CAAD 334/2018-T: Economic Periodization Principle and Loan Interest Recognition Under IRC Article 18

ARBITRAL DECISION - ADMINISTRATIVE ARBITRATION CENTRE (CAAD)

The arbitrators Councillor Maria Fernanda Maçãs (presiding arbitrator), Dr. Paulo Quinas Raposeiro and Dr. Ricardo Rodrigues Pereira (arbitrator members), appointed by the Deontological Council of the Administrative Arbitration Centre to form the Arbitral Tribunal, agree as follows:

I. FACTS

1. On 13 July 2018, the commercial company A..., S.A., NIPC ..., with registered office at ..., ..., ... (hereinafter, Claimant), filed an application for the constitution of an arbitral tribunal, under the combined provisions of Articles 2(1)(a) and 10(1)(a) and (2) of Decree-Law No. 10/2011 of 20 January, which approved the Legal Regime of Arbitration in Tax Matters (hereinafter, abbreviated as RJAT), as amended by Article 228 of Law No. 66-B/2012 of 31 December, with a view to this tribunal's pronouncement on:

(i) Declaration of illegality and annulment:

• of the additional corporate income tax (IRC) assessment No. 2018..., for the year 2014, with the amount due of €101,702.41, of compensatory interest assessments Nos. 2018... and 2018..., in the amounts respectively of €9,134.74 and €8,200.76, and of the respective Statement of Account Reconciliation No. 2018..., from which resulted a total amount due of €182,253.50;

• of the additional IRC assessment No. 2018..., for the year 2015, with the amount due of €230,933.88, of compensatory interest assessments Nos. 2018... and 2018..., in the amounts respectively of €9,206.83 and €14,149.40, and of the respective Statement of Account Reconciliation No. 2018..., from which resulted a total amount due of €373,569.44; and

• of the additional IRC assessment No. 2018..., for the year 2016, with the amount due of €419,375.88, of compensatory interest assessment No. 2018..., in the amount of €11,487.91, and of the respective Statement of Account Reconciliation No. 2018..., from which resulted a total amount due of €419,375.88;

(ii) Reimbursement of the amounts of tax and compensatory interest unduly paid, plus indemnifying interest at the legal rate, from the date of payment until the date of full reimbursement.

The Claimant attached 3 (three) documents and listed 4 (four) witnesses, having not requested the production of any other evidence.

The Respondent is the AT – Tax and Customs Authority (hereinafter, Respondent or AT).

In essence, the Claimant alleges a defect of violation of law, through erroneous interpretation and application, primarily, of the norms contained in Articles 17 and 18(1) of the IRC Code and the consequent voidability, in the applicable parts, of the aforementioned IRC assessments.

As results from the application for arbitral pronouncement, the Claimant bases the challenge to the disputed tax acts, essentially, on the following arguments:

At issue in this case are interests relating to loans in which the debtor, faced with enormous financial difficulties, was unable to generate sufficient cash flow to meet its commitments, having initiated a history of non-payment of instalments relating to principal amortization and interest payments, which constituted undeniable evidence of reduced possibility that future economic benefits would flow to the Claimant.

In light of the provisions of Article 17 of the IRC Code, there exists a relationship of partial dependence of tax law on accounting, since the determination of taxable profit is made on the basis of accounting, without prejudice to the corrections provided for in the same Code.

This relationship of dependence is verified not only in the determination of results, but also at the level of the concepts and terminology used, which is why the IRC Code merely enunciates, in a generic manner, accounting principles, without going into the detail corresponding to accounting norms, and subsequently defines exhaustively which corrections must be made to net income, taking into account the specificities and purposes of the tax.

Thus, the IRC Code incorporates the generality of accounting principles of qualitative and quantitative valuation of elements that make up the balance sheet and statement of results and, except when it provides otherwise, the content of common concepts corresponds to the meaning conveyed by accounting.

For this reason, the accrual basis or economic periodization regime must be contextualized within the framework of SNC, such that contextualizing the presupposition of the accrual basis or economic periodization regime amounts to knowing and applying beforehand the rules that underlie the recognition of income and expenses.

In the specific case, the fundamental question is when a particular asset, in particular income, should be recognized as such in the statement of results. As the main condition for the recognition of income is the actual emergence of an increase in future economic benefits; thus, if there is no emergence of an actual increase in future economic benefits, we are not dealing with an item that can be qualified as income and consequently that can be reflected as such in a statement of results.

Regarding interest, as follows from NCRF 20, revenue from the use by others of an entity's asset that produces interest should be recognized when it is probable that the economic benefits associated with the transaction will flow to the entity and the amount of revenue can be reliably measured.

There is no doubt here as to the ability of revenue to be reliably measured, as what is at issue is the probability of economic benefits, in this case interest in the form of cash flows, flowing to the entity. Thus, if it is probable that interest will be received, the income should be recognized, but if it is more probable that interest will not be received, the income should not be recognized, until that uncertainty is removed.

Thus, both from an accounting perspective and from a tax perspective, in case of uncertainty linked to the flow of future economic benefits, interest should not be recognized in accordance with the effective interest method.

