CAAD Ruling 397/2018-T: Deductibility of Financial Charges on Supplementary Capital Contributions Under IRC

ARBITRAL DECISION (consult full version in PDF)

The arbitrators Dr. José Poças Falcão (presiding arbitrator), Professor Doctor Luís Menezes Leitão and Dr. Leonardo Marques dos Santos (arbitrator members), designated by the Deontological Council of the Administrative Arbitration Centre to form the Arbitral Tribunal, constituted on 29-10-2018, agree as follows:

REPORT

A..., S.A., a commercial company registered under the sole registration number at the Commercial Registry Office and collective person identification number ..., with headquarters at ..., n.º..., ..., ..., with share capital of € 32,500,000.00 (hereinafter, "A..." or "Applicant"), pursuant to articles 2, no. 1, para. a) and 10, nos. 1 and 2, and 17-A of Decree-Law no. 10/2011, of 20 January (Legal Regime for Arbitration in Tax Matters, hereinafter, "LRAT"), submitted a request for constitution of a collective arbitral tribunal, in which the TAX AND CUSTOMS AUTHORITY is defendant (hereinafter, "TA" or "Respondent"), seeking the annulment of the assessment of Corporation Income Tax (hereinafter, "CIT") for the year 2014 with number 2018... and the consequent act assessing interest, in the part resulting from the adjustment consisting of the disallowance of financial charges borne by the Applicant.

1.1. The request for constitution of the arbitral tribunal was accepted by the President of CAAC and automatically notified to the TA on 20-08-2018.

1.2. Pursuant to article 6, no. 2, para. a) and article 11, no. 1, para. b) of the LRAT, as amended by article 228 of Law no. 66-B/2012, of 31 December, the Deontological Council designated as arbitrators of the collective arbitral tribunal the signatories, who communicated acceptance of the appointment within the applicable period.

1.3. On 09-10-2018 the parties were duly notified of this designation, and neither manifested any intention to refuse the designation of the arbitrators, pursuant to the combined provisions of article 11, no. 1, paras. a) and b) of the LRAT and articles 6 and 7 of the Deontological Code.

1.4. Thus, in accordance with the provisions of article 11, no. 1, para. c) of the LRAT, as amended by article 228 of Law no. 66-B/2012, of 31 December, the collective arbitral tribunal was constituted on 29-10-2018.

1.5. The TA responded, arguing that the request should be judged unfounded.

1.6. By order of 28-02-2019, the meeting provided for in article 18 of the LRAT was waived and it was decided that the case proceed with written submissions.

1.7. The parties submitted their arguments.

1.8. The arbitral tribunal was regularly constituted and is materially competent, in light of the provisions of articles 2, no. 1, para. a), and 10, no. 1, of the LRAT.

1.9. The parties are duly represented, possess legal personality and capacity, are legally entitled and are represented (articles 4 and 10, no. 2, of the same statute and article 1 of Ordinance no. 112-A/2011, of 22 March).

1.10. The case is free of nullities and no exceptions were raised.

1.11. Thus, there is no obstacle to the consideration of the merits of the case.

POSITION OF THE PARTIES

2. The Applicant argues that:

2.1. The assessment in question in this proceeding should be considered null or, at the very least, ineffective, due to the absence of a compensation statement act.

2.2. The additional CIT assessment act (and respective compensatory interest), in the total amount due of € 34,936.34, subject to this request for arbitral pronouncement, originated from the additional tax and interest assessment act numbered 2018..., embodied in the account reconciliation statement no. 2018..., in the total amount due of € 340,296.29.

2.3. This first additional assessment act was received by the Applicant on 13-04-2018, but contained an error in determining the allegedly due tax, since the TA had not considered the balance of tax benefits that the Applicant was entitled to deduct from the results of the aforementioned year 2014.

2.4. A request was filed before the deadline for voluntary payment of the aforementioned original assessment, requesting the correction of said error.

2.5. Its request was granted, and consequently the original assessment was annulled and a new assessment issued – the assessment that is partially contested in this proceeding, corresponding to number 2018..., in the amount of € 34,936.34.

2.6. Said assessment was paid.

2.7. The assessment was based on the same Tax Inspection Report that was underlying the original assessment.

2.8. The second (corrected) assessment was not accompanied by the competent compensation statement, despite multiple requests being made to the Finance Service of... – ... .

2.9. It was never able to ascertain the compensation ordered by the TA, its amounts or grounds, payment deadlines or means of challenge.

2.10. The non-existence of a compensation statement act – or the failure to notify it to the Applicant implies the nullity of the corresponding assessment act in question, with all legal consequences, or, even if not understood this way, said failure to notify will nevertheless always, at the very least, result in the ineffectiveness of said act vis-à-vis the Applicant, pursuant to and for the purposes of article 36, no. 1, of the Code of Tax Procedure and Process (hereinafter, "CTPP").

The Applicant further argues that:

2.11. In the inspection conducted by the TA, relating to the year 2013, supplementary contributions and ancillary contributions made to its subsidiaries were investigated, with the regime of supplementary contributions not accruing interest.

2.12. In the same year, it bore financial charges relating to loans and financing obtained from banking entities, intended for "investment, support and restructuring of the operational structure of production units with reduction of personnel, strengthening of working capital and financing for exports".

2.13. The TA concluded that "it was not possible to establish a direct association between the loans obtained by A… SA and the ancillary contributions and supplementary contributions in its subsidiaries".

2.14. The TA merely reflected in 2014 the adjustment it had already made, precisely with respect to financial charges, in the year 2013.

2.15. In the year 2013, it accounted for financial charges in the total amount of € 1,543,106.29.

2.16. In light of the limits provided for in article 67 of the CIT Code, it deducted part of this amount in 2013, and carried forward the remainder for deduction in subsequent years.

2.17. In 2014, it considered for tax purposes the amount (remaining) of € 932,360.24, as "financial charges borne in the year 2013 which, by reason of the limitation on the deductibility of financing costs, could not be considered for tax purposes in that period", pursuant to and for the purposes of article 67 of the CIT Code.

