CAAD Case 511/2018-T: Transfer Pricing and Arm's Length Principle Under Article 63 of the IRC Code

ARBITRAL DECISION

The arbitrators Alexandra Coelho Martins (arbitrator-president), José Alberto Pinheiro Pinto and Paulo Ferreira Alves, designated by the Ethics Council of the Administrative Arbitration Centre ("CAAD") to form the Arbitral Tribunal, agree as follows:

I. REPORT

A..., S.A., hereinafter referred to as "Claimant," a legal entity number..., with registered office at Rua..., no...., ...-... ..., filed an application for establishment of a Collective Arbitral Tribunal, under Articles 5, paragraph 3, 6, paragraph 2, subparagraph a) and 10, paragraph 1, subparagraph a) and paragraph 2 of the Legal Framework for Arbitration in Tax Matters ("RJAT"), approved by Decree-Law no. 10/2011 of 20 January, as subsequently amended, following the dismissal order of the Administrative Complaint that it filed against the Corporate Income Tax (IRC) assessments nos. 2017 ... and 2017 ..., relating to the fiscal years 2013 and 2014, which corrected its taxable income by € 553,706.20 and € 186,478.88, respectively.

The respondent party is the Tax and Customs Authority, hereinafter referred to as "TA" or "Respondent."

The Claimant seeks an arbitral decision declaring the unlawfulness of and annulling the IRC assessments nos. 2017 ... and 2017 ..., dated 27 September 2017, which embody the aforementioned corrections to the taxable income (reduction of tax losses) of fiscal years 2013 and 2014, in the total amount of € 740,185.08, and likewise of the administrative complaint dismissal decision of 10 July 2018, pursuant to Article 163 of the (new) Code of Administrative Procedure ("CPA"), with the legal consequences, namely the restoration of the situation that would have existed had the unlawfulness not been committed, pursuant to Article 100 of the General Tax Law ("LGT"), and condemning the Respondent to pay the costs of the proceedings.

On 16 October 2018, the request for establishment of the Arbitral Tribunal was accepted by the Honorable President of the CAAD and followed its normal course, namely with notification to the TA on 23 October 2018.

In accordance with Articles 5, paragraph 3, subparagraph a), 6, paragraph 2, subparagraph a) and 11, paragraph 1, subparagraph a), all of the RJAT, the Ethics Council of the CAAD designated the arbitrators of the Collective Arbitral Tribunal, who communicated acceptance of the appointment within the applicable period. The Parties, notified of this designation on 6 December 2019, manifested no intention to refuse it.

The Collective Arbitral Tribunal was constituted on 27 December 2018.

1. POSITION OF THE CLAIMANT

As the basis for its claim, the Claimant invokes the failure to apply the transfer pricing regime provided for in Article 63 of the IRC Code, in Order no. 1446-C/2001 of 21 December, in the Recommendations of the Organisation for Economic Co-operation and Development ("OECD") of 2010 [OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2010] and in Article 77, paragraph 3 of the LGT and, thereby, the principles of full competition, tax equality, substance over form, and taxation on actual profit.

The Claimant does not challenge the application of the transfer pricing regime, as it agrees that special relationships exist, nor the invocation of the Net Profit Margin Method ("NPMM"). It disagrees, however, with the elements of comparability used by the TA, which used only internal comparables (sales made by the Claimant to customers), and with the manner in which it did so, concluding that the solution presented by the TA does not constitute the most reliable alternative, nor is it economically justified and compatible with the applicable legal requirements.

In this regard, it begins by stating that the regime of Article 63, paragraph 8 of the IRC Code is not susceptible to application to resident entities, as is the case with the Claimant. Moreover, and if it should be understood otherwise, it considers that the TA violated the duty of reasoning set forth in Article 77, paragraph 3 of the LGT, by not having justified its choice of the method selected and the exclusion of others.

Regarding the quantification procedure, the Claimant alleges that the TA corrected its IRC taxable income based on gross profit margins from which it did not eliminate any indirect expenses, namely supplies and external services, which means that in practice it did not apply the NPMM, contrary to what it invokes, but an ad hoc method that does not rely, as it should, on operational profitability, violating Articles 5 and 10, paragraph 2 of Order no. 1446-C/2001 of 21 December, and ignoring relevant comparability factors.

The determination of the arm's length price must ensure the highest degree of comparability and must be based on a comparable with terms and conditions similar to those of the related party transaction in question. According to the Claimant, the TA did not take into account the nature of the activity pursued in the context of commercial relationships maintained with related entities, which took place predominantly in the context of retail activity, a circumstance that the TA ignored, comparing prices and measuring profit margins without considering the type of market (producer/wholesaler/retailer) in which the respective goods were transacted. It further invokes that the TA did not consider the quantities transacted and the fact that quantity discounts were granted which cause the prices practiced to differ, nor did it take into account the fact that the transacted goods presented distinct characteristics, regarding the material employed (leather or other), the type of product transacted (shoe, boot, among others), and its respective brand. It adds that the TA did not note the differences in the various markets in which the Claimant operates – domestic, community, and international – nor did it conduct any economic analysis of the Claimant's activity.

On the other hand, according to the Claimant, even if it should be understood otherwise, the corrections made by the TA are not consistent with the provisions of Article 10, paragraph 3 of the cited Order no. 1446-C/2001, as excluded from the analysis were "stock sale customers" ["customers who purchase 'collection remnants' and 'defective footwear,' with the selling price being lower than the cost price"]; "samples sold at cost price (0% margin)" and "other customers with negative profit margins on cost," which includes company B... which was, in fiscal years 2013 and 2014, one of the Claimant's principal customers. It argues that the TA could not have done so, given the weight and relevance of this customer (17% in 2013 and 1.6% in 2014), thereby vitiating the average profit margins determined.