In the specific case in question, the Claimant, in compliance with what NCRF 20 requires, given a weak probability that economic benefits arising from the loans granted to its subsidiary company "A... Brasil" would flow, did not recognize interest in accordance with the effective interest method and began to consider them in the exact measure of their receipt, since there was ample evidence at its disposal that, according to plausible and good-faith criteria, pointed to the direction of it not being probable that such benefit flows would enter its assets.

Accordingly, the Claimant understands that the correction made by the AT is illegal, based on the purported obligation of IRC taxpayers to use, in any circumstance, the effective interest method, by violation of the income recognition rules (NCFR 20) that flow from accounting standardization, applicable by force of the model of partial dependence enshrined in Article 17 of the IRC Code.

Lastly, the Claimant states that, despite the illegality of the disputed IRC assessments, it made payment of the same, and is therefore entitled to payment of indemnifying interest on the amounts unduly paid.

1. The application for constitution of the arbitral tribunal was accepted by the President of the CAAD and followed its normal procedure with notification to the AT on 23 July 2018.

The Claimant did not appoint an arbitrator, therefore, in accordance with the provisions of Article 6(2)(a) and Article 11(1)(a) of the RJAT, the President of the Deontological Council of the CAAD appointed as arbitrators of the collective Arbitral Tribunal the undersigned, who communicated acceptance of the assignment within the applicable timeframe.

On 5 September 2018, the Parties were notified of that appointment, neither having manifested willingness to refuse the appointment of the arbitrators, in accordance with the combined provisions of Article 11(1), subparagraphs (b) and (c), of the RJAT and Articles 6 and 7 of the CAAD Code of Ethics.

Thus, in accordance with the provisions of Article 11(1), subparagraph (c) of the RJAT, the Collective Arbitral Tribunal was constituted on 25 September 2018.

1. On 29 October 2018, the Respondent, duly notified for that purpose, filed its Response in which it specifically challenged the arguments advanced by the Claimant, concluding by the lack of merit of the present action, with its consequent dismissal of the claim.

In essence and also briefly, it is important to extract the most relevant arguments on which the Respondent based its Response:

The procedure of charging the interest provided in the loan contracts, that is, recognizing as accounting the respective revenue only when the company already has the certainty of its receipt, or better, in the exact measure of its receipt, is a procedure that contradicts not only accounting norms (Conceptual Framework and NCRF 20), but also tax norms (Article 18 of the IRC Code).

So much so that, in the three periods in question, the Claimant proceeded to the recognition and respective charging of interest to "A... Brasil", even if only partially in relation to what was provided in the loan contracts with it.

The argument adduced by the Claimant is contradictory because if, on the one hand, it states that it was not probable, in the periods under analysis, that the economic benefits associated with the transaction (loans granted to "A... Brasil") would flow to it (later referring to already a weak probability), on the other hand, it emphasizes that, in those same periods of crisis, it bet on the continuity of "A... Brasil" and to do so had to finance it during the period of crisis.

On the other hand, the Claimant invokes that it was obliged to increase the capital stock of "A... Brasil", in 2017, by conversion of loans into capital stock, thereby ceasing to be any maturation of interest so that, by effect of the increase in the capital stock of its subsidiary, it would place itself in the position of being remunerated via dividends.

Indeed, on 31.12.2016, account #411322624 suffers a decrease in the amount of €6,000,000.00, resulting from its conversion into capital stock, such that as to the same amount (of capital) there was not, nor would there be, on that date, any maturation of interest; in light of which the conclusions of the Tax Inspection and respective corrections are in no way altered, with the argument advanced in the sense that by means of said conversion of loans into capital there ceased to be any maturation of interest being therefore without merit.

In another order of considerations, the AT contends that, subsidiarily, regard should be paid to the expenses (financial charges) incurred by the Claimant with the loans obtained, in the periods under analysis, to finance the company "A... Brasil". In this respect, the AT advocates that it should (always subsidiarily) be determined the value of financial charges (interest) eventually not accepted for tax purposes, with respect to each of the aforementioned periods, in the sphere of the Claimant; in light of which, relating to the periods of 2015 and 2016, given that the financing granted by the Claimant was throughout the year always higher than the financing obtained by it and the interest borne substantially higher than the interest obtained, relating to the loans granted to subsidiaries, it is verified that the difference (interest borne – interest obtained) constitutes expenses (with financing interest) not tax-deductible in the mentioned periods, as there correspond to them no taxable income whatsoever (with only the expenses and losses incurred or borne by the taxpayer to obtain or guarantee income subject to IRC being deductible).

Finally, the AT states that, not envisioning any error attributable to the services, nor payment of an amount of tax higher than that due, the requirements for indemnifying interest in favor of the Claimant are not met.

The Respondent did not request the production of evidence and proceeded to attach the administrative file (hereinafter, PA) to the case.

1. By order of 27 October 2018, the Parties were notified of the appointment of the date for the holding of the meeting referred to in Article 18 of the RJAT and for the examination of the witnesses listed by the Claimant.

On 8 January 2019, the meeting referred to in Article 18 of the RJAT took place – in which what appears in the respective minutes was addressed, which is hereby given as entirely reproduced, and the deadline of 25 March 2019 was set as the date limit for rendering the arbitral decision –, having also proceeded with the production of witness evidence.

1. Both Parties filed written submissions, in which they reiterated the positions previously assumed in their respective pleadings.

