependence between the taxation of income of legal persons and accounting (which was already established in the Industrial Tax Code), in accordance with which taxable profit is determined on the basis of the accounting result, being made the positive or negative extra-accounting adjustments provided for in law, to safeguard the objectives and conditions inherent to taxation, in its aspect related to income taxes.

In fact, as constitutionally established, the taxation of companies is based on the economic reality constituted by their profit, which is why accounting, as an instrument of measurement of this reality, assumes a fundamental function in the determination of taxable profit.

In No. 1 of article 18 of the IRC Code it is further added that income and expenses, as well as other positive or negative components of taxable profit, are attributable to the taxation period in which they are obtained or incurred, regardless of their receipt or payment, in accordance with the regime of economic accrual.

It should be noted that the IRC Code does not present any other rule that implies the performance of extra-accounting adjustments for the determination of taxable profit, with respect to the contractual penalty in question, so that its treatment for the purposes of the taxation of income will correspond to its corresponding accounting treatment in accordance with the applicable accounting regulations.

Additionally, in this regard, it is important to point out that, in accordance with No. 2 of article 11 of the General Tax Law (LGT), insofar as, in tax provisions, terms peculiar to other branches of law are not used, they must be interpreted in the same sense that they have there, unless it directly follows from law otherwise.

Tax legislation does not define what is to be understood as the regime of economic accrual, this being a term peculiar to accounting.

Thus, for this purpose, it is important to note that, in accordance with paragraph 22 of the Conceptual Framework of the Accounting Normalization System (SNC) applicable in 2010, published by Notice No. 15652/2009, of September 7, the financial statements are prepared in accordance with the accrual (or economic accrual) basis, and through this regime, the effects of transactions and other events are recognized when they occur (and not when cash or cash equivalent are received or paid) being recorded in accounting and reported in the financial statements of the periods to which they relate.

Thus, financial statements prepared in accordance with the accrual basis inform the users not only of past transactions that involved payments or receipts, but also of obligations to pay in the future and of resources that represent cash to be received in the future.

Additionally, in paragraph 76 of the Conceptual Framework of the SNC, expenses encompass losses as well as expenses that result from the conduct of the current (or ordinary) activities of the entity, these including, for example, the cost of sales, salaries and depreciation.

Furthermore, it should be noted that, in accordance with paragraph 93 of the same Conceptual Framework, expenses are recognized in the statement of results in a direct association between the costs incurred and the obtaining of specific income, in order to ensure the matching of costs with revenues, so as to proceed with the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transactions or other events.

At the end of that paragraph a warning is presented that the application of that matching concept does not permit the recognition of items on the balance sheet that do not satisfy the definition of assets or liabilities.

Paragraph 95 of the same Conceptual Framework further provides that an expense is immediately recognized in the results when the expenditure does not produce future economic benefits or when, and only if, the future economic benefits do not qualify, or cease to qualify, for recognition on the balance sheet as an asset.

Consequently, it is important to consider the conditions to be observed so that an expenditure qualifies as an asset. In fact, the portion of the value of the indemnity that cannot be recorded as an expense will have to meet the criteria for recognition as an asset.

Paragraph 49 defines an asset as a resource controlled by the entity as a result of past events and from which it is expected that there will flow to the entity future economic benefits, which correspond to the potential to contribute, directly or indirectly, to the flows of cash of the entity (which may occur by increase of cash inflows or reduction of cash outflows).

Paragraph 87 further adds that an asset is recognized on the balance sheet when it is probable that future economic benefits will flow to the entity and the asset has a cost or a value that can be measured with reliability.

The concept of probability relates to the degree of uncertainty in which the future economic benefits associated with the asset will flow to, or from the entity, depending on the market/sector in which the company operates, as of the date of preparation of the financial statements.

In this sense, in paragraph 88 of the Conceptual Framework it is established that "an asset is not recognized on the balance sheet when, with respect to the expenditure incurred, it is considered unlikely that economic benefits will flow to the entity beyond the current accounting period. Instead, such transaction results in the recognition of an expense in the statement of results. This treatment does not imply that the intention of the management body, in incurring the expenditure, was other than to generate future economic benefits for the entity, or that the management of the business was misdirected. The only implication is that the degree of certainty that economic benefits will flow to the entity beyond the current accounting period is insufficient to justify the recognition of an asset".

In this line of thinking, the contractual rescission and the corresponding indemnity, although they may aim at the generation of new income in the sphere of the Claimant, do not mean that they originated future economic benefits.

In fact, the payment of the contractual penalty in question did not assure the Claimant access to future economic benefits, given that it aimed only to grant it the freedom to implement the measures arising from the reorientation of its business, optimization of its value chain and access to new markets and new channels.

Therefore, this expense is not associated with the income to be recognized by the Claimant in the following years, even though its amount was determined by reference to estimates of future sales.