The Claimant also points out the fact that the TA limited its analysis to the universe of commercial relationships maintained by the Claimant, not attempting to determine, across the various markets, independent entities with a business model similar to this one, compromising the high degree of comparability and the determination of market prices. It adds that companies that with the Claimant were in a situation of special relationships (level of participation exceeding 10%) should have been excluded from the sample, and were not.

Finally, for the Claimant, the TA should have determined a range of market prices or margins, an arm's length interval, as provided for in Article 4, paragraph 5 of Order no. 1446-C/2001, and not a fixed price.

As a subsidiary basis, the Claimant invokes Article 100, paragraph 1 of the Code of Tax Procedure and Process ("CPPT"), for the doubts raised by the TA's analysis which does not allow the profit margins determined in the Tax Inspection Report to be regarded as reliable. The Claimant submitted 8 documents, having not requested production of other types of evidence.

2. POSITION OF THE RESPONDENT

On 4 February 2019, the Respondent submitted the administrative file ("AF") and filed its Reply, in which it defends itself by contesting.

It begins by mentioning that it was the Claimant's non-compliance with the obligation to prepare transfer pricing documentation, which should have been carried out "at the time the operations took place," which led to the opening of the inspection action.

It emphasizes that the Claimant's application of the NPMM using ten indicators led to results with no useful significance, as the amplitudes of the intervals (distance between minimum and maximum values) are so large that only by mere chance would the Claimant's values fall outside these intervals.

The Claimant's conclusions were rejected because they are based on generic indicators of the entity, without a segmentation of transactions with related and unrelated entities, and because they abstract from an analysis focused on specific transactions.

According to the Respondent, non-compliance with the arm's length principle was evident, as the control of commercialization margins practiced by the Claimant made it possible to verify that, for the same shoe model, those practiced in sales to C..., LDA. and to D..., SL were always lower than those practiced for other "Retail" and "Wholesale" customers.

The TA maintained the same method selected by the Claimant, the NPMM which, unlike so-called traditional methods, does not require "a high degree of similarity between products, but fundamentally, between functions, risks and assets. Additionally, the use of operating margin for purposes of economic analysis makes it possible to avoid distortions resulting from different treatments or classifications of the same reality." In this way, it opted for internal comparables, i.e., similar transactions carried out by the Claimant with unrelated entities, assuming that even if there is not total similarity between the goods and finished products object of the related and unrelated transactions, since it is the same entity – the Claimant – the demonstration of the similarity of functions, risks and assets would be compromised. For the Respondent, contrary to what the Claimant seeks to suggest, the choice of internal comparables (sale transactions of identical or similar products to independent entities) removes relevance from the demonstration of the comparability factors to which Article 5 of Order no. 1446-C/2001 refers.

Indirect expenses were not deducted, due to the natural difficulty raised by their allocation to related transactions and to unrelated transactions. On the other hand, it states that transactions with unrelated entities which, by their specific nature, do not fall within the normality of the transactions carried out, were purged, such as those referring to "stock sales" (collection remnants and defective footwear), carried out at selling prices below cost price; samples sold at cost price; and also transactions with customers in which negative profit margins are practiced.

As to the weighing of the different characteristics of the transacted goods, the Respondent states that this only makes sense when traditional methods are used, such as the comparable uncontrolled price method, and not when methods based on the calculation of profit margins are resorted to, adding that the magnitude of the differences in prices and margins practiced cannot be justified by quantity discounts.

As to the legal basis of the corrections, the Respondent states that although the report, in the summary of violations found, refers to Articles 63, paragraph 8 and 120 of the IRC Code being infringed, it also refers to Articles 63, paragraph 1 (arm's length principle) and paragraph 4, subparagraph h) of that Code and to Order no. 1446-C/2001, norms applicable to both residents and non-residents.

Regarding the determination of a single price, rather than a range of values, the Respondent notes that it is not necessary to indicate an interval when exclusively internal data are used, i.e., extracted from the entity itself.

The Respondent argues for the dismissal of the action and absolution from all claims, with the legal consequences, including the maintenance of the tax acts.

3. INSTRUCTION AND ALLEGATIONS

By order of 5 February 2019, the meeting provided for in Article 18 of the RJAT was dispensed with, as it was considered unnecessary. The Parties were notified to submit successive written submissions, and the deadline for rendering the arbitral decision was set, warning the Claimant that, by that date, it should proceed with the payment of the subsequent arbitral fee.

The Claimant submitted final submissions on 25 February 2019. It reiterates the position assumed in the request for arbitral pronouncement ("ppa") and reinforces that no effect or penalty can be attributed to the delay in fulfilling the ancillary obligation to prepare transfer pricing reports for fiscal years 2013 and 2014, as such delay was addressed in the appropriate forum, via administrative offense proceedings, and was remedied by the Claimant, with the tax inspection services gaining access to the said reports and using the information contained therein.

The Respondent submitted submissions on 7 March 2019, referring to the Reply, as there were no new facts or arguments on which to pronounce itself.

The deadline for rendering the decision was extended, on two occasions, pursuant to Article 21, paragraph 2 of the RJAT.

II. PRELIMINARY EXAMINATION

The Arbitral Tribunal was regularly constituted and, given the nature of the subject matter of the proceedings, is competent ratione materiae to know of the IRC assessment acts that proceeded with the correction of the declared tax losses of fiscal years 2013 and 2014, in accordance with Articles 2, paragraph 1, subparagraph a) and 5 of the RJAT and 2 and 3 of Order no. 112-A/2011 of 22 March ("Binding Order").

The parties possess procedural personality and capacity, have standing, and are duly represented (cf. Articles 4 and 10, paragraph 2 of the RJAT and Article 1 of the Binding Order).