2.18. The TA, following the tax inspection conducted for the year 2013, concluded that the entirety of the recorded financial charges (€ 1,543,106.29) should be disallowed, in light of article 23 of the CIT Code, having added to its taxable income in the year 2013 the portion of financial charges that had been considered in that year for tax purposes.

2.19. In the assessment now being contested, it merely disallowed the portion of financial charges (accounted for in 2013) which, under article 67, it had carried forward to the year 2014, in the amount of € 932,360.24.

2.20. It contested, in arbitral proceedings, the adjustment made by the TA regarding the year 2013, as well as the CIT assessment resulting therefrom, which are being considered by the arbitral tribunal constituted under the aegis of CAAC in case no. 198/2018, so that if its request for arbitral pronouncement is granted, as it anticipates, said adjustment will be annulled, resulting therefrom not only the annulment of its effects in the year 2013, but also the necessary annulment of the effects carried forward to the year 2014 – specifically, the disallowance of said financial charges in the amount of € 932,360.24.

The Applicant also argues that:

2.21. Its corporate purpose, pursuant to article 3, no. 1 of its Bylaws, consists of "the operation of textile industry, being able to engage in any other branch of industrial or commercial activity that the General Assembly decides and is permitted by law, establish or acquire other factories, establish branches or subsidiaries, managing, on a supplementary basis, various shareholdings, with this activity engagement being framed within article 3, no. 2 of its Bylaws which provides that "the company may acquire shareholdings in other limited liability companies, regardless of their corporate purpose, and also acquire shareholdings in companies regulated by special laws and in complementary business associations".

2.22. Together with its subsidiaries, it markets its products predominantly in international markets, channeling more than 95% of its production to them.

2.23. In 2014, the B... Group was composed of the following companies:

2.24. In its capacity as a holding company, it assumed management and direction functions of all subsidiaries, namely appointing the governing bodies of the subsidiary companies, making strategic decisions about their activity, and monitoring their economic and financial situation, providing, whenever necessary and appropriate, the essential resources needed for the pursuit of its corporate purpose.

2.25. It also held a 100% stake in fund C..., with real estate scope, and a 25% stake in company "D..., S.A.", dedicated to cogeneration.

2.26. Both with respect to the companies dominated by it and with respect to these two latter entities, the management activity pursued was within its scope due to their respective bylaws.

2.27. With respect to the first-mentioned companies, management was further justified by reason of the integration and coordination that existed between its activity and the activity of its subsidiaries.

2.28. The year 2014 was a particularly difficult year for the B... Group, which was heavily dependent on its creditors and whose activity was significantly leveraged.

2.29. In 2014, the B... Group was taking its first steps following a profound financial recapitalization, which even culminated in a change to its corporate structure, and which was only concluded in November 2013.

2.30. In 2013, it restructured its bank debt – without which the viability of the B... Group would have been impossible –, which required a thorough review of its work processes, shareholder and management structure, and its business model, with a view to eliminating any inefficiencies.

2.31. In a very restrictive economic context, particularly in the European Union – the main destination for the B... Group's exports –, only with very significant financial, economic and operational effort, especially focused on taking advantage of the Group's internal synergies and the complete elimination of production inefficiencies, and under close supervision of its banking creditors – who had just accepted a restructuring of their credits, in favor of B...'s continuity – was it possible for the Applicant to remain in operation, safeguarding its historical trajectory and the numerous jobs for which it was (and still is) responsible.

2.32. This effort first and foremost involved continuously maximizing the integration of activities pursued by the various companies comprising the B... Group, with the utilization of the synergies created accordingly, and by profitability of its assets.

2.33. In 2014, it made the decision to capitalize its subsidiaries "E..., S.A." (hereinafter, "E..."), "F..., S.A." (hereinafter, "F..."), "G..., S.A." (hereinafter, "G...") and "H..., Sole Member Limited" (hereinafter, "H...", formerly named "I..., Ltd.").

2.34. The funds contributed to each of these companies were as follows:

a) € 20,000.00 to E...;
b) € 511,984.33 to F…;
c) € 4,000.00 to G...;
d) € 635,000.00 to H....

2.35. E... has as its purpose "textile industry, spinning, weaving, dyeing and finishing of cotton and artificial and synthetic fibers".

2.36. E... ceased, in 2004, its industrial activity – concentrated since then in A... itself –, having then devoted itself to the marketing of yarn.

2.37. In the late 2010s, E... was far from obtaining satisfactory results, recording increasing difficulties in customer acquisition and placement in the market, with a notable impact on its operating results.

2.38. E... had no capacity to generate income, but continued to record expenses (current), as it held significant real estate assets: land and industrial buildings, whose maintenance required certain charges, such as property tax, surveillance costs, insurance, energy, among others.

2.39. It was necessary to contribute funds to this company so that it would be able to settle its primary obligations.

2.40. In its capacity as sole shareholder, the Applicant considered itself responsible (and especially interested) in the capitalization that proved necessary, all the more so because recourse to external financing was barred from the outset, having then made ancillary contributions in the amount of € 20,000.00, subjecting their reimbursement to the regime of supplementary contributions.

2.41. E... found this capitalization instrument preferable – which, as is well known, added to the equity of E... – to others closer to credit figures, such as loans or remunerated ancillary contributions.

2.42. It was, in fact, a measure aimed at the strengthening and consolidation of the equity of said subsidiary, whose external dependence, in light of creditors, had no conditions to be aggravated; it was thus capitalization, rather than mere financing, of the company in question, with a view to its maintenance.

2.43. It did not allocate the amounts in question to E... with the intention of making them profitable immediately, through the requirement of interest – which, in any case, E... would not have been in a position to pay. Its intention was to ensure the viability and maintenance of this subsidiary in the medium and long term, with a view to obtaining lasting economic benefits.

2.44. Having conducted its evaluation, it knew it was possible to sell the real property held by E..., or the company's own shareholdings, for a very relevant amount (between € 3,000,000.00 and € 5,000,000.00), which would be more than sufficient not only to offset the investment made to date, but to generate a significant capital gain.

2.45. Sale at a price considered adequate was not feasible during the years of crisis, so it considered it preferable to await improvement in real estate market conditions and proceed with the sale of the property in question only when it would appreciate again (thus ensuring a greater return for its investment), having limited itself to adopting the necessary measures so that, until then, E... would meet its minimum and essential obligations and, in this way, avoid insolvency.

