IRC Fair Value Adjustments and Capital Losses Deductibility - CAAD Case 345/2018-T

ARBITRAL DECISION

They agree in arbitral court

I – Report

1. A..., S.G.P.S., S.A., collective person no. ..., with registered office in ..., ...-... — ..., ..., registered in the Commercial Registry Office of ... under no. ..., hereby requests the constitution of an arbitral court, pursuant to the provisions of articles 2, no. 1, paragraph a), and 10 of Decree-Law no. 10/2011, of 20 January, to assess the legality of the tax acts concerning the assessment of Corporate Income Tax (IRC) no. 2017... and the assessment of interest no. 2017..., relating to the year 2013, as well as the act of dismissal of the administrative claim lodged against those assessment acts, also requesting condemnation to pay compensatory interest.

The request is substantiated in the following terms.

The Claimant was incorporated in December 1993 and dedicates itself to the management of shareholdings held in various Portuguese and foreign companies engaged in the sector of metalworking and base metallurgy, as well as in the sectors of agricultural machinery and implements, real estate and tourism, and held in 2009 a portfolio of 1,715,953 shares of B..., an entity listed and included in the main national stock exchange index (PSI 20), the price of which is determined on a regulated market.

The shares of B... held by the Claimant constituted a participation of less than 5% of the share capital of that entity.

On 1 January 2010, the new Accounting Standardization System, approved by Decree-Law no. 158/2009, of 13 July 2009, came into force, which repealed the previous Official Accounting Plan, whereby the Claimant proceeded to alter its accounting policy for the measurement of financial instruments, transitioning from the cost model to the fair value model.

As a result of that change in accounting policy, the Claimant recorded as an expense the amount of €3,948,044.04, relating to own equity instruments recognized at fair value through profit or loss, which it distributed over five years, in the proportion of 1/5 for each year, in application of the transitional rule of article 5 of Decree-Law no. 159/2009, of 13 July, which resulted in the deduction of €789,608.80 in the years 2010, 2011, 2012, 2013 and 2014.

Following a tax inspection action relating to the financial year 2013, the Tax Authority did not accept the value of €789,608.80 deducted in the year 2013, understanding, in application of the provision of no. 3 of article 45 of the IRC Code, that the value to be deducted would be only half.

The Claimant considers, however, that, by virtue of the exception contained in paragraph a) of no. 9 of article 18 of the IRC Code, adjustments resulting from the application of fair value contribute in full to the formation of taxable profit when they relate to financial instruments recognized at fair value through profit or loss, provided that, where they are own equity instruments, they have a price formed on a regulated market and the taxpayer does not hold, directly or indirectly, a participation in the capital equal to or greater than 5% of the respective share capital.

Being that expenses resulting from the application of fair value to financial instruments, which are relevant for the formation of taxable profit under the terms of paragraph a) of no. 9 of article 18 of the IRC Code, are excluded from the scope of application of no. 3 of article 45 of that same Code.

This aforementioned provision refers to the negative difference between gains and losses realized by means of onerous transfer of capital interests and other losses or negative patrimonial variations relating to capital interests or other components of own capital. There is not, however, at issue in the present case, the existence of gains and losses realized by means of onerous transfer of capital interests, since paragraph b) of no. 1 of article 46 of the IRC Code expressly excludes from the concept the situations described in no. 9 of article 18 of the IRC Code. And, on the other hand, the reference to other losses or negative patrimonial variations should be understood as corresponding to facts that may be qualified as losses and as negative patrimonial variations under the terms of articles 23 and 24 of the IRC Code.

For their part, expenses resulting from the application of fair value to financial instruments should be understood as deductible expenses for tax purposes under article 23, no. 1, of the IRC Code.

Furthermore, in situations covered by article 18, no. 9, paragraph a), of the IRC Code we are dealing with adjustments resulting from the accounting of financial instruments at fair value with a price formed on a regulated market, with no intervention of the taxpayer's will in the value of the negative or positive patrimonial adjustment.

It concludes that the tax acts are based on the erroneous assumption that the fair value variations of the shares held by the Claimant of B... contribute only half their value to the formation of taxable profit and also suffer from the defect of lack of grounds, since the tax inspection report does not contain sufficient grounds to justify the corrections made.

The Tax Authority, in its reply, argues that the legislator adopted the fair value model in the valuation of financial instruments under the terms of paragraph a) of no. 9 of article 18 of the IRC Code.

In accordance with no. 1 of article 20 of the IRC Code, income is understood to mean that resulting from operations of any nature, namely income resulting from the application of fair value to financial instruments (paragraph f), and, in turn, under the terms of no. 1 of article 23 of the IRC Code expenses are understood to mean those that are demonstrably indispensable for the realization of income subject to tax or for the maintenance of the source of income, including also expenses resulting from the application of fair value to financial instruments.

The application of fair value to financial instruments is, however, conditioned by the requirements of no. 9 of article 18 of the IRC Code, to the extent that it determines that adjustments resulting from the application of fair value do not contribute to the formation of taxable profit, except when they relate to financial instruments recognized at fair value through profit or loss, provided that, where they are own equity instruments, they have a price formed on a regulated market and the taxpayer does not hold, directly or indirectly, a participation in the capital of more than 5% of the respective share capital.

With regard to financial instruments not covered by paragraph a) of no. 9 of article 18 of the IRC Code, the legislator chose to apply the regime of gains and losses contained in articles 46 and following of the IRC Code, with article 46 no. 1, paragraph b), stating that gains or losses realized by means of onerous transfer of financial instruments recognized at fair value under the terms of paragraph a) of no. 9 of article 18 of the IRC Code are not to be considered as realized gains or losses.

However, no. 3 of article 45 of the IRC Code provides for a restriction on the deductibility of losses relating to capital interests, which contribute to the formation of taxable profit in only half their value, with this provision defining a regime applicable in general terms regarding the deduction of negative differences between realized gains, as well as other losses and negative patrimonial variations relating to capital interests, being excluded therefrom only in cases for which the law establishes particular treatment, namely in article 23, nos. 3, 4 and 5, of the IRC Code and in article 32, no. 2, of the Commercial Companies Code.

