Transfer Pricing IRC Adjustment: CAAD Arbitral Decision 378/2017-T on Fiscal Loss Correction

ARBITRAL DECISION

The arbitrators Cons. Jorge Lopes de Sousa (arbitrator-president, designated by the other Arbitrators), Dr. Francisco Carvalho Furtado (designated by the Taxpayer) and Dr. Maria Manuela do Nascimento Roseiro (designated by the Tax and Customs Authority) to form the Arbitral Tribunal, constituted on 07-09-2017, agree as follows:

1. Report

A…, S.A., with registered office at …, Rua …, no. …, …, …-… …, NIPC …, hereinafter referred to as "Claimant", came, in accordance with the provisions of paragraph a) of no. 1 of article 2, paragraph b) of no. 3 of article 5 and paragraph b) of no. 2 of article 6 of the Legal Regime for Tax Arbitration (hereinafter "LRTA") to request the Constitution of an Arbitral Tribunal, with a view to the declaration of illegality and consequent annulment of the corporate income tax (IRC) assessment act no. 2017…, of 16-03-2017, relating to the taxation period of 2014, through which the tax loss of the taxation period was corrected to € 101,869.23.

The RESPONDENT is the TAX AND CUSTOMS AUTHORITY.

The Claimant designated as Arbitrator Dr. Francisco Carvalho Furtado, pursuant to the provisions of article 6, no. 2, paragraph b), of the LRTA.

The request for constitution of the Arbitral Tribunal was accepted by the President of CAAD and automatically notified to the Tax and Customs Authority on 21-06-2017.

In accordance with the provisions of paragraph b) of no. 2 of article 6 and no. 3 of the LRTA, and within the deadline provided for in no. 1 of article 13 of the LRTA, the highest official of the Tax Administration service designated as Arbitrator Dr. Maria Manuela do Nascimento Roseiro.

The Arbitrators designated by the Parties designated as Arbitrator President Councilor Jorge Lopes de Sousa, who accepted the designation.

On 31-08-2017 the parties were duly notified of this designation, and did not express any intention to refuse the designation of the arbitrators, in accordance with the combined provisions of article 11 no. 1, paragraphs a) and b) of the LRTA and articles 6 and 7 of the Code of Ethics.

In conformity with the provisions of paragraph c) of no. 1 of article 11 of the LRTA, the collective arbitral tribunal was constituted on 07-09-2017.

The Tax and Customs Authority submitted a response, in which it defended the lack of merit of the request for arbitral pronouncement.

On 19-12-2017 a meeting was held at which testimonial evidence was produced and it was decided that the proceedings continue with successive written submissions.

The Parties submitted arguments.

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

The proceedings do not suffer from nullities and there is no obstacle to the consideration of the merits of the case.

It is necessary to consider as a priority the objection of incompetence (article 13 of the Code of Administrative Court Procedure, applicable to tax arbitration proceedings by virtue of the provisions of article 29, no. 1, paragraph c), of the LRTA).

2. Facts

2.1. Proven Facts

The following facts are considered proven:

• The Claimant is a public limited company, constituted on 23.12.2013 and commenced operations on 26-12-2013;

• The Claimant is registered with main CAE 68100 – Purchase and Sale of Real Estate;

• The Claimant is engaged in the acquisition, for resale, of real estate and credits from financial institutions and in the acquisition of debt securities for subsequent management and profit generation (testimony of B…, C… and D…);

• For IRC purposes, it is taxed under the general regime and for VAT purposes it is registered in the normal regime, registered as a mixed liable person with real allocation of all goods, with quarterly frequency from 30-11-2015;

• On 31-12-2014, the share capital of the Claimant consisted of 1 share with a value of 1 euro held by E…, S.A.R.L., an entity based in Luxembourg, in turn held entirely by funds managed by F…;

• In the 2014 financial year, the Claimant did not have any employees in its service nor did it have its own facilities, with the support and logistics functions for the Claimant being concentrated in G… SA, NIPC … (Tax Inspection Report and testimony of witness B…);

• The Claimant was constituted with the purpose of acquiring the commonly designated "non-performing loans" held by national financial institutions, including the real estate acquired as a result of the execution of the guarantees associated with said credits (testimony of B…, C… and D…);

• Portuguese banking institutions seek to transfer this type of assets so as not to prejudice their viability (Document no. 5 attached with the request for arbitral pronouncement, whose contents are reproduced);

• These are movable and immovable assets with associated risk (testimony of witnesses B… and C…);

• In 2014, acquisitions were carried out essentially from H… (promise-to-sell contract included in the administrative proceedings);

• On 23 December 2014, between A… and H… (H…), a promise-to-sell contract, denominated "Receivables and Properties Promissory Sale Agreement" for € 692,000,000.00 for the acquisition of real estate and a credit portfolio (administrative proceedings);

• In the course of its activities, the Claimant incurred losses when reselling some of the real estate acquired from financial institutions, specifically in the cases indicated in document no. 6-A attached with the request for arbitral pronouncement, whose contents are reproduced (testimony of witness B…);

• Some of the real estate requires repairs to be in condition to be sold (testimony of witness B…);

• Some of the acquired real estate has not yet been resold, specifically those indicated in document no. 8 attached with the request for arbitral pronouncement, whose contents are reproduced;

• With respect to these assets there are no guarantees that any eventual sale, should it occur, will be made at values higher than the acquisition values, plus the management and maintenance costs associated with holding them (testimony of witness B…);

• In the years following 2014 the Claimant purchased debt instruments (document no. 7 attached with the request for arbitral pronouncement, whose contents are reproduced);

• During the 2014 fiscal year, the Claimant obtained financing, in the form of subordinated loans, from its sole shareholder, E…, S.A.R.L. ("E…"), in order to have funds for the adequate development of its activities (administrative proceedings and testimony of witness B…);

• All subordinated loans agreed by the Claimant were established with reference to a maturity of 4 years (administrative proceedings);

• The subordinated loans were denominated in Euros and have amounts ranging from €764,965.00 to €75,127,790.77 (administrative proceedings);

• The contracts in question provide that the repayment of capital and interest occurs only at maturity, although they also provide for the possibility of making early repayments of capital and interest, without any bonus or penalty (administrative proceedings);

• The rate contracted in the subordinated loans is fixed in nature and amounts to 9% on the amount in debt, with the respective interest taking the form of simple interest (administrative proceedings);

• The subordinated loan contracts do not have any associated guarantees (administrative proceedings and testimony of witnesses B…, C… and D…).

• The main activity of the Claimant is the purchase of mortgage credits (testimony of witness B…);

• For the Claimant to proceed with the investments provided for in its business plan, the underlying financing needs always implied the contracting of additional credits from banking entities;

• On 28-05-2015, the Claimant entered into a loan agreement with real estate mortgage with J…, in the amount of € 5,613,072.40 (five million six hundred and thirteen thousand and seventy-two euros and forty cents), constituting as security a mortgage on 84 properties with a total value of € 8,138,954.98 (eight million one hundred and thirty-eight thousand, nine hundred and fifty-four euros and ninety-eight cents) (document no. 9 attached with the request for arbitral pronouncement, whose contents are reproduced);

• On 19-11-2015, the Claimant entered into a new loan agreement with real estate mortgage with J…, in the amount of € 706,870.45, constituting as security a mortgage on 11 properties with a total value of € 1,024,962.15 (document no. 10 attached with the request for arbitral pronouncement, whose contents are reproduced);

• The bank loans obtained in (2015) by the Claimant from banking institutions implied the granting to the bank creditor of mortgages on real estate, whereby these assets became pledged as real guarantees for these bank credits and are not available to offset any potential failure of the Claimant to repay the subordinated loans (testimony of witnesses B… and C…);

• A tax inspection was carried out on the Claimant under service order no. OI2015… in which various corrections were made, including an increase of € 95,426.99 relating to financial charges that it considered non-deductible related to financing received by the Claimant from its sole shareholder, E…, in the form of subordinated loans;

• In the Tax Inspection Report contained in the administrative proceedings, whose contents are reproduced, the following is stated, among others:

III - Description of the facts and grounds for purely arithmetic corrections

As already mentioned, the taxpayer did not file the IRC income tax return model 22 for the period in question.