II. PRELIMINARY MATTERS (SANEAMENTO)

1. The Arbitral Tribunal was regularly constituted and is competent ratione materiae, given the configuration of the object of the case (cf. Articles 2(1)(a) and 5 of the RJAT).

The application for arbitral pronouncement is timely, because submitted within the timeframe provided in Article 10(1)(a) of the RJAT.

The parties possess legal personality and legal capacity, have standing and are regularly represented (cf. Articles 4 and 10(2) of the RJAT and Article 1 of Order No. 112-A/2011 of 22 March).

The joinder of claims is admitted – various IRC assessment acts are at issue, with the declaration of illegality and annulment of each being petitioned –, by virtue of verification that the success of the claims formulated by the Claimant depends essentially on the appreciation of the same circumstances of fact and the interpretation and application of the same principles or rules of law (cf. Article 3(1) of the RJAT).

The case does not suffer from nullities, no exceptions having been invoked that would obstruct knowledge of the merits and that it is incumbent upon the tribunal to address.

III. STATEMENT OF REASONS

III.1. FACTS

§1. PROVEN FACTS

1. The following facts are considered proven:

a) The Claimant's business purpose is the manufacture of plastic articles and components for motor vehicles, being part of the economic group "F..." and being subject to tax under IRC by the general system of taxation. [cf. PA]

b) The periodic income declarations, IRC Form 22, registered in the AT's computer system, relating to the Claimant and the fiscal years 2014, 2015 and 2016, are those appearing in the following table [cf. PA]:

[Table of tax declarations retained]

c) Under Service Orders Nos. OI2017..., OI2017... and OI2018..., inserted in activity code 1212110228 – "Declarative Audit", the Claimant was subject to an internal audit procedure, of partial scope, in IRC, with reference to the economic periods of 2014, 2015 and 2016, directed to the internal analysis of the periodic income declaration IRC Form 22. [cf. PA]

d) In that sequence, the respective Draft Tax Inspection Report was prepared, which is hereby given as entirely reproduced, in which the following corrections were proposed with respect to IRC, with the grounds that are also stated below [cf. PA]:

[Detailed tax inspection findings retained – covering interest on loans granted, references to Articles 18, 17 and 20 of IRC Code for periods 2014-2016]

e) The Claimant was notified, by means of office No. ... of 16.01.2018, sent by registered mail (registration CTT RF ... PT), of the aforesaid Draft Tax Inspection Report and, if it so wished, to exercise the right of prior hearing, which the Claimant did not do. [cf. PA]

f) The Claimant was notified, by means of office No. ... of 05.03.2018, sent by registered mail (registration CTT RF ... PT) with acknowledgment of receipt, of the Tax Inspection Report, which is hereby given as entirely reproduced, in which the aforesaid corrections with respect to IRC were maintained, relating to the fiscal years 2014, 2015 and 2016. [cf. PA]

g) Sequentially, the Claimant was notified [cf. documents attached to the application for arbitral pronouncement]:

(i) of the additional IRC assessment No. 2018..., for the year 2014, with the amount due of €101,702.41, of compensatory interest assessments Nos. 2018... and 2018..., in the amounts respectively of €9,134.74 and €8,200.76, and of the respective Statement of Account Reconciliation No. 2018..., from which resulted a total amount due of €182,253.50, with payment deadline of 26.04.2018;

(ii) of the additional IRC assessment No. 2018..., for the year 2015, with the amount due of €230,933.88, of compensatory interest assessments Nos. 2018... and 2018..., in the amounts respectively of €9,206.83 and €14,149.40, and of the respective Statement of Account Reconciliation No. 2018..., from which resulted a total amount due of €373,569.44, with payment deadline of 26.04.2018; and

(iii) of the additional IRC assessment No. 2018..., for the year 2016, with the amount due of €419,375.88, of compensatory interest assessment No. 2018..., in the amount of €11,487.91, and of the respective Statement of Account Reconciliation No. 2018..., from which resulted a total amount due of €419,375.88, with payment deadline of 30.04.2018.

h) On a date not specifically determined, the Claimant made full payment of the aforementioned amounts of €182,253.50, €373,569.44 and €419,375.88.

i) The Claimant works in the automotive sector, essentially for the various brands of Group B... (..., ... and ...) and the constitution of the company "A... Brasil" resulted from an investment by the Claimant, made following a request made to it by that automotive group to install an industrial unit in Brazil, in order to supply its companies both in that country and in Latin America. [cf. testimony of witness C...]

j) Apart from Brazil in 1999/2000 being a country with high potential in the automotive sector, which was an incentive to invest in that sector of activity, if the Claimant did not answer affirmatively to said request, it would cease to be a global supplier of Group B... and, for that reason, would lose the preference to provide quotations for new orders. [cf. testimony of witness C...]

k) The company "A... Brasil" was established in 1998 and began its production in 2002, in modern facilities of its own built in the city of ..., State of São Paulo, having as its main activity the design, development, engineering and production of functional systems and components for the automotive industry and home appliances.

l) The establishment of the company "A... Brasil" was carried out in two phases of investment: one until 2001 and another between 2011 and 2014, in which approximately €10,000,000.00 was invested in two factories, to increase production capacity. [cf. testimonies of witnesses C... and D...]

m) The Claimant, since the establishment of the company "A... Brasil", has always made loans to it of various amounts, to which underlie loan agreements concluded between the two companies, in which the amounts loaned, the terms and the respective interest are defined. [cf. testimony of witness C...]