The provision of article 18, no. 9, paragraph a), is intended solely to establish a rule of temporal allocation of income/gains and expenses/losses resulting from the application of fair value to own equity instruments contributing to the formation of taxable profit, in implementation of the principle of specialization of exercises or accrual, and therefore does not establish the regime applicable regarding the deductibility of those expenses/losses, and, consequently, the deduction of expenses/losses resulting from the application of fair value to own equity instruments, under the terms of that provision is governed by the provision of article 23, no. 1, paragraph i), and article 45, no. 3, of the IRC Code, that is, they are only deductible in half their value.

Article 45, no. 3, although it was created with the general purpose of limiting tax base erosion, is of automatic application to the realities provided for therein and independently of the consideration of the concrete conditions of the operations that give rise to the losses or other losses or negative patrimonial variations relating to capital interests, with no distinction being made regarding the manner or place where the operations were carried out or regarding the possibility of price formation occurring on regulated markets.

It concludes that the arbitral request is without merit.

1. Witness evidence was not requested and, following the process, the meeting referred to in article 18 of the RJAT was dispensed with and the presentation of optional submissions was determined for successive periods.

In submissions, the parties pronounced themselves on the probative results resulting from the elements of the process and, furthermore, maintained their earlier positions.

1. The request to constitute the arbitral court was accepted by the President of CAAD and automatically notified to the Tax Authority under the regulatory terms.

Under the terms of the provision of paragraph a) of no. 2 of article 6 and paragraph b) of no. 1 of article 11 of the RJAT, in the wording introduced by article 228 of Law no. 66-B/2012, of 31 December, the Deontological Council appointed as arbitrators of the collective arbitral court the signatories, who communicated their acceptance of the office within the applicable period.

The parties were duly and timely notified of this appointment and did not manifest any wish to refuse it, under the combined terms of article 11, no. 1, paragraphs a) and b), of the RJAT and articles 6 and 7 of the Deontological Code.

Thus, in conformity with the provision of paragraph c) of no. 1 of article 11 of the RJAT, in the wording introduced by article 228 of Law no. 66-B/2012, of 31 December, the collective arbitral court was constituted on 4 October 2018.

The arbitral court was regularly constituted and is materially competent, under the provision of articles 2, no. 1, paragraph a), and 30, no. 1, of Decree-Law no. 10/2011, of 20 January.

The parties have legal personality and capacity, are legitimate and are represented (articles 4 and 10, no. 2, of the same act and 1 of Ordinance no. 112-A/2011, of 22 March).

The process does not suffer from nullities and no exceptions were raised.

It falls to us to assess and decide.

II – Grounds

Matters of fact

1. The facts relevant to the decision of the case that may be regarded as established are the following.

A) The Claimant was subject to an inspection action covering the year 2013, pursuant to Service Order no. OI2017..., intended to ascertain the deduction by the totality of negative patrimonial variations resulting from the change in the measurement of financial instruments at fair value and which resulted in arithmetic corrections to the IRC taxable matter in the amount of €394,804.40;

B) The Claimant was notified of the act of assessment of IRC no. 2017..., in the amount of €473,093.95, of the act of assessment of interest no. 2017..., in the amount of €10,023.56, and of the statement of reconciliation of accounts no. 2017..., in the amount of €113,257.27, relating to the year 2013;

C) On 10 January 2018 it filed an administrative claim against the tax assessment acts;

D) On 8 March 2018 it was notified of the draft decision dismissing the administrative claim for the purpose of exercising the right of prior hearing;

E) The Claimant did not exercise the right of prior hearing within the legally prescribed period;

F) The administrative claim was dismissed by order of 13 April 2018, of the head of division of the Tax Office of..., made with delegation of powers;

G) The Claimant was incorporated in December 1993 and dedicates itself to the management of shareholdings held in various Portuguese and foreign companies engaged in the sector of metalworking and base metallurgy, as well as in the sectors of agricultural machinery and implements, real estate and tourism;

H) In 2009 it held a portfolio of 1,715,953 shares of B..., an entity listed and included in the main national stock exchange index, the price of which is determined on a regulated market.

I) The shares of B... held by the Claimant constituted a participation of less than 5% of the share capital of that entity;

J) The aforementioned shares were recorded at their historical cost in accordance with the criterion defined in the Official Accounting Plan;

K) With the entry into force of the new Accounting Standardization System, approved by Decree-Law no. 158/2009, of 13 July 2009, the Claimant proceeded to alter its accounting policy for the measurement of financial instruments, transitioning to the fair value model;

L) On 31 December 2009, the Claimant ascertained a negative patrimonial variation in the amount of €3,948,044.04 corresponding to the difference between the acquisition cost of the participation and the quote of the security on that date, as a result of the application of fair value to own equity financial instruments;

M) This loss was intended to be reflected by means of deduction as a tax expense in the years 2010, 2011, 2012, 2013 and 2014, in the proportion of 1/5 for each year, in application of the transitional rule of article 5 of Decree-Law no. 159/2009, of 13 July;

N) In the tax periods of 2010, 2011 and 2012, the Claimant deducted, for this purpose, the amount of €394,804.40 corresponding to half the value of the proportional annual quota, calculated as follows: €3,948,044.04 : 5 x 50%;

O) In 2013, the Claimant deducted as a tax expense the amount of €789,608.80 corresponding to 100% of the proportional annual quota;

P) Following a tax inspection action relating to the financial year 2013, the Tax Authority did not accept the value of €789,608.80 deducted in the year 2013, considering that the negative transition adjustment contributes to the formation of taxable profit in only half its value, in application of the provision of no. 3 of article 45 of the IRC Code;

Q) The Claimant made the payment of the amount corresponding to the additional assessment of IRC.

The Court formed its conviction as to the established facts on the basis of the documents attached to the petition and the administrative file submitted by the Tax Authority with its reply. Consideration was also given, in light of the provision of article 110, no. 7, of the CPPT, that the tax inspection report did not question, on the level of facts, the fulfillment by the Claimant of the requirements defined in article 18, no. 9, paragraph a), of the IRC Code, nor was this matter the subject of specific challenge in the process.