In this context, the taxpayer was requested at the beginning of the inspection action to present the analytical balance sheet of December 2014 and other documentation supporting the accounting, in order to proceed with the declarative regularization of what was detected.

During the inspection procedure all the accounting was analyzed, and it was verified that, in this period, the accounting result was negative in the value of € 377,551.19.

Given the failure to file the IRC income tax return model 22, the Tax Authority is competent under the provisions of paragraph b) of article 89 of the IRC Code to promote the assessment of IRC.

However, article 17 of the IRC Code establishes that the taxable profit of legal entities consists of the algebraic sum of the net result of the period and the positive and negative changes in equity verified in the same period and not reflected in that result, determined on the basis of accounting and possibly corrected in accordance with the IRC Code.

Thus, from the above, the fiscal result of the 2014 period determined in accordance with articles 17, 89 paragraph b) and 90 no. 1 paragraph c), all of the IRC Code, is determined as follows:

Net Result of the Period (- € 377,551.19) + Increases to NRP = Fiscal Result

III.1 Arithmetic Corrections under IRC

(...)

III.1.2 - ANALYSIS OF FINANCING OBTAINED IN 2014

During the 2014 financial year, the taxpayer incurred various financing from the shareholder (holder of the entire share capital), as detailed below:

With respect to the financing of € 468,254.00, the amount was fully repaid on 19 August 2014, with no financial charges being recorded in this period.

The financing contracts entered into between A… and E… supporting the registered financial expenses were requested. All contracts presented were drafted in a foreign language, so translation into Portuguese was requested for those of greater value.

From the analysis of the mentioned contracts it appears that the contractual clauses established are, generically, identical between the contracts, specifically, with respect to the agreement that capital and interest be repaid at the maturity of the loan.

With the exception of the amount of € 200,000.00 which is an integral part of the financing granted by the shareholder on 20 May 2014 (in the amount of € 764,964.00) and the financing in the amount of €981,512.00, granted on 26 June 2014, whose amounts were credited to the demand deposit account held by the taxpayer with K…, the remaining financing were granted by the shareholder for direct payment of liabilities assumed by A….

The financial expenses related to interest payable to the shareholder by subordinated loans are recorded in account 6911 - Interest on obtained financing (see Annex 3).

The accounting entry in the expense account (debit) occurred as the counterpart of account 272202 - Interest to be accrued (credit) because although no debit note was issued by the shareholder, given the principle of exercise specialization provided for in article 18 of the IRC Code, A… has been calculating interest, recording the respective value in period expenses as the counterpart of this account.

III.1.2.1 - LEGAL FRAMEWORK FOR FINANCIAL EXPENSES RESULTING FROM SUBORDINATED LOAN INTEREST

As provided for in paragraph c) of no. 1 of article 23 of the IRC Code, period expenses are those that are demonstrably incurred or borne in order to obtain or guarantee income subject to tax, namely those of a financial nature, such as interest on third-party capital.

Now, according to the information gathered in the course of the inspection action, the subordinated loans carried out in 2014 by the shareholder had the purpose of providing the company with financial means to acquire real estate. The majority of acquisitions were characterized by being in bulk/packages of real estate belonging to banking institutions, essentially H… (in this case the largest deed of acquisition was executed during 2015) and Bank L… SA.

As already mentioned in this report, the taxpayer began its activities in the late 2013 period, does not have a corporate structure and, in fact, its initial share capital is not by itself sufficient to conduct the planned activities.

Thus it can be concluded that the financing carried out effectively provided the company with financial means so as to present itself more solid and comprehensive in the market in which it operates.

For the above reasons, the interest resulting from the subordinated loans carried out will generally be acceptable for fiscal purposes in accordance with the aforementioned article 23 of the IRC Code.

However, paragraph m) of no. 1 of article 23-A of the IRC Code provides that the following are not deductible for the purpose of determining taxable profit: charges for "interest and other forms of remuneration of subordinated loans and loans made by the shareholder to the company, to the extent that they exceed the rate defined by ordinance of the government member responsible for the finance area, except in the case where the regime established in article 63 applies"

Thus it is necessary to analyze the framing of the specific situation in light of the Arm's Length Principle and Transfer Pricing, provided for in article 63 of the IRC Code, given that these are financing granted by the sole shareholder E…, S.A.R.L. (E…) to the company A….

III.1.2.2 - LEGAL FRAMEWORK FOR THE ARM'S LENGTH PRINCIPLE AND TRANSFER PRICING IN RELATED PARTY TRANSACTIONS

The Arm's Length Principle, established in the national legal system in no. 1 of article 63 of the IRC Code, defines that "in commercial operations, including, in particular, operations or series of operations on goods, rights or services, as well as in financial operations, carried out between a taxpayer and any other entity, subject or not to IRC, with which it is in a situation of special relationships, terms or conditions must be contracted, accepted and practiced substantially identical to those that would normally be contracted, accepted and practiced between independent entities in comparable operations" (emphasis ours).

To determine which terms and conditions are normally agreed, accepted or practiced between independent entities, no. 2 of the same article states that "the taxpayer must adopt (...) the method or methods capable of ensuring the highest degree of comparability between the operations or series of operations it carries out and others substantially identical, in normal market situations or in the absence of special relationships, taking into account, in particular, the characteristics of the goods, rights or services, market position, economic and financial situation, business strategy, and other relevant characteristics of the taxpayers involved, the functions they perform, the assets used and the allocation of risk."

To this end, the taxpayer must choose one of the methods referred to in no. 3 of article 63 of the IRC Code, which are detailed in Ordinance no. 1446-C/2001, of 21 December, which regulated transfer pricing in operations carried out between a taxpayer and any other entity.

Furthermore, the taxpayer must, in accordance with no. 6 of article 63 of the IRC Code, "maintain organized, in accordance with the terms established for the tax documentation process referred to in article 130, the documentation relating to the policy adopted with respect to transfer prices, including the guidelines or instructions relating to its application, the contracts and other legal acts entered into with entities with which it is in a situation of special relationships, with the modifications that occur and with information about its respective compliance, the documentation and information relating to those entities and likewise the companies and the goods or services used as a basis for comparison, the functional and financial analyses and sector data, and other information and elements it took into account to determine the terms and conditions normally agreed, accepted or practiced between independent entities and for the selection of the method or methods used."

III.1.2.3 - SUBORDINATION OF THE SUBORDINATED LOANS CARRIED OUT (RELATED PARTY TRANSACTION) TO TRANSFER PRICING RULES

As already mentioned, for the application of transfer pricing rules, it is necessary that the taxpayer carry out operations with an entity with which it is in a situation of special relationships, and must then ensure that substantially identical terms or conditions are being contracted and practiced to those that would normally be practiced between independent entities in comparable operations.

It is thus necessary to know the legal definition of special relationships and whether it applies to the case under analysis, that is, to the subordinated loans made by the holder of A…'s share capital in 2014.