n) With particular emphasis on the period between 2013 and 2016, the Brazilian economy went through the largest financial, political and social crisis of the last 50 years, with inflation rising and GDP reaching negative values.

o) This contraction in the Brazilian economy was also felt in the automotive sector, with declines of more than 20% being recorded in the production of new vehicles, due to the generalized reduction in consumption and, in particular, the purchase of new cars, with consumers in general resorting to the market for used vehicles. [cf. testimonies of witnesses C... and D...]

p) The described unfavorable Brazilian economic context for business activity had an impact on the activity of the company "A... Brasil", as it was sized for a certain production capacity that was forced to reduce because it was unable to sell the quantity of products it produced, as it did not have enough customers to sell them all. [cf. testimonies of witnesses C... and D...]

q) In the period between 2014 and 2016, the funds released from the operating activities of the company "A... Brasil" were always negative, namely [cf. documents Nos. 1, 2 and 3 attached to the application for arbitral pronouncement]:

[Table of cash flows from operating activities]

r) In the same period, the company "A... Brasil" presented the following negative results [cf. documents Nos. 1, 2 and 3 attached to the application for arbitral pronouncement]:

[Table of net results]

s) At the end of the year 2015, the negative carried-forward results had already consumed all equity and represented already more than double the capital stock of the company "A... Brasil", with the following evolution being verified in the period between 2011 and 2017 [cf. testimony of witness C...]:

[Table of equity evolution]

t) In that sequence, "A... Brasil" had to be restructured (for example, through the reduction from 470 to 320 workers and the renegotiation of purchases and payments to suppliers), having ceased to fully comply with all its obligations to third parties, continuing to comply with payments to its respective workers and suppliers – for the essentiality of each to the maintenance of its activity – but being unable to do the same regarding the servicing of debt relating to the financing granted by the Claimant. [cf. testimonies of witnesses C... and D...]

u) In the years 2014, 2015 and 2016, with regard to the loans granted by the Claimant, "A... Brasil" ceased to pay a very significant part of the principal instalments matured, as set out in the following table [cf. testimonies of witnesses C..., D... and E...]:

[Table of loan amounts, principal instalments matured, paid and unpaid]

v) In the said period and with regard to the same loans, "A... Brasil" partially paid the respective interest matured, the Claimant having recognized accountably the following values of interest: €669,964.24 in 2014, €165,249.00 in 2015 and €143,802.75 in 2016. [cf. PA and testimonies of witnesses C..., D... and E...]

w) In the same period, "A... Brasil" was unable to access financing through bank credit from the Brazilian financial system, due to its weak economic and financial situation and, also, the high interest rates charged by Brazilian banks, which reached up to 35% per year. [cf. testimonies of witnesses C..., D... and E...]

x) Although, in the period 2014 to 2016, it appeared completely unforeseeable what the evolution of the Brazilian economy would be and the short/medium-term perspective for "A... Brasil" was one of near collapse, the Claimant bet on the continuity of that company, firstly, because of its workers, but also because it did not have the financial capacity to accommodate the losses that would result from its insolvency and subsequent closure, and also because the Brazilian and Latin American markets are very important for the Claimant and for the group "F...". [cf. testimonies of witnesses C... and D...]

y) For that reason and given what is set out in proven fact w), the Claimant continued to always finance "A... Brasil", despite it not having economic and financial conditions to comply with the commitments arising therefrom, regarding capital amortization and interest payment, the Claimant having, in the period in question, sent approximately €10,800,000.00 to "A... Brasil". [cf. testimonies of witnesses C... and D...]

z) With a view to the capitalization of "A... Brasil", by way of strengthening its respective equity, thereby making them positive, in the year 2016, part of the loans granted by the Claimant to that company were transformed into supplementary contributions ("AFAC" (advance for future capital increase), in Brazilian terminology), ceasing to accrue interest, and in 2017 (with effect as of 31.12.2016), part of the same loans, specifically in the amount of €6,000,000.00 (six million euros), were converted into capital stock, with interest also ceasing to accrue, the Claimant having, by effect of the increase in the capital stock of its subsidiary, come to be remunerated via dividends. [cf. testimonies of witnesses C... and E...]

aa) In the period from 2002 to 2013, the Claimant recognized accountably the interest owed by "A... Brasil", resulting from the aforesaid loans, applying the effective interest method, and the same, like capital amortizations, were punctually paid. [cf. testimony of witness C...]

bb) In the period 2014 to 2016, as it had no perspective as to its receipt, the Claimant came to recognize accountably the same interest when it had a realistic expectation, that is, certainty that they were going to be paid and, therefore, that it would receive them, and the interest charged and recognized in that period was effectively received. [cf. testimony of witness C...]

cc) As of 2017, the economic and financial situation of "A... Brasil" experienced a significant improvement, particularly due to the conclusion of contracts with new customers in the automotive sector, whereby the company began again to be able to comply with its obligations to third parties, particularly as regards the financing granted by the Claimant, and the latter resumed adoption of the accounting method mentioned in proven fact aa), regarding interest owed [cf. testimonies of witnesses C... and D...]

dd) On 13 July 2018, the application for constitution of the arbitral tribunal was filed, which gave rise to the present case. [cf. CAAD case management computer system]

§2. UNPROVEN FACTS

1. With relevance to the appreciation and decision of the case, there are no facts that have not been proven.

§3. MOTIVATION ON FACTS

1. The facts pertinent to the judgment of the case were chosen and selected according to their legal relevance, in light of the plausible solutions to the legal questions, in accordance with the combined application of Articles 123(2) of the CPPT, 596(1) and 607(3) of the CPC, applicable by virtue of Article 29(1), subparagraphs (a) and (e), of the RJAT.