Matters of law

1. The issue raised concerns the deductibility as a tax expense of negative patrimonial variations resulting from adjustments that result from the application of fair value to shareholdings held by the taxpayer.

The Claimant considers that, by virtue of the exception contained in paragraph a) of no. 9 of article 18 of the IRC Code, adjustments resulting from the application of fair value contribute in full to the formation of taxable profit provided that the assumptions defined in that rule are met, that is, when they relate to financial instruments recognized at fair value through profit or loss and, where they are own equity instruments, have a price formed on a regulated market and the taxpayer does not hold, directly or indirectly, a participation in the capital equal to or greater than 5% of the respective share capital. These adjustments being excluded, consequently, from the limitation contained in no. 3 of article 45 of that Code.

The Tax Authority, for its part, argues that, notwithstanding a certain adjustment at fair value through profit or loss being classifiable under paragraph a) of no. 9 of article 18 of the IRC Code, if the adjustment were negative, even though accepted under the terms of the cited provision, it would only be deductible in 50% of its value in application of the provision of article 45, no. 3, which, being a norm of a general character, applies to all negative patrimonial variations relating to capital interests or other components of own capital.

It should be said from the outset that the issue has not been subject to uniform understanding either in the case law of the first instance tax courts or in the case law of CAAD.

In the sense of the non-applicability of article 45, no. 3, of the IRC Code to adjustments resulting from fair value, pronounced themselves, among others, the arbitral decisions rendered in Cases nos. 108/2013-T, 58/2015-T, 208/2015-T, 473/2015-T, 393/2016-T, 155/2017-T and 30/2015-T. The arbitral decisions rendered in Cases nos. 25/2015-T and 90/2016/T formulated the contrary understanding, considering that the expense for the purposes of the provision of article 18, no. 9, of the IRC Code corresponds to any of the accounting items that may negatively affect the net result of a company, including losses resulting from the reduction in fair value of financial instruments and these fall within the scope of application of article 45, no. 3.

The issue is subsequently clarified by the judgment of the Supreme Administrative Court (STA) of 17 February 2016 (Case no. 01401/14), whose doctrine was more recently reaffirmed by the judgment of the STA of 6 June 2018 (Case no. 0582/17), with specific reference to adjustments resulting from the application of fair value, and we see no reason to dissent now.

The rules of general framework that are most relevant to consider are those of articles 20, no. 1, paragraph f), and 23, no. 1, paragraph i), of the IRC Code. The first of these provisions, in the wording in force at the time of the facts, defines in an exemplary manner as income "resulting from the application of fair value to financial instruments," while the second, parallelly, characterizes as expenses that may be regarded as indispensable for the realization of income subject to tax or for the maintenance of the source of income "resulting from the application of fair value to financial instruments."

For its part, article 18, no. 9, paragraph a), of the IRC Code – which is particularly in focus here – determines that "adjustments resulting from the application of fair value do not contribute to the formation of taxable profit, being allocated as income or expenses in the tax period in which the elements or rights that gave rise to them are disposed of, exercised, extinguished or liquidated," except when "they relate to financial instruments recognized at fair value through profit or loss, provided that, where they are own equity instruments, they have a price formed on a regulated market and the taxpayer does not hold, directly or indirectly, a participation in the capital of more than 5% of the respective share capital."

Each of these provisions was introduced by Decree-Law no. 159/2009, of 13 July, which, following the approval of the Accounting Standardization System, intended to make the necessary changes to adapt the IRC Code to the rules emerging from the new accounting framework.

In this sense, the preamble note of the said diploma refers to the following:

"Still in the field of approximation between accounting and taxation, the application of the fair value model to financial instruments is accepted, the counterpart of which is recognized through profit or loss, but only in cases where the reliability of the determination of fair value is in principle assured. Thus, own equity instruments that do not have a price formed on a regulated market are excluded. Furthermore, the application of the realization principle was maintained with respect to financial instruments measured at fair value whose counterpart is recognized in own capital, as well as capital interests representing more than 5% of the share capital, even if recognized at fair value through profit or loss."

In these terms, the preamble of no. 9 of article 18 maintained as a rule the principle of realization for adjustments resulting from the application of fair value, moving away from the general criterion resulting from no. 1 of that article, which provides for the accounting principle of economic specialization of exercises, which consists of including in tax results the income and expenses corresponding to each financial year, independently of their actual receipt or payment. Exceptions are made only for own equity instruments that meet the characteristics defined in the aforementioned paragraph a) of that no. 9, which means that, for these cases, the legislator brought the tax rule closer to the accounting rule, giving tax relevance to the annual variation in the value of financial instruments with a price formed on a regulated market, when fair value rules are applied.

1. In the present case and in light of the facts established, one cannot but understand that the Claimant meets the requirements of the aforementioned provision of article 18, no. 9, paragraph a), the only question remaining being whether the limitation contained in article 45, no. 3 is applicable.

This rule began by being added by Law no. 32-B/2002, of 30 December (State Budget Law for 2003), then corresponding to article 42, no. 3, which had the following wording: "The negative difference between gains and losses realized by means of onerous transfer of capital interests, including their remission and redemption with capital reduction, contributes to the formation of taxable profit in only half its value."

On the other hand, the Report of the Ministry of Finance for the State Budget of 2003 framed this measure of "partial exclusion (50%) of losses registered in the disposal of shareholdings by companies in general" within the framework of changes in the IRC context intended to implement the "broadening of the tax base and measures for moralization and neutrality" (page 53), which is in line with the priorities that the legislator intended to establish, in the framework of revenues, and which are identified as consisting of "combating tax fraud and evasion and broadening the tax base" (page 34).

Subsequently, Law no. 60-A/2005, of 30 December (State Budget Law for 2006), altered the wording of that article 42 (which was later renumbered as article 45), and its no. 3 came to provide as follows: "The negative difference between gains and losses realized by means of onerous transfer of capital interests, including their remission and redemption with capital reduction, as well as other losses or negative patrimonial variations relating to capital interests or other components of own capital, namely supplementary contributions, contribute to the formation of taxable profit in only half their value."

In this manner, the legislator broadened the limitation on the deductibility of losses resulting from losses, now considering, for this purpose, not only losses realized by means of onerous transfer of capital interests, but also those resulting from the onerous transfer of "other components of own capital."

