Fair Value Adjustments in IRC: CAAD Ruling on Financial Assets Available for Trading (Case 437/2016-T)

ARBITRAL AWARD

I. REPORT

1.              A… SGPS, SA, with unique registration number in the Commercial Registry of Lisbon and identification number for legal entities…, with registered office at …, no.…, … –… Lisbon, with share capital of €1,000,000.00 (one million euros), hereinafter referred to as the "Claimant", notified by the Tax Authority and Customs Authority (AT) of the Corporate Income Tax Assessment Demonstration (IRC) no. 2016 … and the Account Settlement Demonstration no. 2016 …, both relating to the 2012 tax year, requested, pursuant to articles 2, paragraph 1, subparagraph a), and 10 of the Legal Regime of Tax Arbitration (RJAT), which is part of Decree-Law no. 10/2011, of 20 January, the constitution of a sole arbitral tribunal and filed a request for an arbitral award declaring the illegality of the tax act notified.
   

2. The respondent is the TAX AUTHORITY AND CUSTOMS AUTHORITY (hereinafter referred to as "Respondent")

3. The request for constitution of the arbitral tribunal was accepted by the Honourable President of CAAD and automatically notified to the Tax Authority and Customs Authority on 19-08-2016.

4. Since the Claimant did not proceed with the appointment of an arbitrator, pursuant to article 6, paragraph 2, subparagraph a), of the RJAT, the signatory was designated as arbitrator by the President of the Ethics Council of CAAD, with such appointment having been accepted within the legally provided timeframe and terms.

5. On 06-10-2016 the Parties were duly notified of such appointment and did not manifest any intention to refuse the arbitrator's appointment, pursuant to article 11, paragraph 1, subparagraphs a) and b) of the RJAT, in conjunction with articles 6 and 7 of the Code of Ethics.

6. In accordance with the provision contained in subparagraph c), paragraph 1, of article 11 of the RJAT, the Sole Arbitral Tribunal was constituted on 21-10-2016.

7. In the Arbitral Petition submitted by it, the Claimant alleged, in summary, the following:

a) The Respondent determined that the amount of €45,495.71 be added to the taxable income of the Claimant, relating to 50% of losses from variations in fair value recognized in results, concerning securities registered in "Available-for-Sale Financial Assets" ("AFSA");

b) The legal grounds underlying such correction are essentially based on the application of the limitations contained in paragraph 3 of article 45 of the Corporate Income Tax Code to losses from variations in fair value in securities registered in portfolios of AFSA;

c) In turn, the arguments supporting such applicability would also, in practice, reduce to a single argument, namely the literal element of interpretation of legal rules;

d) A proper interpretation of the law cannot disregard the historical element of interpretation, the systematic element and its rational or teleological element;

e) The intention of the legislator, in broadening, in 2006, the scope of application of paragraph 3 of article 45 of the Corporate Income Tax Code, was manifestly not to include therein the impairment provisions mandatorily established by credit institutions relating to capital shares registered as "AFSA";

f) Furthermore, on the level of principles, an exceptional and restrictive rule that limits the deductibility of expenses based on "moralizing" purposes can never be applied to costs whose accounting recognition by the taxpayer not only is not within their free discretion, but is furthermore imposed upon them by a supervisory entity;

g) If we apply to losses from impairment in capital shares, mandatorily recognized by credit institutions in results, simultaneously the provision of article 37 of the Corporate Income Tax Code and the provision of article 45, paragraph 3, of the same statute (assuming – incorrectly in the Claimant's view – that this latter provision covers such expenses), we would, in effect, be annulling, through the application of a general rule, the objectives pursued by a particular and special rule;

h) General rules should not prevail over particular ones, nor general rules over special ones; applying the limits set forth in paragraph 3 of article 45 of the Corporate Income Tax Code to losses from impairment in capital shares recognized by institutions subject to the supervision of the Bank of Portugal, more than disrespecting basic rules of hierarchy of norms, is forgetting the essential aspect of the interpretation task, namely reconstructing, from the texts, the legislative thought, taking especially into account the unity of the legal system, the circumstances in which the law was drafted and the specific conditions of the time in which it is applied;

i) Applying paragraph 3 of article 45 of the Corporate Income Tax Code to the impairment provisions established/deducted by the Claimant in 2010, relating to capital shares qualified as "AFSA", is nothing more than applying a legal rule without first taking care to understand what rule it is, what its ratio is, what its history is and what its relationship is with the other rules of the legal-tax order in which it is inserted;

j) If this correction is maintained, an act that is manifestly illegal would be maintained, by violation of the provision of article 45, paragraph 3, of the Corporate Income Tax Code.

k) In these terms, the Claimant requests that the arbitral tribunal assess the legality of this assessment and, consequently, annul it.