The request for arbitral pronouncement is timely, as it was submitted within the period provided for in Article 10, paragraph 1, subparagraph a) of the RJAT.

No issues were identified that prevent the examination of the merits.

III. FACTUAL FINDINGS

1. PROVEN FACTS

With relevance to the decision, the following facts are considered proven:

A. A..., S.A., here Claimant, is a commercial joint-stock company with registered office and effective management in national territory, constituted on 4 February 2010, being classified, for IRC purposes, under the general regime – cf. document 1 – Tax Inspection Report ("TIR") submitted by the Claimant with the request for arbitral pronouncement (ppa) and contained in the AF.

B. The Claimant has as its corporate purpose the manufacture, commercialization and distribution of footwear, leather goods and similar products, including components and accessories, and is classified under CAE 15 201 – cf. TIR.

C. From 2011 onwards, the Claimant came to be majority-held (51%) by company E..., LTD., an entity inserted in Group F..., headed by G..., a company with registered office in India. In fiscal years 2013 and 2014, the referred to percentage of participation (51%) of E..., LTD. in the capital stock (totaling € 1,000,000.00) of the Claimant was maintained, according to the organizational chart below – cf. TIR:

G...
100%

D. E..., LTD. develops, from Mauritius, activity similar to that pursued by the Claimant in national territory, with its capital being 100% held by the aforesaid Indian law company G... – cf. TIR.

E. E..., LTD. is also the holder of all the capital of the Portuguese law company C..., LDA. which, in turn, is the holder of all the capital of the Spanish law company D..., SL – cf. TIR.

F. Both C..., LDA. (hereinafter C...) and D..., SL (hereinafter D...) are engaged in footwear commerce, having in fiscal years 2013 and 2014 purchased goods (merchandise and finished products) at retail from the Claimant – cf. TIR.

G. From fiscal year 2014 onwards, the Claimant adopted taxation periods comprised between 1 April of the same year and 31 March of the following year, such that in that transition year [2014] it filed two IRC model 22 declarations and two CIT forms, corresponding to the periods of January to March 2014 and April 2014 to March 2015, with the TA, in the context of the inspection action undertaken, considering as fiscal year 2014 the sum of the two declarations and values accounted from January 2014 to March 2015 – cf. TIR.

H. In the mentioned fiscal years (2013 and 2014), the sales made and services provided by the Claimant took place in national, community, and international markets, having reached global amounts of € 5,569,055.85 (2013) and € 11,444,552.07 (2014), respectively (values deducted from returns) – cf. TIR.

I. In concrete terms, the percentage shares reached by the Claimant in the referred to geographic markets were as follows – cf. TIR:

(a) 1 January to 31 March 2014
(b) 1 April 2014 to 31 March 2015

J. In fiscal year 2013, the Claimant had the following principal customers – cf. TIR:

K. In fiscal year 2014, the Claimant had the following principal customers – cf. TIR:

L. At the date when the Legal Certification of Accounts of the Claimant for fiscal years 2013 and 2014 was carried out, the preparation of the transfer pricing dossiers/reports was not concluded, with the documentation and justification of the transfer pricing policy adopted, which gave rise to a qualification from the Statutory Auditor, as it was not possible to determine the respective effects on the financial statements on 31 December 2015 – cf. TIR.

M. Subsequently, transfer pricing reports relating to fiscal years 2013 and 2014, containing the explicit statement of the policy adopted, were exhibited by the Claimant in the context of the inspection action relating to such periods – cf. TIR and documents 5 and 6 submitted with the ppa.

N. According to those transfer pricing reports prepared by the Claimant, the conditions of arm's length and fiscal parity are met, and the terms and conditions of the Claimant's transactions with related entities are generically identical to those that would be practiced between independent parties, a conclusion based on quantification using the Net Profit Margin Method ("NPMM") which those documents define as a "method based on transaction profitability, conducting the arm's length principle test by comparing the operating results obtained by the entity subject to analysis with the operating results obtained by third-party entities that perform similar functions and assume similar risks" – cf. TIR and documents 5 and 6 submitted with the ppa.

O. Within that scope, the Claimant's Transfer Pricing Dossier for period 2013 used a basis of comparison of selected financial indicators from 56 companies, constituted using the SABI Database, with information available up to 2012, as follows – cf. document 5 submitted with the ppa:

P. As regards fiscal year 2014, the Claimant's Transfer Pricing Dossier used a basis of comparison of selected financial indicators from 62 companies, constituted using the SABI Database, with information available up to 2013, as follows – cf. document 6 submitted with the ppa:

Q. On 13 September 2016, the Tax Inspection Services of the Finance Directorate of ... initiated an external inspection action, regarding IRC (transfer pricing) and Value Added Tax, covering fiscal years 2013 and 2014, under service orders nos. OI2015... and OI2016... – cf. TIR.

R. By means of letter no. ..., of 10 August 2017, from the Finance Director of ..., the Claimant was notified of the Draft Report, having chosen not to exercise the right to a prior hearing regarding the projected IRC corrections – cf. TIR.

S. Subsequently, by means of letter no. ..., of 20 September 2017, from the Finance Director of ..., the Claimant was notified of the Tax Inspection Report ("TIR") – cf. TIR.

T. As regards IRC, the Tax Inspection Report reflects corrections to the Claimant's taxable income for fiscal years 2013 and 2014, in the respective amounts of € 553,706.20 and € 186,478.88, on the basis of "omissions of gains due to non-compliance with the arm's length principle in sales made to related entities" – cf. TIR.

U. As a consequence, the tax losses originally declared by the Claimant – of € 2,302,168.87 for fiscal year 2013 and € 2,786,974.55 for fiscal year 2014 – were reduced accordingly, having passed to amount to € 1,748,462.67 and € 2,600,495.67, respectively, corresponding to the negative taxable results of the said fiscal years – cf. TIR and subsequent IRC assessments nos. 2017 ... and 2017 ... of 27 September 2017.

