Process: 59/2015-T

Date: October 5, 2015

Tax Type: IRC

Source: Original CAAD Decision

Summary

This CAAD arbitration decision (Process 59/2015-T) addresses the tax treatment of fair value adjustments on financial instruments under Article 45(3) of the Portuguese Corporate Income Tax Code (CIRC) in its 2011 version. The taxpayer challenged IRC assessments totaling €14,990.93 for fiscal years 2010-2011, arguing that the limitation rule in Article 45(3) should not apply to fair value losses on shareholdings representing less than 5% of capital in listed companies. The company held shares in multiple entities (representing less than 5% of their capital) and recorded fair value losses of €105,666.70 (2010) and €252,238.83 (2011), plus transition adjustments from the POC to SNC accounting regime change. The Tax Authority conducted inspections and made corrections by limiting the deductibility of these fair value losses, increasing taxable income by €52,833.35 (2010) and €126,119.42 (2011). The central legal issue concerned whether Article 45(3) CIRC applies to fair value adjustments contributing to taxable income formation. This provision, as amended by Law 60-A/2005 to combat tax evasion and broaden the tax base, established that negative differences from capital gains/losses on capital interests, plus other losses or negative asset variations relating to such interests, contribute to taxable income at only 50% of their value. The tribunal referenced following precedent CAAD case 108/2013-T on this matter, examining the interpretative challenges arising from the intersection of accounting standards changes (POC to SNC transition) and tax limitations on fair value accounting adjustments for minority shareholdings in listed companies.

Full Decision

ARBITRAL DECISION

CAAD: Tax Arbitration

Case No. 59/2015 – T

Subject Matter: Article 45, paragraph 3, of the CIRC (as amended in 2011); expenses resulting from the application of "fair value" to financial instruments; taxable income

Claimant/Applicant: A… – …, S.A.

Respondent: Tax and Customs Authority (hereinafter AT)

I - REPORT

A… – …, S.A., a legal entity No. …, with registered office at …, …, …, …, …, hereinafter referred to as the Applicant, submitted, on 02-03-2015, to the Administrative Arbitration Centre (CAAD) a request for the constitution of an arbitral tribunal, with a view to declaring unlawful the tax acts of assessment of corporate income tax (hereinafter IRC), relating to the financial years 2010 and 2011, namely,

i. Assessment No. 2014 …, in the amount of € 7,829.55, relating to the period 2010;

ii. Assessment No. 2014 …, in the amount of € 7,161.38, relating to the period 2011.

The Applicant requests the declaration of unlawfulness of the aforementioned acts of assessment of Corporate Income Tax.

The Applicant alleges, therefore, that the regime established in the repealed Article 45, paragraph 3, of the Corporate Income Tax Code (hereinafter CIRC), does not apply to situations in which the adjustment for fair value contributes to the formation of taxable income, when such assets are financial instruments representing less than 5% of the capital of the respective companies.

This Arbitral Tribunal was duly constituted on 13-4-2015.

The Tax and Customs Authority was duly notified in accordance with Article 17 of the RJAT and submitted its response.

By order of 14-5-2015, the meeting provided for in Article 18 of the RJAT was dispensed with, without objection from the parties, as well as the presentation of oral arguments.

Both parties submitted written submissions confirming, in essence, the positions assumed in their respective pleadings.

II – LEGAL REASONING

The Facts

Having examined the documentary evidence produced by the parties and the administrative investigation file compiled by the AT, the following facts are considered proven and relevant to the decision of the case:

a) The Applicant submitted, in 2011 and 2012, its income tax returns (Form 22) for IRC relating, respectively, to the financial years 2010 and 2011;

b) During those financial years (2010 and 2011), the Applicant held financial holdings, consisting of shares representing the capital of B…, S.A., C…, D…, E…, F…, G…, H… and I…;

c) These shares represented less than 5% of the capital of those companies, and such securities were admitted to trading on a regulated market;

d) The Applicant considered the value of 20% of the adjustment balance as a negative variation in assets and as a transition adjustment from the Official Accounting Plan regime (POC) to the SNC regime, that is, the amount of € 2,447.39 (20% of – 12,236.95);

m) The Applicant recorded in account 6610000 — "Losses from fair value reduction" —, the amounts of € 105,666.70 (relating to the financial year 2010) and € 252,238.83 (relating to the financial year 2011), which concerned shares held by it;

e) The Applicant entered € 2,447.39 in field 705 of Form Q07 of both Form 22 returns for 2010 and 2011:

TRANSITION ADJUSTMENTS MADE BY THE APPLICANT (FINANCIAL YEAR 2009)