2.46. The decision to capitalize E... in 2014 was a business decision, sustained from a perspective of obtaining future gains, which – in that year – had as its essential purpose ensuring the survival of the subsidiary in question.

2.47. In a scenario of E...'s insolvency, it would have had only two alternatives: either accept losing said real estate assets – diminishing the potential capital gain arising from its subsequent sale –, or it would be forced to spend very large sums (considerably more than those it contributed as ancillary contributions) to acquire them in public auction. Moreover: E...'s insolvency (or its profound decapitalization) would prevent a third party from being interested in acquiring its shareholdings, thus reducing the possible range of transactions that would allow the Applicant to make its investment profitable.

2.48. In contributing to E... the resources it needed to meet its debts, it was also complying with its obligations as a holding company, avoiding the aggravation of its own liabilities.

2.49. E...'s inability to meet its debts had as background, under the Commercial Companies Code (hereinafter, "CCC"), the accountability of the Applicant – as sole shareholder and dominant company of E... – for the missing amounts.

2.50. By averting E...'s non-compliance, the Applicant directly ensured that the overdue obligations of the former would not aggravate its (own) assets, in terms that would, in the meantime, certainly become more burdensome (more accrued interest, penalties, etc.).

2.51. It also had an interest in ensuring, as much as possible, the reputation of the Group, preventing the market from becoming aware of the difficulties it was experiencing.

2.52. The ancillary contributions (subject to the regime of supplementary contributions) made by the Applicant, albeit of relatively modest amount, were sufficient to contain and slow down the decapitalization of E..., providing it with the necessary means to meet its obligations at the immediate level.

2.53. F... has as its purpose "wholesale trade in clothing items and accessories", serving an extremely important purpose within the B... Group, responsible for enhancing the segment of activity to which the Group as a whole dedicates itself, but which especially benefits the Applicant, relating to the making of products for high-quality clothing in the fashion area, and which has as customers large and prestigious key players in the sector.

2.54. The products made for this business segment are predominantly created from fabrics designed and produced by the Applicant, with a notable interconnection between the activity of the two companies.

2.55. F...'s activity, as a result of the economic situation it had been experiencing in recent years, was significantly deteriorated.

2.56. In its capacity as sole shareholder of F..., the Applicant decided to introduce severe modifications in the way this company operated and produced, with the intention of better preparing it for the years of crisis ahead and seeking to ensure its viability.

2.57. F..., with the support of the Applicant, made a very significant effort, including financial, to reverse the negative trend it had registered in the previous two years and which was also a result of the context the market was traversing, and in 2014, it recorded a sales volume of € 5,750,000.00, with nearly € 2,000,000.00 resulting from supplies made by the Applicant.

2.58. Nevertheless, due to the constraints (macro and own to said company) F... recorded in 2014 negative EBITDA of approximately € 366,000.00, and negative net results of € 407,000.00, so it continued to depend in 2014 on the financial support of its shareholder to carry out the aforementioned improvement effort.

2.59. Thus, it became necessary to inject approximately € 500,000.00 into F... in 2014, under penalty of, failing to do so, registering the loss of more than half the share capital, and requiring the Applicant to adopt the measures referred to in article 35 of the CCC: capital reduction (which was insufficient), dissolution (which was counterproductive and could jeopardize the financial commitments of the Applicant and the Group) or capital injection (as was done).

2.60. Instead of increasing the share capital of its subsidiary, it decided to invest this amount in other equity instruments – more specifically, in the making of ancillary contributions, free of charge, subject to the regime of supplementary contributions, with a view to capitalizing its subsidiary, by allowing it to record said amounts as equity (i.e., increasing the value of assets), and not as liability.

2.61. The economic advantages it expected to derive from this additional investment did not translate into interest, but rather a strengthening of F...'s ability to achieve positive results in its market segment with direct and immediate impact on the results of the Applicant itself and the indirect and mediated effect of translating into an increase in profits distributable by the subsidiary.

2.62. Insofar as the products marketed by F... were preferentially made with fabrics created by the Applicant, the increase in the production of the former had an impact on the results of the latter.

2.63. It is the responsibility of shareholders to contribute the necessary funds to companies so that they are able to pursue their activity, especially when these are in the decapitalization situation referred to in article 35 of the CCC, and even more so when these companies are dominated.

2.64. It was motivated by its own business interests and corporate obligations that it agreed to capitalize F... in terms that allowed the strengthening not of its liabilities, but of its equity, making free ancillary contributions, which, as has been seen, contributed to F... continuing in the coming years to progressively reverse its results.

2.65. With respect to G..., the situation is similar to that of E.... Insofar as it held considerable assets – land and natural resources which in 2014 amounted to the balance sheet value of € 244,340.51, but which the Applicant understood could be sold for a value between € 500,000.00 and € 750,000.00 –, which ceased to be used in the context of its activity, it was decided to keep the company "dormant", while the Board of Directors studied the best way to make profitable the assets in question.

2.66. Insofar as it had no activity, G... generated no income, but was incurring obligations that it had no means to settle, requiring an additional capital injection.

2.67. In that sense, ancillary contributions were made, subject to the regime of supplementary contributions, in the amount of € 4,000.00.

2.68. The decision to make these ancillary contributions was exclusively business-related, being essentially the cost that the Applicant had to bear to keep open the possibility of making its subsidiary (and its assets) profitable, particularly through its sale, a hypothesis that appeared more likely – in fact, as occurred with respect to E....

2.69. In light of this objective, the ancillary contributions could only be free of charge, under penalty of having to be accounted for not in the assets (equity) of G..., but rather in its liabilities, which would thus be aggravated – decreasing, as a result, the potential market interest in the acquisition of the company in question or its real estate assets; in fact, placing the company in true insolvency.

2.70. With respect to H..., this is a commercial company by quotas, which has as its purpose the retail and wholesale trade in clothing and accessories, footwear, leather goods and travel articles, jewelry, costume jewelry and watches, perfumery, cosmetics and personal hygiene articles, textiles for the home, fabrics for clothing and home textiles.

2.71. It is, thus, the company that holds the stores where the textile products made by the B... Group are sold, being held 100% by the Applicant.