No. 4 of article 63 of the IRC Code defines that "special relationships exist between two entities in situations in which one has the power to exercise, directly or indirectly, significant influence over the management decisions of the other, which is considered verified, in particular, between:

a) An entity and the holders of its respective capital, or the spouses, ascendants or descendants thereof, who hold, directly or indirectly, a participation of not less than 20% of the capital or voting rights; (...)

b) (...)

c) An entity and the members of its corporate bodies, or of any bodies of administration, management, direction or supervision, and their respective spouses, ascendants and descendants; (..,)".

With respect to what is stipulated, and considering that A…'s share capital was held entirely by E…, S.A.R.L. (E…), an entity based in Luxembourg, we can conclude that it falls within paragraph a) of no. 4 of article 63 of the IRC Code and consequently, in the period under analysis, the shareholder had the power to exercise significant influence over the management decisions of the company, with special relationships existing between the two entities.

Based on the above, we conclude that the case in question - the carrying out of subordinated loans by the shareholder to the company - is a related party transaction, within the meaning of no. 4 of article 63 of the IRC Code and paragraph b) of no. 3 of article 1 of Ordinance no. 1446-C/2001, of 21 December, and is thus subject to compliance with the Arm's Length Principle, already mentioned.

Given the volume of business, the taxpayer is exempt from preparing the transfer pricing documentation file, in accordance with what is stipulated in no. 3 of article 13 of the aforementioned Ordinance referred to in no. 6 of article 63 of the IRC Code, for the 2014 period.

From the documentary analysis of the values recorded as expenses in the period, it was found that there is no documentation in the accounting that demonstrates the obtaining of the interest rate assumed contractually, and the assumptions inherent in the formula for calculating the interest rates contracted and practiced in 2014 have not been presented.

When questioned by the taxpayer about the determination of the contracted interest rate, it presented, in response to what was requested, a document drawn up in English, prepared by F…, with the designation N…, which is attached to this report. (see Annex 4)

From the aforementioned document, the following conclusions were drawn:

• the taxpayer framed the financing operation as a subordinated debt instrument (subordinated bonds are debt securities covered by a subordination clause, i.e., in case of bankruptcy of the issuing entity, they are only repaid after all other creditors for non-subordinated debt), with a high level of risk;

• as justification for the contracted interest rate, it presents an analysis of interest rates relating to senior debt, to speculative investments and to subordinated debt instruments. It also mentions that the financing obtained, from the capital holder, should have a remuneration that should be between that of deeply subordinated debt and the cost of equity;

• comparative graphs are also presented, relating to loans with a high level of risk, with the behavior of the markets in Europe and the United States and graphs relating to the behavior of the remuneration of sovereign debt in Portugal and Germany.

Regarding the document presented, some considerations must now be made:

• The financing from the holder of A…'s share capital aimed to provide the company with financial means to acquire real property. The use of the funds obtained for this purpose was indeed verified.

• it was verified that the real estate was acquired, for the most part, from banking institutions. The transaction value of the acquired real estate does not assume the characteristic of having intrinsically a speculative value, there being no acquisitions at values above the market value of the goods (on the contrary in some cases they are below market value).

• From the above, it can be inferred that the application of the funds obtained has an inherent reduced risk due to the fact that it is applied in real property and due to the fact that it is acquired at lower prices (values below market value).

• For the reasons described above, it does not seem plausible to us the comparison/justification made by the taxpayer given that it is based on credits that have a high level of risk and with a maturity higher than that contractually assumed by E… and A…. The operations compared, presented by the taxpayer, do not involve similar functions, assets or risks.

It is concluded, therefore, that the operations have different economic and financial characteristics, and therefore the method is not the most appropriate to provide the best and most reliable estimate of the terms and conditions that would normally be contracted, accepted and practiced, in a situation of arm's length, that is, contracted between independent entities.

III.1.2.4 - SELECTION OF THE MOST APPROPRIATE METHOD FOR DETERMINING TRANSFER PRICE IN ACCORDANCE WITH THE ARM'S LENGTH PRINCIPLE

In accordance with the provisions of no. 2 of article 63 of the IRC Code, as well as in no. 1 of article 4 of Ordinance 1446-C/2001, of 21 December, the taxpayer must adopt, for the determination of the terms and conditions that would normally be agreed, accepted or practiced between independent entities, the most appropriate method for each operation or series of operations.

According to no. 2 of article 4 of the aforementioned Ordinance, the most appropriate method for each operation or series of operations is considered to be that which is capable of providing the best and most reliable estimate of the terms and conditions that would normally be contracted, accepted and practiced in a situation of arm's length, with the choice being made for the method most apt to provide the highest degree of comparability between the related operations and other unrelated operations and between the entities selected for comparison, which has better quality and greater quantity of available information for its adequate justification and application and which implies the least number of adjustments for the purpose of eliminating the differences existing between the facts and comparable situations.

The IRC Code and the aforementioned Ordinance enumerate the methods to be used, in line with the OECD Report guidelines, which are grouped into one of two typologies, namely:

--> Traditional Methods or Transaction-Based Methods (Traditional Transactions Methods);

--> Methods Based on Transaction Profits (Transactional Profit Methods).

The following transaction-based methods are identified in no. 3 of article 63 of the IRC Code and in no. 1 of article 4 of the Ordinance:

• Comparable Uncontrolled Price Method;

• Resale Price Method;

• Cost Plus Method

and, furthermore, the following profit-based methods:

• Profit Split Method;

• Net Profit Margin Method.

In accordance with the most recent OECD Guidelines on transfer pricing (see § 2.1 and following of the Guidelines), the selection of one of these methods for evaluating the compliance of a related party transaction with the Arm's Length Principle aims to find the most appropriate method for each specific case.

In this sense, and considering the provisions in § 2.3 of those Guidelines, transaction-based methods are seen as the most direct methods of establishing whether the conditions practiced in the context of a related party transaction are arm's length.

Moreover, since it is possible to identify comparable transactions in the open market, the Comparable Uncontrolled Price Method constitutes the most direct and most reliable means of applying the Arm's Length Principle, and should be given preference over all others.

In accordance with no. 2 of article 6 of the Ordinance, this method can be used, namely, in the following conditions:

"a) When the taxpayer or an entity belonging to the same group carries out a transaction of the same nature that has as its object a service or product identical or similar, in quantity or comparable value, and in substantially identical terms and conditions, with an independent entity in the same or similar markets" (internal comparables);

"b) When an independent entity carries out an operation of the same nature that has as its object a service or identical or similar product, in quantity or comparable value, and in substantially identical terms and conditions, in the same market or similar markets" (external comparables).

The Comparable Uncontrolled Price Method

The Comparable Uncontrolled Price Method (CUPM) consists of comparing the price paid for goods, rights or services transferred in a related party transaction with the price paid for goods, rights or services transferred in a comparable unrelated transaction.

This method can be used, in particular, when the taxpayer under analysis or an entity belonging to the same group carries out an operation of the same nature, which has as its object an identical service, with an independent entity. Since it is possible to identify comparable transactions in the open market, the CUPM constitutes the most direct and most reliable means of applying the arm's length principle. Consequently, in this case this method should be given preference over all others.

Similarly, no. 1 of article 6 of Ordinance no. 1446-C/2001 states that "the adoption of the comparable uncontrolled price method requires the highest degree of comparability with focus both on the object and other terms and conditions of the transaction and on the functional analysis of the intervening entities", which means that, if it can be applied, it satisfies the condition provided for in no. 2 of article 4 of the same ordinance and is therefore considered the most appropriate method.

The Comparable Uncontrolled Price Method thus assumes itself as the most appropriate method to apply, with its preference over other methods deriving from the fact that it constitutes the most direct way to determine whether the conditions agreed between related entities are arm's length conditions.