Adjustment - 2,447.39 (20% x -12,236.95)

f) In compliance with service orders Nos. OI 2013 … and OI 2014 …, the AT conducted, in 2014, inspection actions on the Applicant, of limited scope — IRC, relating to the financial years 2010 and 2011;

f) As a consequence of those inspection actions, the AT did not accept the negative variation in assets presented, having rectified the aforementioned values;

h) The AT established as a transition adjustment reflected in field Q07 of Form 22, as a variation in assets, € 2,279.55, relating to the financial years 2010 and 2011:

TRANSITION ADJUSTMENTS MADE BY THE AT

i) The AT added € 455.91 to the taxable amounts of the financial years 2010 and 2011;

l) The AT corrected, in the context of fair value measurements, the taxable results of IRC of the Applicant, increasing the values by € 52,833.35 (relating to the financial year 2010) and € 126,119.42 (relating to the financial year 2011);

n) By virtue of the correction operations carried out by the AT, the taxable results of IRC of the Applicant increased by € 455.91 (20% of 2,279.55) (2010) and € 455.91 (20% of 2,279.55) (2011);

o) The AT assessed on 08-11-2014 the IRC relating to the years 2010 and 2011, as follows:

i. Assessment No. 2014 …, in the amount of € 7,829.55, relating to the period 2010;

ii. Assessment No. 2014 …, in the amount of € 7,161.38, relating to the period 2011;

p) The Applicant was notified to proceed with the payment of the aforementioned assessments, in the total amount of € 14,990.93.

The Law

The issue to be decided concerns whether the rule set out in the former Article 45, paragraph 3, CIRC, is or is not applicable to situations in which the adjustment for fair value contributes to the formation of taxable income, namely, when capital losses resulting from financial holdings consisting of shares representing less than 5% of the capital of various companies are in question.

In the case sub judice the AT made two types of corrections for the purposes of calculating the taxable base:

i) On the one hand, losses resulting from the application of the fair value model to financial instruments;

ii) On the other hand, transition adjustments, recorded as negative variations in assets, from the Official Accounting Plan regime (POC) to the Accounting Standards System (SN), relating to the application of the fair value model to financial instruments.

The substantive issue concerns the tax consequences of measuring at fair value, in 2010 and 2011, the financial holdings of the Applicant consisting of shares representing the capital of B…, C…, D…, E…, F…, G…, H… and I…, all of them corresponding to less than 5% of the capital of those companies and admitted to trading on a regulated market.

This is a matter that has already been the subject of CAAD decisions, namely the one issued in case 108/2013-T, which we shall follow closely.

Article 45, paragraph 3, CIRC, provided that "the negative difference between capital gains and capital losses realized through the paid transfer of capital interests, including their redemption and amortization with capital reduction, as well as other components of equity capital, in particular additional contributions, contribute to the formation of taxable income in only half of their value."

It must first be noted that the aforementioned Article 45, paragraph 3, CIRC results from a legislative amendment that was guided, according to the Report of the Ministry of Finance for the 2003 State Budget, by "two priorities, namely the fight against fraud and tax evasion and the broadening of the tax base,", with the amendment in question falling within the scope of "Broadening of the tax base and measures for moralization and neutrality".

The wording of the rule in question resulted from the amendment implemented by Law No. 60-A/2005 of 30 December, and according to the corresponding Report of the Ministry of Finance, the measure in question fell within the scope of "COMBATING TAX EVASION AND FRAUD AND OTHER MEASURES AIMED AT BUDGET CONSOLIDATION".

Accordingly, with Law No. 60-A/2005, of 30/12, the rule acquired broader wording, encompassing, in the limitation of losses at 50%, not only the "negative difference between capital gains and capital losses realized through the paid transfer of capital interests", but also "other losses or negative variations in assets relating to capital interests or other components of equity capital, in particular additional contributions".

The rule was amended again in 2014, effective from 1 January of that year. This amendment took place within one of the objectives of the 2014 IRC reform, namely the promotion of competitiveness and investment, through the "Participation Exemption Regime", with basic principles of this regime being the increase in competitiveness (attraction of investment), as well as the improvement of efficiency (reduction of context costs/prevention of substitution behaviors).

In fact, with the reform of the IRC, approved by Law No. 2/2014, of 16-01, Article 45 in question was repealed. Article 23-A then appears, which does not contain the limitation to tax deductibility previously provided for in paragraph 3 of that Article 45, relating to other losses relating to capital interests, according to which these contributed only 50% to the formation of taxable income.

Indeed, Article 45, paragraph 3 of the CIRC is currently repealed.

