IRC Expense Deductibility Under Article 23 CIRC: Arbitral Tribunal Rules on Cost Indispensability

ARBITRAL DECISION

The arbiter Paulo Lourenço, designated by the Ethics Board of the Administrative Arbitration Center (CAAD) to form the Arbitral Tribunal, constituted on 28 October 2015, decides as follows:

I. REPORT

1. On 31 July 2015, A…, Sole Proprietorship Company, Limited Liability, formerly named B…-… Portugal, Limited Liability, taxpayer number …, with registered office at …, Street …, Building …, Floor …, Office …, …, …-… Sintra, filed a request for constitution of an arbitral tribunal, under the combined provisions of articles 2 and 10 of Decree-Law no. 10/2011, of 20 January, which approved the Legal Regime of Arbitration in Tax Matters, as amended by article 228 of Law no. 66-B/2012, of 31 December (hereinafter, abbreviated as LRATM), seeking the declaration of illegality of the assessment act no. 2013 …, relating to the tax year 2011, in the total amount of € 59,893.62.

The Applicant argues that it is upon the Tax Authority that the burden rests to raise and prove the dispensability of the cost or loss, failing which it cannot exercise the right to correct the deduction of the respective amount as a tax cost.

Given the intrinsic link between the costs incurred and the maintenance of the income-producing source, albeit indirectly, the costs incurred with the lease of autonomous units and the depreciation of personal property relating to them should be considered as costs deductible for tax purposes.

Furthermore, in light of the analysis carried out and the statement prepared by company C…, in its capacity as Official Accounts Auditor, it may be concluded that in the change of ownership of the share capital, a shareholding of more than 50% of the share capital of the Applicant was maintained, directly or indirectly, in the sphere of the shareholders, on 1 January 2012.

Accordingly, the correction made by the Tax Authority to the deduction of the tax loss relating to the taxation period 2010 should be annulled, due to lack of legal basis.

The Tax Authority, for its part, argues that the Applicant recorded as operating expenses various costs that are not accepted for tax purposes, in accordance with article 23 of the CIRC, in addition to having deducted the tax loss determined in the year 2010, a deduction that is conditioned, in accordance with what is stipulated in no. 8 of article 52 of the same legal instrument.

Although it is argued that the employees who used the said apartment performed the essential functions of management, supervision and operation during the process of business startup, assembly and consolidation, the fact is that such costs were invoiced to the Applicant by other companies belonging to group D…, among which E… and F….

Similarly, considering the reasons invoked in relation to the lease of the dwelling, in which the lease expense was disregarded for tax purposes, neither can the depreciation and amortization expenses of furniture and domestic equipment that furnished the dwelling be tax deductible, since the conditions have not changed.

Finally, regarding the deduction of the tax loss, the Tax Authority argues that article 52, no. 8 of the CIRC makes no reference to the fact that the participation in the share capital of the company is direct or indirect, since it merely requires ownership of at least 50% of the share capital or the majority of voting rights, therefore the proposed correction should be maintained.

1. The request for constitution of the arbitral tribunal was accepted on the same day, 31 July 2015, and automatically notified to the Tax Authority.

The Applicant did not proceed with the designation of an arbiter, and therefore, pursuant to the provisions of paragraph a) of no. 2 of article 6 and paragraph a) of no. 1 of article 11 of the LRATM, the President of the Ethics Board of CAAD designated the undersigned as arbiter of the singular arbitral tribunal, who communicated acceptance of the appointment within the applicable time period.

On 13 October 2015 both parties were notified of this designation, and neither manifested any desire to refuse.

In accordance with the provision of paragraph c) of no. 1 of article 11 of the LRATM, the singular Arbitral Tribunal was constituted on 28 October 2015.

On 15 December 2015, the respondent Tax Authority, duly notified for this purpose, filed its response, defending itself solely by way of challenge.

On 14 March 2016 the meeting referred to in article 18 of the LRATM took place, during which the witnesses presented by the Applicant were examined.

In said meeting, a successive period of 10 days was granted for the Applicant and the respondent to present their written arguments, which they did, respectively, on 5 April 2016 and 18 April 2016.

Given doubts regarding the direction of the decision, the Tribunal, on 28 April 2016, extended the deadline for the decision by an additional month.

1. The Arbitral Tribunal is materially competent and is regularly constituted, in accordance with the provisions of articles 2, no. 1, paragraph a), 5 and 6, no. 1, of the LRATM.

The parties have legal personality and capacity, are legitimate and are legally represented, in accordance with articles 4 and 10 of the LRATM and article 1 of Ordinance no. 112-A/2011, of 22 March.