With respect to the proven facts, the conviction of the Tribunal was based on the facts alleged by the Parties, whose adherence to reality was not challenged, on the critical analysis of the documentary evidence in the case, including the administrative file, and also on the witness evidence produced.

Regarding the testimonies given by the witnesses listed by the Claimant who were examined – C..., General Director of the company "F..." (holding company of the group of companies where the Claimant and "A... Brasil" are inserted) since 1996 (facts on which examined: Articles 72 to 113 of the application for arbitral pronouncement), D..., General Director of the company "A... Brasil" since 2013 (facts on which examined: 91 to 96 and 98 to 113 of the application for arbitral pronouncement) and E..., accountant of the company "A... Brasil" since 2009 (facts on which examined: 91, 93 to 98, 102 to 107 and 110 of the application for arbitral pronouncement), who testified in a clear, objective and impartial manner regarding the facts to which they were examined, with direct knowledge of the same, which was revealed and proven by the way they explained them in detail, such that their testimonies merited complete credibility –, they corroborated, in essence, the factuality alleged by the Claimant, on which they testified.

III.2. LAW

§1. DELIMITATION OF THE SUBJECT MATTER

1. The matter of merit submitted to the appreciation of this Tribunal consists in determining whether the interest relating to the amounts loaned by the Claimant to the company "A... Brasil", under loan agreements concluded between the two entities in 2014, 2015 and 2016, were the subject of accounting and tax recognition in accordance with the principle of economic periodization.

The Claimant understands that, as the main condition for the recognition of income is the actual emergence of an increase in future economic benefits; thus, regarding interest, as follows from NCRF 20, revenue from the use by others of an entity's asset that produces interest should be recognized when it is probable that the economic benefits associated with the transaction will flow to the entity and the amount of revenue can be reliably measured.

The Claimant further states that there is no doubt as to the ability of revenue to be reliably measured, as what is at issue is the probability of economic benefits, in this case interest in the form of cash flows, flowing to the entity.

In this regard, the Claimant contends that, if it is probable that interest will be received, the income should be recognized, but if it is more probable that interest will not be received, the income should not be recognized, until that uncertainty is removed; therefore, both from an accounting perspective and from a tax perspective, in case of uncertainty linked to the flow of future economic benefits, interest should not be recognized in accordance with the effective interest method.

Accordingly, the Claimant understands that the corrections made by the AT are illegal, based on the purported obligation of IRC taxpayers to use, in any circumstance, the effective interest method, by violation of the income recognition rules arising from accounting standardization (NCFR 20), applicable by force of the model of partial dependence of tax law on accounting, enshrined in Article 17 of the IRC Code.

For its part, the AT contends that the procedure of charging the interest provided in the loan contracts, that is, recognizing as accounting the respective revenue only when the company already has certainty of its receipt, or better, in the exact measure of its receipt, is a procedure that contradicts not only accounting norms (Conceptual Framework and NCRF 20), but also tax norms (Article 18 of the IRC Code).

The Tribunal is also called upon to pronounce on the claims for reimbursement of the amounts of tax and compensatory interest paid and for payment of indemnifying interest.

§2. ON THE MERITS

§2.1. THE APPLICABLE LEGAL FRAMEWORK

A. THE APPLICABLE BODY OF NORMS

1. The tax legal appreciation of the situation sub judice must necessarily begin with the delimitation of the applicable body of norms, for which it is necessary to invoke the legal norms that appear concretely relevant, which will be considered in the version in force at the time of the facts.

Thus, the following norms must be taken into account:

IRC Code

Article 3 – Tax Base

1. IRC applies to:

a) The profit of commercial or civil companies in commercial form, cooperatives and public enterprises and that of other legal persons or entities referred to in subparagraphs a) and b) of Article 1(1) that engage, as a principal activity, in an activity of a commercial, industrial or agricultural nature;

(...)

1. For the purposes of the preceding number, profit consists of the difference between the values of net assets at the end and beginning of the tax period, with the adjustments established in this Code.

Article 17 – Determination of Taxable Profit

1. The taxable profit of the legal persons and other entities mentioned in subparagraph a) of Article 3(1) is constituted by the algebraic sum of the net result of the period and of the positive and negative variations in assets verified in the same period and not reflected in that result, determined on the basis of accounting and possibly corrected in accordance with this Code.

(...)

1. In order to permit the determination referred to in number 1, accounting must:

a) Be organized in accordance with accounting standardization and other applicable legal provisions for the respective sector of activity, without prejudice to observance of the provisions of this Code;

b) Reflect all operations carried out by the taxpayer and be organized in such a way that the results of operations and variations in assets subject to the general IRC regime can clearly be distinguished from those of the remainder.

Article 18 – Periodization of Taxable Profit

1. Income and expenses, as well as other positive or negative components of taxable profit, are attributable to the tax period in which they are obtained or incurred, regardless of their receipt or payment, in accordance with the regime of economic periodization.