The controversy raised in the proceedings is directly related to the following articles: Article 17, paragraph 1, CIRC; paragraph 9 of Article 18; Article 20, paragraph 1, Article 23, paragraph 1, Article 21, paragraph 1, Article 24, paragraph 1, Article 46, paragraph 1, and, finally, the aforementioned Article 45, paragraph 3.

One of the relevant legal aspects for the question under consideration is the application of the fair value accounting model as an accounting valuation criterion with tax relevance. This point also resulted from an amendment to the legal regime for the taxation of the income of legal entities, specifically with regard to the acquisition of financial instruments, namely shares representing the capital of companies admitted to trading on a regulated market. This is the point that directly concerns us.

Prior to the adoption of fair value, variations in assets relating to financial instruments were irrelevant from the perspective of the formation of taxable income for each period, by virtue of Article 21, paragraph 1, sub-paragraph b) of the CIRC. Only at the moment of realization of the capital gain or loss did the variation in assets verified become tax-relevant.

On the other hand, given the relevance of the will of the taxpayer in the mechanism of tax relevance of the variation in assets, the system established was suited to the adoption of mechanisms for conditioning that will, in order to conform it to economically more desirable behaviors, which, in this case, involve the preference for realization of capital gains, to the detriment of the realization of capital losses.

However, the fair value model significantly changed the landscape of the CIRC and consequently, the interpretation to be made of the legal norms affected, namely Article 45, paragraph 3.

A critical look at Article 45, paragraph 3, id., which admitted within its scope not only losses (as defined in Article 23) but also negative variations in assets (as defined in Article 24), as well as costs (as defined in Article 23), would lead to the situation that, for example, the cost of acquisition of capital interests would only contribute half of its respective value to the calculation of taxable income, which would obviously be inconceivable in a reasonably legislator.

By "losses" should be understood facts that qualify as such in light of the CIRC and by "negative variations in assets" should be understood negative variations in assets not reflected in the net income of the financial year, as defined in Article 24.

It must then be understood, in light of the situation presented, that Decree-Law No. 159/2009, of 13 July, introduced, with respect to the part covered by acceptance of the application of the fair value model to financial instruments, a special regime of relevance for the calculation of taxable income, justified both by its own objectivity and by the avowed intention to bring accounting closer to taxation. This change cannot be disregarded when analyzing the legal issue to be resolved.

Now, in light of the current wording of the CIRC, that statement raises no doubts, as is evident, in particular, from the wording of Articles 20, paragraph 1, sub-paragraphs f) and h), 23, paragraph 1, sub-paragraphs i) and l), and in particular Article 46, paragraph 1, sub-paragraph b), in light of which it is clearly evident the intention of the legislator to exclude the adjustments arising from the application of the fair value criterion to financial instruments, as recognized by the CIRC, from the regime of capital gains and losses. However, the situation is different when it comes to the former Article 45, paragraph 3, CIRC, with this article appearing as an antithesis to that coherence of norms surrounding it.

That is: in the regime for which the rule of Article 45, paragraph 3, was conceived and instituted, the realization of capital losses, and other situations listed, was dependent on a voluntary action corresponding to the realization thereof. Now, in this context, it will be understandable that the legislator institutes mechanisms to discourage an action that might be considered undesirable, in this case the realization of capital losses or other negative variations in assets. By providing that such situations will only be relevant in 50% of the recorded amount, the tax legislator is objectively conditioning the actions covered by the legal provision, imposing a negative incentive thereto.

On the other hand, given that financial instruments are of value not objectively quantifiable, the disregard of 50% of the negative variations in assets verified would also serve to "compensate" the natural tendency of economic operators to, at the fiscal level, inflate losses.

However, the same cannot be concluded in situations covered by Article 18, paragraph 9, sub-paragraph a) – such as the present case. Here, when dealing with adjustments resulting from the recording of fair value, determined by objective criteria (with "a price formed on a regulated market"), there is no doubt or intervention of the will of the taxpayer in the occurrence of the negative or positive adjustment in assets. That is, these will or will not occur, regardless of the action and will of the taxpayer.

Now, to penalize the taxpayer in such cases with a disregard of 50% of the expense incurred would be entirely unjustified, both from an economic and legal point of view and certainly not from an accounting perspective.

Given that, in the regime of the former Article 45, paragraph 3, the realization of capital losses, and other situations provided for, was dependent on voluntary action corresponding to their realization. In view of this factuality, it will be understandable that the legislator institutes mechanisms to discourage action that might be considered undesirable, in this case the realization of capital losses or other negative variations in assets. By providing that such situations will only be relevant in 50% of the recorded amount, the tax legislator is objectively conditioning the actions covered by the legal provision, imposing a disincentive thereto.