V. As the basis for the said corrections, the following excerpts are extracted from the TIR:

"[…]

From 2011 onwards, the company [Claimant] is majority-held (51%) by 'E...), Ltd.', an entity inserted in group F..., with registered office in India (Parent Company: G...[...].

As stated in the Management Report for the year 2012, two new companies were established by the F... group (in which 'A..., SA' is inserted), which are:

• C..., Lda (with registered office in Portugal), and

• D..., SL (with registered office in Spain).

These two companies operate a set of stores in Portugal and Spain, respectively, for which the company 'A..., SA' sold merchandise (footwear imported from India and China) and finished products (footwear produced at the factory in Esmoriz), both in 2013 and in 2014.

[...]

In these fiscal years, 2013 and 2014, A... produced approximately 70% for AA... [C...– in the capacity of entity responsible for the commercialization of that brand in the domestic market] and the remainder for third-party brands (..., ..., ..., etc), among various products (boots, high boots, shoes and sandals) and market segments (retail and wholesale).

[...]

In the years analyzed, the company made sales both to the domestic market (where its principal customer was the company 'C..., Lda') as well as to the intra-community and external markets.

[...]

In the maps constituting Annex 20, we separate sales by model and it is verified that the selling prices practiced for 'C...' and for 'D...' [D...] are lower than those practiced for other customers, and with a margin lower than normally practiced, when models are sold solely to these two companies.

[…]

In the maps constituting Annex 32, we separate sales by model and it is verified that the selling prices practiced for 'C...' and for 'D...' [D...] are lower than those practiced for other customers, and with a margin lower than normally practiced, when models are sold solely to these two companies.

[…]

In the maps constituting Annex 33, we verify that the selling prices practiced are always lower than the cost prices, with the majority of sales having been made to 'C...':

[...]

After analyzing the 'Transfer Pricing Dossier' presented by the taxpayer and the elements contained therein, it is not at all possible to conclude that A... carried out transactions with related entities, under the terms and conditions identical to those it practiced with independent entities, as it is based on a general analysis of several indicators it presented, comparing them with the same indicators presented by a group of companies in the same sector. It is clear that, taking as comparable a generic indicator of the company, to which the transactions with related entities and unrelated entities contribute, that indicator will be within the interval. The analysis must necessarily be conducted by comparing transactions with related entities with transactions with unrelated entities, that is, the methodology adopted by the taxpayer does not serve to prove compliance with the arm's length principle.

No specific transaction was analyzed, nor was the method of calculating the prices of 'merchandise and product sales' for related entities explained.

It is stated in the 'Dossier' that the Net Profit Margin Method (NPMM) was used, but in reality 'relevant financial indicators' were calculated taking into account annual values, and not by transaction, which in this case does not allow any conclusion to be drawn.

DEFINITION OF THE USE OF NPMM as stated in the TRANSFER PRICING DOSSIER OF THE TAXPAYER

The NPMM is a method based on transaction profitability, conducting the arm's length principle test by comparing the operating results obtained by the entity subject to analysis with the operating results obtained by third-party entities that perform similar functions and assume similar risks.

[…]

Analyzing these two definitions – that of the taxpayer and that which is stated in Article 10 of order 1446/2001 of 21 December – of the use of the Net Profit Margin Method (NPMM), the first has nothing to do with the second.

[…]

III. DESCRIPTION OF FACTS AND BASES FOR MERELY ARITHMETIC CORRECTIONS

III.1. REGARDING IRC

III.1.1. TRANSFER PRICING

III.1.1.1. Legal Framework

Pursuant to paragraph 1 of Article 63 of the IRC Code and paragraph 1 of Article 1 of Order no. 1446/2001 of 21 December, which regulates the application of transfer pricing determination methods, the taxpayer must adopt, in commercial or financial transactions carried out with related entities, conditions substantially identical to those normally contracted, accepted or practiced with independent entities in comparable transactions.

In turn, paragraph 4 of Article 63 of the IRC Code considers that special relationships exist between two entities in situations in which one has the power to exercise, directly or indirectly, significant influence on the management decisions of the other, which is considered to be verified, in particular, between:

a) An entity and the holders of its capital, or the spouses, ascendants or descendants thereof, who hold, directly or indirectly, a participation not less than 10% of the capital or voting rights;

b) Entities in which the same holders of capital, their respective spouses, ascendants or descendants hold, directly or indirectly, a participation not less than 10% of the capital or voting rights;

c) An entity and the members of its administrative bodies, or any bodies of administration, direction, management or oversight, and their respective spouses, ascendants and descendants.

III.1.1.2. Classification of Transactions for Transfer Pricing Purposes

The company A... carries out transactions with related entities classified under the following subparagraphs of paragraph 4 of Article 63 of the IRC Code:

The relationships with 'C..., LDA' and 'D...' fall within subparagraph b) 'Entities in which the same holders of capital, their respective spouses, ascendants or descendants hold, directly or indirectly, a participation not less than 10% of the capital or voting rights'.

The company 'C..., LDA' is 100% held by the company 'E..., Lda', with registered office in India, which in fiscal years 2013 and 2014, held 51% of the Capital Stock of A....

The company 'D...' is 100% held by company C..., LDA.

In years 2013 and 2014, the company 'A...' sold to these two related companies, merchandise and finished products with commercialization margins lower than normally practiced with other customers, independent entities, in comparable transactions, such as, for example, in the sale of the same shoe model.

