IRS Rental Income Deductions: CAAD Arbitration on Category F Expenses and Negative Net Income (Case 338/2016-T)

ARBITRAL DECISION

I. Report

1. A…, taxpayer no. … and B…, taxpayer no. …, resident in …, …, … floor, …-… Lisbon, requested the constitution of a tax arbitral tribunal with a view to declaring illegal the income tax (IRS) assessment act relating to the year 2014 which, after the legal deductions were made, resulted in a refund amount of € 5,051.43. As a consequence of the declaration of illegality of the said act, the Requesters request that the annulment of the assessment in question be determined.

2. As the basis for their request, the Requesters allege, in summary, that the questioned assessment is vitiated by illegality because:

a) Certain expenses totalling € 13,212.68 were not considered in determining the net income of Category F – rental income;

b) The assessment does not reflect the negative net result of the family unit determined in Category F, totalling € 40,470.36.

1. The request for constitution of the arbitral tribunal, presented on 23-06-2016, was accepted by the President of CAAD and automatically notified to the Respondent, the Tax and Customs Authority (AT), on 12-07-2016.

2. Pursuant to the provisions of paragraph a) of section 2 of article 6 and paragraph b) of section 1 of article 11 of Decree-Law no. 10/2011, of 20/01, as amended by article 228 of Law no. 66-B/2012, of 31/12, the Ethics Council designated as arbitrator of the sole arbitral tribunal the signatory, who communicated acceptance of the assignment within the applicable period and notified the parties of such designation on 29-08-2016.

3. Having been duly notified of such designation, the parties did not express the intention to refuse the arbitrator's designation, in accordance with the combined provisions of article 11, section 1, paragraphs a) and b) of the RJAT and articles 6 and 7 of the Code of Ethics.

4. Thus, in accordance with the provisions of paragraph c) of section 1 of article 11 of the RJAT, as amended by article 228 of Law no. 66-B/2012, of 31/12, the sole arbitral tribunal was constituted on 13-09-2016.

5. Regularly constituted, the arbitral tribunal has substantive competence, given the provisions of articles 2, section 1, paragraph a), of the RJAT.

6. The parties possess legal personality and capacity and have standing (articles 4 and 10, section 2, of the RJAT, and article 1 of Order no. 112-A/2011, of 22/03).

7. Given the knowledge derived from the procedural documents submitted by the parties, which is deemed sufficient for the decision, the Tribunal decided to waive the meeting referred to in article 18 of the RJAT.

8. The proceedings are not vitiated by any nullities and no other issues have been raised that would prevent consideration of the merits of the case, with all conditions being met for a final decision to be rendered.

II. Factual Background

1. With relevance to consideration of the issue raised, the following factual elements are noted:

11.1. Regarding income earned by the respective family unit in 2014, the Requesters submitted on 29-05-2015 the periodic income declaration form 3, for IRS, which was received on the same date by the competent service of the Tax and Customs Authority (AT).

11.2. Together with declarative annexes relating to other categories of income earned by the entire family unit, the said declaration includes Annex F – Rental Income.

11.3. This declarative annex shows that the taxpayers earned in that year 2014 an amount of € 58,433.28 in gross income from Category F of IRS and incurred a total value of € 112,720.36 of deductible expenses, of which € 64,058.75 is attributed to taxpayer A – A… – and € 48,661.61 to taxpayer B – B… – (Doc. 1, annex to the Respondent's reply).

11.4. The said declaration also shows that the Requesters, resident in national territory, did not opt for inclusion of the income in question.

11.5. Within the scope of a procedure to verify the amounts of deductible expenses for the purpose of determining net income in Category F of IRS, the AT, following review of the evidence presented by the taxpayers on 03-07-2015, considered certain expenses not to be relevant for that purpose.

11.6. Thus, through letter no. …, of 11-08-2015, it notified the taxpayers to, within a period of 15 days, submit a corrected IRS declaration for 2014 altering the expenses of the rented properties taking into consideration, for that purpose, only those identified in the said letter, excluding the remainder, in accordance with the detailed grounds set out therein (Doc. 2).

11.7. Through the same letter, the taxpayers are also notified to, if they wish, exercise in writing the right of prior hearing in accordance with article 60 of the General Tax Code (LGT), with a period of 15 days being set for that purpose.

11.8. In exercise of said right, the Requesters, on 24-08-2015, submitted documentary evidence of the declared expenses, accompanied by a statement setting out their justification (Doc. 3).

11.9. Following review of the documents and statement submitted in exercise of the right of prior hearing, in accordance with section 7 of article 60 of the LGT, the AT "decided to correct the elements declared as expenses on rental income in Annex F, with expenses totalling € 98,903.64 being accepted and proven."

11.10. From the said decision and its respective justification, communicated to the taxpayers through letter dated 12-02-2016, from the Finance Service of Lisbon…, the values accepted by taxpayer and the justification for each document presented regarding non-accepted expense are highlighted.

11.11. While the AT accepted all expenses attributed to taxpayer B – B… – in the amount of € 48,661.61, those for which taxpayer A – A… – was responsible were, however, subject to official correction.