Thus, since, as will be seen, the conditions for applying this method to the financial operation under analysis are met, the choice of this method over the others is perfectly justified.

Rejection of the Resale Price Method

The Resale Price Method is based on the resale price practiced by the Taxpayer in a comparable transaction carried out with an independent entity, having as its object a product acquired from an entity with which it is in a situation of special relationships, from which the gross profit margin practiced by a third entity in a comparable transaction is subtracted (see article 7 of the Ordinance).

This method is especially recommended for distribution activities (see paragraphs 2.14 to 2.31 of the 1995 OECD Report). Thus, since the operations under analysis do not fall within the category of distribution activities, we reject the use of this method.

Rejection of the Cost Plus Method

The Cost Plus Method is based on the amount of costs incurred by a supplier of a product or service supplied in a related party transaction, to which is added the gross profit margin practiced in a comparable unrelated transaction (see article 8 of the Ordinance).

The use of this method is recommended by the OECD essentially in the case of sales of semi-finished products between associated companies, within the framework of agreements concluded between associated companies in order to jointly benefit from equipment or for long-term supply, or when the related party transaction consists of the provision of services (see paragraph 2.32 of the 1995 OECD Report). Thus, given the controversial operation, we reject the use of this method.

Rejection of non-traditional methods

The commonly designated non-traditional methods (profit split method and net profit margin method) will only be capable of use when traditional methods (comparable uncontrolled price method, resale price method and cost plus method) cannot be applied (see paragraph b) at the end of no. 1 of article 4 of the Ordinance).

In light of all that has been stated, the comparable uncontrolled price method proves to be the most appropriate in accordance with the provisions of no. 2 of article 4 of the Ordinance, and will therefore be used in the search for conditions that would be practiced between independent entities in operations similar to those now analyzed.

Search for a Comparable Transaction

The Comparable Uncontrolled Price Method can be used by comparing the conditions that occurred in a related party transaction with the conditions practiced in a transaction carried out with an independent entity.

According to no. 3 of article 4 of Ordinance no. 1446-C/2001, two transactions meet the conditions to be considered comparable if they are substantially identical, which means that their relevant economic and financial characteristics are analogous or sufficiently similar, such that the differences existing between the transactions or between the companies involved in them are not capable of significantly affecting the terms and conditions that would be practiced in a normal market situation or, if they are, it is possible to make the necessary adjustments that eliminate the relevant effects caused by the differences verified.

Now, for the case in question, with respect to 2014, an analysis was carried out:

• of the interest rates disclosed monthly by the European Central Bank (ECB) - MFI interest Rates, and it was found that, on an annual basis, they do not exceed the rate of 4.5% (see Annex 5);

• of the statistical information disclosed by the Bank of Portugal, and it was found that the annualized agreed rate ("aar)" during 2014, for financing with the characteristics of the taxpayer's financing, is generically in the interval between 3% and 5%, with the aar reported in December 2014, for transactions above 1 million euros, being 3.48% (see Annex 6);

• the statistical note relating to interest rates for 2014, disclosed by the Bank of Portugal, which states that the reduction in interest rates was more pronounced in new loans granted to non-financial companies, whose average rate was set, in December 2014, at 4.09 per cent, 99 basis points (b.p.) less than in the comparable period. (see Annex 7).

As can be seen, the remuneration of the taxpayer's financing is being remunerated at rates higher than those contained in the statistical information described above.

Now it is understood that by comparable or similar lending, it will be necessary to consider the following factors, such as the amount and duration of the loan, its nature or purpose, the currency in which it is specified, and the financial situation of the borrower.

Given the lack of presentation of a comparable transaction by the taxpayer, it was decided to use as source the data from the entity Bank of Portugal, compiled by PORDATA, obtaining as the annual average of the interest rate on lending operations to companies, during the 2014 period, the

percentage of 4.89% (see Annex 8), on the grounds that it does not contradict all the statistical information provided by the ECB, takes into account the characteristics of the Portuguese financial market and is the one that presents the highest value.

In fact, from the analysis of all statistical information, reported to the 2014 period, provided by official entities, where rates are depicted that result from averages practiced in the market, it was opted for the present effect by the one that presents the highest value, and is therefore the most favorable to the taxpayer.

In light of all that has been mentioned, we conclude that the external comparables used by the taxpayer to justify the conformity of the related party transaction with the Arm's Length Principle do not meet the requirements imposed by Ordinance no. 1446-C/2001, of 21/12, thus not providing the highest degree of comparability between the related transaction and other unrelated transaction(s) and, consequently, not satisfying the Arm's Length Principle.

It was concluded, then, that the interest rate assumed contractually by the taxpayer manifests a way of remonerating the holder of its share capital, since it exceeds the remuneration rates of financing used by monetary financial institutions.

Given the grounds adduced in the preceding points, if the transactions contracted between A… and E… had been entered into between independent entities, terms similar to those defined in the financial market would have been contracted, accepted and practiced, and A… would have borne a lower financing rate. Thus, its taxable profit is under-quantified, as a result of the accounting of excessive financial charges, relative to those that would be required in conditions of arm's length, with a violation of the Arm's Length Principle established in no. 1 of article 63 of the IRC Code thus being verified.

III.1.2.5 - IMPACT OF VIOLATION OF THE ARM'S LENGTH PRINCIPLE ON THE DETERMINATION OF TAXABLE RESULT

In light of all the above, it is necessary to calculate the impact of the violation of the Arm's Length Principle on the determination of the taxable profit of A…, considering that such transaction, in conditions of arm's length, and in compliance with the provisions of no. 1 of article 63 of the IRC Code, should involve terms analogous to those that would be defined between independent entities in comparable transactions, using for this purpose an interest rate similar to the market rates indicated above. Consequently, it is considered that the interest rate of 4.89% is applicable to the 2014 loans granted by the parent company.

Thus, verifying that the interest rates applied by the taxpayer for the remuneration of loans, of 9%, 8.8297%, 7.9895%, 7.7574%, respectively for the financing mentioned above in point III.1.1 of this report, do not constitute the market rates for this purpose and there being a reference rate for the period under analysis, stated above, it is verified that they are not accepted as fiscal costs the charges (interest) corresponding to the excess in the interest rate of the loans, whereby in the table below the interest accepted as fiscal costs is calculated.

In these terms, considering the provisions of article 3 of Ordinance no. 1446-C/2001, of 21 December, which states that "whenever the terms and conditions of a related party transaction in which a taxpayer and an entity not resident in Portuguese territory intervene differ from those that would normally be agreed, accepted or practiced between independent entities, that entity must make, in the periodic income tax return referred to in article 112 of the IRC Code, a positive correction corresponding to the fiscal effects attributable to that deviation, so that taxable profit is not different from what would be determined in the absence of special relationships" and the provisions of no. 1 of article 63 of the IRC Code, the amount of € 95,426.99 must be added to the result determined by the taxpayer, corresponding to non-deductible charges. This value results from the difference between the financial expenses recorded in the accounting by the taxpayer and the financial expenses considered as corresponding to transactions carried out between independent entities (€ 242,408.00 - € 146,981.01).

In sum of the above, regarding arithmetic corrections under IRC, it was determined that fiscally non-deductible expenses in the amount of € 275,681.96 (€ 180,254.97 + € 95,426.99)

(...)

IX - Right to Hearing

On 2016/10/18 through office no. … the taxpayer was notified to exercise the right to hearing in accordance with articles 60 of the General Tax Law and 60 of the Complementary Regime of Tax and Customs Inspection Procedure.