1.              The Respondent filed a Response, in which it defends itself through contestation, alleging, in the sense of the lack of merit of the request for an arbitral award, in summary, the following:
   

a) Article 45, paragraph 3, of the CIRC, like others scattered throughout the Corporate Income Tax Code, is based on the purpose of mitigating the effects of tax base erosion practices, which also fall within, currently, the objectives of tax policy;

b) The legislator, in giving article 45, paragraph 3, of the CIRC a comprehensive and generic wording, opted not to include in its provision any consideration of particular circumstances of the specific operations that give rise to losses, as well as other losses and negative patrimonial variations;

c) The concept of "losses" inherent in article 45, paragraph 3, of the CIRC has an open formulation, within the scope of which all types of losses relating to capital shares are included, including potential losses, from which it results that the legislator did not intend to exclude any losses relating to capital shares that are reflected in accounting, not having expressly excluded potential losses resulting from the application of fair value to financial instruments, whether recorded in expense and loss accounts or in equity accounts;

d) The legislator, when referring to "other losses relating to or negative patrimonial variations relating to capital shares", did not classify them, leaving a door open for all losses to be subsumed here, including expenses/losses resulting from fair value measurement;

e) Regarding the fact that the subsumption to the partial deduction regime provided for in article 45, paragraph 3, of expenses/losses determined in accordance with the terms and conditions referred to in article 18, paragraph 9, subparagraph a), of the CIRC, is not accompanied by symmetric treatment for income/gains, and the potential injustice that may result therefrom, in fact there is no legal provision that allows the consideration of only half of its value in the calculation of taxable profit;

f) And if the legislator, neither before nor after 2010, introduced any provision establishing a symmetric solution for income/gains and expenses/losses resulting from the application of fair value, under the terms and conditions referred to in article 18, paragraph 9, subparagraph a), neither can the interpreter, whether the AT or the taxpayer, replace the legislator in this task;

g) Contrary to what the Claimant maintains, from both the accounting and tax points of view, since 2006, on the one hand, "impairment losses" have been reflected in the accounting of Banks although, from the point of view of terminology, the same concrete reality – yielding the same accounting result as a result of the adoption of the same accounting principles and rules – has, until the 2010 tax year, borne the designation of "provisions";

h) It is also since 2006 that the non-deductibility of 50% of such "provisions", as costs, expenses or losses accounting reflected, is verified, by force of the provision in the final part of paragraph 3 of article 45 of the CIRC, as "other losses or negative patrimonial variations relating to capital shares or other components of equity, namely supplementary contributions" (wording which has remained in force since 2006 – the same year in which the new accounting regulations applicable to the banking sector entered into force), so it is not correct to state that the meaning of the rule was altered;

i) All losses relating to capital shares are encompassed by the rule contained in article 45, paragraph 3, of the CIRC, whether it is the negative difference between realized gains and losses or other potential expenses/losses, such as, for example, expenses resulting from the recognition of impairment losses, there being no exception for losses relating to capital shares of credit institutions;

j) Now, precisely because it comprehends the spirit of the legislator and the letter of the law, the AT would not be acting in accordance with the same if it did not encompass impairment losses in "other losses or negative patrimonial variations";

k) In respect of the principles of equality, equity, uniformity and tax capacity (article 4 of the General Tax Law and articles 13, 103 and 104 of the Constitution), between Credit Institutions and other companies subject to Corporate Income Tax ("taxpayers that are legal entities or similar"), it would always have to be concluded that paragraph 3 of article 45 of the CIRC was equally applicable to Credit Institutions and other companies subject to Corporate Income Tax;

l) Applying to the legal rule contained in paragraph 3 of article 45 of the CIRC the interpretation defended by the Claimant would obtain a result in which two substantially identical economic operations – purchase and sale of capital shares – would be taxed quite diversely, only as a function of having been performed by taxpayers operating in different sectors of activity, so the interpretation defended by the Claimant is manifestly contrary to the constitutional principle of equality;

m) The tax act challenged does not affront the principle of taxation of real income, because such principle established in paragraph 2 of article 104 of the Constitution is the general regime, which admits exceptions, such as, among many others, the limitations to the deductibility of expenses for tax purposes provided for in article 45 of the CIRC;

n) In these terms, the Respondent defends the total lack of merit, as not proven, of the present request for an arbitral award.

1.              By order of 07-12-2016, given that no exceptions were invoked and that there is only dispute concerning matters of law, this Tribunal dispensed with the holding of the meeting provided for in article 18 of the RJAT, in application of the principles of autonomy in the conduct of proceedings, celerity, simplification and procedural informality, and decided that the proceedings would continue with optional written submissions, having set the day 21-03-2017 as the deadline for issuing the arbitral award.
   