11.12. Of the respective expenses declared, attributable to taxpayer B, in the amount of € 64,058.75, the AT considered expenses of € 50,242.03 to be accepted and proven.

11.13. In accordance with the said letter (Doc. 4), the deductibility of the expenses indicated in the following table was refused, based on the following grounds:

a) Document for acquisition of "domestic appliances". Article 41 of the Income Tax Code (CIRS) provides that from rental income "there shall be deducted expenses for maintenance and conservation". Among maintenance expenses, the following are admissible by way of example: energy and maintenance of elevators, escalators and lifts, doormen; lighting, heating or central air conditioning; property management; cleaning; insurance premiums. As regards conservation expenses, although article 41 does not specify them, all expenses necessary to perform and bear to maintain the condition of the property and which are not encompassed within the concept of maintenance expenses should be considered as such. Thus, we can consider as conservation works, the responsibility of the lessor, repair and general cleaning works of the property and its dependencies and all interventions intended to maintain or restore the property with a level of habitability identical to that existing on the date of execution of the contract and those required by the Administration, in view of general or local regulations applicable, to provide it with the habitational characteristics existing at the time of granting the use license. By contraposition, therefore, construction works that alter the structure of the property shall not be deductible; acquisition of furniture or domestic appliances; installation of air conditioning equipment and property valorization works;

b) Illegible document;

c) Document with transport services. See paragraph b);

d) Document paid outside the 2014 fiscal year. The concept of expenses and income follows the principle of specialization of the fiscal period and adopts the "cash" system;

e) Document without identification of the property or part of property;

f) Description of the invoice mentions "Works executed at property no. … of Street …— …", that is, they were works common to the property. Checking the registry one finds that it is composed of 3 floors susceptible of independent use, namely basement, ground floor and 1st floor. With the ground floor and 1st floor being rented, it was allocated on the basis of the permilage of each floor and in accordance with section 1 of article 41 of the CIRS, 1/3 of the value to each rented floor, that is €12,320.05 for the ground floor and €12,320.05 for the 1st floor.

11.14. Notwithstanding the official correction made by the AT, reducing the value of expenses considered relevant for determining net income in Category F from € 112,720.36 to € 98,903.64 and this value still being higher than that of declared income, the respective assessment does not reflect the difference as an amount to be carried forward to subsequent years (Doc.1).

11.15. The assessment in question, involving amounts encompassed in various categories of income subject to IRS, determines a refund amount of € 5,051.43, being notified to the taxpayers on 28-03-2016 (Doc. 1).

1. There are no other facts relevant to the decision on the merits that have not been proven.

III. Legal Issues

1. The claim of the Requesters, directed toward the annulment of the IRS assessment relating to income earned by them in 2014, is based on the following assumptions and justification summarized:

13.1. Incorrect official correction of declared expenses relating to the determination of net income in Category F, by violation of articles 8 and 41 of the CIRS.

13.2. Incorrect disregard of the negative net result in Category F to be carried forward to subsequent years, in violation of the provisions of article 55 of the said Code;

13.3. Incorrect equating of properties in full ownership (vertical property) with autonomous units in horizontal property regime for purposes of limiting the deduction of maintenance and conservation expenses, by violation of article 41 of the CIRS.

13.4. Furthermore, the AT's decision constitutes violation of article 41, section 1, of the CIRS, by non-conformity with the constitutional principle of contributive capacity, and subsidiarily, violation of article 60, section 1, a) of the LGT, due to the omission of the right of prior hearing regarding the refusal of deductibility of invoices nos. …, … and … .

1. The present request for arbitral pronouncement thus concerns the assessment of the legality of the corrections made by the AT regarding expenses relevant to determining net income in Category F, as well as the fact that the assessment for 2014 does not reflect, as an amount to be carried forward to subsequent years, the negative net result determined in said income Category.

2. Subsidiarily, the violation of the right to prior hearing is raised with reference to the non-acceptance of specific deductible expenses in the scope of said income category, documented by various invoices identified in the request.

3. In conclusion, the Requesters request approval of their request, with the consequent declaration of annulment of the IRS assessment for 2014 on the grounds of illegality due to violation of law, summarized in the following terms:

a) Due to error in the application of law resulting from violation of the provisions of article 55, section 2, of the Income Tax Code, on the grounds of the disregard of the negative net result determined in said Category F, in the amount of € 40,470.36, to be carried forward to positive net results determined in subsequent years in that Category.

b) Due to error in the application of law resulting from violation of the provisions of article 41, section 1, of the Income Tax Code, on the grounds of the illegal interpretation of the first and second blocks of said section leading to the improper equating of the specific and autonomous requirements of each of those blocks, for the purpose of limiting the deduction of expenses in the amount of € 12,320.05, actually incurred and documentary proven by the male Requester, to income of Category F, an amount which, when added to the negative net result determined in said Category F, would be susceptible of deduction to positive net results determined in that Category in subsequent years.