In fact, the sales of the Claimant in the period from July 2010 to March 2014 to customers previously intermediated by D…, S.A. could have been much higher or much lower than estimated for purposes of determining the amount of the contractual penalty.

In effect, neither did the payment of the contractual penalty assure the Claimant any future advantage (namely a certain level of sales to existing customers) nor would it be adjusted in accordance with the actual future sales.

On the other hand, the attribution of this expense to the following years would result in the penalization of the results of financial years in which the commercialization contract no longer was in force, and it is certain that that expense is not related to future sales.

Additionally, it is important to analyze whether a possible asset relating to the indemnity came to be controlled by the Claimant after the rescission of the contract concluded with D…, S.A..

As to the concept of control, for this purpose, it is important to consider the Accounting and Financial Reporting Standard (NCRF) No. 6, relating to intangible assets, according to which an entity controls an asset if it has the power to obtain future economic benefits that flow from the underlying resource and can restrict the access of others to those benefits.

Now, it is not apparent, nor did the Respondent prove, that the Claimant had, as a result of the rescission of the contract, come to assure that the customers previously managed by D…, S.A. would continue to be only its customers and that they could not purchase equivalent products from entities competing with the Claimant.

In other words, the Claimant had no legal or contractual instrument that would guarantee that it would be the exclusive supplier of products to the customers acquired and/or previously managed by D…, S.A..

Moreover, the said NCRF presents some situations in which assets are not controlled by the entity, among which it is important to consider particularly that relating to a customer portfolio or a market share.

Notwithstanding the fact that the Company may expect that, due to its efforts to create relationships and retain customers, these will continue to do business with the company, in the absence of legal rights to protect, or otherwise control, the relationship with customers or their loyalty to the entity, the entity generally does not have sufficient control over the expected economic benefits derived from the relationship and retention of customers for such items (for example, customer portfolio, market shares, customer relationships and customer loyalty) to satisfy the definition of intangible assets.

In light of the above, the indemnity in question did not meet the criteria for recognition as an asset and should, therefore, be entirely recognized as an expense of the 2010 financial year for accounting purposes and, consequently, for tax purposes.

It should also be noted that the fact that, for purposes of analyzing the operating margin on the costs of the Company, in the transfer pricing file, the Claimant considered as cost only the proportion of the indemnity that relates to sales of 2010, does not mean that, for purposes of calculating the taxable profit of 2010, the indemnity could only be considered in that amount. In fact, as mentioned in the said transfer pricing report, this adjustment was made "taking into account the exceptional character of the said indemnity, and so as not to introduce distortions in the analysis of the operating margin on costs of the Company, for purposes of the test carried out (…)".

If this adjustment to the operating margin had not been made, the reader of the transfer pricing report could be led to conclude that the operating margin of the Claimant in 2010 was not within the range of perfect competition identified to determine whether the transactions carried out (with the exception of the indemnity) by the Claimant with related entities complied with transfer pricing rules.

It being certain that this non-compliance derived only from an extraordinary fact occurring in the 2010 financial year and relating to the payment of the contractual penalty to D…, SA, which is why the adjustment of that margin was justified, considering, for this purpose, only the amount of commissions that, in the scenario of continuity of the contract concluded between the Claimant and D…, S.A., would be due by the former to the latter.

Additionally, it should be noted that, contrary to what was mentioned in the tax inspection report, the provision of item a) of No. 3 of article 18 of the IRC Code is not applicable to the case in question.

That item determines that income relating to sales is generally considered realized and the corresponding expenses incurred on the date of delivery or dispatch of the corresponding goods or, if earlier, on the date in which the transfer of ownership occurs.

Now, NCRF 18 relating to inventories expressly excludes from the cost of inventories and, consequently, from the cost of goods sold, the costs of selling, which include commissions for intermediation of the sale.

Thus, the expense relating to the indemnity is not an expense incurred with sales, which is why the provision of item a) of No. 3 of article 18 of the IRC Code is not applicable to it.

In terms of which it is concluded that the IRC assessment statement in question relating to the 2010 financial year suffers from a defect of violation of law regarding the correction to the taxable matter relating to the contractual penalty paid by the Claimant to D…, S.A., which justifies its annulment, the same occurring with the decision of the gracious complaint, in the part in which it did not recognize that illegality.

V. DECISION

In view of the above, it is decided:

  1. To find the arbitral petition well-founded, and, consequently, to annul the decision of the gracious complaint, as well as the assessment act that preceded it;

  2. To condemn the Tax Administration to pay the costs of the proceedings.

VI. VALUE OF THE PROCEEDINGS

The value of the proceedings is fixed at € 1,977,301.79.

VII. VALUE OF THE COSTS

The costs are computed in the amount of € 26,010.00, in accordance with Table I attached to the Regulation of Costs in Tax Arbitration Proceedings.