2.          The Claimant filed final submissions, in which it maintained and reinforced the arguments invoked in the Request for Arbitral Award, concluding that the assessment now challenged suffers, among others, from the following defects:
   

a) Defect of violation of the constitutional principles of equality and tax capacity, arising from articles 13, paragraph 1 and 104, paragraph 1 of the Constitution of the Portuguese Republic;

b) Defect of violation of the provision of article 23 of the Corporate Income Tax Code, by not permitting the deduction of tax expenses resulting from impairment losses;

c) Defect of violation of the provision of article 35, paragraph 2 of the Corporate Income Tax Code, by not permitting the tax deduction of impairment losses established by force of rules issued by the Bank of Portugal.

1.          The Respondent filed final submissions, in which it maintained, in full, the tenor of its Response, sustaining, in summary, that the correction made does not suffer from any illegality nor, contrary to what the Claimant alleges, did it harm the constitutional principles of equality and tax capacity in its aspect of taxation by real profit.
   

II. PRELIMINARY MATTERS

1.          No exceptions were invoked.
   

2.          The parties have legal personality and capacity, are legitimate with respect to the request for an arbitral award and are duly represented, pursuant to the provisions of articles 4 and 10 of the RJAT and article 1 of Ordinance no. 112-A/2011, of 22 March.
   

3.          There are no nullities, so it is necessary to address the merits.
   

III. MERITS

III. 1. MATERIAL FACTS

§1. Proven Facts

1.           The following facts are deemed proven:
   

a) The Claimant is a company subject to the supervisory powers of the Bank of Portugal;

b) The Claimant was subject to a tax inspection action, developed by the Tax Inspection Division of the Finance Directorate of Lisbon, in compliance with Service Order no. OI2014…, which began on 21 January 2016;

c) As a result of that inspection action, a Draft Tax Inspection Report was prepared, which proposed the addition of €45,495.71 to the taxable income of the Claimant, for purposes of Corporate Income Tax for the 2012 tax year, by force of the non-consideration of only half of losses relating to capital shares (€90,991.42), pursuant to article 45, paragraph 3 of the Corporate Income Tax Code;

d) This Draft was made final, with the Claimant having been notified of the Tax Inspection Report on 15 April 2016;

e) Thus, the amount of €45,495.71 was added to the taxable income of the Claimant, corresponding to half of the capital losses accounted for, which resulted in the reduction of the tax loss determined by the Claimant in the 2012 tax year by the same amount;

f) On 27 April 2016, the Claimant was notified of the Corporate Income Tax Assessment Demonstration no. 2016…, which reduced to €7,327,477.11 the amount to be refunded as determined in the self-assessment;

g) Not agreeing with the understanding of the AT regarding the non-consideration of only half of losses relating to capital shares, pursuant to article 45, paragraph 3 of the CIRC, the Claimant filed the request for an arbitral award now under consideration.

§2. Unproven Facts

With relevance to the decision, there are no essential unproven facts.

§3. Reasoning Regarding Material Facts

With respect to the material facts proven, the Tribunal's conviction was based on the free assessment of the positions assumed by the Parties regarding facts, in the administrative proceedings and on the tenor of the documents attached to the record, not contested by the Parties.

III.2. LEGAL MATTERS

§1. Question to be Decided

With the relevant facts established, it appears that the present proceedings concern exclusively matters of law.

The central question to be decided in the case sub judice is that which concerns knowing whether, with respect to the 2012 tax year, the rule contained in paragraph 3 of article 45 of the Corporate Income Tax Code, then in force, is applicable to impairment provisions relating to capital shares qualified as "Available-for-Sale Financial Assets", established in accordance with the rules issued by the Bank of Portugal, with the consequent deduction of 50% of their respective value, or if, on the contrary, the same are fully deductible, by force of the application of the rule contained in paragraph 2 of article 35 of the Corporate Income Tax Code, also in force at the date of the facts.

§2. Legal Framework

The question to be decided centers on the interpretation of the provision of paragraph 3 of article 45 of the CIRC, in force at the date of the facts, whose wording is as follows:

«The negative difference between gains and losses realized through the onerous transfer of capital shares, including their redemption and amortization with capital reduction, as well as other losses or negative patrimonial variations relating to capital shares or other components of equity, namely supplementary contributions, concur for the formation of taxable profit at only half their value.»