c) Due to error in the application of law resulting from violation of the provisions of articles 8, 41, section 1, and 55, section 2, of the Income Tax Code, and article 2 of the Property Tax Code (IMI), on the grounds not only of the incorrect interpretation of article 41, section 1, referred to in the preceding request [b)], but also the illegal equating of properties in vertical ownership with autonomous units, for purposes of limiting the deduction of expenses in the amount of € 12,320.05, actually incurred and documentary proven by the male Requester, to income of Category F, because the basement of the property in full ownership is not being rented;

d) Due to error in the application of law resulting from violation of the provisions of article 41, section 1, of the Income Tax Code, on the grounds of the disregard of the amount of € 1,277.66 incurred by the male Requester as maintenance expenses legally deductible to income of Category F;

e) Due to error in the application of law resulting from the application of article 41, section 1, of the Income Tax Code, non-conformable with the constitutional principle of contributive capacity, inherent in article 104, section 1, of the Constitution of the Portuguese Republic (CRP).

f) Subsidiarily, should the preceding requests not be upheld, due to error in the application of law resulting from violation of the provisions of article 60, section 1, paragraph a), of the LGT, on the grounds of the illegal omission of the right of prior hearing of the male Requester regarding the arguments advanced by the AT for the refusal of deductibility of invoices nos. …, … and … ."

1. Considering the request formulated by the Requesters, as well as the factual background established, the following emerge as the main issues submitted to consideration of this Arbitral Tribunal: those relating to the deductibility of expenses in determining net income in Category F and the possibility of carrying forward to subsequent years losses incurred by taxpayers not deducted in the year in which they were incurred due to insufficient income.

Specific Deductions within Category F

1. In the taxation of personal income, the legislator of the IRS expressly adopted the principle of taxation of net income growth. Thus, within the scope of the various categories of income subject to IRS, the taxation of income earned by taxpayers resident in Portuguese territory is, as a rule, based on the net income earned in each year by their respective holders.

2. The net income of each category is the value resulting from the deduction from the respective gross income of expenses considered indispensable for its obtainment.

3. Regarding rental income, which is part of Category F of income subject to IRS, the expenses relevant to its obtainment are set out in article 41 of the CIRS, the text of which, in force at the date to which the questioned assessment relates, was as follows:

Article 41

Deductions

1 - From the gross income referred to in article 8, there shall be deducted maintenance and conservation expenses incumbent on the taxpayer, actually incurred and documented, as well as the municipal property tax and stamp duty imposed on the value of properties or parts of properties the income of which is subject to taxation in the fiscal year.[i]

2 - In the case of an autonomous unit of a property under horizontal property regime, the conservation, use and other charges which, under civil law, the condominium owner is obligated to incur, actually incurred and documented, shall also be deducted.[ii]

3 - In subletting, the difference between the rent received by the sublessor and the rent paid by this person does not benefit from any deduction."i

1. The legal provision cited defines, without, however, typifying, the expenses and charges – considered indispensable for obtaining the income, making their deductibility dependent on the following legal requirements:

• They configure themselves as maintenance and conservation expenses;

• They are incumbent on the taxpayer;

• They are actually incurred and documented.

1. In addition to the expenses and charges referred to, the IMI and stamp duty imposing on the value of rented property, the income of which is subject to taxation in the fiscal year, are also deductible for determining the net income of the Category.

2. From the correction of deductible expenses made by the AT based on the understanding that they do not meet the requirements of the legal provision cited, the Requesters "accept the non-deductibility of the expenses contained in (i) invoice no. …, of 13 December 2014, in the total amount of € 365.00, (ii) invoice no. …/…, of 18 February 2014, in the total amount of € 14.90, (iii) invoice no. …, of 14 January 2015, in the total amount of € 130.00, and (iv) invoice no. …/…, of 18 December 2014, in the total amount of € 67.65."

3. However, " ... they cannot conform with the disregard of the other expenses incurred within Category F of IRS, in the total amount of € 13,597.71 [corresponding to the proportionate share of expenses incurred by the male Requester evidenced through invoices no. …/… (in the amount of € 129.63), no. …/… (in the amount of € 129.38), no. …/… (in the amount of € 357.73), no. …/… (in the amount of € 372.87), no. …/… (in the amount of € 288.05) and no. …/… (in the amount of € 12,320.05 — relating to one of the 3 floors)."

4. Of the expenses disregarded by the AT, whose decision is contested by the Requesters, it is verified that they total € 13,597.71, with the amount of € 1,277.66 relating to the acquisition of domestic appliances and € 12,320.05 relating to expenses for works common to the property in proportion to the non-rented part.

Regarding Charges for the Acquisition of Domestic Appliances

1. Regarding the exclusion from the scope of deduction of charges for the acquisition of domestic appliances, the AT's decision is justified in the following terms: "Article 41 of the CIRS provides that from rental income 'there shall be deducted maintenance and conservation expenses'. Among maintenance expenses, the following are admissible by way of example: energy and maintenance of elevators, escalators and lifts, doormen; lighting, heating or central air conditioning; property management; cleaning; insurance premiums. As regards conservation expenses, although article 41 does not specify them, all expenses necessary to perform and bear to maintain the condition of the property and which are not encompassed within the concept of maintenance expenses should be considered as such. Thus, we can consider as conservation works, the responsibility of the lessor, repair and general cleaning works of the property and its dependencies and all interventions intended to maintain or restore the property with a level of habitability identical to that existing on the date of execution of the contract and those required by the Administration, in view of general or local regulations applicable, to provide it with the habitational characteristics existing at the time of granting the use license. By contraposition, therefore, construction works that alter the structure of the property shall not be deductible; acquisition of furniture or domestic appliances; installation of air conditioning equipment and property valorization works.";

2. According to the Requesters, the expenses in question relate to the acquisition of kitchen equipment, more specifically cookers and washing machines, with a view to replacing equipment that was damaged in the rented properties.