2.72. As part of the strategy to restructure its activity, H... also opened a new store in ... (on 15-07-2014) and a sales space in a multi-brand store located in Lisbon (on 09-05-2014).

2.73. Although H... recorded a sales volume of approximately € 743,000.00, it concluded the year 2014 with only a slightly positive gross margin, recording negative EBITDA (of approximately € 360,000.00), as well as also negative net results (more than € 400,000.00).

2.74. So that, to ensure the maintenance of H..., continuing to support it in the ongoing restructuring and improvement process, it had to make additional capital contributions in the form of supplementary contributions, which served essentially to strengthen equity and settle operational debts of H....

2.75. Here too, the aforementioned considerations apply regarding the absolute necessity of recording the contributed amounts (€ 635,000.00) as capital, as moreover required by article 35 of the CCC, and not as liability; which is why they were delivered to H... in the form of supplementary contributions.

2.76. It was these supplementary contributions that opposed (partially) the deterioration of H...'s asset and financial situation, allowing it to settle its debts and thus ensure its activity, without having to "resort to any financing liability" – which not only would have been impossible at the time, given the particular circumstances of the subsidiary in question, but would only aggravate its financial condition.

2.77. It was, once again, a matter of complying with its corporate obligations, caring for the maintenance of a subsidiary (held 100%) whose activity, moreover, was fully integrated in its own activity, with manifest advantages in terms of the synergies created.

2.78. For H...'s sales volume in 2014, in the amount of € 743,000.00, operations with the Applicant contributed almost € 500,000.00.

2.79. The financial support provided to this subsidiary proved insufficient and, in late 2017, A... ultimately made the decision to dissolve H....

2.80. In all the cases discriminated above, the decision to contribute funds to its subsidiaries was underlain by its own business motivations.

2.81. In all cases, the companies that served a purpose in the Applicant's structure, that had utility for its activity, or whose success or maintenance reflected positively in the sphere of the Applicant.

2.82. To this is added that it was absolutely convinced that the economic failure of just one of the subsidiaries would have a systemic effect, on the financial health of the Group and its holding, impossible to control.

2.83. On the other hand, it was in 2014, the holder (directly or indirectly) of all of the share capital of the subsidiaries, from which it follows that the commitment to capitalize them was not only motivated by its own direct (or operational) business interest, but ultimately constitutes a corporate obligation.

2.84. Under corporate law, supplementary contributions – as are ancillary contributions subject to the regime of those – do not accrue interest, being equivalent to a strengthening of the equity of the companies that benefit from them. This is not the case, however, with remunerated ancillary contributions, as well as with loans.

2.85. Remunerated ancillary contributions and loans aggravate liabilities, being consequently considered as debt of the company that receives them. Thus, had these been the instruments used, the Applicant would have contributed precisely to the effect it intended to avoid: the aggravation of the economic and financial situation of the subsidiaries, with the diminishment of the value of its investment and the probabilities of recovering it, the deterioration of the B... brand – whose effects would be felt first and foremost in the sphere of the Applicant itself –, the risk of loss of (common) clientele, as well as the risk of insolvency, and the impact which, in general terms, the failure of said subsidiaries would have on the productive activity of the Applicant company in question.

2.86. The contributions it made were absolutely essential, represented a strategic decision, taken with medium and long-term perspective, which instead of focusing on the interest that it might perhaps be possible to realize with the amounts contributed to the subsidiaries – which, in any case, were not at the time in a position to pay – was centered on the maintenance of the respective shareholdings in the sphere of the Applicant – ensuring that these assets would survive the period of economic crisis – and in their recovery, with a view to obtaining gains (in the immediate sense, of operational advantages, and mediate sense, of profits or capital gains) in the future.

2.87. In light of the economic context described, the Applicant itself had been facing, since 2012, considerable financial difficulties, its activity being profoundly leveraged, in such terms that made indispensable and urgent its recapitalization.

2.88. This recapitalization occurred in late 2013, having been carried out by a banking syndicate composed of its two largest creditors, J... and K..., and culminated in the subscription of a 10% stake by a venture capital fund held by (currently) L... the M....

2.89. The entry of this new shareholder into its shareholding structure and the subjection of this to generally close control and supervision of its banking creditors, led to the reduction also of the main operating costs – through the elimination of inefficiencies, the utilization of synergies, notably with the above-indicated subsidiaries, etc. –, and the initiation of measures aimed at increasing sales volume.

2.90. In this context, its operating results recorded an improvement in 2014, but the Applicant was still profoundly leveraged, with banking commitments intended to remain in effect for at least the following decade, with a significant impact on the level of financial charges borne.

2.91. The amounts of bank financing borne by A... in 2014 amounted to more than € 78,000,000.00, with the overall amount of ancillary or supplementary contributions made in favor of the subsidiaries in that same year (€ 1,100,000.00).

2.92. It is not possible to establish a direct relationship between the bank debt borne by the Applicant and the need to contribute funds to the above-indicated companies.

2.93. The financial charges that the Applicant bore in 2014 derived, almost entirely, from the financial restructuring carried out a few months earlier, more specifically: from the loan made by the banking syndicate composed of J... and K... which the Applicant needed to ensure its viability in that year.

2.94. The bank loans were not related to the contributions made.

2.95. On the other hand, having demonstrated an (business) interest in capitalizing its subsidiaries, there are no doubts as to the (business and, in that measure, indispensable) nature of the financial charges relating to loans which, in abstract terms, may have contributed to the contributions made.

2.96. There being no difference, from the point of view of the indispensability of the financial charges borne, between capitalizing the subsidiaries or using the same amounts in the development of means that would allow A... to carry out the complementary activities to which those engaged.

2.97. In contributing to their capitalization the Applicant directly ensured its own viability, the increase in the value of its assets, in certain cases the growth of its productive activity, and also the strengthening of its brand and the reputation of which the Group enjoyed in the market – and which benefits, in first place, A....

2.98. The amount invested in the other subsidiaries was apt to return to the Applicant in the form of future profits, or capital gains should it be possible to sell the respective shareholdings or its real estate assets (followed by the dissolution and liquidation of the entities in question).