The following provisions also assume relevance in the case in question, in the wording in force at the date of the facts:

· Article 18, paragraph 9, subparagraph a), of the CIRC:

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

a) They respect financial instruments recognized at fair value through results, provided that, in the case of equity instruments, they have a price formed in a regulated market and the taxpayer does not hold, directly or indirectly, a participation in capital exceeding 5% of its share capital»;

· Article 23, paragraph 1, of the CIRC:

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

a) Those relating to the production or acquisition of any goods or services, such as materials used, labor, energy and other general expenses for production, conservation and repair;

b) Those relating to distribution and sale, covering transportation, advertising and marketing of goods and products;

c) Of a financial nature, such as interest on foreign capital applied to operations, discounts, premiums, transfers, exchange differences, expenses with credit operations, debt collection and issuance of bonds and other securities, redemption premiums and those resulting from the application of the effective interest method to financial instruments valued at amortized cost;

d) Of an administrative nature, such as remuneration, including those attributed as participation in profits, allowances, current consumable materials, transportation and communications, rents, litigation, insurance, including life insurance and operations of the "Life" branch, contributions to savings-retirement funds, contributions to pension funds and to any supplementary social security schemes, as well as expenses with employment termination benefits and other post-employment or long-term benefits of employees;

e) Those relating to analyses, rationalization, research and consultation;

f) Of a fiscal and parafiscal nature;

g) Depreciation and amortization;

h) Adjustments in inventories, impairment losses and provisions;

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

j) Expenses resulting from the application of fair value in consumable biological assets that are not multi-annual forestry operations;

l) Realized losses;

m) Indemnities resulting from events whose risk is not insurable.

        …»;

· Article 35, paragraph 2, of the CIRC:

«Impairment losses and other value corrections accounted for in the same tax period or in previous tax periods may also be deducted for tax purposes, when mandatorily established by force of rules issued by the Bank of Portugal, of generic and abstract character, by entities subject to its supervision and by branches in Portugal of credit institutions and other financial institutions with headquarters in another Member State of the European Union, intended to cover specific credit risk and country-risk and for losses from securities and other applications.»

· Article 37 of the CIRC:

«1 — The annual cumulative amount of impairment losses and other value corrections for specific credit risk and for country-risk referred to in paragraph 2 of article 35 cannot exceed what corresponds to the application of the mandatory minimum limits by force of notices and instructions issued by the supervisory entity.

2 — The impairment losses and other value corrections referred to in the preceding paragraph are only accepted when relating to credits resulting from normal activities, not encompassing credits excluded by the rules issued by the supervisory entity and also the following:

a) Credits in which the State, Autonomous Regions, municipalities and other public entities have provided a guarantee;

b) Credits covered by real rights over real estate;

c) Credits guaranteed by credit insurance contracts or surety, with the exception of the amount corresponding to the percentage of the mandatory shortfall;

d) Credits in the conditions provided for in subparagraphs c) and d) of paragraph 3 of article 36.

3 — The losses from applications referred to in paragraph 2 of article 35 must correspond to the total of the differences between the cost of applications resulting from the recovery of credits resulting from normal activities and their respective market value, when this is lower than that.

4 — The annual cumulative amounts of impairment losses and other value corrections referred to in paragraph 2 of article 35 shall not exceed the minimum values that result from the application of the rules issued by the supervisory entity.

5 — The regime contained in this article, insofar as it is not specifically provided herein, obeys the specific regulations applicable.

6 — When the annulation of provisions for general credit risks occurs, as well as impairment losses and other value corrections not provided for in paragraph 2 of article 35, are considered income of the tax period, first of all, those that have been accepted as tax expenses in the tax period of their establishment.»

· Article 46, paragraph 1, of the CIRC:

«1 — Gains realized or losses suffered are considered through onerous transfer, whatever the title by which it operates and also those resulting from claims or those resulting from permanent allocation to purposes unrelated to the activity carried out, relating to:

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

b) Financial instruments, with the exception of those recognized at fair value under the terms of subparagraphs a) and b) of paragraph 9 of article 18.»

§3. Application of Law to the Case Sub Judice

The Constitution of the Portuguese Republic provides for in its article 104, paragraph 2, the principle of taxation of real income. The constitutional legislator, in affirming in the said provision that "the taxation of companies is fundamentally based on their real income", uses a sense moderator – "fundamentally" -, admitting deviations from the principle established therein, which should be duly justified and be adequate, necessary and proportional, in the strict sense, to the aim pursued. This is what occurs with the limitation, conditioning or prohibition of deduction of certain expenses borne by companies.

The rule contained in paragraph 3 of article 45 configures a situation of limitation of the deduction of expenses in Corporate Income Tax, justified by the objective of prevention of tax avoidance practices and protection of the tax base against erosion risks, as the Respondent rightly points out.

It was precisely in this sense that the Constitutional Court ruled, in its Award no. 85/2010, of 3 March 2010 (Case no. 653/09), in line with its previous case law (see, for example, Awards nos. 418/2000 and 451/2002).