Regarding the facts and grounds described in the corresponding draft report, the taxpayer came to pronounce itself on 2016/11/02. (see Annex 9)

The taxpayer came to present the grounds for its disagreement regarding the arithmetic correction under IRC relating to financial charges.

The taxpayer states that, effectively, the terms and conditions practiced in the operations carried out with the E… company are subject to the transfer pricing rules provided for in article 63 of the IRC Code.

In this sense, the taxpayer again referred to a study developed in order to support the definition of interest rates applicable to the financing granted by the parent company. It emphasizes that the conclusions of such study take into account the specific characteristics of the operations in question, such as, the currency, the market where they were established and the type of subordination, thus considering that there is a degree of comparability of market data "by virtue of reflecting conditions similar to those set out in the intragroup financial operations established between the applicant and its sole shareholder.

The taxpayer reiterates the idea that there are "premiums" added to the market rates listed that are intrinsic to the degree of subordination of the debt operations under analysis. It is argued that the financing in question, by assuming the nature of subordinated loans, are automatically characterized as subordinated debt, and therefore the agreed interest rate respects the arm's length principle.

It further states that, assuming the disregard by the Inspection Services of the presented study "it is not considered that the factors of comparability most appropriate and required in a specific analysis to this type of financial operations with peculiar characteristics and in a specific and proper context are respected in the selection of comparables made by the Inspection Services".

It argues that the sources of information considered by the Tax Authority provide information on interest rates resulting from a weighted average "of the sample collected which does not allow identifying the interval of interest rates agreed by the entities involved in the unrelated transactions considered for the definition of the average interest rate of the banking system." It states that the use of weighted averages for the intended purpose is questionable, stating that it cannot be assumed that averages are the only admissible reference for assessing market remuneration for the operations in question since the interval of market remuneration rates in the transactions used to measure that average is unknown.

In conclusion of the exercise of the right to hearing, the taxpayer, considering that the information relating to the annual average interest rate on loans granted to companies, prepared by the Bank of Portugal, does not consider elements of comparability, submits an economic analysis of transfer prices developed by an independent entity (the consulting company O…), based on the use of information provided by the Bloomberg database. This analysis was attached to the taxpayer's submission. (see Annex 10)

From this report, it appears that the framing given to the financial operations under analysis is that it concerns subordinated debt, given the provisions of paragraph a) of no. 3 of article 245 of the Commercial Code which provides that if bankruptcy or insolvency is decreed "the subordinated loans can only be repaid to their creditors after all the company's debts to third parties are completely satisfied".

In these terms, the aforementioned entity, in the search in the Bloomberg database, in defining the criteria that allow obtaining comparable market transactions, required, among others, that only loans with characteristics of subordinated transactions and with absence of guarantee (this definition was considered in the criteria for exporting data regarding the type of collateral) be selected.

From the analysis of the data obtained from Bloomberg, the O… company concluded that the interest rate agreed in the subordinated loans incurred by A… with E… is in line with the market interval obtained with the interest rates established in the transactions selected as comparable, presenting the following table with the arm's length interval:

Now, and in accordance with the market interval obtained from the analysis of the Bloomberg data, it appears that 50% of the financing in the transactions selected as comparable have an interest rate up to 4.80, 75% up to 7.00%, the taxpayer considers that the applied rate of 9% would be acceptable by still being less than the maximum observed of 15%. However, analyzing the graph of the distribution of these observed rates and considered comparable by the taxpayer, the entire 4th quartile should be considered "outlier" and abnormal.

Now, analyzing this list, it is found that, in addition to all the financing having a very high exposure risk, there are very few transactions relating to companies engaged in the real estate sector (consequently with underlying real estate) and all of them with rates lower than those practiced by the taxpayer and the proposal of the Tax Authority in the context of this inspection procedure.

In fact, all rates presented above 8.13% refer to financing granted to companies in the financial services area (Financial Services). Another finding regarding the aforementioned report is that although the sample was established as a criterion for countries that make up the European Union, it appears that in the conclusions obtained no transaction located in Portugal was considered.

Despite the conclusions described, it is noted that, possibly, the only transaction that could be considered comparable with the taxpayer's financing transaction would be the one identified with "…/BE /M…/05-12-2014 /05-02-2021 /6 /EUR /SUBORDINATED /4.85%" because it is a company related to the real estate sector, whose financing was contracted in December 2014, a time of year coinciding with the date on which the taxpayer contracted its financing. In line with what has already been mentioned, it appears that the interest rate considered by the Tax Authority as being the reference does not deviate from the interest rates practiced at European level for companies that develop activities that fall within the taxpayer's area of activity.

In light of the above, it is considered that the transactions contained in the presented report include observations that are not comparable to the financing obtained by A…, whereby it is not acceptable fiscally to accept the conclusion presented regarding the arm's length interval.

Finally, regarding the fact that the taxpayer contests the use by the Inspection Services of an average rate as a reference, it should be argued that, not having been able to obtain a transaction exactly comparable to the transaction under analysis (comparison with market situations or absence of special relationships taking into account, namely, the characteristics of the goods and business strategy) it was considered to use as a reference the statistical information published by the entity that oversees the activity of credit institutions in Portugal. As the taxpayer states, the published average rate refers to transactions denominated in euros, contracted by financial institutions and granted to residents, with its value resulting from a sample that contains transactions with rates higher than the average and others lower than the average.

In these terms, given the absence of an exactly comparable transaction, it is considered fiscally that the most balanced approach is to use as a reference, for calculating financial charges that are fiscally deductible, the average rate published by the Bank of Portugal, which was found to fall below those practiced in the observations considered in the study presented by the taxpayer for P…, Q… and M…, contracted at the end of 2014.

Now, taking into account all that has been stated and, considering that the taxpayer presented as comparable operations which these Inspection Services do not consider comparable, and having not presented an interest rate that is adjacent to the average rate published by the Bank of Portugal for 2014, these services understand that it is appropriate to maintain the proposed correction.

• In the context of the right to hearing, the Claimant only contested the correction made in terms of transfer pricing;

• On 26-11-2016, the Tax and Customs Authority issued the additional IRC assessment no. 2016…, of 23-11-2016, relating to the taxation period of 2014, in which it fixed the taxable loss of the Claimant at € 0.00 (zero euros and zero cents) (Document no. 4 attached with the request for arbitral pronouncement, whose contents are reproduced); [1]

• On 23-02-2017, the Claimant submitted the periodic income tax return/IRC model 22 for the same period of 2014 (document no. 3 attached with the request for arbitral pronouncement, whose contents are reproduced);

• On 22-03-2017, the Claimant was notified of the additional IRC assessment no. 2017…, of 16-03-2017, relating to the taxation period of 2014, through which the tax loss of the taxation period was corrected to € 101,869.23 (one hundred and one thousand eight hundred and sixty-nine euros and twenty-three cents) (Documents nos. 1 and 2 attached with the request for arbitral pronouncement, whose contents are reproduced);

• On 20-06-2017, the Claimant submitted the request for arbitral pronouncement that gave rise to the present proceedings.

2.2. Unproven Facts and Statement of Facts

There are no facts relevant to the decision of the case that have not been proven.

The determination of the facts is based on the Tax Inspection Report, the documents attached with the request for arbitral pronouncement and the testimonies referred to on specific points.

The witnesses appeared to testify with impartiality and with knowledge of the facts on which they testified.

The Tax and Customs Authority explicitly states that it finds a true divergence between the Claimant and the Respondent on the facts (article 114 of the Response).

3. Law

3.1. Scope of the Proceedings

The Tax and Customs Authority made various corrections to the Claimant's taxable matter, but the Claimant only impugns the assessment insofar as it is based on the correction made on the basis of the application of the transfer pricing regime.

