IRS Category F Deductions: Arbitral Challenge to Additional Assessments on Rental Income (2010-2013)

ARBITRATION AWARD

A..., with TAX NUMBER ... and B..., with TAX NUMBER..., resident in..., ..., MC ..., Monaco, represented for tax purposes in Portugal by Company C..., Ltd., with TAXPAYER ID ..., with registered office at Rua ..., … ..., ... ...-... Albufeira, having been notified of additional Personal Income Tax assessments for the years 2010 to 2013, in the total amount to be paid of €10,400.29, including compensatory interest (conf. assessments constituting doc. 1), hereby submit, pursuant to the terms and for the purposes of the provision laid down in subparagraph a) of Article 2, section 1 and Articles 15 et seq., all of Decree-Law No. 10/2011, of 20 January ("Legal Framework for Tax Arbitration"), an ARBITRATION APPEAL against those acts of Personal Income Tax assessment.

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The additional Personal Income Tax assessments under challenge, relating to the years 2010 to 2013 and respective compensatory interest, in the amounts of €3,155.65, €3,038.50, €2,925.39 and €1,280.75, respectively, totalling €10,400.29, were notified to the Appellants on 05/01/2015, regarding the 2010 additional assessment, and on 08/01/2015, regarding the remaining assessments, whose respective payment due dates were as follows: 2010 – 04/02/2015, 2011 – 11/02/2015, 2012 – 11/02/2015 and 2013 – 11/02/2015.

The Appellant submitted its Arbitration Appeal on 05/05/2015, accepted by CAAD on 07/05/2015, whereby it is timely, pursuant to Article 10, section 1, letter a) of the LFTA.

The Respondent is the Tax and Customs Authority (TCA).

The Appellants opted not to appoint an arbitrator, having CAAD proceeded with the appointment of Dr. José Rodrigo de Castro.

The arbitral tribunal was constituted on 22/07/2015.

The parties are legitimate and are duly represented, the proceedings are appropriate and there are no nullities or exceptions that require prior consideration.

The TCA submitted its Response in a timely manner.

The holding of the Meeting referred to in Article 18 of the LFTA was dispensed with and there were no pleadings.

I – REPORT

The Appellants are owners of the Tourist Resort D..., commonly referred to as E..., corresponding to the urban property registered in the urban property record of the parish of ... and ... under number..., .

The Appellants, non-residents, transferred, by means of a Tourism Exploitation Agreement, dated 01/01/2006, to F..., S.A., with TAXPAYER ID ..., the tourism exploitation of the enterprise, for a period of 3 years, successively and automatically renewed, unless terminated, highlighting the following most relevant aspects:

• exclusive right of tourism exploitation of said E..., through short-term tourism rentals;

• The Appellants have the right to occupy and/or permit another person designated by them to occupy the property, upon payment of the rate applicable to the respective occupation, depending on the period in which it occurs - high, medium or low season - by notifying the contracting operating entity with 8 months' advance notice, under penalty of the reservation not being considered;

• F... the contracting operator, shall pay annually to the Appellants, for tourism exploitation license of the property, an amount equivalent to 75% of total revenue, net of VAT, with the remaining 25% designated to F..., as an administration fee;

• The owner Appellants shall be responsible for payment of condominium expenses, due on an annual basis, as well as for normal maintenance, repair and conservation expenses, that result from normal use or are caused by any risk that should be covered by the property insurance, which should cover risks of fire, explosion, vandalism, demonstrations, riots, earthquakes, storms, floods, collision or theft and provided they are not caused by F... employees;

• The owner Appellants are also responsible for any contributions, fees, taxes and fiscal or parafiscal charges resulting from the exploitation agreement and from the property;

• The Appellants undertake to maintain the property and all furniture, utensils and equipment at the high standard of quality inherent to the tourism classification of a 5-star establishment.

The Appellants filed their respective income tax returns, form 3 of Personal Income Tax, regarding the years 2010 to 2013, which are now at issue.

In those returns, the following items were indicated in Annex F, relating to real property income:

The TCA, in the context of an inspection action conducted under Inspection Orders OI2014..., OI2014..., OI2014..., all of 13/10/2013 and OI2014..., of 17/11/2014, initiated on 23/09/2014 and concluded on 18/11/2014, carried out various corrections, which shall be detailed below.