But the recognition of the constitutional admissibility of article 45, paragraph 3, is far from solving the interpretative difficulties of this provision. And it tells us nothing about the central question in the present proceedings, which concerns knowing whether article 45, paragraph 3, is applicable to impairment provisions relating to capital shares qualified as "Available-for-Sale Financial Assets", established in accordance with the rules issued by the Bank of Portugal.

Let us begin with the interpretative controversy concerning the meaning of the expression "other losses or negative patrimonial variations relating to capital shares".

According to the Respondent's understanding, «the legislator, when referring to "other losses or negative patrimonial variations relating to capital shares", did not classify them, leaving a door open for all losses to be subsumed here, including expenses/losses resulting from fair value measurement».

In the opposite sense, the Claimant, citing António Borges and Pedro Cabrita, in "Gains and Losses – Taxation and Reinvestment", Áreas Editora, Lisbon, 1999, page 16, understands that «"costs", in the proper sense, should not be confused with "losses", with the former being linked to the ordinary activities of the company and the latter, a priori, to extraordinary ones», and that «for credit institutions subject to the supervision of the Bank of Portugal, impairment losses in capital shares do not result from an extraordinary activity of such institution, but from an ordinary activity», concluding that «any costs other than losses, although relating to capital shares, do not fall within the scope of application of paragraph 3 of article 45 of the Corporate Income Tax Code».

On the concept of losses and its relevance for the interpretation and application of paragraph 3 of article 45 of the CIRC, a tribunal arbitral pronounced itself in depth in an award delivered in the context of Case 231/2015-T, of 9 December 2015, which, on this matter, we endorse and which we now transcribe:

«The dissection of the concept of "loss" (and also of "expense", as will be seen) is thus of clear centrality.

The adaptation of the CIRC to the new accounting rules arising with the SNC, operated by Decree-Law no. 159/2009, of 13 July, brought serious technical-interpretative difficulties, especially regarding the question with which we are concerned.

That this is so results clearly from the fact that the parties in dispute extract from the same accounting-tax provisions conclusions that are diametrically opposed. Indeed, in the initial petition, the claimant maintains that, with the requirements provided for in paragraph 9 of article 18 of the Corporate Income Tax Code met, the variations in the value of financial instruments will be considered income (subparagraph f) of paragraph 1 of article 20 of the Corporate Income Tax Code), or expenses (subparagraph i) of paragraph 1 of article 23 of the CIRC) of the tax period to which they relate. Thus, from the perspective of the claimant, the qualification of expenses that article 23 contained for fair value reductions in financial instruments would exclude from the scope of article 45, paragraph 3, the facts that can be qualified as expenses by the Corporate Income Tax Code, because said article 45, paragraph 3, only referred to other losses. Now if expenses and losses are different economic realities, the mere literal interpretation would exclude, in the claimant's view, the thesis of the AT.

To this view of the problem the AT contraposes that the income/gains and expenses/losses to which article 18, paragraph 9, subparagraph a) referred would have to be confronted with the treatment given to them by the provisions of articles 20, 23 and 45 of the CIRC. It deems the claimant's view as irrelevant the semantic question that emerges from the arbitral decision issued in case no. 108/2013-T, constructed, in its perspective, around the dichotomy between the term "losses" used in article 45, paragraph 3, and the term "expenses" used in article 23 and in article 18, paragraph 9, subparagraph a), of the CIRC.

That is, for the AT, the term expenses used both in the title given to article 23, within the scope of the changes introduced by Decree-Law no. 159/2009, of 13 July, and in the wording of subparagraph i) of paragraph 1 of that provision (Expenses resulting from the application of fair value in financial instruments), necessarily must be understood in a broad sense, i.e., covering, in substance, the expenses proper and the losses.

The AT emphasizes that, although each of those terms has its own meaning, that dichotomy between "expenses" and "losses" can only be qualified as a terminological imprecision of the legislator without consequences at the level of interpretation of those provisions. And, it adds, nor could it be otherwise, taking into account article 17, paragraph 1 of the CIRC, since, in the Chart of Accounts of the Accounting Standardization System (SNC), account 661, where negative adjustments resulting from the use of fair value are recorded, has always been denominated "Losses from fair value reductions in financial instruments".

Now, the decision based on the apprehension of the literality of the provisions is not, therefore, a simple task. Moreover, there is no definition (but an enumeration) of expenses or losses in the CIRC. Such definition exists indeed in the SNC, especially in the Conceptual Framework. There it is stated that (bold ours):

69 — The elements of income and expenses are defined as follows:

….

(b) Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or the incurrence of liabilities that result in decreases in equity, other than those related to distributions to participants in equity capital.