The tax arbitration proceeding, as an alternative means to the judicial challenge proceeding (no. 2 of article 124 of Law no. 3-B/2010, of 28 April), is, like the latter, a procedural means of mere legality, which aims to declare the illegality of acts of the types indicated in article 2 of the LRTA and to eliminate the legal effects produced by them, annulling them or declaring their nullity or non-existence [articles 99 and 124 of the CPPT, applicable by virtue of the provisions of article 29, no. 1, paragraph a), thereof].

Therefore, the Arbitral Tribunal's object of appraisal being the act practiced, its legality must be appraised in light of its tenor, as it was practiced, and the tribunal cannot, faced with the finding of the invocation of an illegal ground as support for the administrative decision, appraise whether its action could be based on other grounds. ( [2] )

On the other hand, being the impugned act the object of the proceeding, it is not a question of appraising whether or not the Claimant's application of the transfer pricing regime was correct, but only of determining whether the correction made by the Tax and Customs Authority has legal support.

3.2. Appraisal of the Question

The Claimant was constituted with the purpose of acquiring the commonly designated "non-performing loans" held by national financial institutions, including the real estate acquired as a result of the execution of the guarantees associated with said credits.

The Claimant obtained financing through subordinated loans made by its sole shareholder, E…, S.A.R.L..

In accordance with the provisions of paragraph m) of no. 1 of article 23-A of the IRC Code, the following are not deductible for the purpose of determining taxable profit: "interest and other forms of remuneration of subordinated loans and loans made by shareholders to the company, to the extent that they exceed the rate defined by ordinance of the government member responsible for the finance area, except in the case where the regime established in article 63 applies".

Article 63 of the IRC Code establishes the following, insofar as it is relevant here:

Article 63

Transfer Pricing

1 - In commercial operations, including, in particular, operations or series of operations on goods, rights or services, as well as in financial operations, carried out between a taxpayer and any other entity, subject or not to IRC, with which it is in a situation of special relationships, terms or conditions must be contracted, accepted and practiced substantially identical to those that would normally be contracted, accepted and practiced between independent entities in comparable operations.

2 - The taxpayer must adopt, for the determination of the terms and conditions that would normally be agreed, accepted or practiced between independent entities, the method or methods capable of ensuring the highest degree of comparability between the operations or series of operations it carries out and others substantially identical, in normal market situations or in the absence of special relationships, taking into account, in particular, the characteristics of the goods, rights or services, market position, economic and financial situation, business strategy, and other relevant characteristics of the taxpayers involved, the functions they perform, the assets used and the allocation of risk.

3 - The methods used must be:

a) The comparable uncontrolled price method, the resale price method or the cost plus method;

b) The profit split method, the net profit margin method or another method, when the methods referred to in the preceding paragraph cannot be applied or, if they can, do not allow obtaining the most reliable measure of the terms and conditions that independent entities would normally agree, accept or practice.

4 - Special relationships are considered to exist between two entities in situations in which one has the power to exercise, directly or indirectly, significant influence over the management decisions of the other, which is considered verified, in particular, between:

a) An entity and the holders of its respective capital, or the spouses, ascendants or descendants thereof, who hold, directly or indirectly, a participation of not less than 20 % of the capital or voting rights;

b) Entities in which the same capital holders, their respective spouses, ascendants or descendants hold, directly or indirectly, a participation of not less than 20 % of the capital or voting rights;

c) An entity and the members of its corporate bodies, or of any bodies of administration, management, direction or supervision, and their respective spouses, ascendants and descendants;

d) Entities in which the majority of the members of corporate bodies, or members of any bodies of administration, management, direction or supervision, are the same persons or, being different persons, are linked by marriage, a legally recognized de facto union or straight-line kinship;

e) Entities linked by a subordination contract, an equal group contract or another contract with equivalent effect;

f) Companies that are in a relationship of control, in accordance with article 486 of the Commercial Code;

g) Entities whose legal relationship makes it possible, by its terms and conditions, for one to condition the management decisions of the other, based on facts or circumstances unrelated to the commercial or professional relationship itself;

h) An entity, whether resident or non-resident with a permanent establishment situated in Portuguese territory, and an entity subject to a clearly more favorable tax regime, resident in a country, territory or region contained in the list approved by ordinance of the government member responsible for the finance area.

This regime is complemented by Ordinance no. 1446-C/2001, of 21 December, which establishes the following in its articles 4 and 6, invoked by the Claimant:

Article 4

Determination of the Most Appropriate Method

1 - The taxpayer must adopt, for determining the terms and conditions that would normally be agreed, accepted or practiced between independent entities, the most appropriate method for each operation or series of operations, taking into account the following:

a) The comparable uncontrolled price method, the resale price method or the cost plus method;

b) The profit split method, the net profit margin method or another method appropriate to the facts and specific circumstances of each transaction that satisfies the principle stated in no. 1 of article 1 of this ordinance, when the methods referred to in the preceding subparagraph cannot be applied or, if they can, do not allow obtaining the most reliable measure of the terms and conditions that independent entities would normally agree, accept or practice.

2 - The most appropriate method for each operation or series of operations is considered to be that which is capable of providing the best and most reliable estimate of the terms and conditions that would normally be agreed, accepted or practiced in a situation of arm's length, with the choice being made for the method most apt to provide the highest degree of comparability between the related transactions and other unrelated transactions and between the entities selected for comparison, which has better quality and greater quantity of available information for its adequate justification and application and which implies the least number of adjustments for the purpose of eliminating the differences existing between the facts and comparable situations.

3 - Two transactions meet the conditions to be considered comparable if they are substantially identical, which means that their relevant economic and financial characteristics are analogous or sufficiently similar, such that the differences existing between the transactions or between the companies involved in them are not capable of significantly affecting the terms and conditions that would be practiced in a normal market situation or, if they are, it is possible to make the necessary adjustments that eliminate the relevant effects caused by the differences verified.

4 - Whenever there are well-founded doubts about the reliability of the values that would be obtained with the application of a given method, the taxpayer must attempt to confirm such values by means of the application of other methods, either in isolation or in combination.

5 - If, within the scope of application of a method, the use of two or more comparable unrelated transactions or the application of more than one method considered equally appropriate leads to a range of values that ensures a reasonable degree of comparability, no correction becomes necessary, if the relevant conditions of the related transaction, in particular the price or profit margin, are within that range.

(...)

Article 6

Comparable Uncontrolled Price Method

1 - The adoption of the comparable uncontrolled price method requires the highest degree of comparability with focus both on the object and other terms and conditions of the transaction and on the functional analysis of the intervening entities.

2 - This method can be used, in particular, in the following situations:

a) When the taxpayer or an entity belonging to the same group carries out a transaction of the same nature that has as its object a service or product identical or similar, in quantity or comparable value, and in substantially identical terms and conditions, with an independent entity in the same or similar markets;

b) When an independent entity carries out an operation of the same nature that has as its object a service or identical or similar product, in quantity or comparable value, and in substantially identical terms and conditions, in the same market or similar markets.

3 - Whenever a related party transaction and an unrelated transaction are not substantially comparable, the taxpayer must identify and quantify the effects caused by the differences existing in transfer prices, which must be of a secondary nature, making the necessary adjustments to eliminate them, in order to determine an adjusted price corresponding to that of a comparable unrelated transaction.