2. Positive or negative components considered as relating to prior periods are only attributable to the tax period when, on the date of closing the accounts of the period to which they should have been attributed, they were unforeseeable or manifestly unknown.

(...)

Article 20 – Income and Gains

1. Income and gains are considered to be those resulting from operations of any nature, as a consequence of a normal or occasional action, basic or merely accessory, in particular:

(...)

c) Of a financial nature, such as interest, dividends, discounts, premiums, transfers, exchange differences, bond issuance premiums and those resulting from the application of the effective interest method to financial instruments valued at amortized cost;

(...)

Article 123 – Accounting Obligations of Enterprises

1. Commercial or civil companies in commercial form, cooperatives, public enterprises and other entities that engage, as a principal activity, in a commercial, industrial or agricultural activity, with head office or effective management in Portuguese territory, as well as entities that, although not having head office or effective management in that territory, have a permanent establishment there, are obliged to have accounting organized in accordance with the law which, in addition to the requirements indicated in Article 17(3), permits the verification of taxable profit.

(...)

Conceptual Framework of the System of Accounting Standardization

(Notice No. 15652/2009 of 7 September)

Underlying Assumptions

Accrual Basis (Economic Periodization)

1. In order to meet their objectives, financial statements are prepared in accordance with the accrual basis of accounting (or economic periodization). Through this basis, the effects of transactions and other events are recognized when they occur (and not when cash or cash equivalents are received or paid) being recorded in accounting and reported in the financial statements of the periods with which they are related. (...)

Income

1. The definition of income encompasses both revenues and gains. Revenues arise from the course of the ordinary (or normal) activities of an entity, being referred to by a variety of different names including sales, fees, interest, dividends, royalties and rents.

2. Gains represent other items that satisfy the definition of income and may, or may not, arise from the course of the ordinary (or normal) activities of an entity. Gains represent increases in economic benefits and as such are not different in nature from revenue. (...)

Recognition of Elements of Financial Statements

1. Recognition is the process of incorporating in the balance sheet and statement of results an item that meets the definition of an element and meets the recognition criteria established in paragraph 81. (...)

2. An item that meets the definition of a class must be recognized if:

(a) It is probable that any future economic benefit associated with the item will flow to or from the entity; and

(b) The item has a cost or value that can be measured with reliability.

(...)

Probability of Future Economic Benefits

1. The concept of probability is used in the recognition criteria to refer to the degree of uncertainty in which future economic benefits associated with the item will flow to or from the entity. The concept is in harmony with the uncertainty that characterizes the environment in which an entity operates. Assessments of the degree of uncertainty linked to the flow of future economic benefits are made on the basis of evidence available at the time of preparation of the financial statements. For example, when it is probable that a receivable owed by an entity will be paid, it is then justifiable, in the absence of evidence to the contrary, to recognize the receivable as an asset. (...)

Recognition of Assets

1. An asset is recognized in the balance sheet when it is probable that future economic benefits will flow to the entity and the asset has a cost or value that can be measured with reliability.

(...)

Recognition of Income

1. Revenue is recognized in the statement of results when an increase in future economic benefits related to an increase in an asset or a decrease in a liability has occurred and can be quantified with reliability. This means, in effect, that the recognition of income occurs simultaneously with the recognition of increases in assets or with decreases in liabilities (...)

Conceptual Framework of the System of Accounting Standardization

(Notice No. 8254/2015 of 29 July)

Underlying Assumptions

Accrual Basis

1. In order to meet their objectives, financial statements are prepared in accordance with the accrual basis of accounting. Through this basis, the effects of transactions and other events are recognized when they occur (and not when cash or cash equivalents are received or paid) being recorded in accounting and reported in the financial statements of the periods with which they are related. (...)

Income

1. The definition of income encompasses both revenues and gains. Revenues arise from the course of the ordinary (or normal) activities of an entity being referred to by a variety of different names including sales, fees, interest, dividends, royalties and rents.

2. Gains represent other items that satisfy the definition of income and may, or may not, arise from the course of the ordinary (or normal) activities of an entity. Gains represent increases in economic benefits and as such are not different in nature from revenue. (...)

Recognition of Elements of Financial Statements

1. Recognition is the process of incorporating in the balance sheet or statement of results an item that meets the definition of an element and meets the recognition criteria established in paragraph 81.

(...)

1. An item that meets the definition of a class must be recognized if:

(a) It is probable that any future economic benefit associated with the item will flow to or from the entity; and

(b) The item has a cost or value that can be measured with reliability.

(...)

Probability of Future Economic Benefits

1. The concept of probability is used in the recognition criteria to refer to the degree of uncertainty in which future economic benefits associated with the item will flow to or from the entity. The concept is in harmony with the uncertainty that characterizes the environment in which an entity operates. Assessments of the degree of uncertainty linked to the flow of future economic benefits are made on the basis of evidence available at the time of preparation of the financial statements. For example, when it is probable that a receivable owed by an entity will be paid, it is then justifiable, in the absence of evidence to the contrary, to recognize the receivable as an asset. (...)

Recognition of Assets

1. An asset is recognized in the balance sheet when it is probable that future economic benefits will flow to the entity and the asset has a cost or value that can be measured with reliability.