76 — The definition of expenses includes losses as well as those expenses that result from the course of the entity's ordinary activities. Expenses that result from the course of the entity's ordinary activities typically include, for example, the cost of goods sold, salaries and depreciation. They typically take the form of an outflow or depletion of assets such as cash and its equivalents, inventories and tangible fixed assets.

77 — Losses represent other items that satisfy the definition of expenses and may or may not arise in the course of the entity's ordinary activities. Losses represent decreases in economic benefits and as such are not in their nature different from other expenses. Hence they are not seen as a separate element in this Conceptual Framework.

78 — Losses include, for example, those resulting from disasters such as fires and floods as well as those from the disposal of non-current assets. The definition of expenses also includes unrealized losses such as, for example, those from the effects of increases in the exchange rate of a foreign currency relating to borrowings obtained from an entity in that currency. When losses are recognized in the income statement, they are generally shown separately because knowledge of them is useful for purposes of making economic decisions. Losses are often reported net of related income.

This definition of expenses in the SNC, which, in the absence of a definition in the CIRC and in light of the provision of article 17 of the CIRC will be imported into the process of determining taxable profit, establishes that, in fact, the general concept of expense encompasses losses. But, when the legislator, in the already mentioned adaptation of the CIRC to the SNC, in article 23, paragraph 1, subparagraph h) refers to "Impairment losses", shows that it imported into the CIRC the concept of the "65 - Impairment Losses" account of the SNC, but that in subparagraphs i) and j) it catalogs as "expenses resulting from fair value application" the amounts that in account 66 of the SNC are designated as losses from fair value reductions. Evident imprecisions are thus observed.

Since fair value reductions are designated in the SNC as losses, and that the CIRC, in article 23, never refers to fair value losses but rather to expenses, there would thus be, on a strictly literal plane an evident conceptual disconnection. And it is largely from this disconnection that the divergent interpretations that the provision raises for the claimant and for the AT arise. And also the various degrees of relative importance that the decisions taken in cases 108/2013-T and 25/2015-T attribute to the literal element in the qualification of expenses or losses, when the provision of article 23 of the CIRC is calibrated with the limitation contained in article 45, paragraph 3, of the same code, regarding the impact of fair value reductions in financial instruments.

Systematizing the question, for now only on an accounting-tax plane, with respect to the ambiguity of the wording of the rules: can the claimant argue – and it does – that insofar as article 23 of the CIRC does not provide for "fair value losses" but rather "expenses", this legal qualification removes such reductions from article 45, paragraph 3, where it is required that such facts are qualified as losses.

The AT can contend - and it has - that account 66 of the SNC qualifies as losses the fair value reductions, and this would qualify them as phenomena to subsume in the provision of article 45, paragraph 3. And that the concept of expenses contained in article 23 encompasses losses.

Now, faced with such breadth of interpretation, how to assess the question?

For this tribunal, the key to interpretation, on this accounting-tax plane, rests on the distinction in doctrine between expense and loss, and its application to the specific case in the record.

Thus, from the excerpt above transcribed from the Conceptual Framework of the SNC (§§ 69-b and 76 to 78) it follows that the concept of loss is translated (as is that of expense) into a reduction of economic benefits. However, losses are distinguished, in general, by their non-regular, non-recurring nature. They are thus the result of phenomena with a degree of occasionality or non-repeatability well superior to "those expenses that result from the course of the entity's ordinary activities" (§76).

That this is so is also observed in the extensive assessment that appears in Statement of Financial Accounting Concepts no. 6, issued by the Financial Accounting Standards Board, where the concepts of expenses (expenses) and losses (losses) are developed. Indeed, there they are defined (§§ 81 and following, bold and underline ours):

-Expenses are outflows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major or central operations.

• Losses are decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from expenses or distributions to owners.

Gains and losses result from entities' peripheral or incidental transactions and from other events and circumstances stemming from the environment that may be largely beyond the control of individual entities and their managements. Thus, gains and losses are not all alike. There are several kinds, even in a single entity, and they may be described or classified in a variety of ways that are not necessarily mutually exclusive.

Gains and losses may also be described or classified as "operating" or "nonoperating," depending on their relation to an entity's major ongoing or central operations. For example, losses on writing down inventory from cost to market are usually considered to be operating losses, while major casualty losses are usually considered nonoperating losses.

Distinctions between revenues and gains and between expenses and losses in a particular entity depend to a significant extent on the nature of the entity, its operations, and its other activities. Items that are revenues for one kind of entity may be gains for another, and items that are expenses for one kind of entity may be losses for another. For example, investments in securities that may be sources of revenues and expenses for insurance or investment companies may be sources of gains and losses in manufacturing or merchandising companies. Technological changes may be sources of gains or losses for most kinds of enterprises but may be characteristic of the operations of high-technology or research-oriented enterprises."