III.1.1.3. Determination of Transfer Prices

To determine transfer prices in accordance with the arm's length principle, we will use the Net Profit Margin Method (NPMM), whose definition is contained in Article 10 of Order 1446-C/2001, of 21 December – I Series B, and which was used in the preparation of the 'Tax Dossiers' exhibited to us for the years 2013 and 2014, albeit without taking into account what was mentioned in the referred to order.

Thus, we will calculate the 'net profit margin' practiced in 'merchandise and finished product sales' to 'C...' and to D...' and compare it with the same margin in 'merchandise and product sales' made to independent entities.

From our analysis we excluded, sales that do not form part of the company's normal activity:

• 'stock sale' customers, which according to information from the CC and D..., are customers who purchase 'collection remnants' and 'defective footwear', with the selling price being below cost price.

• 'samples' sold at cost price (0% margin), and

• other customers with negative profit margins on cost, as can be seen in the following tables:

[Tables of margins with various customers and products excluded from analysis]

[Additional detailed tables showing margin calculations for 2013, 2014, and 2015 with related and independent entities]

W. The Claimant was notified of the IRC assessments nos. 2017... and 2017..., of 27 September 2017, which reflect the corrections made by the TA – reduction of the Claimant's declared tax losses – with the losses being officially fixed, for the fiscal years in question, in the amounts of € 1,748,462.67 (2013) and € 2,600,495.67 (2014) – cf. documents 2 and 3 submitted with the ppa.

X. On 26 January 2018, disagreeing with the said corrections to the IRC taxable income for years 2013 and 2014, the Claimant filed an Administrative Complaint – cf. document 7 (copy of the Administrative Complaint) submitted with the ppa.

Y. By letter of 16 May 2018, from the Finance Director of ..., the Claimant was notified of the draft dismissal of the Administrative Complaint – cf. document 8 submitted with the ppa.

Z. The draft dismissal of the Administrative Complaint contains the following reasoning:

"The IT [Inspection Service] is legitimized to challenge the methodology for compliance with the arm's length principle used by the taxpayer whenever it considers that the same does not satisfy the legal criteria [...]. Thus [...], the IT proceeded to calculate the 'net profit margin' practiced in merchandise and finished product sales to the related companies – C... and D...– and compared it with the same margin practiced in merchandise and finished product sales to independent companies [...]. For this purpose, some factors were taken into account:

– It was based on the cost and selling prices recorded in the maps provided by the certified accountant, whose sales had already been deducted from 'returns' to the same customers and credit notes [...];

– Calculation of the commercialization margins practiced by A..., relating to the same shoe models, separated by merchandise and finished product sales, with related companies and other 'Retail' and 'Wholesale' customers who purchase the same products;

– Exclusion of sales to customers who present specific characteristics, namely, 'stock sale' customers, who are customers who purchase 'collection remnants' and 'defective footwear'.

[...] contrary to what is alleged by the complainant 'in which the TA does not use a net margin, but calculated the gross profit margin of the transactions (selling price – cost price)', the calculation of the commercialization margin was based on the provisions of the final part of paragraph 2 of Article 10 of Order no. 1446-C/2001, which provides that 'The net profit margin is calculated in relation to an appropriate indicator (...) and may be represented by sales, cost or assets used (...).

It cannot be considered that it is a gross profit margin because it took into account returns and credit notes relating to the invoiced amounts, that is, the quantities taken into consideration for calculating the margin were net.

As to the aggregation of transactions, Article 2, paragraph 1, of the referred to order allows this aggregation when transactions are interlinked or continuous. In this case, the TA took into account for purposes of comparing the commercialization margins practiced the same shoe models for each type of entity (related and unrelated) and the commercialization margin that A... practiced under the same conditions.

The complainant further states that regarding the adjustments there was 'erroneous reasoning in accordance with paragraph 8 of Article 63 of the IRC Code regarding transactions with MORS since it is a non-resident entity'.

Portuguese legislation provides, with a mandatory character, in its paragraph 8 of Article 63 of the IRC Code, regulated by paragraph 1 of Article 3 of Order no. 1446-C/2001, that the taxpayer must make the necessary positive corrections in the periodic income declaration (form 22) in determining taxable profit by the amount corresponding to the tax effects derived from violation of the arm's length principle, consequent to related transactions with non-resident entities.

Now, it is precisely to transactions conducted with non-resident entities that paragraph 8 of Article 63 of the IRC Code refers, as was stated previously.

Regarding the violation of comparability factors, it should be noted that:

– In accordance with what is stipulated in Article 4 of Order no. 1446-C/2001, the taxpayer must adopt the method that it considers most appropriate for each transaction in order to provide the highest degree of comparability, for which purpose it must take into account the comparability factors referred to in Article 5 of said Order, such as: the specific characteristics of goods, the functions performed by the entities involved, contractual terms and conditions, economic circumstances, business strategy, etc.

– Now, the method adopted by A... – Net Profit Margin Method – was accepted by the IT. The comparability factors were either already considered or should have been considered by the complainant when adopting the method.

– There is thus no violation by the IT regarding the comparability factors." – cf. document 8 submitted with the ppa.

AA. By letter of 11 July 2018, from the Finance Director of ..., the Claimant learned of the decision to dismiss the Administrative Complaint, pursuant to the following order: "I convert into final the draft decision and with the reasoning contained therein I dismiss the claim as proposed". – cf. document 4 submitted with the ppa.

BB. Maintaining its disagreement regarding the corrections to the IRC taxable income for fiscal years 2013 and 2014, the Claimant filed with the CAAD, on 15 October 2018, the request for establishment of the Arbitral Tribunal that gave rise to the present proceedings.

2. UNPROVEN FACTS

With relevance to the decision, there are no facts that should be considered unproven.