In the case in question, there is agreement between the Parties regarding the application of the transfer pricing regime provided for in article 63 of the IRC Code, specifically regarding the existence of "special relationships" between the Claimant and the sole shareholder, as referred to in the Tax Inspection Report: "the share capital of A… was held entirely by E…, S.A.R.L. (E…), an entity based in Luxembourg, we can conclude that it falls within paragraph a) of no. 4 of article 63 of the IRC Code and consequently, in the period under analysis, the shareholder had the power to exercise significant influence over the management decisions of the company, with special relationships existing between the two entities".

Thus, the remuneration of the subordinated loans for the determination of the Claimant's taxable profit will be relevant in terms and conditions that would normally be contracted, accepted and practiced between independent entities in comparable operations, determined in accordance with the transfer pricing regime referred to in article 63 of the IRC Code and Ordinance no. 1446-C/2001, of 21 December.

At the request of the Tax and Customs Authority, the Claimant presented to it a document written in English, prepared by F…, with the designation N…, relating to the determination of the contracted interest rate, which was 9% per annum, for loans with a duration of 4 years, with interest rates actually practiced in 2014 between 7.9895% and 9%.

The Claimant framed the financing operation as a subordinated debt instrument, with a high level of risk.

The Tax and Customs Authority did not accept what was invoked by the Claimant for determining the aforementioned interest rate, on the grounds, in summary, of the following:

– The financing from the holder of A…'s share capital aimed to provide the company with financial means to acquire real property. The use of the funds obtained for this purpose was indeed verified.

– it was verified that the real estate was acquired, for the most part, from banking institutions. The transaction value of the acquired real estate does not assume the characteristic of having intrinsically a speculative value, there being no acquisitions at values above the market value of the goods (on the contrary in some cases they are below market value).

– From the above, it can be inferred that the application of the funds obtained has an inherent reduced risk due to the fact that it is applied in real property and due to the fact that it is acquired at lower prices (values below market value);

– it does not seem plausible to us the comparison/justification made by the taxpayer given that it is based on credits that have a high level of risk and with a maturity higher than that contractually assumed by E… and A…. The operations compared, presented by the taxpayer, do not involve similar functions, assets or risks.

Analyzing the methods provided for in article 63, no. 4, of the IRC Code for determining the terms and conditions that would normally be agreed, accepted or practiced between independent entities, the Tax and Customs Authority understood that the conditions for applying the Comparable Uncontrolled Price Method are met.

"The adoption of the comparable uncontrolled price method requires the highest degree of comparability with focus both on the object and other terms and conditions of the transaction and on the functional analysis of the intervening entities" (article 6, no. 1, of Ordinance no. 1446-C/2001, of 21 December).

"Two transactions meet the conditions to be considered comparable if they are substantially identical, which means that their relevant economic and financial characteristics are analogous or sufficiently similar, such that the differences existing between the transactions or between the companies involved in them are not capable of significantly affecting the terms and conditions that would be practiced in a normal market situation or, if they are, it is possible to make the necessary adjustments that eliminate the relevant effects caused by the differences verified" (no. 4 of article 4 of Ordinance no. 1446-C/2001).

To apply this method, the Tax and Customs Authority took into account:

– the interest rates disclosed monthly by the European Central Bank (ECB) - MFI interest Rates, and verified that, on an annual basis, they do not exceed the rate of 4.5%;

– the statistical information disclosed by the Bank of Portugal, and found that the annualized agreed rate (aar)" during 2014, for financing with the characteristics of the taxpayer's financing, is generically in the interval between 3% and 5%, with the aar reported in December 2014, for transactions above 1 million euros, being 3.48%;

• the statistical note relating to interest rates for 2014, disclosed by the Bank of Portugal, which states that the reduction in interest rates was more pronounced in new loans granted to non-financial companies, whose average rate was set, in December 2014, at 4.09 per cent, 99 basis points (b.p.) less than in the comparable period.

Following this analysis, the Tax and Customs Authority concluded the following:

Given the lack of presentation of a comparable transaction by the taxpayer, it was decided to use as a source the data from the entity Bank of Portugal, compiled by PORDATA, obtaining as the annual average of the interest rate on lending operations to companies, during 2014, the

percentage of 4.89% (see Annex 8), on the grounds that it does not contradict all the statistical information provided by the ECB, takes into account the characteristics of the Portuguese financial market and is the one that presents the highest value.

It is manifest that the use of the average interest rate on lending operations to companies is not a method that satisfies the requirements of comparability of transactions formulated by no. 2 of article 63 of the IRC Code, which refers to the consideration of "the characteristics of the goods, rights or services, market position, economic and financial situation, business strategy, and other relevant characteristics of the taxpayers involved, the functions they perform, the assets used and the allocation of risk".

In fact, underlying that average interest rate on lending operations to companies are necessarily underlying transactions that are completely different: of short, medium and long-term; guaranteed and unsecured; subordinated and senior debt; financing of activities with aggravated risk and of lower risk; loans to debtors with exemplary payment history and with payment default history and to debtors with good financial situation and with poor financial situation; loans to companies that deal only in the sale of real estate and to companies that engage in other activities; loans between companies with special relationships and between independent companies; loans repaid in tranches and loans with repayment only at maturity; loans at variable rates and at fixed rates; loans made before the economic crisis beginning in 2008 and after that beginning.

In any case, the transfer price correction provided for in article 63 of the IRC Code must be made through the methods provided for by law.

In the case in question, the Tax and Customs Authority opted to use one of the methods provided for by law, which is the comparable uncontrolled price method.

However, it is manifest that the requirements provided by law for the use of this method were not observed by the Tax and Customs Authority, which "requires the highest degree of comparability with focus both on the object and other terms and conditions of the transaction and on the functional analysis of the intervening entities" (article 6, no. 1, of Ordinance no. 1446-C/2001).

In fact, for two transactions to be considered comparable it is necessary that they are "substantially identical, which means that their relevant economic and financial characteristics are analogous or sufficiently similar" (no. 4 of article 4 of Ordinance no. 1446-C/2001), which clearly precludes the possibility of using for the purpose of determining the terms and conditions that would normally be agreed, accepted or practiced between independent entities an average value for whose determination an indefinite set of transactions whose characteristics are not determined was considered, as happens with a general average of loans to companies, but in which, surely and inevitably, by being all loans in euros granted by financial institutions in 2014, transactions substantially different are included, with relevant economic and financial characteristics completely different from those that the related transactions have, at the level of guarantees and credit risk.

Thus, it must be concluded that the method used by the Tax and Customs Authority violates the aforementioned no. 2 of article 63 of the IRC Code and no. 4 of article 4 and no. 1 of article 6 of Ordinance no. 1446-C/2001, of 21 December, which justifies the annulment of the assessment made on the basis of the correction illegally made, in accordance with the provisions of article 163, no. 1, of the Code of Administrative Procedure subsidiarily applicable in accordance with the provisions of article 2, paragraph c), of the General Tax Law.

Being justified the annulment of the assessment on this ground, the consideration of the remaining questions of legality raised by the Claimant is rendered unnecessary (article 130 of the Code of Civil Procedure).

4. Decision

In accordance with the above, the members of this Arbitral Tribunal agree to:

• Decide that the request for arbitral pronouncement for declaration of the illegality of the additional IRC assessment act no. 2017…, of 16-03-2017, relating to the taxation period of 2014, is well-founded, to the extent that it concerns the amount of € 95,426.99 relating to non-deductible financial charges related to financing received by the Claimant from its sole shareholder, E…, in the form of subordinated loans;

• Annul the assessment to that extent.

5. Case Value

In accordance with the provisions of article 305, no. 2, of the Code of Civil Procedure and article 97-A, no. 1, paragraph a), of the Code of Administrative Court Procedure and article 3, no. 2, of the Regulation of Costs in Tax Arbitration Proceedings, the case is valued at € 95,426.99.