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

All things considered, it is necessary to render a decision.

II. DECISION

Proven Facts

1. The Applicant is a commercial limited liability company engaged in retail trade, importation and exportation of goldwork, watchmaking and jewelry articles, which forms part of the international group that operated under the D… brand.

2. The Applicant is subject to the general corporate income tax regime, adopting a taxation period coinciding with the calendar year, in accordance with the provision of article 8, no. 1 of the CIRC.

3. In the course of a tax inspection, it was established that the Applicant is engaged in the purchase of gold and silver artifacts, which it acquires from individuals, subsequently proceeding with their sale.

4. The Applicant owns a network of stores (kiosks) located in the main shopping centers in the country, where it acquires gold and silver artifacts from individuals, issuing a purchase document that contains, in addition to the identification of the seller, a description of the goods acquired.

5. The Applicant was established on 9 August 2010, under the name "G… Limited Liability.

6. On 2 November 2010 the company name was changed to B… – … PORTUGAL, LIMITED LIABILITY, and subsequently to the name it currently maintains.

7. The Applicant filed its respective model 22 declaration of Corporate Income Tax, relating to the tax year 2011, on 30 May 2012, in which it calculated taxable profit of € 3,119,526.17, to which it deducted the loss determined in the previous year, in the amount of € 185,849.18, resulting in taxable income of € 2,933,676.99.

8. The Applicant, following Service Order no. OI2012…, was subject to an external inspection, regarding the tax year 2011.

9. On 9 January 2013, the Applicant was notified of the Draft Tax Inspection Report, prepared following the external inspection action carried out by the Tax Authority Services.

10. In said draft, the Tax Authority proposed a correction to the tax result in the total amount of € 233,261.05, a situation that resulted in the change of the Applicant's taxable income to € 3,166,938.04, in addition to a correction in autonomous taxation in the amount of € 50.52.

11. The proposed corrections resulted from the following situations:

a) Disregard of the cost associated with the lease of an autonomous unit in Ericeira, in the amount of € 11,000.00;

b) Disregard of the costs associated with trips and accommodations, in the amount of € 3,751.64;

c) Disregard of the costs associated with depreciation of tangible fixed assets corresponding to the furniture of said autonomous unit, in the amount of € 2,271.32;

d) Disregard of financing costs incurred, in the amount of € 32,208.22;

e) Consideration of the cost relating to VAT improperly deducted in favor of the Applicant, in the amount of € 1,819.31;

f) Annulment of the deduction of the tax loss determined in the period 2010 in the amount of € 185,849.18.

1. The Applicant accepted the corrections referred to in paragraphs b), d) and e) above mentioned, as well as the correction relating to autonomous taxation.

2. On 11 February 2013, the Applicant was notified of the Tax Inspection Report, which made definitive the corrections to the Corporate Income Tax taxable income initially proposed in the draft.

3. On 24 April 2013, the Applicant was notified of the assessment act now being contested and the corresponding account settlement, resulting in a tax payment of € 59,893.63.

4. The Applicant was notified, on 20 June 2012, of the Corporate Income Tax assessment resulting from the declaration filed, which resulted in an amount to be reimbursed in the amount of € 46,792.90, as shown in assessment statement no. 2012 ….

5. Following the corrections resulting from the inspection carried out, the Applicant was notified of a new Corporate Income Tax assessment statement, dated 21 February 2013, which resulted in an amount to be paid in the amount of € 13,100.73, as shown in assessment statement no. 2013 ….

6. Following the assessment notice and the absence of payment by the Applicant, a tax enforcement proceeding was instituted, corresponding to no. …2013…, relating to the tax year 2011, in the amount of € 61,150.69.

7. The Applicant, in order to suspend said enforcement proceeding, made a deposit in Caixa Geral de Depósitos in an amount corresponding to € 76,240.54.

III. Facts Found Not Proven

Insofar as relevant to the decision, there are no facts that should be considered as not proven.

IV. Substantiation of the Proven and Unproven Facts

Regarding the factual matter, the Tribunal has the duty to select the facts that matter for the decision (article 123, no. 2, of the CPPT and article 607, no. 3 of the CPC, applicable pursuant to article 29, no. 1, paragraphs a) and e), of the LRATM).

The facts pertinent to the judgment of the case are chosen based on their legal relevance, which is established in light of the various plausible solutions of the legal question (former article 511, no. 1, of the CPC, corresponding to current article 596, applicable pursuant to article 29, no. 1, paragraph e), of the LRATM).