3. REASONING REGARDING FACTUAL FINDINGS

The facts pertinent to the judgment of the case were selected and delimited according to their legal relevance, in light of the plausible solutions to the legal issues, pursuant to the application of Articles 123, paragraph 2 of the CPPT, 596, paragraph 1 and 607, paragraph 3 of the Code of Civil Procedure ("CCP"), applicable by referral of Article 29, paragraph 1, subparagraphs a) and e) of the RJAT.

No allegations made by the parties and presented as facts, consisting of strictly conclusive statements insusceptible of proof, were regarded as proven or unproven, whose validity must be assessed in relation to the specific factual matter established.

As regards the proven facts, the conviction of the arbitrators was based on the critical analysis of the documentary evidence submitted to the file by both Parties and their positions regarding the essential facts.

IV. EXAMINATION OF THE MERITS

1. THE EXISTENCE OF SPECIAL RELATIONSHIPS. CONSEQUENT APPLICATION OF THE TRANSFER PRICING REGIME

The IRC tax acts whose legality is relevant to assess derive, exclusively, from the implementation of the transfer pricing regime provided for in Article 63 of the IRC Code and in Order no. 1466-C/2001 of 21 December, with the Claimant invoking that the said acts suffer from the defect of violation of law, due to error in the assumptions, and from defect of reasoning.

The fiscal years 2013 and 2014 are covered, during which the Claimant and companies C... and D... were integral parts of Group F..., with their capital stock held, directly or indirectly, by company C..., LTD., in the case of the Claimant at 51% and in the case of those companies at 100%. Relevant capital relationships thus existed between these companies at the date of the facts, classifiable as special relationships, pursuant to the provisions of Article 63, paragraphs 1 and 4 (subparagraph b)) of the IRC Code, a configuration that is accepted by both Parties.

It is therefore indisputable that special relationships exist between the Claimant and companies C... and D... and that those relationships are subject to the transfer pricing regime (cf. Article 63, paragraph 1 and paragraph 4, subparagraph b) of the mentioned Code).

Within this scope, the issues raised regarding the formal defect of lack of reasoning of the tax acts and the material defect of error in the assumptions in the application of the transfer pricing regime and corresponding quantification are examined below.

2. THE ALLEGED DEFECT OF REASONING OF THE TAX ACTS

The Claimant considers that the TA violated the duty to provide reasoning for tax acts as provided in Article 77, paragraph 3 of the LGT, by not having justified its choice of the method selected and the consequent exclusion of others.

In this matter, it is important to recall that the duty to provide reasoning for acts of the Public Administration that affect rights or legally protected interests of citizens derives from a constitutional imperative, covering harmful and imposing acts, in particular those that deny, extinguish, restrict or affect those rights and interests, or aggravate duties, burdens, charges, subjections or sanctions. This duty of reasoning does not, however, apply to favorable acts or to situations in which the Administration adheres to the position of citizens (in the tax domain, also referred to as taxpayers or liable parties), as in that case there is no alteration, by act of authority, of the substantive position of these in a manner that is unfavorable to them, or, in other words, the requisite of harmfulness (lesivity) is not met (cf. Articles 268, paragraph 3 of the Constitution and 152 of the CPA).

It should also be noted that, according to the jurisprudence of the Supreme Administrative Court ("SAC"), reasoning is a relative concept that varies according to the legal type of act and aims to respond to the need to clarify the taxpayer, enabling them to know the reasons, in fact and in law, that determined its adoption and why a decision was made in one sense and not another, or, in other words, the cognitive and evaluative course (iter cognoscitivo e valorativo) of the act (cf. Judgment of the SAC of 2 February 2006, case no. 01114/05). An act is sufficiently reasoned whenever a normal recipient, placed before it, may become aware of the reasons that support the decision contained therein (cf. Judgment of the SAC of 20 November 2002, case no. 42180), understand the reasoning for the decision, the causes and the sense of the decision (cf. Judgment of the SAC of 14 March 2001, case no. 46796).

The reasoning of acts fulfills the primary function of permitting the control of their validity through the analysis of their respective assumptions and access to contentious guarantee. The CPA densifies, in its scope and requirements, the duty to provide reasoning (Articles 152 to 154) which, in the tax domain, is specifically regulated by Article 77 of the LGT.

Beyond the generic requirements for reasoning contained in paragraphs 1 and 2 of Article 77 of the LGT, paragraph 3 of this provision contains additional requirements applicable to corrections resulting from the effects of special relationships, in the following terms:

"Article 77
Reasoning and Effectiveness

1 – A procedural decision is always reasoned through a succinct statement of the factual and legal reasons that motivated it, and the reasoning may consist of a mere declaration of agreement with the reasoning of previous opinions, information or proposals, including those forming part of the tax inspection report.

2 – The reasoning of tax acts may be carried out in summary form, and must always contain the applicable legal provisions, the qualification and quantification of taxable facts and the operations for determining taxable income and the tax.

3 – In the event of the existence of transactions or series of transactions involving goods, rights or services, or financial transactions, conducted between a taxpayer liable to income tax and any other entity, whether or not subject to income tax, with which the former is in a situation of special relationships, and whenever there is non-compliance with any obligation established by law for that situation, the reasoning for the determination of corrected taxable income for the effects of special relationships must observe the following requirements:

a) Description of special relationships;

b) Indication of obligations not fulfilled by the taxpayer;

c) Application of the methods provided for by law, with the Tax Authority being able to use any elements at its disposal and the duty to provide reasoning of the elements of comparison appropriately being considered fulfilled even if from such elements are purged the data susceptible to identifying the entities to which they refer;

d) Quantification of the respective effects.

4 – […]"

Examining the arbitral file, it is noted that the Inspection Report contains clearly and in detail the arguments, in fact and in law, on which the TA based the correction of the Claimant's IRC taxable income, which were well perceived by the Claimant, including the application of the method and the criteria used.