The non-application of Article 45, paragraph 3, CIRC to expenses and, specifically, to "Expenses resulting from the application of fair value to financial instruments", with full consideration of the asset variations verified, whether positive or negative, leads to a coherence of taxation regardless of when the disposal of the financial instrument occurs.

Conversely, if the rule of Article 45, paragraph 3, CIRC is applied, as the AT intends, from the moment a negative change in assets is verified, there will be a disparity between the tax relevance of negative and positive variations in assets, without any justification.

It is clear that random results and without any substantial foundation to support them could not have been intended by a reasonable legislator.

It is true that the alternative solution, which excludes the application of Article 45, paragraph 3, CIRC, leads to the situation that, in case a capital loss is ultimately verified, it ends up being considered at 100%, rather than 50%, as would occur under the realization principle. However, this positive discrimination (or rather, lack of negative discrimination) by choosing the fair value criterion may be justified, if only because in the regime of Article 18, paragraph 9, sub-paragraph a), there is no longer any point to any disincentive to the realization of capital losses, since they will have tax relevance regardless of their actual realization. One should also not overlook that, on the one hand, recording at fair value is considered more in line with the approximation between accounting and taxation, a purpose admittedly pursued by the legislator of Decree-Law No. 159/2009, of 13 July, and, on the other, the fact that we are dealing with objectively evaluated realities, without there being significant room for tax-convenient manipulations. That is, as stated above, the reasons for combating fraud and tax evasion, nor the reasons for budget consolidation, are not verified, which demonstrably were at the genesis of the rule of Article 45, paragraph 3 of the CIRC.

The analysis to be conducted must take into account the systematic perspective of the integration of the rule, also considering the historical context of its genesis, as already listed above.

Thus, as we have had the opportunity to present, the rule of paragraph 3 of Article 45 of the CIRC appears totally decontextualized from the normative framework surrounding it. The same conclusion must be drawn from the action of the AT.

In effect, each of the rules considered relevant to the assessment of the question to be decided should be understood in the corresponding concrete framework, from which its meaningful content should be extracted.

As a consequence of the foregoing, and in compliance with the hermeneutical requirements of Article 9, CCiv., it is understood that Article 45, paragraph 3, CIRC, should be interpreted in the sense that its provision does not include expenses resulting from the application of fair value to financial instruments that are relevant to the formation of taxable income, in accordance with sub-paragraph a) of paragraph 9 of Article 18.

Having regard to the logical, systematic and rational organization of the legal framework of the rule set out in Article 45, paragraph 3 of the CIRC, within the set of norms in which it is integrated and which was explained above, there is a clear incongruence between the strict application of this provision, as the AT intends, and the implicit (and erroneous) results to which this application leads.

Namely, by applying Article 45, paragraph 3 of the CIRC rigorously, we have a clear violation of the principle of equity.

The corrections made by the AT denote a strict application of the law, even though from an accounting perspective it is detected that this procedure fails. In fact, the AT is not responsible for the interpretation of legal norms. However, it is up to it to advocate for the congruence of accounting results obtained with its correction actions. This was not the procedure respected by the AT. Looking only at Article 45, paragraph 3 of the CIRC, the AT applied this rule indiscriminately.

The corrections made by the AT during its partial inspection of the Applicant resulted from an error in the interpretation of tax law, attempting to make a restrictive interpretation of Article 45, paragraph 3 of the CIRC, as worded at the time of the facts, which is totally incompatible with the new measurement method that came into force.

In summary: all corrections made by the AT in this case resulted from the same defect in the interpretation of tax law which consisted of attempting to make an extensive interpretation of paragraph 3 of Article 45 of the CIRC as worded at the time of the dispute totally incompatible with a new measurement method that came to allow, in certain and limited cases, taxation based on potential gains or losses and not actual ones.

For which reason, it is concluded that the corporate income tax assessments challenged by the Applicant and the subject matter of these proceedings are unlawful, due to the erroneous application of the regime of Article 45, paragraph 3, of the CIRC, the respective tax acts being vitiated by the defect of violation of law, due to error in the legal prerequisites.

III - DECISION

As a consequence of the foregoing, the arbitrators who constitute this Arbitral Tribunal agree to rule entirely in favor of the request for a declaration of unlawfulness of the tax assessment acts that are the subject of this request for an arbitral pronouncement (Nos. 2014 … and 2014 …, relating to the financial years 2010 and 2011 – cf. Assessment Notes submitted by the Applicant with Nos. 1 and 2), with the inherent legal consequences.