However, the Report of the Ministry of Finance for the 2006 Budget continued to justify the legislative change within the framework of measures aimed at "combating tax fraud and evasion and other measures directed at budget consolidation" (page 31). This led the cited judgment of the STA of 17 February 2016 to conclude that the rule, in any of its versions, is an anti-abuse measure, to the extent that the legislator intended (in addition to broadening the tax base) to prevent manipulation of the tax result.

And thus, as is also recognized in the judgment of the STA of 6 June 2018, the rule was intended "directly to combat tax fraud and evasion, prevent manipulation of tax results, and indirectly to obtain a broadening of the tax base resulting from the significant reduction of those mechanisms used by taxpayers to reduce or eliminate the amount of tax to be paid."

1. It remains now to verify to what extent the measurement of financial instruments listed on regulated markets at fair value can be reconciled with the limitation resulting from article 45, no. 3.

The most recently cited judgment responds to this question in the following terms.

"The concept of fair value resulting from accounting rules, whether national (Accounting Standardization System) or international (International Accounting Standards), when incorporated into the tax system, is essentially embodied in the sum for which an asset can be exchanged, or a liability settled, between parties who are knowledgeable and willing to do so, in a transaction in which there is no relationship between the parties. José de Campos Amorim notes that, 'The IAS/IFRS [International Accounting Standards/International Financial Reporting Standards] and the SNC [Accounting Standardization System] with the changes in financial reporting standards, introduced greater fairness in the valuation of the company's assets for the benefit of users of the company's economic, financial and patrimonial situation. This opening of accounting to fair value meets the needs of investors who wish to obtain real and reliable information before deciding to invest in the company.

It is not information that can condition certain economic or financial operations, such as, for example, the increase or decrease of capital, but it is of great relevance to the investor who wishes to have a real and current notion of the company's assets. It is for this reason that accounting is oriented not towards historical cost, but towards the current value of assets.', cf. Fair value and its tax implications, IV Congress of Tax Law, Vida Económica, page 168.

Therefore, the consideration of fair value, insofar as it concerns us here (...) and for tax purposes (which, under the terms of article 17, no. 1, of the IRC Code is directly linked to the company's own accounting), has an immediate connection to the official quote of the securities, and in the case of the proceedings it is subject to a market regulated by official entities, ceasing the tax fact to be associated with the sale of the securities - realization of gains or losses - now being associated with the oscillation of the official quote between the beginning and end of the tax period, cf. Tomás Castro Tavares, Fair value and taxation of gains on shares of listed companies, Studies in Memory of Professor Doctor J.L. Saldanha Sanches, vol. IV, pages 1137 and 1138.

These "gains or losses" thus determined by fair value are merely potential or provisional - the value of the assets is embodied in a financial position - because there is no effective inflow of capital or loss of capital compared to historical cost, as is recognized by the national legislator himself in article 32, no. 2 of the Commercial Companies Code.

There is, therefore, no doubt that (...) to the negative financial position resulting from fair value, there is not 'an underlying motivation of tax evasion, by arbitrary valuation, for the simple reason that the taxation of fair value is limited to assets transacted on an organized market, where the quote of the asset (appreciation and depreciation) is completely divorced from the taxpayer's tax will… The taxpayer's will never shapes the tax fact based on fair value: the economic obstacle of lock-in disappears (the tax fact is disconnected from the decision to sell); if fair value gains are fully taxed (the regime of gains and losses is never applied to them), expenses should also be accepted in full; and there is no, finally, an asymmetrical inclination for the realization of the fair value cost, by comparison with the gain - for the simple reason that the tax fact of fair value (positive and negative) is completely divorced from the will of the taxpayer' (cf. Tomás Castro Tavares, idem, pages 1143 and 1144)."

It is further noted that the rule of article 45, no. 3 of the IRC Code has a teleological relationship with the rule of article 48 of that same Code, in particular, as is relevant to the case, with its no. 4, to the extent that the negative contribution of half the value for the formation of taxable profit imposed by the first of the aforementioned rules is compensated by the positive contribution in equal measure (half the value), provided for by the second.

However, in this latter rule, the legislator imposed conditions, one of which is that the beneficiary of this reduction in the tax base must reinvest the value that it realized with the sale of the goods that generated the positive balance between gains and losses.

It happens that, in relation to gains relating to the accounting of capital interests at the fair value model, an impossibility emerges, since when the entity that obtains income (gain) resulting from the application of fair value to financial instruments, is unable to benefit from the reduction of the value subject to tax by half its value.

Indeed, for this to be possible, the company would have to reinvest the realization value of the goods that generated the "gain" (income/revenue) in question, and in the fair value model there is no realization value to reinvest, hence it is not possible to fulfill the reinvestment obligation.

Because there is no realization value in the fair value model, neither in fact nor in law (for example the legislator could have equated the use of fair value with the realization value or established a presumption of successive sale and purchase), the reinvestment of the realization value becomes impossible to fulfill, in the event that the balance of gains and losses generated with the use of the fair value model in the accounting of financial instruments is negative.

Such impossibility, which determines the non-application of the benefit of taxation of the "gain" generated by fair value, in half its positive balance, should also determine that the "loss" generated with the application of the fair value model to financial investments, cannot be deducted in half its value, therefore both – income and expense – should be included in taxable profit in full.

Furthermore, the part of no. 3 of article 45 - at the time article 42 - which refers to "… as well as other losses or negative patrimonial variations relating to capital interests or other components of own capital…" was added to its respective no. 3 by Law no. 60-A/2005 of 30 December, and the fair value model first appeared in the IRC code with Decree-Law no. 159/2009 of 13 July, which proceeded to adapt the IRC code to International Accounting Standards, reason for which it cannot be sustained that the legislator, with the amendment made in 2005, would have intended to frame in the law gains or losses relating to a reality that would only be born in 2009, many years later, given that the fair value model was not part of the accounting regulations nor the tax laws.