3. Basing their understanding with respect to the deductibility of the referred expenses, the Requesters state that:

"82.

The mentioned properties were always equipped with a cooker and washing machine, being this the condition in which they were rented, and it being a contractual obligation of the lessor to maintain them in this condition — see rental contracts which are hereby attached together as Document no. 5.

Consequently, faced with the damage to those items, it fell to Requester A…, as lessor, the obligation to proceed with their replacement, in order to restore the initial conditions of habitability of the leased premises, ensuring that the lessees suffer no diminution of enjoyment of the property.

And according to the justification presented by the AT, these expenses configure conservation expenses, inasmuch as they are subsumed to "interventions intended to maintain or restore the property with a level of habitability identical to that existing on the date of execution of the contract".

It is therefore incomprehensible how the deductibility of such expenses can be refused when they are subsumed to the very interpretation the AT makes of article 41 of the Income Tax Code.

1. Emphasizing that it is incomprehensible the refusal by the AT of the deductibility of equipment that are an integral part of the leased premises and which are, moreover, undoubtedly essential to ensure the minimum habitability conditions of any property let for residential purposes, the Requesters further invoke the Arbitral Decision rendered in Case no. 435/2014-T: to the effect that "Should be included in the concept of maintenance expenses, all those necessary, including in these concepts, the expenses incurred by the owner and lessor, such as the renewal of equipment relating to the property, and this includes kitchen and bathroom equipment.

This is because kitchen and bathroom equipment are an integral part of the building"

1. In response to the allegation of the Requesters, the AT comes to question their statement that the acquired equipment were damaged, arguing that no evidence was provided "regarding the alleged damage". The Respondent further questions the assertion of the Requesters that they were obligated to replace the equipment, which it considers "manifestly false and contradicted by the documents submitted by the Requesters."

2. Continuing with its thesis on the alleged falsity of the Requesters' assertion, the Respondent states "How can the Requesters claim that the equipment was purchased to replace damaged equipment in the course of the lease, when the two rental contracts were executed at dates subsequent to the acquisition of the domestic appliances?

That is, how could equipment purchased in February 2014 be intended to replace damaged equipment during leases executed in March and April 2014?"

1. The Respondent further questions the reference made by the Requesters to the circumstance that the equipment in question could be integrated into the notion of integral parts of the property, concluding that the interpretation proposed by the Requesters has no support in the letter of the law, further stating in this regard, "that the current wording of article 41 of the CIRS (by virtue of Law 82-E/2014, of 31/12), has definitively clarified – if any doubts existed – that the expenses in question are not deductible."

2. In assessing the legality of the questioned decision, the Arbitral Tribunal cannot fail to adhere to the justification contained in the administrative act, being irrelevant for that purpose reasons which could, perhaps, justify the decision but which were not expressly stated as grounds of the act. It is thus prohibited from weighing reasons of fact and law which, not appearing in that justification, come to be subsequently invoked (In this sense, among many other decisions regarding the inadmissibility of post-hoc justification, see Administrative Court of Appeal, Decisions of 12.3.2003, Case 01661/02 and of 27.1.2016, Case 043/16).

3. Without need, therefore, for more extensive explanations, the Tribunal will consider only the justification expressly stated in the questioned administrative act and this is limited to expressing the understanding that expenses relating to the acquisition of domestic appliances are not contemplated in the concepts of maintenance and conservation expenses, and therefore are excluded from the scope of the specific deduction provided for in article 41 of the CIRS.

4. As already referred above, the expenses and charges referred to in the cited rule constitute specific deductions of Category F, aimed at determining the respective net income. On the other hand, they constitute gross income of the same category not only rental income, in the civil law sense, but also other economic realities. In addition to being considered as such the amounts relating to the granting of use of property or part thereof, the amounts relating to services connected with such granting are also considered as rental income and, where applicable, those relating to the lease of machinery and furniture installed in the leased property (See CIRS, article 8, sections 1 and 2, paragraphs a) and b);

5. In the specific situation under analysis, it is found that the rental contracts executed by the Requesters include equipment listed in attached inventory, namely cooker plate, oven, extractor, water heater and dishwashing machine.

6. In the light of experience, it is not difficult to admit that the total rent stipulated in the contracts also reflects compensation for the granting of the referred equipment and, to that extent, the costs relating to their acquisition cannot fail to integrate the maintenance and conservation expenses referred to, without, however, defining article 41 of the CIRS.

7. It is true, as the Respondent rightly points out, that, in accordance with the current wording of the cited rule, expenses relating to the acquisition of domestic appliances are expressly excluded from that scope, among others.

8. This exclusion, resulting from an amendment introduced by Law no. 82-E/2014, of 31/12, applies only to situations occurring after the effective date of said law, since that law does not attribute retroactive effect to the new wording introduced to that provision.