Thus, taking into account the positions assumed by the parties, in light of article 110, no. 7 of the CPPT, the documentary and testimonial evidence and the administrative proceedings joined to the case file, it was considered proven, insofar as relevant to the decision, the facts listed above.

V. ON THE LAW

The Applicant, in order to support its thesis, invokes, as previously stated, that in order to drive its business, which lacked knowledge and experience, it was necessary to request the support of foreign employees from other companies belonging to the Group, who would assist in implementing the strategy for startup of operations in Portugal (e.g., recruitment, training, opening of kiosks, marketing, etc.).

In this sense, the Applicant reaffirms that the knowledge and experience shared by foreign employees was decisive in achieving the results presented.

To accommodate the foreign employees who were displaced in Portugal, a lease agreement was concluded by the Applicant, with the intention of providing them with temporary accommodation.

The Applicant further invokes that it resulted from the analysis carried out that the costs inherent to the lease of the apartment would correspond to a daily cost of approximately € 37.00, an amount lower than what would be paid if the employees were accommodated in a hotel or any other type of accommodation.

According to the preamble to article 23 of the Corporate Income Tax Code, in the version applicable at the time of the facts, "...costs are understood to be those that are demonstrably essential for the realization of income subject to tax or for the maintenance of the income-producing source".

Thus, provided that the reasonableness of the cost incurred is demonstrated, as well as its causal nexus with the realization of income subject to tax or with the maintenance of the income-producing source, the respective deductibility and classification under article 23 of the Corporate Income Tax Code is accepted.

According to the understanding of the South Administrative Court "...the legal notion of essentiality is therefore delimited, on an economic-business perspective, by direct or indirect fulfillment of the ultimate motivation of contribution to obtaining profit" (Judgment of the SCAS, of 27 March 2012, Case no. 05312/12).

The above-mentioned judgment further adds that "...the deductibility of the cost depends, merely, on a causal and justified relationship with the company's activity. And outside the concept of essentiality will remain only acts that are inconsistent with the corporate purpose, those that do not fall within the company's interest, especially because they do not aim at profit".

In this sense, as the Applicant states, once it is proven that the costs are directed toward the pursuit of the company's activity and, consequently, toward the obtaining of profit, it is understood that the criterion of essentiality is met, being outside the scope of the Tax Authority to make value judgments about the quality of the business management pursued by the Applicant.

Accordingly, it is defensible that the support provided by foreign employees contributed to the maintenance of the Applicant's income-producing source, having enabled the development of its business, through the opening of new stores and hiring of new employees.

All the more so, as the Applicant argues, the cost incurred with the accommodation of these employees was an inevitably necessary expense for the pursuit of the company's strategy, in that it allowed, with their presence in national territory, the implementation of supervision and support necessary for the development of the business in a manner more closely aligned with the Portuguese market.

This understanding is, moreover, what has been followed by the CAAD arbitral tribunals.

In fact, according to judgment 444/2015T, "from a general point of view, the essential features of the path established by national doctrine and case law regarding the essentiality of costs incurred can be summarized as follows":

• The judgment on the essentiality of costs incurred implies that their contribution to the obtaining of income or gains subject to tax or to the maintenance of the income-producing source be verified, whereby "The legal notion of essentiality is therefore delimited, on an economic-business perspective, by direct or indirect fulfillment of the ultimate motivation of contribution to obtaining profit" and "the fiscal deductibility of the cost depends, merely, on a causal and justified relationship with the company's activity." (Judgment of the STA, rendered on 30-11-2011, in case no. 0107/11);

• "The costs (...) cannot fail to relate, from the outset, to the company itself. That is, in order for a certain amount to be considered a cost of that company, it is necessary that the respective activity be carried out by it itself, not by other companies." (Judgment of the STA, rendered on 30-05-2012, in case no. 0171/11);

• "A concept of essentiality which, departing definitively from the idea of causality between costs and income, places emphasis on the relationship of costs with the activity pursued by the taxpayer, that is, considering that the said concept of essentiality is verified whenever costs are incurred in the interest of the company, in the pursuit of its respective activities." (Judgment of the STA, rendered on 04-09-2013, in case no. 0164/12);

• The concept of essentiality is to be determined on a case-by-case basis and the nexus of economic causality cannot be disconnected from the factuality of the specific case, such that "the Tax Authority cannot evaluate the essentiality of costs in light of criteria relating to the appropriateness and merit of the expense. A cost is essential when it relates to the company's activity, and costs unrelated to the company's activity will only be those in which it is not possible to discern any causal nexus with the income or gains (or with income, in the current expression of the code - see art. 23, no. 1, of the C.I.R.C.), explained in terms of normality, necessity, congruence and economic rationality." (Judgment of the South TAC, rendered on 16-10-2014, case no. 06754/13);