Having on the basis of all these considerations, it becomes possible to conclude that the rule of article 45, no. 3 of the IRC Code, interpreted in accordance with the purpose intended by the legislator and having regard to the circumstances that determined the legislative decision, cannot be understood as encompassing expenses resulting from the application of fair value in a regulated market, in which case the taxpayer's will is not relevant to the appreciation or depreciation of financial assets, and no reason subsists for the penalization of those expenses for tax purposes.

It is understood, accordingly, and in line with what was decided in the judgment of the STA of 6 June 2018, that the negative difference is relevant in full to the formation of taxable profit, and not only in half its value, therefore it appears to be illegal the correction made in IRC by the Tax Authority.

Finally, it remains to consider that the judgment of the Constitutional Court no. 85/2010, which is invoked by the Respondent, has no relevance for the case. The decision limited itself to judging not unconstitutional the rule of article 45, no. 3, of the IRC Code in confrontation with the principles of prohibition of retroactivity of tax law, protection of legitimate expectations and taxation according to actual income. In the present case, however, no issue of constitutionality is raised, and everything is reduced to the interpretation of the rule at the level of infra-constitutional law.

Requests whose consideration is prejudiced

1. In light of the legal solution of the case, the consideration of the defect of lack of grounds is prejudiced, which, even if judged to have merit, would not prevent the renewal of the challenged acts.

Compensatory interest

1. The Claimant further requests condemnation of the Tax Authority to pay compensatory interest, at the legal rate, calculated on the tax, until full reimbursement of the amount due.

In accordance with the provision of paragraph b) of article 24 of the RJAT, the arbitral decision on the merits of the claim that is not subject to appeal or challenge binds the Tax Authority, in the exact terms of the success of the arbitral decision in favor of the taxpayer, requiring it to "restore the situation that would have existed if the tax act that is the subject of the arbitral decision had not been enacted, adopting the necessary acts and operations for that purpose." This is in line with the provision of article 100 of the LGT, applicable by virtue of the provision of paragraph a) of no. 1 of article 29 of the RJAT.

Furthermore, under the terms of no. 5 of article 24 of the RJAT "payment of interest is due, regardless of its nature, under the terms provided for in the General Tax Law and the Code of Tax Procedure and Process," which refers to the provision of articles 43, no. 1, and 61, no. 5, of each of those acts, involving the payment of compensatory interest from the date of improper payment of the tax until the date of processing of the respective credit note.

There is therefore occasion, following the declaration of illegality of the tax assessment acts, to the payment of compensatory interest, under the terms of the cited provisions of articles 43, no. 1, of the LGT and 61, no. 5, of the CPPT, calculated on the amount that the Claimant improperly paid, at the rate of legal interest (articles 35, no. 10, and 43, no. 4, of the LGT).

III – Decision

It is therefore decided:

a) To judge the arbitral request as well-founded and to annul the tax acts of assessment of IRC no. 2017... and of assessment of interest no. 2017..., relating to the year 2013;

b) Consequently, to annul the act of dismissal of the administrative claim lodged against the tax assessment acts;

c) To condemn the Tax Authority to pay compensatory interest from the date of improper payment of the tax until the date of processing of the respective credit note.

Value of the case

The Claimant indicated as the value of the case the amount of €473,093.95, which was not contested by the Respondent and corresponds to the value of the assessment that it was sought to challenge, therefore the value of the case is fixed at that amount.

Notify.

Lisbon, 27 February 2019

The President of the Arbitral Court

Carlos Fernandes Cadilha

The Arbitrator Member

José Pedro Carvalho

The Arbitrator Member

Henrique Fiúza

(With attached dissenting opinion)

Dissenting Opinion

With all due respect for the grounds set forth in the present decision and in the decisions rendered within CAAD in the cases mentioned in the present arbitral decision, as well as in the mentioned judgments of the Supreme Administrative Court (STA), because in the fundamental respect I do not agree with them, I deemed it appropriate to issue this dissenting opinion.

The reasoning used in the arbitral decisions issued within CAAD, as well as in the STA judgments referred to in the present arbitral decision, centers its position on three vectors, which can be briefly presented as follows:

1. No. 3 of article "45 – Non-deductible expenses for tax purposes" was created with the intention of combating tax fraud and evasion that the deduction of losses on onerous transfer of financial instruments could provide;

2. No. 3 of article 45 was intended to broaden the IRC tax base (by reducing expenses to be considered as tax deductible); and

3. As fair value is determined by a regulated market, not depending on the interplay of the taxpayer's interests, and therefore not conducive to tax evasion, the limitation imposed by no. 3 of article 45 does not make sense in the case of fair value losses in shareholdings.

This reading of no. 3 of article 45 of the CIRC, with all due respect, suffers from an error which is that of considering that this no. 3 is a rule of a general character with aims of combating tax evasion and broadening the tax base, with which one cannot agree.

For this purpose, we conducted a historical survey of the law, and from such work, it can easily be concluded that this rule was created not with a general purpose of combating tax fraud and evasion and broadening the tax base, but with a specific and clearly defined purpose: when in 2002 the law began to exclude from taxation half of the gains realized with the onerous disposal of capital interests, the legislator did not safeguard a symmetric rule that would prevent the realization of losses with the onerous disposal of capital interests, as a way of reducing taxable profit and the tax to be paid, since the negative difference between gains and losses were deductible for tax purposes in their entirety.

Facing the lack of symmetry in the law, the legislator corrected such situation in the following year, having created no. 3 of article 45 to, with respect to the taxation of gains and losses, make it symmetric and therefore more fair and equitable.

Thus, as from 1 January 2003, the taxpayers subject to IRC who had proceeded to the onerous transfer of capital interests and who had reinvested the realization values were taxed on half the value of the positive balance of gains and losses. In the event that the annual balance was negative, the amount calculated was to be considered deductible in only half its value, for the purposes of calculating taxable profit.

With all due respect for the grounds produced in the referenced decisions, I understand that this was the reason for the creation of no. 3 of article 45 of the CIRC and not the justifications and arguments that are produced in the arbitral decisions and in the STA judgments given as reference in the present arbitral decision.

This is what we propose to do in the argument that follows.

The taxation of the positive difference between gains and losses realized by means of onerous transfer of elements of tangible fixed assets has, since the creation of the Corporate Income Tax (IRC), been subject to a more favorable tax treatment than other types of income.