3. The Respondent, for its part, argues that:

3.1. Following the external inspective action carried out under Service Order no. OI2017... issued on 29-09-2017 to carry out declarative control, of partial scope directed to the year 2014, a single correction document was drawn up from which resulted assessment no. 2018..., in the amount of € 305,289.08, plus compensatory interest, and the reversal of assessment no. 2015... in the amount of € 403.51.

3.2. The Applicant requested the correction of said assessments on the ground that, in determining the tax resulting from the adjustments made to the taxable base, the TA did not consider, in deductions from tax and up to their amount, the tax benefits it held on 31-12-2014, in the amount of € 1,600,000, requesting the annulment of said additional CIT assessment and the corresponding compensatory interest, as well as the issuance of a new CIT assessment that includes, in its determination, the deduction of tax benefits in the amount of € 273,944.45, from the available balance of the tax benefit from the Research and Development Tax Incentives System ("SIFIDE").

3.3. The claim was granted, deciding to annul the CIT assessment for the year 2014 originating from the single correction document prepared by the Tax Inspection on 29-03-2018, and issuing a new assessment in which, to the value of the CIT collection of € 769,031.79, was deducted the amount of € 769,031.79, relating to tax benefits whose increase, with respect to what was initially declared in the self-assessment made by the taxpayer, respects the use of € 273,944.44, of tax benefits from the SIFIDE program, having also annulled the assessments of compensatory interest made with respect to the year 2014.

3.4. In this context, no defense possibilities of the Applicant were affected, since the substantiation of the disputed assessment acts, as well as of the tax inspection report, is express, clear, sufficient and congruent, the Applicant defending a different framing of the factuality that supports the adjustments made, which cannot be confused in any way with the insufficiency of substantiation.

3.5. Having regard to the factual and legal grounds alleged by the Applicant in this proceeding, it became aware of the cognitive and evaluative course pursued by the Tax Administration in determining the disputed acts, so the defect of lack of elements of article 36, no. 2 of the CTPP should be judged unfounded.

The Respondent further argues that:

3.6. From the combination of article 11, nos. 4 to 6 of the CCC, it follows that mere statutory permission for acquisition of shareholdings does not constitute an extension of its corporate purpose, the corporate purpose of the enterprise remaining unchanged.

3.7. From the TA's database, it results that the Applicant carries on the following main activities: FINISHING OF YARN, FABRICS AND TEXTILE ARTICLES, N.E.C., corresponding to CAE 13303, and secondary activities of PREPARATION AND SPINNING OF LINEN AND OTHER TEXTILE FIBERS (CAE 13105), WEAVING OF SILK-LIKE YARN AND OTHER TEXTILES (CAE 13203) and BLEACHING AND DYEING (CAE 13301). On 01-01-2017, registration was also made for the carrying on of REAL ESTATE RENTAL ACTIVITY (CAE 68200).

3.8. In the context of the inspective action credentialed by service order no. OI2017... directed to the year 2013 to carry out declarative control, in the context of CIT, whose tax inspection report was prepared on 27-11-2017, the TA ascertained that, in determining the taxable result of that period, the taxpayer considered charges with financing in the amount of € 1,543,106.29 which, pursuant to article 23 of the CIT Code, did not prove indispensable for obtaining its income, as substantiated in the said report. However, pursuant to article 67 of the CIT Code, in the wording at the time of the facts, combined with article 192 of Law no. 66-B/2012, of 31 December, the taxpayer increased, in field 748 of table 07 of the income statement model 22, the amount of € 1,114,756.62, relating to charges with financing borne, so the adjustment to the taxable result made by the TA and relating to this matter amounted to only € 428,349.67.

3.9. The taxpayer deducted, in field 795 of table 07 of the income statement model 22 of the year 2014, the amount of € 932,360.24, relating to financial charges borne in the year 2013 which, by reason of the limitation on the deductibility of financing costs, could not be considered for tax purposes in that period. However, because the TA disallowed the amount of € 1,543,106.29, despite having made a partial adjustment to the taxable result, the amount carried forward by the taxpayer in the year 2014 relating to financing expenses from previous periods will now be increased.

3.10. From the inspective procedure no. OI2017..., it was ascertained that the Applicant made the following movements at debit in sub-accounts of account 41- Financial Investments:

1) E...

2) F…

3.11. In the sub-account "41410000 FIN. INV.- EQUITY SHARES - OTHER COMPANIES", it made the following movements:

1) G...

3.12. In the sub-account "41420000 FIN. INV. Loans Granted - other companies, it made the following movements:

1) H...

3.13. Regarding the deliberations on ancillary and supplementary contributions in the subsidiary companies, the following was ascertained:

1. E...

"On 2014-12-15 the General Assembly of company E... SA met, minutes no. 56, through which was proposed and approved by the representative of the sole shareholder A... SA, the (…) formalization of the constitution of Ancillary Contributions, in cash, free of charge, statutorily subject to a regime identical to that provided for in articles 211 to 213 of the Commercial Companies Code, in the total amount of € 20,000.00 (twenty thousand euros), already previously delivered to the company", to meet "the needs arising from the activity currently carried on by the company, in the course of this year, (…)"

2. F...

"On 2014-11-14, the General Assembly of company F... SA met, minutes no. 8, through which was proposed and approved by the representative of the sole shareholder A... SA, the …making, by the next 30 November, in cash and free of charge, of ancillary contributions in the amount of € 511,984.33 (five hundred eleven thousand, nine hundred eighty-four euros and thirty-three cents), contributions which, pursuant to no. 5 of article 4 of the Bylaws, will be subject to a regime identical to that provided for in articles 211 to 213 of the Commercial Companies Code.", "which prove necessary for the development of the company's social activity."

3. G...

"On 2014-12-16, the General Assembly of company G... SA met, minutes no. 67, through which was proposed and approved by the representative of the sole shareholder A... SA, the … formalization of the constitution of Ancillary Contributions, in cash, free of charge, statutorily subject to a regime identical to that provided for in articles 211 to 213 of the Commercial Companies Code, in the total amount of € 4,000.00 (four thousand euros), already delivered to the company", to meet "the needs arising from the activity currently carried on by the company, in the course of the current year 2014".