9. Contrary to the conclusion which the Respondent draws from this amendment introduced to the rule by said Law, it is understood that, prior to its effective date, such charges would be deductible, provided that their connection with the source of income subject to taxation was proven. Only thus would it not be if retroactive effect were attributed to that amendment, which is not the case here.

10. In these terms, it is concluded that the Requesters are correct regarding the deductibility of expenses relating to the acquisition of domestic appliances installed in the rented properties and, therefore, the decision in question should be revised in order to include in expenses that constitute specific deduction of Category F for 2014 the amount of € 1,277.66 relating to those acquisitions.

Regarding Charges for Works Common to the Property

1. Regarding expenses for works executed in partially rented property in the year to which the income relates, the AT considered that they would only be deductible in proportion to the value of each rented floor, in the following terms: "Description of the invoice mentions 'Works executed at property no. … of Street …–…', that is, they were works common to the property. Checking the registry one finds that it is composed of 3 floors susceptible of independent use, namely basement, ground floor and 1st floor. With the ground floor and 1st floor being rented, it was allocated on the basis of the permilage of each floor and in accordance with section 1 of article 41 of the CIRS, 1/3 of the value to each rented floor, that is € 12,320.05 for the ground floor and 12,320.05 for the 1st floor".

2. Disagreeing with the AT's decision, the Requesters consider that the value of the expenses relating to the property located on Street …, no. …, in …, which is subject to lease, should be entirely deductible, in accordance with article 41 of the CIRS.

3. They base the understanding they express, essentially, in the following terms:

"65.

(…) being the said property in vertical ownership, the interpreter (rectius the applicator of the law, such as the AT), in an abusive reading of the legal provisions, cannot pretend to equate the divisions susceptible of independent economic use to autonomous units in horizontal property regime, which, as such, are classified in law as properties.

(…)

Consequently, it is incomprehensible the AT's position of partial non-acceptance of the referred expenses incurred on the grounds that only two of the parts susceptible of independent use were rented in 2014, when it is clear from the combined reading of the provisions of articles 8 and 41, section 1, of the Income Tax Code, that the deductibility of maintenance and conservation expenses shall be made against the income earned in Category F.

1. Therefore, according to the Requesters, "The interpreter of the tax law cannot, therefore, by the hermeneutics of the Income Tax Code, namely by its articles 8 and 41, section 1, pretend to equate these two regimes, treating distinct realities as equal, when it is clear in civil law and tax law that these realities merit different treatment: property is any fraction of territory belonging to the patrimony of a natural or legal person and each autonomous unit, under horizontal property regime, is regarded as constituting a property."

2. In support of the thesis they sustain, the Requesters propose the following interpretation of the provision of article 41 of the CIRS:

Article 41, section 1, of the Income Tax Code treats in a distinct manner, on the one hand, the deduction of all "maintenance and conservation expenses" incumbent on the taxpayer, without any reference being made to property or parts of property, and, on the other hand, the right to deduction of the Municipal Property Tax ("IMI") and Stamp Duty ("IS").

Only this second block of section 1 of article 41, which regulates the right to deduction of IMI and IS, is conditional on properties or parts of property the income of which is subject to taxation in the fiscal year.

Therefore, the limitation imposed in the phrase segment "on the value of properties the income of which is subject to taxation in the fiscal year", of the second block, applies only to IS and IMI – and not to expenses – since that expression "the income of which is subject to taxation in the fiscal year" is not preceded by a comma.

By contrast, if that comma existed, the expression "properties the income of which is subject to taxation in the fiscal year" would apply to both blocks of section 1 of article 41 of the Income Tax Code, that is, would apply to said maintenance and conservation expenses and also to IS and IMI.

But this is not the case, since the legislator did not introduce the said comma in the article.

And it is understandable that it be so, because IMI and IS have a continuous, periodic character, just like rents, related one-to-one year by year, while conservation and maintenance expenses have a one-off incidence and always have as their economic counterpart rents from various years: previous rents related to the damage that will be repaired and which result directly from the use of the leased property, and current and/or subsequent rents which would only be possible if the repair is performed.

And this interpretation of article 41, section 1, is confirmed by the historical legislative evolution of said provision.

In fact, the original version of the provision – introduced by Law no. 75/93, of 20 December – contained in the then article 40 had the following wording "From the gross income referred to in article 9, there shall be deducted maintenance and conservation expenses incumbent on the taxpayer, actually incurred and documented".

Only with the entry into force of Law no. 30-G/2000, of 29 December, was the letter of the said article altered, then coming to provide that "From the gross income referred to in article 9, there shall be deducted maintenance and conservation expenses incumbent on the taxpayer, actually incurred and documented, as well as the municipal levy imposed on the value of properties or parts of properties the income of which has been included" – highlights of our authorship which evidence the alteration to the wording of said section.

The said wording remained substantially unchanged following this legislative amendment, merely substituting the reference to "municipal levy" for "municipal property tax and stamp duty".

This means that the second block of section 1 of article 41 of the Income Tax Code should be read in an autonomous and independent manner from the first block, each having its own requirements.