The Claimant itself states in paragraphs 49 and 50 of its initial pleading that the Parties "do not disagree regarding the method for determining transfer prices: net profit margin method" and points out that the disagreement is delimited to the "comparability elements considered most appropriate: the Claimant selected external comparables (financial indicators applicable to companies belonging to the same activity sector); the Respondent Entity selected internal comparables (the sales of merchandise and finished products made by the Claimant to customers)".

Thus, given that there is no dispute regarding the method applied – Net Profit Margin Method or NPMM – which both Parties invoke, the Claimant's allegation that the TA should have justified its choice of the method selected is not upheld, as to that extent the TA did not produce any alteration to what had been declared by the Claimant, which was maintained (although, as will be seen below, the said method was "adapted", both by the Claimant and by the TA, so that, strictly speaking, in both cases these were "ad hoc" methods).

Indeed, with the method applied by the TA coinciding with that which had constituted the option of the liable party, on this point the TA did not alter the status quo declared by the liable party, so that given that there is no correction or alteration, the question of the corresponding reasoning does not arise, with the TA having limited itself to adhering to what was contained in the Transfer Pricing Dossiers for which, on this point, the TIR makes an express reference.

Regarding the matter that constitutes the center of disagreement, that is, the comparability elements considered appropriate for purposes of applying the NPMM, the TA justified in the TIR the departure from the Claimant's methodology. In this context, the TA states that that methodology is based on an analysis of generic indicators of the Claimant's activity, also incorporating transactions (significant) with unrelated entities, and comparing them with indicators of entities in the same sector. Such procedure does not, thus, compare related transactions with unrelated transactions, but the totality of the Claimant's transactions, including unrelated ones, with those of other companies, nor does it analyze any specific transaction, and is therefore not apt for demonstrating compliance with the arm's length principle regarding related transactions.

The TIR thus expressed the reasons why the comparability elements employed by the Claimant were rejected and, as is evident from the evidence, made explicit the criteria used in their place, quantifying their effects, as provided for in Article 77, paragraph 3 of the LGT, having the Claimant perceived the meaning and scope thereof, opposing the same in a circumstantiated manner, so the alleged defect of reasoning is unfounded.

A distinct question, of substantive nature and not already formal, is whether the Claimant disagrees with the reasoning because it does not consider the assumptions of taxation depicted therein to be verified or demonstrated. In this case, it is not a matter of assessing the defect of (lack of) reasoning, but the material validity of the tax act, which is examined below.

3. THE ALLEGED MATERIAL DEFECTS

3.1. ERROR OF LAW IN THE APPLICATION OF ARTICLE 63, PARAGRAPH 8 OF THE IRC CODE TO C...

The Claimant understands that the impugned IRC corrections are based on the failure to apply Article 63, paragraph 8 of the IRC Code, as is evident from Section I of the TIR ("CONCLUSIONS OF THE INSPECTION ACTION"). Since this provision is only applicable to transactions with non-resident entities, the transactions conducted between the Claimant and C... cannot, under its aegis, be covered, as this company has its registered office and effective management in national territory. Thus, it concludes that the corrections to transactions conducted with C... stem from a legal framework insusceptible of application to this entity, therefore suffering from the defect of violation of law.

The Claimant's statement that the provision of Article 63, paragraph 8 of the IRC Code is applicable to transactions conducted between the Claimant and non-resident entities in Portugal, such that its legal hypothesis only permits covering transactions related to D... and not those relating to C..., appears to be correct.

However, the TIR does not support the corrections made solely on the basis of the mentioned provision. In reality, the section "III.1.1.1. Legal Framework" expressly mentions Articles 63, paragraphs 1 and 4 of the IRC Code and Order no. 1446-C/2001 of 21 December, within the framework of which the TA developed the quantification methodology that it considered appropriate to the Claimant's situation. Thus, the fact that a specific part of the TIR contains only reference to paragraph 8 of the cited Article 63 does not legitimate the interpretation, unduly reductive, that the other bases and norms that punctuate the TA's reasoning as set out in the TIR are irrelevant, or that it is only that provision that is the foundation of the corrections made, when, in various passages of the inspection report, it is intelligible that the application of the arm's length principle provided for in Article 63, paragraph 1 of the IRC Code is at issue, mentioned expressly, which undoubtedly covers special relationships between/with resident entities. On the other hand, the regulation of the scope of application of the transfer pricing regime contained in Article 2 of Order no. 1446-C/2001, also invoked in the TIR, equally contemplates transactions conducted with non-resident entities (subparagraph a)), as well as those conducted with (between) resident entities in Portuguese territory, liable parties to IRC (subparagraph c)).

In light of the foregoing, the Claimant is not correct in invoking the alleged defect of error of law in the application of Article 63, paragraph 8 to transactions conducted with C..., since that is neither the sole nor the primary legal basis of the reasoning contained in the TIR for the corrections to the IRC taxable income, which rests on Articles 63, paragraphs 1 and 4 of the IRC Code and Order no. 1446-C/2001.

3.2. INCORRECT APPLICATION BY THE TA OF THE NET PROFIT MARGIN METHOD AND INCONSISTENCY OF THE SAMPLE AND THE MARGINS FIXED

Given that the applicability of the transfer pricing regime to transactions occurring between the Claimant, on one hand, and C... and D..., on the other hand, is established, the former invokes that the TA failed to apply the regime provided for in Article 63 of the IRC Code, in Order no. 1446-C/2001 (hereinafter also referred to merely as "Order") and in the OECD 2010 Recommendations, by not presenting, as was incumbent upon it, an alternative solution that is more reliable, economically justified and compatible with the applicable legal requirements, understanding that the internal comparables used by the TA are inappropriate as a substitute criterion for the external comparables contained in the dossiers presented by it [Claimant].