4. H...

"On 2014-12-17 the General Assembly of H... LDA met, at the time named H..., LDA, having been recorded minutes no. 70, in which was approved the resolution on the formalization of the making of supplementary contributions in the total amount of 635,000.00 EUR made by the sole shareholder A... SA, to meet (…) the needs arising from the activity developed by the company, in the course of this year, the sole shareholder A... SA, undertook to constitute Supplementary Contributions, having, for that purpose, delivered to the company, throughout the year 2014, the amount of € 635,000.00 (six hundred thirty-five thousand euros) which must now be formalized".

3.14. From the content of the above-mentioned minutes and the supporting documents for the accounting records analyzed, it results that, during the year 2014, the Applicant made:

a) ancillary contributions to its subsidiaries E..., F... and G... in the total amount of € 535,984.33, having with respect to them resolved, as concerns interest, remuneration and restitution, to apply to them a regime identical to that of supplementary contributions provided for in articles 211 to 213 of the CCC, so that the ancillary contributions did not accrue interest nor were remunerated in any way, with restitution foreseen only when the net situation of the subsidiary companies so allowed.

b) supplementary contributions to its subsidiary H... in the amount of € 635,000.00.

3.15. In all minutes it is stated that the constitution of ancillary contributions and supplementary contributions by the Applicant in favor of its subsidiaries occurred to meet needs arising from the activity developed by those companies.

3.16. According to note 5.2 of the Annex to the Balance Sheet and to the Statement of Results, on 31-12-2014 the loans granted by the Applicant to its subsidiaries and subsidiaries amounted to € 11,145,186.30, taking into account the amounts determined in the previous period plus the movements occurring in the period, as shown:

3.17. On 31-12-2014, the taxpayer had recorded in the SNC account "25 – Financing Obtained", the total credit value of € 77,249,873.24, as ascertained by the analytical trial balance at the end of the period, distributed among the following financing entities:

3.18. From the content of the above-mentioned minutes and the supporting documents for the accounting records analyzed, it results that, during the year 2014, the taxpayer bore the following charges:

1. Interest

On 31-12-2014, the financing and loss expenses recorded in the SNC accounts "69111000 - GPF – BANK LOANS", "69117000 GPF - INTEREST FACTORING", "69119000 GPF - BONDS" and "69180000 GPF – OTHER INTEREST", amounted to € 5,198,784.31, as ascertained by the movements and balances extracted from the analytical trial balance and current accounts. However, the amount of € 338,815.58, of that value recorded in the GPF - BANK LOANS item, refers to interest borne by virtue of the return of incentives, so does not pertain to bank loans.

2. Banking Services

The banking services associated with these loans obtained in the year 2014, recorded in the SNC account "62270001 - FSE - BANKING SERVICES", amounted to € 399,021.51, as ascertained by the movements and balances contained in the analytical trial balance and current account.

3. Stamp Duty

Additionally, the stamp duty relating to financing borne by the taxpayer in the year 2014, recorded in the SNC account "68120002-IMP. INDIRECT - STAMP DUTY", amounted to € 199,240.15, as ascertained by the movements and balances extracted from the analytical trial balance and current account.

3.19. Thus, in the year 2014, the charges with financing recorded and deducted by the taxpayer were as follows:

3.20. Verifying that the Applicant financed itself from financial institutions by contracting loans for which it bore financial charges and stamp duty, and that through the analysis of the accounts it was not possible to identify which loans in particular were allocated to the making of ancillary and supplementary contributions, applying a portion of that financing in the granting of non-remunerated ancillary and supplementary contributions to its subsidiaries, the part of the financial charges and stamp duty corresponding to that portion does not constitute an expense with tax relevance in that sphere.

3.21. The Applicant:

a. Granted ancillary contributions subject to a regime identical to that provided for in articles 211 to 213 of the CCC and non-remunerated supplementary contributions to its subsidiaries;

b. Resorted to loans;

c. Due to resorting to loans, bore financial charges and stamp duty;

d. Through the analysis of the accounts it was not possible to identify which loans, in particular, were allocated to the making of ancillary and supplementary contributions.

FACTUAL MATTER

4. Proven Facts

Based on the elements in the case file and the administrative case file attached to the record, the following facts are considered proven:

4.1. The Applicant's purpose is, according to point 1 of article 3 of the Company's Bylaws, the "carrying on of textile industry, being able to engage in any other branch of industrial or commercial activity that the General Assembly decides and is permitted by law, establish or acquire other factories, establish branches or subsidiaries".

4.2. Article 3, no. 2 of the Applicant's Bylaws further states that "the company may also acquire shareholdings in other limited liability companies, regardless of their corporate purpose, and also acquire shareholdings in companies regulated by special laws and in complementary business associations".

4.3. The TA conducted an inspective action on the Applicant in compliance with Service Order no. OI2017..., issued on 29-09-2017, and a Tax Inspection Report was prepared, a copy of which is attached as document no. 5 with the request for arbitral pronouncement, the content of which is reproduced below, which refers, among other things, to the following:

4.4. Following the inspective action, the TA issued the additional CIT assessment no. 2018..., and the account reconciliation statement ID Document 2018... and compensation no. 2018... whose copies are attached as document no. 2 with the request for arbitral pronouncement, the content of which is reproduced below;

4.5. On 20-08-2018, the Applicant filed the request for constitution of the arbitral tribunal that gave rise to this proceeding, in which it contests only the CIT assessments and compensatory interest in the part that rest on said adjustment, quantifying the action at € 407,823.60, which is embodied in the tax disallowance, in light of the provision of article 23, no. 1 of the CIT Code, of part of the financial charges and Stamp Duty borne in the year 2014, with bank financing.