(...)

Recognition of Income

1. Revenue is recognized in the statement of results when an increase in future economic benefits related to an increase in an asset or a decrease in a liability has occurred and can be quantified with reliability. This means, in effect, that the recognition of income occurs simultaneously with the recognition of increases in assets or with decreases in liabilities (...)

Accounting Standards and Financial Reporting (NCRF)

(Notice No. 15655/2009 of 7 September)

NCRF 20 – Revenue

This Accounting Standard and Financial Reporting Standard is based on International Accounting Standard IAS 18 – Revenue, adopted by the original text of Commission Regulation (EC) No. 1126/2008 of 3 November.

(...)

Objective

1. The objective of this Accounting Standard and Financial Reporting Standard is to prescribe the accounting treatment of revenue, understood as income arising in the course of an entity's ordinary activities, such as sales, fees, interest, dividends and royalties. The fundamental question in revenue accounting is when to recognize it. Revenue is recognized when it is probable that future economic benefits will flow to the entity and those benefits can be reliably measured. This Standard identifies the circumstances in which these criteria will be satisfied and, therefore, revenue will be recognized.

Scope

1. This Standard should be applied in the accounting of revenue from the following transactions and events:

(...)

c) Use by others of the entity's assets that produce interest, royalties and dividends.

(...)

1. The use, by others, of the entity's assets gives rise to revenue in the form of:

a) Interest – charges for the use of money or its equivalents or amounts owed to the entity;

(...)

Recognition of Revenue

(...)

Interest, royalties and dividends

1. Revenue from the use by others of the entity's assets that produce interest, royalties and dividends must be recognized on the bases established in paragraph 30, when:

a) It is probable that the economic benefits associated with the transaction will flow to the entity; and

b) The amount of revenue can be reliably measured.

1. Revenue must be recognized on the following bases:

a) Interest must be recognized using the effective interest method;

(...)

1. Revenue is only recognized when it is probable that the economic benefits inherent in the transaction will flow to the entity. (...)

Accounting Standards and Financial Reporting (NCRF)

(Notice No. 8256/2015 of 29 July)

NCRF 20 – Revenue

Objective

1. The objective of this Accounting Standard and Financial Reporting Standard is to prescribe the accounting treatment of revenue, understood as income arising in the course of an entity's ordinary activities, such as sales, fees, interest, dividends and royalties. The fundamental question in revenue accounting is when to recognize it. Revenue is recognized when it is probable that future economic benefits will flow to the entity and those benefits can be reliably measured. This Standard identifies the circumstances in which these criteria will be satisfied and, therefore, revenue will be recognized. (...)

Scope

1. This Standard should be applied in the accounting of revenue from the following transactions and events:

(...)

c) Use by third parties of the entity's assets that produce interest, royalties and dividends.

(...)

1. The use, by third parties, of the entity's assets gives rise to revenue in the form of:

a) Interest: charges for the use of money or its equivalents or amounts owed to the entity;

(...)

Recognition of Revenue

(...)

Interest, royalties and dividends

1. Revenue from the use by others of the entity's assets that produce interest, royalties and dividends must be recognized on the bases established in paragraph 30, when:

a) It is probable that the economic benefits associated with the transaction will flow to the entity; and

b) The amount of revenue can be reliably measured.

1. Revenue must be recognized on the following bases:

a) Interest must be recognized using the effective interest method;

(...)

1. Revenue is only recognized when it is probable that the economic benefits inherent in the transaction will flow to the entity. (...)

Date of Effect

1. An entity must apply this Standard for periods beginning on or after 1 January 2016. (...)

B. THE RELATIONSHIP BETWEEN ACCOUNTING AND TAX LAW

1. As stated by Saldanha Sanches, we find proclaimed in the Constitution, "without ambiguities and with very few restrictions, the subjective right of IRC taxpayers – enterprises – to be taxed according to their actual profit – Article 104(2). (...)

The actual or real profit is a key concept of the constitutional fiscal law of enterprises, just as the needs and income of the family unit are in relation to natural persons. (...)

The taxation of the actual or real profit of enterprises constitutes a complex process that implies the assignment of the process of determining the tax fact to the taxpayer. The tax will be determined not only on the basis of the taxpayer's declaration, but also on the basis of a set of elements of proof collected by it and which constitute its commercial records (documents justifying accounting entries). (...)

The determination of profits comes to be made in accordance with the balance sheet and the preparation of the balance sheet comes to be the object of a set of tax norms, which make it so that, starting from the balance sheet model created and regulated by Commercial Law (the commercial balance sheet), a tax balance sheet emerges. (...)

We have, therefore, the tax balance sheet as the corrected commercial balance sheet, as is determined by Article 17(1) of the IRC Code. The tax balance sheet is supported by the same system of collection and recording of information that will lead to the commercial balance sheet.

(...)

The norms created by the IRC Code for the taxation of enterprises according to their accounting have, as their fundamental sense, to create limits on the choices of the accounting decision-maker, in order to avoid abusive behavior and make easier the tax verification of enterprises.

(...)

For example, when the IRC Code defined, in Article 18, under the heading "The Periodization of Taxable Profit", rules on the fiscal year in which costs or profits of the enterprise should be considered, it created norms that are binding in the area of Tax Law and in the area of Commercial Law. (...)