The TCA corrected the charges and expenses declared to the following values:

The TCA justifies the corrections of expenses and charges for less, for two reasons, namely:

a. For there not having been full occupancy of the enterprise during the 52 weeks of the year, for which it determined the following annual occupancy rates:

i. Year 2010 – 79 nights of occupancy/365 days = 21.6438%

ii. Year 2011 – 153 nights of occupancy/365 days = 37.8082%

iii. Year 2012 – 95 nights of occupancy/366 days = 25.9563%

iv. Year 2013 – 133 nights of occupancy/365 days = 36.4384%

b. For not having been fully considered as falling within the scope of Article 41 of the CITPS, relating to deductions from Category F of Personal Income Tax, namely some of the expenses and charges, on the ground that, in the view of the Respondent, "they have no correlation whatsoever with maintenance and conservation of..., necessary and indispensable to obtain income from category F in Personal Income Tax", relating to:

• Management expenses relating to the Contract Property Management, in the part concerning "mail forwarding, property accounting and preference of additional services, etc. - €39.00 monthly" as they relate solely to the tourism exploitation agreement concluded with F..., S.A.;

• Expenses relating to "cleaning services, whereby the taxpayer pays monthly €157.00 if the property is not occupied by clients, and €64.50, per night, if the property is occupied by clients";

• Expenses relating to "maintenance services, namely, annual maintenance report, verification of the condition of doors, windows, plumbing, etc. - €120.00 monthly";

The TCA justifies the corrections made in the following terms:

"Analyzing the various types of expenses, it is concluded that the expenses relating to Contract Property Management - Management, Housekeeping and Maid Services (or Contract Housekeeping), Cleaning Owners and Laundry Owners are not accepted. With regard to expenses relating to Contract Property Management - Management, their non-acceptance is due to the fact that management expenses do not fall within the deductible expenses and charges referred to in Article 41 of the CITPS. In the remaining cases, they will not be accepted as they are not considered to be related to the obtaining of income, being expenses relating to periods in which the property is not occupied, in the case of Housekeeping, or even personal to the taxpayers, in the case of Cleaning and Laundry (Cleaning and Laundry referring to the Owners)".

The Appellants object to the corrections of deductions within Category F, which affected the net income of this category and, consequently, the taxable income of Personal Income Tax for the said years 2010 to 2013 and determined acts of additional Personal Income Tax assessments for the years in question, in the amounts of €3,155.65, €3,038.50, €2,925.39 and €1,280.75, respectively, totalling €10,400.29, of Personal Income Tax to be paid, including compensatory interest, conf. doc. 1.

The Appellants first contest the application of the "occupancy coefficient" for each of the years, insofar as the TCA "restricted the acceptance of the value of the charges and expenses declared to the product of these by said occupancy coefficients that it determined".

On the other hand, the Appellants clarify that the Enterprise E... "was not between 2010 and 2013 subject to private use or own occupation by the now Appellants, but rather constituted a real estate investment of theirs consisting in holding it to obtain the greatest possible income that the tourism enterprise could extract over the 52 weeks in each year".

The Appellants further clarify that the expenses that were incurred and that they bore, such as the periodic painting of the property, the Property Tax, water and electricity are fixed costs inherent to the property, whether occupied or unoccupied, and therefore there is no sense in applying any "occupancy coefficient".

And the Appellants cite, as an illustrative example, the situation of hotels, in which the deductibility of their operational expenses cannot be conditioned by any occupancy rate.

The same applies, the Appellants emphasize, as an illustrative example, to the maintenance of the swimming pool of the tourism enterprise, which must be carried out, regardless of the occupancy rate, as a matter of health and sanitation for those who use E....

They also point out that the corrected charges and expenses are indispensable to keeping E... in a state of suitability to provide tourism accommodation services, by virtue of the agreement concluded and legal requirements, further arguing that those do not vary, as a rule, in function of the use or actual occupation made of it.

II – FACTS PROVEN

With interest for a proper decision of the case, the following facts are shown to be proven by documentation:

1. The Appellants are owners of the urban property registered in the urban property record of the parish of ... and ... under number..., conf. doc. 2, which is inserted in the Tourist Resort D..., commonly referred to as E....

2. The values resulting from the cessation of tourism exploitation E..., considered as real property income of Category F, were respectively the following and were not contested:

a. Year 2010 - €35,915.08

b. Year 2011 - €76,779.79

c. Year 2012 - €51,024.53

d. Year 2013 - €84,583.73, conf. doc. no. 5.

1. The expenses and charges incurred and declared were as follows:

a. Year 2010 - €28,200.12

b. Year 2011 - €37,943.07

c. Year 2012 - €22,111.87

d. Year 2013 - €20,536.85, conf. doc. 5.