4.6. The Applicant financed its subsidiaries, all held directly or indirectly at 100%, through supplementary contributions and ancillary contributions subject to the regime of supplementary contributions to avoid the negative consequences that would result for it from their insolvency, in reputational and credit analysis terms;

4.7. The Applicant has an integral textile production and marketing activity divided among its subsidiaries, encompassing the complete production of fabrics (from spinning, weaving, finishing, dyeing), making of complete garments and direct sale to the public through its own brand, which the Applicant acquired;

4.8. The marketing of items by subsidiary companies allows for the increase of the Applicant's production activity;

4.9. The Applicant is the parent company that manages the entirety of production and marketing;

4.10. In addition to production and direct marketing to the public through subsidiaries, the Applicant also exports and produces for other companies and brands;

4.11. E... in 2014 was already inactive, but it was in its interest to keep the facilities as they had real estate that the Applicant intended to sell for a high amount, and then dissolve that company;

4.12. E..., despite being inactive, had charges to bear with the management and maintenance of its assets, so needed to be financed, as it had no possibility of generating means to bear them;

4.13. The Applicant did not want E... to be declared insolvent, as it would risk depleting its value;

4.14. F... recorded negative EBITDA of approximately € 366,000.00 in 2014, and negative net results of € 407,000.00, so it continued to depend in 2014 on the financial support of its shareholder to carry out the aforementioned improvement effort, making it necessary to inject approximately € 500,000.00 into the company, under penalty of, failing to do so, registering the loss of more than half the share capital, and requiring the Applicant to adopt the measures referred to in article 35 of the CCC. Insofar as the products marketed by F... were preferentially made with fabrics created by the Applicant, the increase in the production of the former had an impact on the results of the latter.

4.15. G... had no activity, but had considerable assets that the Applicant understood could be sold for a value between € 500,000.00 (minimum) and € 750,000.00.

4.16. Insofar as it had no activity, G..., generated no income, but was incurring obligations that it had no means to settle, requiring an additional capital injection. In that sense, ancillary contributions were made, subject to the regime of supplementary contributions, in the amount of € 4,000.00.

4.17. H... holds the stores where the textile products made by the B... Group are sold.

4.18. H... recorded a sales volume of approximately € 743,000.00, having concluded the year 2014 with only a slightly positive gross margin, and recording negative EBITDA (of approximately € 360,000.00), as well as also negative net results (more than € 400,000.00).

4.19. So that, to ensure the maintenance of H..., continuing to support it in the ongoing restructuring and improvement process, it had to make additional capital contributions in the form of supplementary contributions, which served essentially to strengthen equity and settle operational debts of H....

4.20. The Applicant was a highly leveraged company, resorting intensely to credit, being under close attention from the banking sector and by companies providing financial information that assign ratings, so had an interest in avoiding that companies dominated by it became insolvent, because that would have a negative impact on the conditions for obtaining credit by the Applicant;

4.21. The Applicant was convinced that, had it not made the investments in the subsidiaries, it would have suffered greater losses than the opposite;

4.22. The Applicant did not make said capital contributions with interest, as the subsidiaries could not pay them;

4.23. If it had not made the investments in the subsidiaries, the Applicant would not necessarily reduce its bank debts, as it could increase its investments or make other expenses;

4.24. On 08-06-2018 the Applicant paid the amount assessed (document no. 4 attached with the request for arbitral pronouncement, the content of which is reproduced below).

5. Unproven Facts

5.1. It was not proven that the bank loans contracted by the Applicant were related to the investments made in its subsidiaries.

5.2. As to this point, the TA itself acknowledged in the Tax Inspection Report that "through the analysis of the accounts it was not possible to identify which loans in particular were allocated to the making of ancillary and supplementary contributions" (page 10).

6. Grounds for Factual Determination

6.1. The proven facts are based on the Tax Inspection Report and on the documents attached with the request for arbitral pronouncement.

ON THE LAW

On the Tax Deductibility of Financial Charges

7.1. The fundamental issue that arises in this proceeding is whether the tax act under review, which rests on the non-deductibility of financial charges resulting from obtaining financing from financial institutions, can or cannot be accepted as a tax expense, in light of the provisions of article 23 of the CIT Code.

7.2. The issue in question has already been addressed in previous proceedings at CAAC, particularly in cases nos. 585/2014-T and 298/2017-T, which we shall follow closely as we identify with the position then adopted.

7.3. Pursuant to article 23 of the CIT Code (in the wording in force in 2014), "For determining taxable profit, all expenses and losses incurred or borne by the taxpayer to obtain or ensure income subject to CIT are deductible".

7.4. The concept of indispensability has been repeatedly assessed by arbitral jurisprudence, particularly with respect to the strengthening of investment by a company in its subsidiaries.

7.5. Indeed, as Tomás Tavares writes and follows from Ruling no. 298/2017-T, the "legal notion of indispensability is carved out (…) from an economic-business perspective, by filling, direct or indirect, the ultimate motivation for obtaining profit. Indispensable costs are equivalent to expenses incurred in the interest of the company or, in other words, in all acts abstractly subsumed under a profit-making profile." Adding that the "legal notion of indispensability represses, therefore, acts not in conformity with the company's purpose, not inserting into corporate interest, especially because they do not aim at profit". (See Tomás Tavares, "On the relationship of partial dependence between accounting and tax law in determining the taxable income of legal persons: some reflections at the level of costs", in Tax Science and Technique, no. 396, 1999, page 136).

7.6. This being so, "[i]ndispensability does not mean, therefore, an obligatory causal nexus with income/revenues, nor that, a posteriori, the economic effects must be verified or necessarily demonstrated as lucrative resulting from such expenses. As long as expenses result from management acts which, based on information known at the time of their execution, could have as their objective the expected obtaining of income or the maintenance of the productive source (physical, intangible, financial or other), this should lead to the acceptance of their deductibility". (See Arbitral Ruling of 21-04-2015, made in case no. 644/2014-T, made on a situation of free financing to subsidiaries).

7.7. It is also relevant to this decision to note, in the ruling made in case no. 585/2014-T that "[t]here is not, therefore, a necessary link to revenues, an obligatory causal nexus between expenses and revenues. On the other hand, judgments by the Tax Administration about the merits of management decisions are not relevant for that purpose, it being sufficient that the same be taken within the interest of the company.".

7.8. In this sense, also the Central Administrative Court South, in case no. 06754/13 CT- 2nd Court, of 16-10-2014, points to the following solution: "It is the understanding of jurisprudence and doctrine that the Tax Authority cannot assess the indispensability of costs in light of criteria focused on the opportunity and merit of the expense. A cost is indispensable when it is related to the activity of the company, with costs foreign to the company's activity being only those in which it is not possible to discern any causal nexus with revenues or gains".