Since its creation (1 January 1989) until the publication of Law no. 71/93 of 26 November (Supplementary Budget Law to the State Budget for 1993) the positive difference between gains and losses realized in each year was entirely excluded from IRC taxation.

After the legislative change brought about by Law no. 71/93 of 26 November, the gains regime ceased to constitute an exclusion from its taxation, becoming merely a deferral of taxation. That is, in the year in which the onerous disposal of tangible fixed assets elements occurred, the positive difference between gains and losses did not contribute to the formation of taxable profit, but, on the other hand, the reintegrations of the assets in which the reinvestment of the realization values had been made were not tax deductible in the part corresponding to the positive balance of gains and losses that, for this purpose, was allocated to the acquisition value of each asset.

It was a solution intended to introduce more fairness in the allocation of this benefit, but which brought, in practice, more administrative work to taxpayers and greater difficulties for tax control for the Tax Administration.

The legislative solution that came to provide for the taxation of only half of the positive balance calculated between gains and losses generated in a given year, subject to reinvestment of the realization value, was introduced in the IRC code by the 2002 State Budget Law, Law no. 109-B/2001 of 29 December.

The aforementioned law stipulated that article 45 of the CIRC would be altered as follows, with effect from 1 January 2002:

"Article 45

Reinvestment of realization values

1 – For the purposes of determining taxable profit, the positive difference between gains and losses, calculated in accordance with the preceding articles, realized by means of onerous transfer of elements of tangible fixed assets, held for a period of not less than one year, or as a result of indemnities for losses occurring in these elements, is considered at half its value, provided that, in the tax period preceding the realization, in the tax period itself, or until the end of the second following tax period, the realization value corresponding to the entirety of the aforementioned elements is reinvested in the acquisition, manufacture or construction of elements of tangible fixed assets used in the business, with the exception of goods acquired in used state from a taxpayer subject to personal income tax or IRC with whom there are special relationships as defined in no. 4 of article 58.

2 - ....................................................................................................................................

3 - ....................................................................................................................................

4 – The provisions of the preceding numbers are applicable to the positive difference between gains and losses realized by means of onerous transfer of capital interests, including their remission and redemption with capital reduction, with the following specificities:

a) The realization value corresponding to the entirety of the capital interests must be reinvested, in whole or in part, in the acquisition of capital interests of commercial or civil companies in commercial form with registered office or effective management in Portuguese territory or else in securities of the Portuguese State;

b) The capital interests disposed of must have been held for a period of not less than one year and correspond to at least 10% of the share capital of the company in which the participation is held.

5 – For the purposes of the provisions of nos. 1, 2 and 4, taxpayers must mention the intention to carry out the reinvestment in the declaration referred to in paragraph c) of no. 1 of article 109, of the year of realization, proving in the same and in the declarations of the two following years the reinvestments carried out.

6 – Where the reinvestment is not fully or partially realized until the end of the second tax period following that of realization, the difference or the proportional part of the difference provided for in nos. 1 and 4 not included in taxable profit is considered as income or gain of that tax period, increased by 15%.

Throughout 2002, with the new law, the positive balance between gains and losses realized in each year was taxed at half its value, on the condition that the taxpayer reinvested the entirety of the realization value of the assets that generated the respective gains and losses. But, in cases where the balance between gains and losses generated in each year was negative, the taxpayer could deduct the entirety of that negative balance.

Having detected this situation of inequity and ineffectiveness of the legislative solution that came into force on 1 January 2002, the legislator proceeded to correct it, so that the new law came into force on 1 January 2003. Such correction of the inequity was made by the State Budget Law for the year 2003 by Law no. 32-B/2002 of 30 December.

The aforementioned law stipulated that article 42 of the CIRC would be altered as follows:

Article 42

Non-deductible expenses for tax purposes

1 - ...

2 - ...

3 - The negative difference between gains and losses realized by means of onerous transfer of capital interests, including their remission and redemption with capital reduction, contributes to the formation of taxable profit in only half its value.

With this amendment, the law, with respect to the taxation of gains obtained with the transfer of capital interests in companies with registered office or effective management in Portuguese territory, became more balanced, more equitable. The principle of symmetry prevailed.

As from 1 January 2003, the taxpayers subject to IRC, who proceed to the onerous transfer of capital interests, under certain conditions, and who make the reinvestment of the realization values, will be taxed on half the value of the positive balance of gains and losses generated in each year. In the event that the annual balance is negative, the amount calculated will be considered deductible in only half its value, for the purposes of calculating taxable profit.

This was the reason for being of no. 3 of article 45 of the IRC code. Its ratio was to correct the legislative solution created in the previous year, because it had proved unbalanced, failing to comply with the principle of symmetry.

Three years later, the State Budget Law for 2006 (Law no. 60-A/2005 of 30 December) came to amend no. 3 of article 42 of the IRC code, becoming as follows transcribed:

Article 42

Non-deductible expenses for tax purposes

1 — …

2 — ….

3 — The negative difference between gains and losses realized by means of onerous transfer of capital interests, including their remission and redemption with capital reduction, as well as other losses or negative patrimonial variations relating to capital interests or other components of own capital, namely supplementary contributions, contribute to the formation of taxable profit in only half their value. (underlined)

4 — …

This amendment to the legal text had a well clear and precise objective, without the general purposes that some wish to attribute to it. This new text of no. 3 must be interpreted within the context of onerous transfer of capital interests and in accordance with the legislator's intention at the time. Always keeping in mind that the gains regime is applicable exclusively to onerous transfers.

And the legislative amendment was intended to, within the framework of the losses, realized through onerous transfers, broaden the range of financial assets that would receive the same treatment as capital interests, with the law itself giving supplementary contributions as an example – to which we would add accessory contributions, reserves and contingent capital instruments (CoCos) - and also to broaden the operations that came to be equated with onerous transfers for the purposes of losses, as is the case with remission and redemption operations with capital reduction, already previously provided for in the capital context and now extended to other components of own capital that are not the capital itself.