• Case Value: In accordance with Article 306, paragraph 2 of the CPC and Article 97-A, paragraph 1, sub-paragraph a) of the CPPT and 3, paragraph 2 of the Rules of Costs in Tax Arbitration Proceedings, the value of the case is fixed at the amount corresponding to the corrections made by the Tax Administration, namely €184,759.37 (one hundred eighty-four thousand seven hundred fifty-nine euros and thirty-seven cents).

• Costs: The amount of costs is fixed at € 3,672.00 (Article 2-1 of the Rules of Costs in Tax Arbitration Proceedings and attached Table I), with the respective payment to be borne by the Respondent.

Lisbon and CAAD, 5 October 2015

The Court,

José Poças Falcão

(President)

Ricardo Marques Candeias

(Member)

Luís Janeiro

(Member)

Document prepared on computer, pursuant to paragraph 5 of Article 131 of the CPC, applicable by reference to sub-paragraph e) of paragraph 1 of Article 29 of Decree-Law No. 10/2011, of 20/01.

The drafting of this decision is governed by the old spelling.

Frequently Asked Questions

Automatically Created

What does Article 45(3) of the CIRC establish regarding fair value adjustments on financial instruments for IRC purposes?
Article 45(3) of the CIRC, in its 2011 version as amended by Law 60-A/2005, establishes that negative differences between capital gains and losses from transfers of capital interests, as well as other losses or negative variations in assets relating to capital interests or equity components, contribute to taxable income at only 50% of their value. This means that fair value losses on financial instruments representing capital interests are subject to a 50% deductibility limitation for IRC purposes. The provision was introduced as part of measures to combat tax evasion and broaden the tax base, with the 2005 amendment expanding its scope beyond realized transfers to include unrealized losses and negative asset variations.
How are expenses from fair value adjustments on shareholdings below 5% treated for corporate income tax (IRC) in Portugal?
Under the Tax Authority's interpretation applied in this case, expenses from fair value adjustments on shareholdings below 5% are subject to the limitation rule of Article 45(3) CIRC. This means only 50% of fair value losses on such minority shareholdings can be deducted from taxable income for IRC purposes. In this case, the AT corrected the taxpayer's IRC returns by limiting the deductibility of fair value losses recorded on shares representing less than 5% of capital in various listed companies, increasing taxable income by €52,833.35 for 2010 and €126,119.42 for 2011. The taxpayer also faced adjustments to transition corrections from the POC to SNC accounting regime relating to these fair value measurements.
What was the outcome of CAAD arbitration process 59/2015-T on the deductibility of fair value losses in taxable profit?
While the provided excerpt does not contain the complete final decision, the case involved IRC assessments totaling €14,990.93 for 2010-2011 periods. The taxpayer argued that Article 45(3) CIRC should not apply to fair value adjustments on shareholdings below 5% of capital. The Tax Authority had limited the deductibility of fair value losses to 50% of their value. The arbitral tribunal indicated it would follow the precedent established in CAAD case 108/2013-T, which had previously addressed this interpretative issue. The case examined whether the limitation rule applies specifically to situations where fair value adjustments contribute to taxable income formation for minority shareholdings in listed companies.
Can fair value adjustments on listed shares representing less than 5% of share capital affect IRC taxable income under the 2011 CIRC rules?
Yes, fair value adjustments on listed shares representing less than 5% of share capital can significantly affect IRC taxable income under the 2011 CIRC rules. Under Article 45(3) as amended by Law 60-A/2005, such adjustments are subject to a 50% deductibility limitation, meaning negative variations (losses) from fair value measurements contribute to taxable income at only half their accounting value. In this case, the taxpayer recorded fair value losses of €105,666.70 (2010) and €252,238.83 (2011), but the Tax Authority limited their deductibility, resulting in substantial increases to taxable income. This applies both to annual fair value adjustments and to transition adjustments arising from changes in accounting standards (such as the POC to SNC transition).
What is the procedure for challenging IRC tax assessments through CAAD tax arbitration in Portugal?
The procedure for challenging IRC assessments through CAAD tax arbitration, as demonstrated in this case, involves several steps: (1) The taxpayer submits a request for constitution of an arbitral tribunal to the Administrative Arbitration Centre (CAAD), specifying the contested tax assessments and legal grounds; (2) The arbitral tribunal is constituted (in this case, on 13-04-2015); (3) The Tax and Customs Authority is notified under Article 17 of RJAT and submits its response; (4) The tribunal may dispense with meetings and oral arguments under Article 18 of RJAT if parties agree; (5) Both parties submit written submissions confirming their positions; (6) The tribunal examines documentary evidence and the administrative investigation file compiled by the AT; (7) The tribunal issues a reasoned arbitral decision on the lawfulness of the challenged assessments.