Let it be notified.

Lisbon, January 4, 2017.

The arbitrators

(José Baeta de Queiroz)

(Maria Cristina Aragão Seia)

(João Gonçalves da Silva)

(Text prepared by computer, in accordance with article 138, No. 5, of the Code of Civil Procedure, applicable by reference of article 29, No. 1, item e), of the Legal Regime of Tax Arbitration, with blank lines and revised by us. The text adopts the orthography prior to the Orthographic Agreement)

Frequently Asked Questions

Automatically Created

Is an indemnity paid for unilateral contract rescission deductible as a business expense under IRC?
Under Portuguese IRC law, indemnities paid for unilateral contract rescission are generally deductible as business expenses if they meet the requirements of Article 23 of the IRC Code (incurred to obtain or guarantee taxable income). However, the timing of deduction depends on the accrual principle in Article 18(1). In CAAD decision 289/2016-T, the Tax Administration argued that a rescission indemnity calculated on projected future commissions should be recognized proportionally over the periods generating corresponding benefits, not entirely in the payment year. Only the portion relating to actual economic activity in the payment year would be immediately deductible, with the remainder potentially requiring deferral or reclassification.
What are the requirements for recognizing contract termination costs as tax-deductible expenses in Portuguese corporate tax law?
Portuguese corporate tax law requires contract termination costs to satisfy several criteria for tax deductibility: (1) expenses must be incurred to obtain or guarantee taxable income (Article 23 IRC Code); (2) proper documentation and accounting support (Article 17(3)(a)); (3) compliance with the accrual principle—expenses attributed to the period when incurred, regardless of payment timing (Article 18(1)); (4) matching principle—expenses generating future benefits should align with the periods benefiting from them; (5) arm's-length terms for related-party transactions. In rescission indemnities calculated on projected future revenues, tax authorities may require proportional recognition over affected periods rather than immediate full deduction, particularly when the compensation explicitly relates to foregone future commissions or benefits extending beyond the payment year.
How does CAAD arbitration resolve disputes over additional IRC tax assessments on disallowed expenses?
CAAD (Centro de Arbitragem Administrativa) provides an alternative dispute resolution mechanism for IRC assessment challenges in Portugal. The process involves: (1) taxpayer receives IRC assessment and related interest/adjustment statements following inspection; (2) taxpayer files gracious complaint (reclamação graciosa) with Tax Administration within specified deadline; (3) if the complaint is denied or partially allowed, taxpayer may request CAAD arbitration; (4) arbitral tribunal is constituted with appointed arbitrators; (5) Tax Administration submits defense and administrative file; (6) parties may produce written submissions and attend hearings; (7) tribunal issues binding decision on assessment legality. In case 289/2016-T, the taxpayer followed this complete pathway, challenging a €6 million IRC correction after partial gracious complaint allowance, with the tribunal examining whether the expense timing correction complied with accrual accounting principles under the IRC Code.
Can a company deduct compensation payments arising from early termination of a commercial agency contract for IRC purposes?
Commercial agency contract termination payments present complex IRC deductibility issues in Portuguese tax law. While generally deductible under Article 23 (expenses incurred to obtain taxable income), the timing depends on the payment's nature. In CAAD decision 289/2016-T, an indemnity calculated as projected commissions through the contract's original term raised questions about whether it constituted: (a) an immediate expense of rescission deductible entirely in the payment year, or (b) a substitute for future operating expenses requiring proportional recognition. Tax authorities applied the accrual matching principle, limiting immediate deduction to the portion corresponding to the payment year's actual sales activity. This approach treats such indemnities as economically equivalent to the foregone commissions they replace, requiring temporal allocation. Companies should carefully structure and document termination agreements to support their preferred tax treatment.
What is the procedure for challenging an additional IRC assessment through gracious complaint and tax arbitration in Portugal?
The procedure for challenging additional IRC assessments in Portugal involves two main stages: (1) Administrative Phase—taxpayer files reclamação graciosa (gracious complaint) within the legal deadline after notification of assessment, interest, and adjustment statements; Tax Administration reviews and issues decision (total allowance, partial allowance, or denial); (2) Arbitration Phase—if unsatisfied with the gracious complaint outcome, taxpayer may request CAAD arbitration under the RJAT (Legal Regime of Tax Arbitration); tribunal constitution with appointed or selected arbitrators; Tax Administration submits defense with administrative file; parties produce written submissions; tribunal may hold hearings under Article 18 RJAT; binding arbitral decision issued within established timeframe. In case 289/2016-T, the taxpayer challenged a €6 million IRC correction following inspection, filed gracious complaint in September 2015, received partial allowance in May 2016, then initiated CAAD arbitration with tribunal constitution in August 2016, demonstrating the complete procedural pathway.