It is important to examine what is provided in this regard by Article 63 of the IRC Code:

"Article 63
Transfer Pricing

1 - In commercial transactions, including in particular transactions or series of transactions involving goods, rights or services, as well as in financial transactions, conducted between a liable party and any other entity, whether or not liable to IRC, with which the former is in a situation of special relationships, terms or conditions substantially identical to those that would normally be contracted, accepted and practiced between independent entities in comparable transactions must be agreed upon, accepted and practiced.

2 - The liable party must adopt, for the determination of the terms and conditions that would normally be agreed, accepted or practiced between independent entities, the method or methods capable of ensuring the highest degree of comparability between the transactions or series of transactions it conducts and others substantially identical, in normal market situations or in the absence of special relationships, taking into account, in particular, the characteristics of the goods, rights or services, the market position, the economic and financial situation, the business strategy, and other relevant characteristics of the liable parties involved, the functions performed by them, the assets utilized and the distribution of risk.

3 - The methods used must be:

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

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

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

a) An entity and the holders of its capital, or the spouses, ascendants or descendants thereof, who hold, directly or indirectly, a participation not less than 10% of the capital or voting rights;

b) Entities in which the same holders of capital, their respective spouses, ascendants or descendants hold, directly or indirectly, a participation not less than 10% of the capital or voting rights;

[…]".

This regime is complemented by Order no. 1446-C/2001 of 21 December, which regulates the quantification procedures, beginning with the determination of the most appropriate method, the need to attend to comparability factors and the requirements of the net profit margin method, in accordance with OECD guidelines.

Within this scope, it is important to highlight that the determination of the arm's length price must, as a rule, be based on an individualized analysis of transactions, which, however, has exceptions, such as when there is no or insufficient information on comparable transactions (Article 1, paragraph 2 of the Order). As to the most appropriate method for each transaction or series of transactions, that is considered which is capable of providing the best and most reliable estimate of the terms and conditions that would normally be agreed, accepted or practiced in a situation of full competition, "the choice being made by the method most apt to provide the highest degree of comparability between related transactions and other unrelated ones" (Article 4, paragraph 2 of the Order). Whenever there are reasonable doubts as to the reliability of the values that would be obtained with the application of a given method, the liable party must attempt to confirm such values through the application of other methods, either isolated or combined (Article 4, paragraph 4 of the Order).

The methods capable of being used are those listed in Article 63, paragraph 3 of the IRC Code and Article 4, paragraph 1 of the Order. The legislator expressed an order of preference, which begins with transactional and traditional methods (comparable uncontrolled price, resale price, cost-plus). If these methods cannot be applied, or their application does not allow obtaining a reliable measure of the arm's length price, methods based on profit from operations are used. In the latter case, the profit split method, the net profit margin method or another method that is appropriate to the facts and specific circumstances of each transaction are indicated.

Regarding comparability factors, Article 5 of the Order provides that the degree of comparability must take into account, among others, the following elements:

a) The specific characteristics of goods, rights or services that may be capable of influencing the price of transactions;

b) The functions performed by the entities involved in the transactions, taking into account the assets utilized and the risks assumed;

c) The contractual terms and conditions that define how responsibilities, risks and profits are distributed among the parties involved in the transaction;

d) The economic circumstances prevailing in the markets in which the parties operate:

e) The level of supply and demand and the degree of general development of the markets;

f) The business strategy of the companies.

Regarding the characterization of the net profit margin method, Article 10, paragraph 1 of the Order establishes that this method is based "on the calculation of the net profit margin obtained by a liable party in a related transaction or in a series of related transactions by reference to the net profit margin obtained in a comparable unrelated transaction conducted by the liable party, by an entity belonging to the same group or by an independent entity."

Still regarding this method (NPMM), the cited Article 10 of the Order, in its paragraph 2, provides that "the net profit margin is calculated in relation to an appropriate indicator, according to the circumstances and characteristics of each transaction, as well as the nature of the activity, and may be represented by sales, cost or assets utilized, or other relevant quantity" and paragraph 3 concludes that "whenever the transactions or the companies involved therein are not comparable in all aspects considered relevant and the differences identified produce a significant effect on the net profit margin of the transactions, the liable party must make the necessary adjustments to eliminate such effect, in order to determine the adjusted net profit margin, corresponding to that of a comparable unrelated transaction."

In the specific situation, the Claimant, although belatedly, proceeded with the preparation and submission of transfer pricing documentation for the fiscal years in question (2013 and 2014), which it exhibited in the course of the inspection action in fulfillment of the ancillary obligation provided for in Article 63, paragraphs 6 and 7 of the IRC Code and taking into account the principle of cooperation, as provided for in Article 59, paragraph 4 of the LGT.

In this domain, it is consolidated jurisprudence of the Supreme Administrative Court ("SAC") that it is the TA that bears the burden of proving the assumptions on which transfer pricing corrections are based, a burden that includes the identification and proof of special relationships, that the price practiced is not the market price, and what the applicable market price is – cf. Judgments of the SAC in cases no. 01402/17 of 27 June 2018; no. 0571/13 of 21 September 2016; no. 0833/13 of 14 May 2015; no. 0145/14 of 11 March 2015; 0228/05 of 1 June 2005 and no. 021240 of 21 January 2003.

If there remain no doubts regarding the identification and proof of special relationships, analyzed above in point 1, it remains to assess whether the TA succeeded in demonstrating that the price practiced with the Group entities is not at arm's length, i.e., differs from that which would normally be agreed between independent entities, and subsequently, what that would be, determined in accordance with an appropriate method, under the provisions of Article 63 of the IRC Code, Order no. 1446-C/2001 and Article 77, paragraph [incomplete in source]