Furthermore, common sense dictates that the right to deduction of expenses cannot be related to fortuitous circumstances of the month in which works begin and/or end, or with the date on which the issuance of the respective invoice occurs – closer to or further from the end or beginning of the fiscal year – with the real commercial possibility of there being or not sufficient time to terminate a lease and begin another.

Consequently, in the case sub judice, it was required that the value of expenses incurred by Requester A… in the property located on Street …, no. …, … be entirely considered as a loss to be carried forward to subsequent fiscal years, in accordance with the provisions of article 55, section 2, of the Income Tax Code.

1. The Respondent, not following the understanding expressed by the Requesters, above transcribed in its essential aspects, expresses its position in the following terms:

… the articulation of the rules set out in articles 8 and 41 of the CIRS leaves no room for doubt as to the necessity of a nexus between the deduction of conservation expenses and properties, or parts thereof, generating rental income.

In effect, article 41/1, initial part, of the CIRS, when referring to the 'gross income referred to in article 8', is thereby already referring to property rents, with article 8/2-a) of the same statute being crystal clear when it states that 'amounts relating to the granting of use of property or part thereof (…) are regarded as rents'.

Therefore, the argument of the alleged absence of a comma in the 1st segment of article 41/1 of the CIRS is completely refuted when the good interpreter of the law articulates that rule with what article 8 of the CIRS has long provided.

(...)

Given this, let us turn to the subsidiary argument raised by the Requesters, namely that the Respondent made an abusive interpretation of the law when pretending to equate the 3 divisions susceptible of independent use with autonomous units under horizontal property regime, thus disregarding the value of the expense relating to the non-rented basement.

However, here too the Requesters lack reason and once again make a skewed interpretation of the applicable rules.

In the first place, the Requesters bring to bear the civil law notion of property, when they well know (or, at least, should know) that in tax law the tax law notion of property applies.

In the second place, the Requesters bring to bear the tax law notion of property set out in article 2 of the Property Tax Code ("CIMI"), when they well know (or, at least, should know) that in the context of IRS the notion of property set out in article 8/3 of the CIRS applies.

Therefore, in the context of IRS, the notion of property contained in article 8/3 applies, which provides that: 'for IRS purposes, (…) urban property is considered any building incorporated in the soil and the land that serves as its ground (…).'

Now, articulating article 8/3 with the already cited article 8/2-a), both of the CIRS, no doubt can remain as to the necessity of a nexus between the deduction of conservation expenses and properties, or parts thereof, generating rental income.

A nexus that does not exist as to the basement of the property in question here, since it is not rented and, thereby, incapable of generating rental income.

In the third place, even if one were to follow the tax law notion of property set out in the CIMI, the thesis of the Requesters continues to fail, since, as one knows (or, at least, should know), 'each floor or part of property susceptible of independent use is considered separately in the property registration, which also discriminates the respective taxable property value.'

As SILVÉRIO MATEUS and CORVELO DE FREITAS explain, 'Another aspect that should be highlighted in the registry concerns the need to make evident the autonomy which, within the same property, can be attributed to each of its parts, functionally and economically independent. In such cases, the property registration should not only make reference to each of these parts but should make express reference to the taxable property value corresponding to each of them. An example that can illustrate this situation is the case of an urban property, not established under the horizontal property regime and composed of various floors. Legally this property constitutes a single unit and its ownership cannot be attributed to more than one owner, without prejudice to the regime of co-ownership. However, as each of these units can be subject to lease or any other use by its respective owner, the registry must evidence these units and must assign taxable property value to each of them.'

In summary, the calculation made by the Respondent and which led to the disregard of the expense regarding the non-rented basement not only finds support in article 8 of the CIRS, but also the calculation underlying that disregard is legally supported in article 12/3 of the CIMI.

Therefore, the Respondent made no abusive reading, but merely followed what tax law clearly provides."

1. Analyzing the positions in confrontation, the Tribunal cannot fail to follow the understanding conveyed by the AT, in the terms and with the justifications above transcribed.

2. In effect, the tax legislator attributes autonomy to parts of properties functionally and economically independent, both for purposes of their registration in the property registries and taxation in the area of municipal property tax, and for purposes of taxation of the respective income. In the area of IRS, the rule of article 8, section 2, paragraph a), leaves no doubt as to this equating, by qualifying as rental income "Amounts relating to the granting of use of property or part thereof ...".

3. For its part, the rule of article 41 of the same Code, in articulation with the principle of net income growth, presupposes that deductible expenses and charges be closely connected with the source generating the income or, in other words, that such expenses be indispensable to the formation of income.

4. Thus, in the situation under analysis it is verified that the expenses in question result from works common to the property and that the AT, officially, disregarded, for purposes of determining the specific deduction of the category, a portion of the respective value in proportion to the value of the non-rented part.

5. In these terms, it is concluded that the request is unfounded regarding the consideration of the totality of expenses which, relating to the property in question, are attributable to Requester A…, the questioned decision being maintained in this respect.

Regarding Losses to be Carried Forward to Subsequent Years

1. Notwithstanding the amount of charges considered by the AT as encompassed within the scope of the specific deduction of Category F exceeding the value of the corresponding gross income of the same category, this excess was not considered as a loss to be carried forward to subsequent years, as shown in the assessment statement (Doc. 1).