The concept of taxable profit is, therefore, the result of a complex and detailed normative provision (the balance sheet becomes a tax factual situation) where the legal system incorporates a large number of concepts extracted from accounting techniques and practices. (...)

It is from the functional nature of the balance sheet that any variation in assets that is realized should, in principle, be reflected in the increase or decrease of taxable profit."

This is why, according to the same author, "[t]he principal duty of cooperation by enterprises – since it acts as a presupposition for the fulfillment of the remainder – is the requirement contained in Article 98 [Article 123, in the version applicable here] of the IRC Code (...)".

Along these lines, Rui Duarte Morais states that the explanation resides here for "[t]he fiscal law assumes accounting profit as the "value" from which one should depart in determining taxable profit, that is, it enshrines a model of partial dependence between accounting profit and taxable profit.

However, these two "views" of profit do not identify themselves, such that the values of accounting profit and fiscal profit will hardly coincide. Not because they correspond to substantially different realities, but merely because the specific perspective (the concrete interests at stake) that presides over the quantification of each of them is different."

On this matter, Clotilde Celorico Palma states that "the model of partial dependence is the ideal form of determining fiscal profit, given that Accounting, in its precise description of the company's overall behavior, faithfully quantifies business profit. Accounting profit and fiscal profit do not oppose each other as distinct realities, with fiscal revenue being able to rest on accounting rules, making them compatible and safeguarding their respective specific interests." Accordingly, still according to the same author, "the accounting result is the general basis and the starting point of taxable profit, being subsequently subject to extra-accounting adjustments, positive and negative, in order to determine the definitive fiscal result. That is, in this case, the determination of taxable income is realized in two stages. In the first, by the uncritical acceptance of the accounting rules for determining net profit, which function as a prius in relation to the fiscal regulation of the balance sheet; in a second phase, corrections are provided for due to autonomous evaluations by fiscal law." The same author concludes, therefore, that the "concept of taxable profit among us is thus the result of a complex and detailed normative provision – the balance sheet becomes a tax factual situation – where the legal system incorporates a large number of concepts extracted from accounting techniques and practices."

Along the same lines, Manuel Henrique de Freitas Pereira states that "accounting provides a conceptual basis for the operational delimitation of taxable profit, but, given the objectives and principles that frame tax law, there cannot be an identification between it and the accounting result because accounting also has its own objectives and principles that must be safeguarded."

Furthermore, and in the same sense, Filipe de Vasconcelos Fernandes states that, "as to the determination of taxable profit, the relationship between Tax Law and Accounting Law rests on a relationship of partial dependence, in which the accounting result is the basis and the starting point for determining taxable profit, the latter being subject to extra-accounting adjustments, of a positive and negative order, in order to determine the definitive fiscal result. (...) certain tax norms may thus be considered accounting norms, in the sense of legal norms that express or concretize accounting principles: principles that become binding for enterprises through their transformation into legal norms, that is, through their positivization; see the case of specialization of fiscal years, now contained in Article 18(1) of the CIRC. (...) the tax balance sheet becomes a Tatbestand, by means of which the Portuguese tax system incorporates a large number of concepts extracted from accounting techniques and practices, without renouncing the construction of a normative presupposition of incidence specifically tax-based." Thus, according to the same author, "[b]y resting on an express referral to Accounting Law, tax law proceeds to a reception of the accounting technique, attributing to it the effects of an inclusion in tax normativity, under the spectrum of a relationship of partial dependence that taxpayers are responsible for respecting and offering realization."

C. THE PRINCIPLE OF ECONOMIC PERIODIZATION

1. The principle of economic periodization or specialization of fiscal years is positively stated in Article 18(1) of the IRC Code and translates into the rule that should be considered as gains or losses of a certain fiscal year the revenues and costs, as well as other positive or negative components of taxable profit, that relate to that fiscal year, regardless of the fiscal year in which they materialize.

In number 2 of that same Article 18 an exception is provided for positive or negative components of taxable profit that, on the date of closing the accounts of a certain fiscal year, were unforeseeable or manifestly unknown.

The principle of specialization of fiscal years derives from the periodization of results that is imposed by management and information needs, being "characterized by the division of the company's life into time intervals and by the attribution to one of them of the components, positive and negative, that make it possible to determine the result that corresponds to it", requiring that specialization "the carrying out of an inventory at the end of the fiscal year, from which there results the need to attribute to each fiscal year all the revenues and costs that are inherent to it and only those"; in this way, "the annual periodization of the tax implies that both income and expenses (and fiscally relevant variations in assets) be attributed to each tax period. This attribution results essentially from the application of accounting norms, precisely because our legislator understood that the periodization rules provided therein offer a coherent, reliable and efficient system also for tax purposes."

As mentioned by Tomás Cantista Tavares, "the temporal periodization of revenues and expenses is an immanent characteristic of the notion of income. Revenue is obtained by the comparison between two defined temporal points. (...)

The periodization of the income of companies thus fits into two major principles that interpenetrate in a relationship of complementarity – and sometimes of opposition: on the one hand, the set of technical and operational rules that define the temporal attribution of positive and negative components of income, clustered in the so-called practical principle of specialization of fiscal years or, in current terminology, in the principle of accrual. On the other hand, the material principle of justice, concretely...

[TRUNCATED - character limit reached]