Lisbon, 26-02-2018

The Arbitrators

(Jorge Lopes de Sousa)

(Francisco Carvalho Furtado)

(Maria Manuela do Nascimento Roseiro)
(dissenting as per attached declaration)

Dissenting Opinion

1. I agree that, as stated in the learned arbitral decision which was issued, the object of appraisal of the present Arbitral Tribunal is the act practiced, taking into account its tenor, as it was practiced, without being able to take into consideration other alternative grounds. That is, in the present case, it is a question of deciding whether the correction made by the Tax and Customs Authority has legal support. But, in my opinion, this judgment cannot be separated from an appraisal of the Claimant's practice in the application of the transfer pricing regime (it being certain that the Parties agree with the application of that regime to the situation in the case). And, in that perspective, I do not subscribe to some of the considerations and the conclusion of the present arbitral decision, for the reasons presented below.

2. Regarding the facts, I consider that the following aspects should be highlighted:

2.1. Amount of Financing Obtained and Guarantees Existing

The Claimant is a public limited company, constituted in late 2013 and which began its activities then, with the share capital consisting of one share, with a value of 1 (one) euro, held by a holding company based in Luxembourg, which, in turn, is held entirely by Funds managed by F… (RIT, p. 5).

In 2014, the period to which the assessment act impugned in the case relates, the Claimant – which did not have any employees in its service nor did it have its own facilities - obtained various loans from the shareholder holder of the entire share capital, to apply in the acquisition of real estate, with the following being relevant for the present case: € 764,964.00 (on 20/05/2014), € 981,512.00 (on 26/06/2014), €75,127,791.00 (on 22/12/2014) and € 1,258,964.00 (on 31/12/2014)[3].

On 23 December 2014, the Claimant entered into a promise-to-sell contract with H…, in the value of € 692,000,000.00 for the acquisition of real estate and credits. The list attached to the contract contained several hundred real estate properties to be acquired. This agreement provided for the payment of an advance payment corresponding to 20%, in the value of € 75,127,791.00, which was directly deposited by E… in an escrow bank account (blocked guarantee account) opened at H… (RIT, p. 23). In the loan contracts with the shareholder, an interest rate of 9% was provided for. [4]

This means that for a total financing of € 78,133,231.00 granted in 2014 by the sole shareholder, the amount of € 242,408.00 of interest was recorded in accounting.

In 2015, in the period following the one in question, the Claimant entered into two loan agreements with J…, in the values of € 5,613,072.40 and € 706,870.45, the first guaranteed with a mortgage on 84 properties (total value of € 8,138,954.98) and the second guaranteed with a mortgage on 11 properties (total value of € 1,024,962.15).

That is, the Claimant obtained bank loans in a total amount of € 6,319,942.85, giving as security a mortgage on only 95 properties.

Which leads us to conclude that, having acquired, only in 2014 and 2015, hundreds of properties (even not having executed the purchase of about 1,500 contained in the list of the promise contract, it will have acquired a high number of properties, to that or other entities, since the list of unsold properties acquired in 2015 is still quite large[5]), only 95 were burdened by mortgage.

Therefore, there is nothing preventing us from considering that the total amount of loans made by the shareholder to the Claimant, in the value of € 78,133,231.00 (an amount significantly higher than the financing obtained from the banking sector in 2015, in the total amount of 6,319,942.85) is not an unsecured loan, since the assets of the borrowing entity became significantly more important than the portion of the goods burdened with mortgage.

Therefore, it does not seem correct to me to draw from the fact proven in paragraph aa) of point 2.1 of the decision above - "The bank loans obtained in (2015) by the Claimant from banking institutions implied the granting to the bank creditor of mortgages on real estate, whereby these assets became pledged as real guarantees for these bank credits and are not available to offset any potential failure of the Claimant to repay the subordinated loans" - the inference that the remaining credits (relating to the subordinated loans) were prevented from being satisfied on still substantial assets, as one might be led to infer from paragraph v) - "the subordinated loan contracts do not have any associated guarantees".

2.2. Risk of Credits Granted as Subordinated Loans

The Claimant justifies the rate contracted with the sole shareholder, of 9%, in documents successively presented on the question, throughout the entire proceeding.[6]

However, regardless of the criteria used in the choice of comparables, it can be said that the justification presented by the Claimant in any of those moments, based on the respective documentation, is rooted in the attribution of a high level of risk to the financing operation carried out by its sole shareholder.

But this is not the conclusion that, in my assessment, is drawn from the evidence resulting from the case: the financing from the sole shareholder used in the acquisition of real property from banking institutions does not appear to have special risk and, although the credits of the shareholders are satisfied only after the other creditors, not only was the credit assumed in 2014 prior to the loans made with third parties only in 2015, but it is found that these loans (of much lower value than the subordinated loans made by the shareholder) will be guaranteed by mortgages on a reduced number of properties compared to those that will have been acquired by the Claimant.

And while it is true that the acquisition of a credit portfolio, provided for in the promise contract executed with H… in 2014, could constitute a greater risk, the truth is that such acquisition did not materialize due to the assignment of the Claimant's contractual position, during 2015, to another entity, I…, SA, with only the acquisition of real property being executed (RIT, p. 23). Thus, the characterization of the Claimant as having the activity that it itself chose as its object was maintained - the purchase and sale of real estate and not as an entity dedicated to purchasing financial products.

1. Application of the Transfer Pricing Regime by the AT

However, considering that the methods proposed by the Claimant do not succeed in justifying the adequacy of the contracted rate to the application of the transfer pricing regime, does not necessarily lead to the conclusion that the criterion used by the Tax Administration in the application of the "comparable uncontrolled price method" is justified. Let us see.

3.1. In the interpretation adopted by the Illustrious Colleagues of the Bench, it appears that the use by the AT of the average interest rate realized on lending operations to companies is not a method that satisfies the requirements of comparability of transactions formulated by no. 2 of article 63 of the IRC Code. Because the said average interest rate on lending operations to companies encompasses completely different transactions when "in fact for two transactions to be considered comparable it is necessary that they are "substantially identical, which means that their relevant economic and financial characteristics are analogous or sufficiently similar" (no. 4 of article 4 of Ordinance no. 1446-C/2001), which clearly precludes the possibility of using for the purpose of determining the terms and conditions that would normally be agreed, accepted or practiced between independent entities an average value for whose determination an indefinite set of transactions whose characteristics are not determined was considered, as happens with a general average of loans to companies, but in which, surely and inevitably, by being all loans in euros granted by financial institutions in 2014, substantially different transactions are included, with relevant economic and financial characteristics completely different from those that the related transactions have, at the level of guarantees and credit risk." (citing text from the judgment).

3.2. "Transfer pricing rules are (…) generally considered anti-abuse rules, which aim to eliminate for fiscal purposes any potential abusive situations in which prices practiced between entities in a situation of special relationships are used, with tax motivations (causing a displacement of taxable results to entities with losses or with registered office in the jurisdiction of lower tax pressure)". [7]

No. 2 of article 63 of the IRC Code provides that: "The taxpayer must adopt, for the determination of the terms and conditions that would normally be agreed, accepted or practiced between independent entities, the method or methods capable of ensuring the highest degree of comparability between the operations or series of operations it carries out and others substantially identical, in normal market situations or in the absence of special relationships, taking into account, in particular, the characteristics of the goods, rights or services, market position, economic and financial situation, business strategy, and other relevant characteristics of the taxpayers involved, the functions they perform, the assets used and the allocation of risk."

[Rest of dissenting opinion truncated in source document]