7.9. As follows both from Ruling no. 585/2014-T and from Ruling no. 298/2017-T:

"the "activity" of a company is not exhausted in the set of productive or operational transactions. "Activity" is also the set of transactions that have the purpose of making investments or disposing of assets, the acquisition of financial shareholdings and their subsequent disposal, the application of liquidity in short-term investments or securities and their management, the receipts and payments resulting from operating or non-operating income and expenses, and many others. It will be activity both the management of a physical asset, and that of an intangible asset, and that of a non-current asset held for sale, and that of a financial asset.

The business activity that generates deductible costs must be the one that translates into transactions that have a purpose, an intent of obtaining income or the aim of maintaining the potential of an income-producing source.

In cases of investment by a company in its subsidiary, the financing from the parent will be made in the interest of; in this case it serves so that therefrom an expectation of future income directly flowing from it results.

The deductibility of interest borne by the parent will depend on the fact that the financing contributes, according to normal rules of management, to increase the expectation of future benefits or to maintain the producing source (financial asset).

The fact that decisions taken in the sphere of the subsidiary influence the assets of the subsidiary does not mean that they are made in the interest of third parties. They are made from the interest of the parent in ensuring the operationalization and profitability of its investment in the subsidiary.

The subsidiary uses funds that are contributed to it, but that contribution of funds is made in the interest of the parent, that is, in the context of normal management acts that can be encompassed within its purpose or lucrative objective.

In situations where the parent holds all of the subsidiary's capital and, therefore, has total possibility of intervening in the subsidiary's management and ensuring that the investment is used in its interest, the investment in the subsidiary is reduced to management of the shareholding and constitutes exercise by the parent of the economic activity that the subsidiary carries on, indirectly, whose positive or negative reflexes end up repercussing entirely in the legal sphere of the parent through the appreciation or depreciation of its shareholding, so the costs necessary to ensure the investment enhancing the obtaining of future benefits fall within the concept of economic indispensability, with the said sense of expenses entirely made in the interest of the company.".

7.10. As also follows from case no. 264/2016-T, the "subsidiary is not any entity foreign to the activity and interests of the parent. There is no expense in the sphere of the latter that has nothing to do with its corporate interest. The expense with interest incurred with capital obtained and subsequently contributed to the subsidiary is made in the interest of the parent, as a direct consequence of its activity of managing an asset that emerges from a shareholding, which is real or potentially income-producing."

7.11. In the case at hand, it results from the evidence produced that the investments were made by the Applicant to address economic difficulties of the subsidiaries, so as to keep their assets in conditions allowing the obtaining of better prices in future sales of that same property or maintaining the possibility of obtaining benefits in the future, so it must be concluded that the Applicant has its own interest in making those investments.

7.12. On the other hand, it results from the evidence produced that the Applicant had its own interest in avoiding that companies it controls 100% be declared insolvent, due to the reputational damage it would suffer and which could even entail difficulties or worsening of conditions in obtaining credit, to which the Applicant resorted intensely, being a highly leveraged company, under close attention of the banking sector.

7.13. Thus, the investments in subsidiaries appear to be necessary or, at the least, convenient not only for the direct pursuit of the interests of each of the subsidiary companies but also, directly, for the pursuit of the Applicant's purpose at the level of "obtaining income subject to tax" (in particular, with the improvement of its results through the maintenance of the present or even obtaining better conditions with the Bank with the repudiation of damage resulting from insolvency of any of its subsidiaries), as well as the maintenance of the producing source, which includes the benefits that may arise from the sale of property by financial assets (subsidiaries), where it strengthened its investment through the granting of ancillary contributions subject to the regime of supplementary contributions.

7.14. From the above it follows that the adjustment made relating to the deductibility of the financial charges borne by the Applicant in 2014 to finance its subsidiaries violates article 23, no. 1, of the CIT Code, which constitutes a violation of law defect, justifying the annulment of the assessment, in the part corresponding to that adjustment.

7.15. Indeed, as results from case no. 160/2018-T, "the tax expense equals the actual expenses incurred by the taxpayer, in the pursuit of its activity, and generated within that organization – and which will therefore always have a necessary causal link, in economic terms, with the revenues or with the maintenance of the organization".

Issues of Prejudiced Knowledge

7.16. Should the request for arbitral pronouncement proceed for the reasons stated, the knowledge of the issue raised regarding the legality or ineffectiveness of the assessment act in question in this proceeding is rendered prejudiced, as being futile, due to the absence of a compensation statement act.

Restitution of Amount Paid

7.17. The Applicant paid the amount assessed (document no. 4 attached with the request for arbitral pronouncement), so it is entitled to reimbursement of the overpaid amount, corresponding to the adjustment whose legality is contested in this proceeding.

DECISION

The Arbitral Tribunal hereby agrees to:

a. Judge the request for arbitral pronouncement entirely founded;

b. Annul the additional CIT assessment for the year 2014 numbered 2018... and the corresponding compensatory interest assessment in the part that results from the adjustment, as petitioned, relating to the disallowance of financial charges and Stamp Duty borne by the Applicant;

c. Judge founded the request for restitution of the amounts paid by the Applicant in the part respecting the partial annulment of the aforementioned additional assessment and compensatory interest, so as to fully restore the restoration of legality and

d. Condemn the TA to pay these amounts to the Applicant, as requested.

CASE VALUE

In accordance with article 306, no. 2, of the Code of Civil Procedure and 97-A, no. 1, para. a), of the CTPP and 3, no. 2, of the Regulation of Costs in Tax Arbitration Proceedings, the case is assigned the value indicated by the Applicant and not contested by the defendant, of € 407,823.60 (four hundred seven thousand eight hundred twenty-three euros and sixty cents).

COSTS

Pursuant to article 22, no. 4, of the LRAT, the amount of costs is set at € 6,732.00 (six thousand seven hundred thirty-two euros), pursuant to Table I attached to the Regulation of Costs in Tax Arbitration Proceedings, to be borne by the Respondent, given its loss.

Lisbon, 10-04-2019

The Arbitrators,

(José Poças Falcão)

(Luís Menezes Leitão)

(Leonardo Marques dos Santos)