As can be seen, this important North American doctrinal source maintains that losses have a peripheral or lateral nature to the regular activities of an entity. And even that the same phenomenon can be economically classified as expense in some cases and loss in others, everything depending on the economic and substantive framework of the economic facts in question in light of the activity (or activities) carried out by business entities.

In national doctrine, J. Braz Machado emphasizes that "Losses are extinct costs, which do not benefit income-producing activities". Income, as defined by the Conceptual Framework of the SNC, is constituted by the revenues of the regular activities of an entity.

In international literature, Libby et al define losses (losses) as being "decreases in assets or increases in liabilities from peripheral transactions".

Moreover, the distinction between costs and losses is ancient in Portuguese accounting tradition, and was well marked in the POC. The SNC also distinguishes between expenses and losses. And the CIRC (in the version in force at the date of the facts) mentions the concept of losses in several articles.

And, for what matters here, article 45, paragraph 3, is clear. What is limited is the deductibility of "other losses" and not that of "other expenses" or "other expenses and losses".»

Similarly, in the award issued in the context of Case no. 108/2013-T, of 25 November, it is maintained that «[t]he provision of article 42, paragraph 3 (predecessor of the current 45, paragraph 3), should thus be considered, as reported to these concepts, defined in articles 23 and 24. Thus, and for obvious reasons, from the provision of that rule should be excluded costs relating to "capital shares or other components of equity", including only losses (as defined in article 23) and negative patrimonial variations (as defined in article 24), relating to those shares»,

That is, the literal element of interpretation points to the exclusion from the scope of the rule contained in paragraph 3 of article 45 of the CIRC of costs relating to "capital shares or other components of equity".

This meaning is confirmed by the historical element of interpretation.

Indeed, the provision contained in article 45 of the CIRC did not contain, in its original version, any disposition relating to the deductibility of losses, losses or patrimonial variations relating to capital shares.

Only with the entry into force of Law no. 32-B/2002, of 30 December (State Budget Law for 2003) was a new paragraph 3 added to article 42, then, with the following wording: «the negative difference between gains and losses realized through the onerous transfer of capital shares, including their redemption and amortization with capital reduction, is considered for the formation of taxable profit at only half their value».

Through Law no. 60-A/2005, of 30 December (State Budget Law for 2006), the scope of application of article 45, paragraph 3, of the CIRC was broadened, coming to comprise «other losses or negative patrimonial variations relating to capital shares or other components of equity, namely supplementary contributions».

Now, despite this amendment, and beyond the already mentioned distinction between "losses" and "expenses", the legislator maintained the wording of articles 35 and 37 of the CIRC.

Furthermore, one year after introducing an express reference "to losses and negative variations in capital shares" in paragraph 3 of article 45 of the Corporate Income Tax Code, the tax legislator came to provide in subparagraph e) of paragraph 2 of article 57 of Law no. 53-A/2006, of 29 December (State Budget Law for 2007), that impairment provisions would not be deductible to taxable profit, relating to the years 2005, 2006 and 2007, "except insofar as the same would likewise be deductible should the entity apply the Chart of Accounts for the Banking Sector (PCSB) in force on this date, equating, for this purpose, securities classified in "available-for-sale assets", which do not correspond to interests in subsidiaries or associates, to "investment securities".

As the Claimant rightly states, «in 2007, already after the most recent changes to article 45, paragraph 3 of the Corporate Income Tax Code were introduced, the tax legislator reiterated the particular tax treatment of impairment provisions in capital shares established by credit institutions subject to the supervision of the Bank of Portugal, ensuring their deductibility insofar as the regulatory framework imposed by the supervisor is complied with.»

This means that it was not the legislator's intention to include within the scope of application of the second part of paragraph 3 of article 45 of the Corporate Income Tax Code the impairment provisions in capital shares established by institutions subject to the supervision of the Bank of Portugal.

From the systematic point of view, we verify that article 35 of the CIRC, under the heading "impairment losses fiscally deductible", is inserted in subsection IV, referring to "impairments and provisions". Article 45 of the CIRC, on the other hand, under the heading "expenses not deductible for tax purposes", is inserted in subsection V, which defines the "regime of other expenses". Article 45 establishes a general rule, applicable if, and only if, there is no special rule applicable. Now, the provision of "impairment losses fiscally deductible" is found in article 35, and not in article 45 of the CIRC.

Article 35 permits the deduction, for tax purposes, «of impairment losses and other value corrections accounted for in the same tax period or in previous tax periods, when mandatorily established by force of rules issued by the Bank of Portugal, of generic and abstract character, by entities subject to its supervision…».