• "The essentiality of the cost must result simply from its link to business activity. If the cost is not unrelated to the company's activity, that is, if it relates to the company's normal activity (regardless of whether the degree of intensity or proximity is greater or lesser), and if its existence is accepted (we are not faced with an apparent or simulated cost), the cost is essential." (Judgment of the North TAC, rendered on 20-12-2011, case no. 01747/06.3BEVIS);

• "From the legal notion of cost provided by article 23 of the CIRC, it does not follow that the TA can call into question the principle of freedom of management, scrutinizing the quality and appropriateness of the business management decisions and considering that only those from which profits directly flow to the company or which prove convenient for the company can be assumed fiscally. The essentiality referred to in article 23 of the CIRC as a condition for a cost to be deductible does not refer to necessity (the expense as a sine qua non condition of income), nor even to convenience (the expense as convenient for business organization), on pain of intolerable intrusion by the TA in the autonomy and freedom of management of the taxpayer, but requires, only, a relationship of economic causality, in the sense that it is sufficient that the cost be incurred in the interest of the company, in order, directly or indirectly, to obtain profits.

The legal notion of essentiality is therefore delimited, on an economic-business perspective, by direct or indirect fulfillment of the ultimate motivation of contribution to obtaining profit. Essential costs are equivalent to expenses incurred in the interest of the company or, in other words, in all acts abstractly subsumed in a profit-making profile. This objective brings, intentionally, economic and tax categories closer together, through a primarily logical and economic interpretation of legal causality. The necessary expense is equivalent to any cost incurred in order to obtain income and which represents an economic decline for the company. As a rule, therefore, the fiscal deductibility of the cost depends, merely, on a causal and justified relationship with the company's activity. And outside the concept of essentiality will remain only acts that are inconsistent with the corporate purpose, those that do not fall within the company's interest, especially because they do not aim at profit." (Judgment STA, rendered on 30-11-2011, case no. 0107/11);

• "The rule is that correctly accounted expenses are tax costs; the criterion of essentiality was created by the legislature, not to allow the Administration to intrude on business management, dictating how it should apply its resources, but to prevent the fiscal consideration of expenses that, although accounted as costs, do not fall within the scope of the company's activity, were incurred not for its pursuit but for other extraneous interests. Strictly speaking, these are not true company costs, but expenses that, given their object, were abusively accounted as such. Without the Administration being able to evaluate the essentiality of costs in light of criteria relating to their appropriateness and merit.

The concept of essentiality not only cannot be equated to a strict judgment of imperative necessity, as has been said, but also cannot rest on a judgment about the convenience of the expense, made, necessarily, a posteriori. For example, expenses incurred with an advertising campaign that proved unsuccessful cannot, solely based on that result, be declared dispensable.

The judgment on the appropriateness and convenience of expenses is the exclusive prerogative of the entrepreneur. If he decides to incur expenses with a view to pursuing the company's purpose but is unsuccessful and those expenses prove, in the end, to be fruitless, they do not cease to be tax costs. But any expense that is accounted as a cost and proves unrelated to the company's purpose is not a tax cost, because not essential.

We understand (...) that, under pain of violation of the principle of tax capacity, the Administration can only exclude expenses not directly precluded by law under a strong motivation that convinces that they were incurred beyond the corporate purpose, that is, in pursuit of another interest than the business one or, at least, with clear excess, deviating, with respect to the objective needs and capacities of the company." (Judgment of the STA, rendered on 29-03-2006, case no. 01236/05).

Having thus defined the criteria for evaluating the essentiality of costs, in light of article 23 of the CIRC, it then remains the operation of applying such criteria to the specific case, evaluating, in that light, the arguments of the TA that support its position.

All things considered, taking into account the case law mentioned above and the arguments presented by the Applicant, it can then be concluded that the costs incurred with the lease of autonomous units should be considered as costs deductible for tax purposes.

Similarly, having regard to the fact that the lease is justified, it is easily concluded that there was a need to acquire furniture, domestic utensils and appliances, in order to make the apartment functional and usable.

In this context, it is understood that the depreciation of goods that constituted the apartment's furniture should also be considered as expenses deductible for tax purposes.