2. According to the allegation of the Requesters, the IRS assessment for 2014 "by not considering the negative net result determined by the Requesters in the scope of Category F as a loss to be carried forward to subsequent fiscal years in accordance with expressly provided in article 55, section 2, of the Income Tax Code, is illegal, on the grounds of error in the application of law (…) which constitutes a violation of law and consequently, under the provisions of article 163, section 1, of the Code of Administrative Procedure ("CPA"), applicable ex vi of article 2, paragraph d), of the CPPT, determines the annulability of said IRS assessment (…) Annulment which is hereby requested"

3. From the explanatory note of the assessment (Doc.1), no justification appears supporting the non-consideration of such losses which, moreover, was not subject of notification to the taxpayers.

4. However, in its reply to the request formulated by the Requesters, the Respondent expresses its position on this matter in the following terms:

"20.

In the first place, the Requesters expressly declared themselves to be resident on the Portuguese mainland (DOCUMENT 1 HEREBY ATTACHED – Form 3 of IRS, section 5).

In the second place, the Requesters expressly declared not to opt for inclusion of the rental income earned by them (DOCUMENT 1 HEREBY ATTACHED – Form 3 – Annex F of IRS, section 5-B, field 11).

(as, indeed, they had already done in the 2013 period – DOCUMENT 2 HEREBY ATTACHED)

Therefore, by not opting for inclusion, the here resident Requesters chose to tax separately the income of the "F" category through the application of a fixed autonomous rate on such gross income,

(…) Although the obligation remained for them to include such income in the respective IRS declaration.

In summary, the Requesters, being present, as they were, with the requirement of national residence set out in article 22, section 3, paragraph b) of the CIRS and having opted, as they actually did, for non-inclusion of income of Category "F", naturally they are now barred from the possibility of seeing the negative net result reflected in the total value of € 40,470.36.

Since loss carryforward is a downstream operation which presupposes the adoption upstream of the option of inclusion – which, it is stressed, did not occur in the present case.

Hence, not having the Requesters opted for inclusion, they cannot now – to put it mildly – "obtain the best of two worlds", namely: The application of an autonomous rate to income of Category "F" to the detriment of the option of inclusion; and

Simultaneously the carryforward of losses inherent to an inclusion option that was not taken.

And this is sufficient, without more, for the request for arbitral pronouncement to fail insofar as concerns the issue of loss carryforward, given that the assessment sub judice more than reflects the result of the taxation option freely taken by the Requesters themselves and, consequently, what flows from tax law."

1. The divergence between the position expressed by the Requesters and the Respondent centers, therefore, on the interpretation of the rule of article 55, sections 1 and 2, of the CIRS, relating to the deduction of losses, which, in the wording in force at the date to which the questioned assessment relates, provided that:

Article 55

Deduction of Losses

1 - Without prejudice to the provisions of the following sections, the negative net result determined in any category of income is deductible from the aggregate net income subject to taxation.ii

2 - The negative net result determined in Category F may only be carried forward to the five following years and shall be deducted from positive net results of the same category.[iii]

1. According to what can be inferred from the Respondent's reply, it is the AT's understanding that, being in question losses relating to rental income not entirely deducted from the gross income of the respective category due to insufficiency thereof in the year in which they were incurred, the carryforward to subsequent years is conditioned on the option for inclusion of that income.

2. As already referred, such understanding is not present in the decision relating to the disputed assessment nor was it notified to the respective taxpayers. For that reason, only the justification produced in the AT's reply will be analyzed, with relevance to the decision to be rendered.

On the Autonomous Taxation of Rental Income

1. Under article 72, section 7, of the CIRS, added by Law no. 66-B/2012, of 31/12, in force at the date of the occurrence of the disputed tax fact, rental income became subject to autonomous taxation at a rate of 28%.

2. The autonomous taxation of said income – which does not have a liberatory nature – does not prejudice its inclusion for joint taxation with other income by option of the respective holders resident in Portuguese territory, as results from section 8 of the same article, as amended by the cited law.

3. There is no indication in the text of the law of any conditioning of loss carryforward in Category F of income subject to IRS to the option for inclusion of such income and consequent waiver of their autonomous taxation. Nor is it understood how this autonomous taxation could be imposed on gross income, to the detriment of the principle of taxation of net income growth which constitutes a structuring principle of said tax.

4. In fact, it is noted that this matter was already subject to arbitral decision[iv], and due to its exemplary clarity and solid justification, the following excerpt is transcribed:

"Now, considering that losses to be carried forward are nothing more than the accumulation of specific deductions which, in each year, can only be subtracted from the taxable matter of that same year, up to their concurrence, and can be subtracted from the positive taxable matter of subsequent years, within the time limit legally established, it is not seen how the said principle of taxation of net income can be satisfied without losses to be carried forward from previous years being taken into account.

On the other hand, there is no rule which excludes the possibility of deduction of losses by non-resident taxpayers.