1. Therefore, the net income of Category F determined and declared by the Appellants was as follows:

1. The TCA, in the context of the inspection action previously referred to, made various corrections, with the grounds previously referred to and which total:

1. Part of the corrections made relate, on the one hand, to expenses and charges actually incurred on the building in question, whose documentary evidence was not contested, but reduced according to the annual occupancy rate, conf. doc. 5.

2. Other corrections relate to expenses and charges considered by the Respondent as not falling within the scope of Article 41 of the CITPS - Personal Income Tax Code, as per Article 3 of the Pleadings and the lists of expenses and charges included therein and in accordance with and on the grounds previously referred to.

3. The Appellants proved the expenses and charges declared and paid by them through the contracted company, whose veracity of the documents was not contested.

4. The charges and expenses were attributed to the Appellants, although incurred by F..., S.A., with TAXPAYER ID..., to whom the exclusive tourism exploitation was contractually transferred.

5. The corrections made by the TCA, with both grounds previously referred to, with the exception of situations relating to some corrections regarding amounts paid improperly and for which credit notes were issued (such as Insurance) and also for not belonging to the property in question or not being indispensable for income generation, materialized in the following terms, as per the detailed lists of justification of Article 11 of the Response of the Respondent:

a. Year 2010 – Declared €28,200.12 – Corrected to €9,559.18

b. Year 2011 – Declared €37,943.07 – Corrected to €19,239.81

c. Year 2012 – Declared €22,112.17 – Corrected to €5,172.31

d. Year 2013 – Declared €20,536.85 – Corrected to €15,938.22

1. From all the foregoing, the following values resulted:

III – FACTS NOT PROVEN

Neither the Appellants nor the Respondent presented the documents to which the declared values subject to analysis and correction by the Respondent refer, although, in light of the Tax Inspection Report, they were all subject to verification and analysis.

It was not proven that any apartment was occupied by the owner Appellants or by persons recommended by them, during the years in question, despite, contractually, only F... being required to reserve it, provided this is done with proper advance notice, nor were they even dispensed from the corresponding payment, depending on the period of its use.

IV – APPLICABLE LAW

The issue at stake in these proceedings relates to the application of Article 41 of the CITPS, whose wording is as follows, inserted in Section V – Real Property Income, regarding the years 2010 to 2013, with adjustments for this latter year:

"Article 41 – Deductions

1 – From the gross income referred to in Article 8, deductible are maintenance and conservation expenses that are incumbent upon the taxpayer, borne by it and are documentally proven, as well as property tax and stamp duty that incides on the value of the properties or part of the properties whose income is subject to taxation in the tax year[1].

2 – In the case of an autonomous fraction of property under a horizontal ownership regime, the conservation, enjoyment and other charges that, under civil law, the condominium must mandatorily bear are also deductible, borne by it, and are documentally proven.

3 – In the case of subletting, the difference between the rent received by the sublessor and the rent paid by it does not benefit from any deduction".

The applicable law results from the legal provision cited, with emphasis on the legal requirements demanded by the provision, for consideration of the expenses and charges incurred, namely:

a) Maintenance and conservation expenses incumbent upon the taxpayer;

b) Expenses actually borne and documentally proven;

c) Property Tax inciding on the value of the rented property, whose income is subject to taxation in the tax year, that is to say, paid in the year of the income to be taxed in Personal Income Tax.

There is here at issue a relationship of cost indispensable to obtaining income, when documentally proven and actually borne by the title holder of the asset.

It is worth noting that this arbitral tribunal conducted a search of the case law of superior courts and administrative doctrine of the TCA (including binding opinions obligatorily published by the TCA, pursuant to section 19 of Article 68 of the General Tax Law), and located no judicial or administrative decision with contours even remotely similar to the issue now under consideration, which seems to indicate that this is an innovative position of the Tax Inspection.

It is worth noting that the wording of section 1 of Article 41 of the CITPS has remained practically unchanged since the entry into force of this code in the late 1980s, which makes it even more surprising that only now the Tax Inspection adopts such a singular interpretation of this rule.

In fact, the rule of deductibility of costs in Category F has always been associated with maintenance costs necessary to obtain taxable real property income, which the legislator has never, not even by way of example, specified.

The first issue to analyze is whether it has any tax relevance, to the issue under analysis, the fact that the Appellants concluded a management agreement for the Tourist Resort in question, designated as E..., with a legal entity resident in Portuguese territory, in exchange for remuneration, pursuant to the exploitation agreement that constitutes doc. 3.