In fact, it is the Bank of Portugal that imposes the establishment of impairment provisions in capital shares by entities subject to its supervision.

On this matter, Instruction no. 7/2005 of the Bank of Portugal applies, which entered into force on 1 March 2005 and ceased to have effect from 1 January 2017, which determines, in paragraph 2, that:

"With respect to financial assets, and in accordance with the relevant provisions of International Accounting Standard 39, there is impairment or impairment losses are incurred in a financial asset or a group of financial assets if, and only if, there is objective evidence of impairment as a result of one or more events that occurred after the initial recognition of the asset (a 'loss event') and if that event (or events) of loss has an impact on the estimated future cash flows of the financial asset or group of financial assets that can be reliably estimated."

And where it is added that:

"Objective evidence that a financial asset or a group of assets is impaired includes observable data that call to the attention of the holder of the asset about, in particular, the following loss events:

a) evident financial difficulty of the issuer or debtor;

b) breach of contract, such as default or delay in the payment of interest or principal;

c) significant probability that the borrower will enter into bankruptcy or other financial restructuring;

d) disappearance, for this financial asset, of a liquid market with sufficient depth, if due to financial difficulties of the issuer."

The Claimant is subject to the rules imposed by the supervisor, and the rule contained in article 35, paragraph 2, of the CIRC is applicable, which permits the deduction of the entire amount of losses relating to capital shares, in the amount of €90,991.42. This is also the meaning consistent with the provision of article 37, in which the legislator recognized the specificities of the banking sector.

This means that the legislator decided to treat differently an reality that involves diverse specificities, which explains the legal provision of articles 35 and 37 of the CIRC. And the differentiated treatment of different situations does not merit censure from the point of view of respect for the constitutional principle of equality, understood in a material sense.

With respect to the teleological element, and as referred to above, the rule contained in article 45, paragraph 3, of the CIRC aims at "the broadening of the tax base" and "measures for the moralization of taxation", as the objective assumed in the Report of the Proposal for the State Budget for 2003.

It happens that, as Tomás Cantista Tavares states, «underlying negative fair value there is never a motivation of tax evasion, by arbitrary valuation, for the simple reason that the taxation of fair value is limited to assets transacted in an organized market, where the asset's quote (appreciation and depreciation) is drawn, entirely from the taxpayer's tax will»[1].

Thus, and as stated in the award issued in the context of Case no. 108/2013-T, of 25 November, «[i]n this framework, manifestly cease to exist any needs relating to the combating of tax fraud and evasion, not only because the tax relevance of patrimonial variations ceases to be conditioned by an act of will of the taxpayer, but also because the valuation is objectively fixed. On the other hand, and for the same reasons, it also lacks sense any measure of conditioning of the will of the taxpayer, in the sense of favoring economically more "desirable" behaviors and, as such, conforming to the interests of broadening the tax base and budgetary consolidation».

The situation is even clearer in the case of entities subject to the supervisory powers of the Bank of Portugal, as is the case in the case in question, since «[t]he impairment losses recorded in accordance with the rules of the Bank of Portugal do not result from the will of the taxpayer but from the mandatory regulatory rules issued by the Bank of Portugal» (Arbitral decision issued in the context of Case no. 271/2014-T, of 17 October 2014).

In light of the grounds set forth, it is concluded that article 45, paragraph 3, of the CIRC is not applicable to impairment losses relating to capital shares, established under general and abstract rules issued by the Bank of Portugal.

IV. DECISION

In these terms, and with the grounds set forth, this Tribunal decides to find the request for an arbitral award well-founded and, consequently, to annul, on the grounds of illegality, and with all legal consequences, the tax act of additional Corporate Income Tax assessment, relating to the 2012 tax year, insofar as it concerns the addition of €45,495.71 to the taxable income of the Claimant.

V. VALUE OF THE CASE

In accordance with the provision of article 306, paragraph 2, of the CPC, 97-A, paragraph 1, subparagraph a), of the CPPT and 3, paragraph 2, of the Regulations of Costs in Tax Arbitration Proceedings, the value of the case is set at €11,373.75.

VI. COSTS

Pursuant to article 22, paragraph 4, of the RJAT, the amount of costs is set at €918.00, in accordance with the Table I attached to the Regulations of Costs in Tax Arbitration Proceedings, to be borne by the Respondent.

Notify accordingly.

Lisbon, 20 March 2017

The Arbitrator

Paulo Nogueira da Costa

[1] Tomás de Castro Tavares, Fair Value and Taxation of Capital Gains of Listed Companies: Regarding the Interpretation of Article 18, Paragraph 9, Subparagraph a), of the CIRC, Studies in Memory of Professor Doctor J.L. Saldanha Sanches, Volume IV, page 1143.