If it is true that inclusion operates in a subsequent phase to that of the subtraction of 'deductions and allowances provided for in the following sections', in accordance with the provision of section 1 of article 22 of the Income Tax Code (the term 'deductions' will refer both to the specific deductions of each income category, as to the deduction of losses, while there ceased to be 'allowances' since the repeal of article 56 by Law no. 64-A/2008, of 31 December), it does not necessarily follow from this that, should inclusion not be possible, it ceases to be possible to benefit from the 'deductions' provided for in the following sections.

Naturally the taxation of net income is what best conforms with the principle of contributive capacity, but this, when referred to taxpayers resident in national territory, is not satisfied merely by the taxation of net income, being advanced by their global taxation, through the application of a table of progressive rates and deductions at source, of a personalizing character.

The AT states that 'that prior operation (loss deduction) is not capable of being performed, since the same would always be conditioned by the prior inclusion of income'.

The difficulty in understanding that a prior reality be conditioned by the subsequent one, since, as a rule, causes are prior to their consequences, does not mean that, in the Income Tax Code, this is not possible, constituting an exception to the possibility of deduction of losses from previous years.

However, curiously, the only exception of this type is the one referring to the deduction of losses in Category G (relating to certain capital gains on securities), for residents in national territory, in accordance with section 6 of article 55 of the Income Tax Code, in the wording in force in the years under analysis, according to which 'Section 6 - The negative balance determined in a given year, relating to the operations provided for in paragraphs b), e), f) and g) of section 1 of article 10, may be carried forward for the following two years, to income with the same nature, when the taxpayer opts for inclusion.' (underlined by us).

Contrarian to the position transmitted by the AT on the possibility of loss deduction without prior inclusion, doctrine has already spoken regarding the taxation of Category F income earned by residents, by proportional rates (although these may opt for inclusion), instituted by Law no. 66-B/2012, of 31 December (article 72, section 7, of the Income Tax Code). We permit ourselves to cite Rui Duarte Morais, who states 'Note that, being in question a special rate (and not a liberatory rate), this applies to income determined in general terms, that is, to net income, which is to say that the taxpayer continues to be admitted to make the specific deductions that the law provides. As will also maintain the right to the carryforward of losses that he may have had in this category in previous years.'"[v]

1. Adhering fully to the position transcribed above, the Arbitral Tribunal thus understands that the carryforward of losses in subsequent years in Category F is not dependent on the option for inclusion, being the same admitted in the case of such option not being manifested for the reason that there is no legal provision excluding that possibility, on the one hand, and, on the other, in compliance with the structuring principle of taxation of net income earned by the respective taxpayers.

On the Violation of the Right of Prior Hearing

1. The Requesters further formulate, subsidiarily, a request to the effect of approval of their claim "should the preceding requests not be upheld, due to error in the application of law resulting from violation of the provisions of article 60, section 1, paragraph a), of the LGT, on the grounds of the illegal omission of the right of prior hearing of the male Requester regarding the arguments advanced by the AT for the refusal of deductibility of invoices nos. …, … and … ."

2. From the facts given as proven it is extracted that the male Requester was not only notified to exercise the right of prior hearing regarding the administrative decision taken on the non-consideration of certain expenses for purposes of determining net income in Category F, but also effectively exercised that right.

3. In the exercise of that right, also as extracted from the documents attached, no new elements were brought that should be considered in the AT's decision: regarding expenses documented through invoices … and … no issue arises since the Requesters recognize the good foundation of the administrative decision which, expressly, they declare to accept (see Request, section 17).

4. As for expenses documented through invoice …, relating to works common in property in full ownership partially rented, no new elements are perceived that would be capable of leading to a different decision than the one adopted by the AT.

5. Thus, having the male Requester been granted the right of prior hearing regarding the AT's draft decision, such right having been actually exercised and no new elements being brought to the procedure capable of modifying the tenor of the decision in the aspect considered above, the Tribunal considers the subsidiary request unfounded.

V. Decision

In these terms, and with the grounds set out above, the Arbitral Tribunal decides to rule partially upheld the request for arbitral pronouncement, determining the partial annulment of the disputed assessment, which should be reformulated as follows:

• Acceptance of declared expenses relating to the acquisition of domestic appliances, in the amount of € 1,277.66;

• Non-consideration, as deductible charge, of the amount of € 12,320.05, relating to works common to the property in full ownership, partially rented;

• Consideration, as losses to be carried forward to subsequent years, of the amount which, after the aforementioned corrections are made, results in not being capable of deduction in determining net income of Category F of IRS for 2014, due to insufficiency of the corresponding gross income.

Process Value: The process value is fixed at € 54,068.07, in accordance with article 97-A, section 1, paragraph a) of the CPPT, applicable by reference of article 29, section 1, paragraphs a) and b), of the RJAT and article 3, section 2, of the Regulations of Costs in Tax Arbitration Proceedings.

Costs: Under article 22, section 4, of the RJAT, and in accordance with Table I attached to the Regulations of Costs in Tax Arbitration Proceedings, I fix the amount of costs at € 2,142.00, the responsibility of the Respondent (AT) and the Requesters, in proportion to their success, being € 1,653.92 the responsibility of the former and € 488.08 the responsibility of the latter.

Lisbon, 10 March 2017

The Arbitrator,

Álvaro Caneira