The amendment made to this no. 3 was intended to include in it losses generated with the onerous transfer of other components of own capital other than share capital. That is, it intended to include in the law, among others, losses with the transfer or reimbursement of supplementary contributions, with the transfer or reimbursement of accessory contributions, with the transfer or reimbursement of contingent capital titles (CoCos) and equivalents. Losses that were not provided for in said no. 3 before the legislative amendment, being therefore deductible in their entirety for tax purposes.

As has been said, no. 3 of article 42 of the IRC code was created within the context of gains and losses generated with the onerous transfer of capital interests and later extended to losses in other components of own capital (generated by onerous transfer), and it is within this context that its interpretation should be made.

Reason for which, as will be concluded further ahead, this no. 3 cannot be applicable to reductions in the value of shareholdings with a price formed on a regulated market, by the use of the fair value model.

Decree-Law no. 159/2009 of 13 July made various changes to the IRC code and complementary legislation, in order to adapt the rules for determining taxable profit of taxpayers subject to IRC to the International Accounting Standards (IAS) within the context of the new Accounting Standardization System (SNC) approved by Decree-Law no. 158/2009 of 13 July.

The most relevant changes for assessment of the case are those indicated below, with the articles already renumbered for the purposes of their republication:

Article 18

Timing 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 actual receipt or payment, in accordance with the economic accrual method of accounting.

2 - …

9 — Adjustments resulting from the application of fair value do not contribute to the formation of taxable profit, being attributed as income or expenses in the tax period in which the elements or rights that gave rise to them are disposed of, exercised, extinguished or liquidated, except when:

a) They relate to financial instruments recognized at fair value through profit or loss, provided that, where they are own equity instruments, they have a price formed on a regulated market and the taxpayer does not hold, directly or indirectly, a participation in the capital of more than 5% of the respective share capital; or

b) This is expressly provided for in this Code.

10 - …

Article 20

Income

1 — Income is understood to mean that resulting from operations of any nature, as a result of a normal or occasional action, basic or merely accessory, namely:

a) …

f) Income resulting from the application of fair value to financial instruments;

g) …

h) Realized gains;

i) …

Article 21

Positive patrimonial variations

1 — Furthermore, positive patrimonial variations not reflected in the net result of the tax period contribute to the formation of taxable profit, except:

a) …

b) Potential or latent gains, even if expressed in the accounting, including revaluation reserves under fiscal legislation;

Article 23

Expenses

1 — Expenses are understood to mean those that are demonstrably indispensable for the realization of income subject to tax or for the maintenance of the source of income, namely:

a) . . .

i) Expenses resulting from the application of fair value to financial instruments;

j) …

l) Realized losses;

Article 24

Negative patrimonial variations

Under the same conditions referred to for expenses, negative patrimonial variations not reflected in the net result of the tax period further contribute to the formation of taxable profit, except:

a) …

b) Potential or latent losses, even if expressed in the accounting;

Article 45

Non-deductible expenses for tax purposes

1 — The following expenses are not deductible for the purposes of determining taxable profit, even when recorded as expenses of the tax period:

a) …

2 — …

3 — The negative difference between gains and losses realized by means of onerous transfer of capital interests, including their remission and redemption with capital reduction, as well as other losses or negative patrimonial variations relating to capital interests or other components of own capital, namely supplementary contributions, contribute to the formation of taxable profit in only half their value.

NOTE: no. 3 of article 42 was not amended by Decree-Law no. 159/2009 of 13 July, maintaining the text that had been in force since 1 January 2006.

Article 46

Concept of gains and losses

1 — Gains or losses realized are understood to mean the gains obtained or losses suffered by means of onerous transfer, by whatever title it takes place and, likewise, those resulting from losses or those resulting from permanent allocation to purposes outside the business activity, concerning:

a) Tangible fixed assets, intangible assets, biological assets that are not consumables and investment properties, even if any of these assets has been reclassified as non-current asset held for sale;

b) Financial instruments, with the exception of those recognized at fair value under the terms of paragraphs a) and b) of no. 9 of article 18

4 - …

5 — The following are assimilated to onerous transfers:

a) …

b) Changes in the valuation model that are relevant for tax purposes, under the terms of no. 9 of article 18, and that result, in particular, from accounting reclassification or changes in the assumptions referred to in paragraph a) of no. 9 of this same article.

Article 48

Reinvestment of realization values

1 — For the purposes of determining taxable profit, the positive difference between gains and losses, calculated in accordance with the preceding articles, realized by means of onerous transfer of tangible fixed assets, biological assets that are not consumables and investment properties, held for a period of not less than one year, even if any of these assets has been reclassified as non-current asset held for sale, or as a result of indemnities for losses occurring in these elements, is considered at half its value, provided that, in the tax period preceding the realization, in the tax period itself, or until the end of the second following tax period, the realization value corresponding to the entirety of the aforementioned assets is reinvested in the acquisition, production or construction of tangible fixed assets, of biological assets that are not consumables or in investment properties, used in the business, with the exception of goods acquired in used state from a taxpayer subject to personal income tax or IRC with whom there are special relationships as defined in no. 4 of article 58.

2 — . .

3 — . . .

4 — The provisions of the preceding numbers are applicable to the positive difference between gains and losses realized by means of onerous transfer of capital interests, including their remission and redemption with capital reduction, with the following specificities:

a) The realization value corresponding to the entirety of the capital interests must be reinvested, in whole or in part, in the acquisition of participations in the capital of commercial or civil companies in commercial form or in securities of the Portuguese State, or in the acquisition, production or construction of tangible fixed assets, of biological assets that are not consumables or in investment properties, used in the business, under the conditions referred to in the final part of no. 1;

b) . . .

It is within this legal framework that it is important to ascertain whether the corrections made by the Respondent to the taxable profit of the Claimant, by reference to the tax period of 2010, suffer from any illegality.

In summary, it could be said that the issue raised concerns the deductibility as a tax expense of expenses recorded with adjustments that resulted from the application of fair value to shareholdings held by the Claimant on 31 December 2009.

More precisely, what it behooves the Court to ascertain is whether or not the limitation on the deduction to half its value provided in no. 3 of article 45 of the IRC code is applicable to losses calculated with the use of the fair value model on capital interests held on 31 December 2009 by the Claimant.