Well, knowing that the owners are non-residents, they had no possibility of making the enterprise profitable and maintaining it in conditions of use, without being through this usual contractual means or other similar, as is moreover the rule in housing integrated in tourism villages, even if held by resident taxpayers.

It is, therefore, to F..., S.A. that it is incumbent, contractually, to carry out all expenses inherent to maintenance and conservation of the property, keeping it in normal rental conditions.

All these expenses, namely, minor repairs, including paintings, maintenance of pool use, condominium expenses, insurance premium, Property Tax, among others, cannot fail to be considered as falling within the scope of Article 41 of the CITPS, provided that duly proven and borne by the taxpayers.

And the Respondent did not contest the existence of such expenses and charges, as well as the requirement of payment of the same by the contracted company.

Moreover, the fact that there is a tourism exploitation agreement, obviously onerous, cannot this charge fail to be considered a mandatory and indispensable expense for income generation, and therefore cannot fail to be considered as covered by the letter and spirit of the rule of Article 41 of the CITPS.

As regards the charges with accounting expenses, which, moreover, are not contractually attributable to the Appellants, but rather a responsibility of F..., within the scope of its exploitation function of the enterprise, cannot be considered as falling within the scope of Article 41 of the CITPS, especially since, being a Public Company, it must necessarily organize its accounting, for financial reporting to its client.

Moreover, the payment to F... by virtue of the contractual provisions, of 25% of revenues, cannot fail to include not only the charge of ensuring maintenance in conditions of functioning of the tourism enterprise, but also the rendering of accounts to the contracting Owners.

As regards the expenses of mail, registrations and other contacts, informing the Owners of occurrences that require contacts through any of these means, with no contractual provision regulating them, it is also recognized that they cannot fall within the scope of maintenance expenses provided for in Article 41 of the CITPS, as they are included in the functions and obligations of F..., as is normal and customary.

With regard to the reduction of expenses and charges by application of an "occupancy coefficient", such procedure cannot be accepted, since all expenses incurred, such as cleaning of dwellings and pool and its sanitation treatment, water, electricity, insurance, Property Tax and others, must always be borne, regardless of the occupancy rate.

Such "occupancy coefficient", as referred to, a "sui generis" ground that apparently had not hitherto been used by the Inspection, has, in the view of this tribunal, no legal basis.

V – DECISION

In light of the foregoing, the Court decides as follows:

a) Partially annul the additional assessments under challenge, which must be reformulated in the following terms:

a.1) - Acceptance of all expenses and charges included in the accounts of F... and the responsibility of the Appellants and, therefore, borne by them, as considered to fall within the scope of Article 41 of the CITPS;

a.2) - Non-consideration within the scope of Article 41 of the CITPS and, therefore, non-acceptance of the charges inherent to the accounting of F..., as well as expenses for communication with the Appellants, such as mail, registrations and other forms of contact, as they are the responsibility of F..., within the scope of its functions, and not of the Appellants.

b) Condemn the Respondent, Tax and Customs Authority, to pay compensatory interest improperly paid by the Appellants on 05/02/2015 and further to the payment of indemnity interest to be calculated on the Personal Income Tax improperly paid, pursuant to Article 43 of the General Tax Law, in proportion to the annulled tax and from the date on which such tax was improperly paid, until the date on which the taxpayer is reimbursed of such tax, at the legally due rate.

VI – VALUE OF THE ACTION

The value of the action is fixed at €10,400.29, as results from the records and attached documents, in accordance with the provision laid down in Article 306, section 2 of the Code of Civil Procedure and Article 97-A, section 1, letter a) of the Code of Tax Procedure, applicable ex vi Article 29, section 1, letter a) of the LFTA.

VII – COSTS

Pursuant to Articles 12, section 2 and 22, section 4, of the LFTA and Article 4 of Table I of the Regulations of Costs in Tax Arbitration Proceedings, costs to be paid by the Appellants and Respondent, in the proportion to which they failed, whose values the Court considers to be 5% charged to the Appellants and 95% to the Respondent.

The Parties are hereby notified.

Lisbon, 21 January 2016.

The Arbitrator,

(José Rodrigo de Castro)

[1] In 2010, 2011 and 2012, the CITPS still referred to municipal tax, due to being outdated. In the 2013 Budget (Law 66-B/2012, of 31/12) the update was made to Property Tax and Stamp Duty, changing the italicized part.