Regarding the deduction of the tax loss, it follows from the provision of no. 8 of article 52 of the Corporate Income Tax Code that the possibility of deducting tax losses from prior periods "...ceases to be applicable when it is verified, on the date of the end of the taxation period in which the deduction is made, that, in relation to the one to which the losses relate, the corporate purpose of the entity to which it relates was modified or the nature of the activity previously pursued was substantially altered or that there was a change in the ownership of at least 50% of the share capital or the majority of voting rights."

The share capital of the Applicant, on 31/12/2010, the year in which the tax losses were determined, was distributed as follows:

Name | NIF | Amount | Percentage
H… | … | € 500.00 | 10%
I… | … | € 500.00 | 10%
J… | … | € 1,500.00 | 30%
K… | … | € 2,500.00 | 50%
Total | | € 5,000.00 | 100%

On the other hand, on 31/12/2011, the share capital of the Applicant was held by the following shareholders:

Name | NIF | Amount | Percentage
H… | … | € 500.00 | 10%
L… | … | € 2,500.00 | 50%
M… | … | € 2,000.00 | 40%
Total | | € 5,000.00 | 100%

Accordingly, it can be concluded, in the first place, that the direct ownership of the share capital was altered by more than 50%, as shareholders I…, who previously held 10%, J…, who held 30%, and K…, who was holder of 50%, ceased to be direct holders of capital.

Thus, it remains to determine whether the right to deduct tax losses is or is not possible in cases where the change in share capital is less than 50% by way of indirect ownership, that is, in cases where the holder ceases to be a holder of share capital in a certain entity but becomes a holder of share capital in another entity that, in turn, is the holder of share capital in the entity first mentioned.

The Tax Authority has understood that in cases where the transfer of shareholdings is made between companies in the same group, without this implying a change in control of the company, by way of indirect ownership, the limitation on the right to deduct tax losses is not applicable, a situation that is not applicable in the specific case at hand.

On the other hand, it is settled understanding that the limitation of tax loss carryforwards established in no. 8 of article 52 of the CIRC has underlying it the will of the legislature to avoid the practice of buying and selling companies with tax losses in carryforward, for the purpose of making use of those losses by the new holders of the majority of the capital.

Having regard to the fact that, although by way of indirect ownership, the change in ownership of the share capital was less than 50% and that the entities that became the new holders of the share capital were already themselves held, in whole or in part, by the original holders, the limitation provided for in no. 8 of article 52 of the CIRC is not applicable to the specific case at hand, and therefore the additional Corporate Income Tax assessment should also be annulled.

In fact, as the Applicant states in its petition, there was no transfer of control to another economic group, having occurred only a change from a position of indirect control to a position of direct control, for which reason the rule provided for in no. 8 of article 52 of the CIRC is not applicable.

Nor can it be invoked that the operation had as one of its objectives the making use of tax losses, since the capital of the society to which the losses relate was already held, albeit by way of indirect ownership, by the new holders.

Finally, regarding the request for compensation for alleged losses with the provision of a guarantee, it is important to note, in the first place, that the deposit-guarantee offered by the Applicant constitutes an adequate guarantee, having regard to the provisions of articles 169 and 199, both of the Code of Tax Procedure and Process.

The compensation legally provided for is susceptible to operating only if the provision of the guarantee has caused actual losses to the party who had to provide it.

Since the existence of any losses is not demonstrated and it is for the Applicant to bear the burden of proof thereof, the request for compensation cannot proceed in this part.

VI. DECISION

For these reasons, this singular Arbitral Tribunal decides:

a. To grant the request for annulment of the assessment act no. 2013 …, relating to the tax year 2011, in the total amount of € 59,893.62;

b. To dismiss the request for compensation made on the basis of the provision of a guarantee;

c. To condemn the respondent to the costs of the proceedings.

VII. Value of the Case

The value of the case is set at € 59,893.62, in accordance with article 97-A, no. 1, a), of the Code of Tax Procedure and Process, applicable pursuant to paragraphs a) and b) of no. 1 of article 29 of the LRATM and no. 2 of article 3 of the Regulation on Costs in Tax Arbitration Proceedings.

VIII. Costs

The arbitration fee is set at € 2,142.00, in accordance with Table I of the Regulation on Costs in Tax Arbitration Proceedings, to be paid by the respondent, in accordance with articles 12, no. 2, and 22, no. 4, both of the LRATM, and article 4, no. 4, of the said Regulation.

Notice is to be given.

Lisbon, 31 May 2016

The Arbiter

Paulo Lourenço

[1] Available at www.dgsi.pt, as with the remaining case law cited without mention of source.