For this, it will be necessary to know whether the loss (or expense) in question is characterized as an "expense resulting from the application of fair value to financial instruments" provided in paragraph i) of no. 1 of article 23 of the CIRC or whether it is a loss that can be classified under paragraph l) of the same number and article.

Once the expense is characterized as belonging to one or the other type, the answer to the question raised will have been found.

The law (Decree-Law no. 442-B/88) which deals with gains and losses (in IRC) dates from 30 November 1988 and came into force on 1 January 1989. The taxation of gains and losses underwent various changes and adjustments to arrive in 2010 at the texts that are reproduced above.

As was demonstrated above, no. 3 of article 45 of the IRC code was created to come into force as from 1 January 2003 with the intention of balancing the deduction of only half of losses generated with the transfer of capital interests, with the non-taxation of half of gains generated with the transfer of assets of the same type, in accordance with no. 4 of article 48, which had been created one year earlier.

That is, with on one side of the balance a rule that, subject to the condition of reinvestment of the realization value, provided for the taxation of only half of the positive difference of gains and losses generated with the onerous transfer of equity interests (no. 4 of article 48), the legislator placed on the other side of the balance a rule that provided for the deduction of only half of the negative difference between gains and losses generated with the onerous transfer of equity interests (no. 3 of article 45). This balance of the law is characteristic of a fair and equitable tax system.

And the inclusion in the law of the principle of symmetry is the structural harmonization of the model of taxation of the balance of gains and losses.

Thus, as from 1 January 2003, subject to the condition of reinvestment of the realization value, the positive difference between gains and losses generated with the onerous transfer of shareholdings, under certain conditions, is taxed at half its value and the negative difference between gains and losses generated with the onerous transfer of shareholdings is deductible for tax purposes at half its value.

Symmetry implies equitable treatment of gains and losses – if those are taxable, these should be entirely deductible.

It should be recalled that the rules in question came into force on 1 January 2002 and 1 January 2003.

In the year 2005, to come into force on 1 January 2006, no. 3 of article 42 was amended, which came to have the following wording, having had added to it the underlined part.

3 — The negative difference between gains and losses realized by means of onerous transfer of capital interests, including their remission and redemption with capital reduction, as well as other losses or negative patrimonial variations relating to capital interests or other components of own capital, namely supplementary contributions, contribute to the formation of taxable profit in only half their value.

And, as has been said, such legislative amendment was intended to, within the framework of losses, realized through onerous transfers, broaden the range of financial assets equivalent to capital interests, with the law itself giving supplementary contributions as an example – to which we would add accessory contributions, reserves and contingent capital instruments (CoCos), by way of example - and also to broaden the operations that came to be equated with onerous transfers for the purposes of losses, as is the case with remission and redemption operations with capital reduction, already previously provided for in the capital context and now extended to onerous transfers of other components of own capital other than capital.

The amendment made to this no. 3 was intended to include in it losses generated with the onerous transfer of other components of own capital other than share capital. That is, it intended to include in the law losses with the transfer or reimbursement of supplementary contributions, with the transfer or reimbursement of accessory contributions, with the transfer or reimbursement of contingent capital titles (CoCos) and equivalents. That, without this amendment, would be deductible in their entirety.

It is noted that it is not imaginable that, in 2005, the legislator would amend the law because it foresaw that in 2010 the SNC would come into force and that this reality could generate losses that should only be accepted as tax expenses at half their value, having safeguarded that reality which only four years later came to happen.

And if it were so, if the legislator had the ability to foresee, he should have created another number of article 45 to place in it the limitation of deduction at half its value of depreciations generated by the use of the fair value model in capital interests traded on a regulated market. Because that no. 3 is applicable exclusively to the negative balance of gains and losses and other losses generated by means of onerous transfer of capital interests and other components of own capital. Which is not the case with losses resulting from the application of fair value.

Decree-Law no. 159/2009 of 13 July made various changes to the IRC code and complementary legislation, in order to adapt the rules for determining taxable profit of taxpayers subject to IRC to the International Accounting Standards (IAS) within the context of the new Accounting Standardization System (SNC) approved by Decree-Law no. 158/2009 of 13 July, to come into force on 1 January 2010 or in the tax period with commencement after this date.

This new law clearly came to distinguish gains considered as gains, and losses as losses, from gains and losses generated by the use of the fair value model in financial investments, among which stand out the shareholdings listed on regulated markets.

The new law – paragraph b) of no. 1 of article 46 – clearly states that gains and losses generated by the use of the fair value model in shareholdings are not gains or losses.

As such, being no. 3 of article 42 of the CIRC a rule applicable exclusively to the negative balance of gains and losses and other losses generated by means of onerous transfer of capital interests or other components of own capital, it is clear that it is not applicable to losses calculated by the use of the fair value model in shareholdings.

And let it not be said that, when the IRC code was amended to adapt to the SNC, the legislator did not amend the aforementioned no. 3 because he considered that losses from the fair value model were already included in it; it will be said that the legislator did not amend no. 3 because, knowing that those losses were not included in it, he could not exclude a reality that was not included in it.

Losses from the use of fair value (obviously) were not in no. 3 before the legislative amendment of 2010 (adaptation of the CIRC to the SNC) nor did they come to be in it after that amendment, because, as has been demonstrated, at no time could they be there, on the one hand by the imposition of the principle of symmetry, and on the other, because losses from the use of fair value in capital interests are not generated within the context of onerous transfers.

And as has been said before, no. 3 of article 42 (then 45) was born (in 2003) from the need to establish clear symmetry between the taxation of gains and the deduction of losses generated with the onerous transfer of capital interests, later extended (in 2006) to the onerous transfer of other components of own capital. Always within the context of onerous transfers, which is not the case with losses from the use of fair value.

These are the reasons why I understand that losses calculated with the use of fair value in shareholdings with a price set on a regulated market – commonly known as the stock exchange – should be considered as losses for tax purposes for the entirety of their value.

Although not in agreement with the reasoning produced throughout the present arbitral decision, I understand that no. 3 of article 45 of the CIRC is not applicable to losses calculated with the use of the fair value model in shareholdings with a price formed on a regulated market, thus supporting the decision rendered.

The arbitrator

Henrique Fiúza

(Economist)