CAAD 602/2017-T: Deductibility of Financial Charges from Bond Loan for Company Acquisition Under IRC Article 23

ARBITRAL DECISION

They hereby agree in arbitral tribunal

I - Report

1. A..., Lda., Tax Number (NIPC) ... with registered office at ..., ... ..., ...-..., in ..., submitted, pursuant to Articles 10 and 2(1)(a) of Decree-Law No. 10/2011 of 20 January, a request for constitution of a collective arbitral tribunal with a view to declaring the illegality of the additional assessment of Corporate Income Tax (IRC), in the amount of €2,781,557.01 and demonstrating the calculation of interest, which, according to the statement of accounts reconciliation, resulted in tax payable in the total amount of €2,910,756.02, and which was subject to an administrative appeal that was dismissed.

Having provided a bank guarantee to obtain the suspension of the coercive collection proceedings instituted as a result of the tax assessment acts, it further requested compensation for improper provision of guarantee, pursuant to Articles 171 of the Code of Tax Procedure (CPPT) and 53 of the General Tax Law (LGT).

It alleges, in summary, that the financial charges relating to the bond loan, which determined the correction of the IRC assessment, are related to the Applicant's business activity and contribute to the generation of income subject to tax, insofar as such loan was contracted to finance the acquisition of another company and, thereby, to ensure the incorporation of assets and liabilities that generate operating results that may be attributed to the Applicant in the exercise of its own activity.

In its reply, the Tax Authority argues, in general terms, that the interest on the bond loan was not paid by the beneficial company, which appears in the contract as borrower, but by a third entity that was subsequently acquired by the present Applicant, the latter assuming, following the incorporation, the liability resulting from such loan, thereby obtaining a reduction in taxable profit through the deduction of financing costs, despite these costs not being related to its business activity nor serving to maintain the source of income generation, and therefore not being deductible as costs pursuant to Article 23 of the Corporate Income Tax Code (CIRC).

1. In the course of the proceedings, the meeting referred to in Article 18 of the Tax Arbitration Procedure Regulations (RJAT) was waived, as well as the production of witness evidence.

In their submissions, the parties reiterated their previous positions.

1. The request for constitution of the arbitral tribunal was accepted by the President of CAAD (Tax Arbitration Centre) and notified to the Tax and Customs Authority in accordance with applicable regulations.

The collective arbitral tribunal was thereby constituted by the present signatories, who communicated their acceptance of the appointment within the applicable time period.

Thus, in accordance with the provisions of Article 11(7) of the RJAT, as amended by Article 228 of Law No. 66-B/2012 of 31 December, the collective arbitral tribunal was constituted on 6 February 2018.

The arbitral tribunal was properly constituted and is substantively competent, pursuant to Articles 2(1)(a) and 30(1) of Decree-Law No. 10/2011 of 20 January.

The parties have legal personality and capacity, are legitimate and are represented (Articles 4 and 10(2) of the same act and 1 of Regulatory Decree No. 112-A/2011 of 22 March).

The proceedings are not affected by any defects and no exceptions have been raised.

It is incumbent upon us to review and decide.

II - Reasoning

1. The factual matters relevant to the decision of the case are as follows:

a) The Applicant, A..., Lda. (Tax Number....), is a limited liability company which, according to the permanent certificate attached to the administrative proceedings, has as its object "consultancy and provision of business services in the areas of administrative, financial and personnel management, accounting, information technology, scientific research, professional training, the marketing of equipment, implements and products intended for the healthcare service sector and the preparation of studies and provision of medical services in all specialities, as well as the provision of related or similar services";

b) The Applicant had as previous designations B..., Lda. (until July 2008) and C..., Lda. (until December 2008);

c) Until 25 June 2007, this company was held by D... SGPS, S.A., and had virtually no activity since its inception;

d) On 26 June 2007, this entity sold its shares in B... to the company E..., with registered office in Luxembourg;

e) E... (Tax Number....), subsequently designated F..., SARL, is held by a venture capital company called G..., with registered office in England, and served as a vehicle for the acquisition of the H... Group in 2007, information which appears in a request made by G... to the European Commission's Competition Authority in connection with the acquisition of the H... Group;

f) On 28 June 2007, the entity B... proceeded to issue a bond loan in the amount of €81,700,000.00, fully subscribed by its sole shareholder, E..., SARL;

g) To this end, a resolution was adopted on 27 June 2007, as per Minutes No. 14 of company B..., which, given the capitalization requirements the company would need to meet for the transactions it intended to undertake and having the intention to proceed with payment of the price under the share purchase agreement representing the entire share capital of company I..., later designated L..., Lda. (Tax Number....), would proceed to issue a bond loan in the amount of €81,700,000.00, which would be fully subscribed by its sole shareholder (E..., SARL);

h) For the implementation of the bond loan, J..., S.A., also participated, which proceeded to pay interest to the subscriber company E..., SARL, and K..., S.A., which registered this loan;

i) Through analysis of the accounts, the Tax Authority found that the €81,700,000.00 never entered the entity's accounts, with this amount recorded as third-party debts in counterpart to loans;

j) On 1 August 2007, L..., Lda. (Tax Number...), previously designated I..., was acquired by the Applicant for the amount of €122,611,711.00;

k) This acquisition operation was recorded in the accounts through a transfer of debit balances—third-party debts (shareholders' contributions to capital increase and the bond loan) to financial investments instead of a withdrawal from available funds, whereby the Tax Authority concluded that the monetary funds relating to both the capital increase and the bond loan never entered the accounts of B...;

l) With regard to interest, as shown in the accounts for 2007 and 2008, it was paid through J..., S.A., by L..., the company acquired through that loan, with B... having no operating activity, serving only as a vehicle for that acquisition;

m) This same interest paid to entity E... was not subject to tax in Portugal pursuant to Decree-Law No. 193/2005 of 7 November;

n) In the two years in which analysis of the accounts of B... was carried out under service orders OI2010.../..., the Tax Authority found that it had no significant operating results, showing losses deriving from negative financial results arising from the bond loan, which were paid by A... (the entity acquired by B...);

o) In July 2008, company B... changed its name and registered office to C... Lda., changing the location of its office, previously in the Madeira Free Zone, and establishing itself in ..., at its present registered office;

p) In December 2008, C... (former B...) incorporated, through a merger process, its subsidiary L... (former I...);

q) With this merger, C... adopted the name of the incorporated entity (A..., Lda.), which corresponds to its current designation, assuming the functions and social objectives of that other company;

r) Through this operation, all of the assets of the incorporated company, L..., were transferred to its incorporating company, C..., now designated A..., Lda.;

s) And all assets and liabilities became incorporated into the same entity, with the incorporating entity assuming the obligations established between company E... and company B..., arising from the bond loan contracted for the acquisition of company L... (I...);

t) As a result of the merger, the Applicant became the direct owner of a series of companies in the healthcare sector;

u) L..., Lda. (Tax Number...) held the entire capital of the following entities:

1. M..., S.A., Tax Number...;
2. N..., Lda., Tax Number...;
3. O..., Lda., Tax Number...;
4. P..., Lda., Tax Number...;
5. Q..., S.A., Tax Number...;
6. R..., S.A., Tax Number...;
7. S..., S.A., Tax Number...;
8. T..., S.A. Tax Number...;
9. U..., Lda., Tax Number...;
10. V..., Lda., Tax Number...;
11. W..., S.A., Tax Number...;
12. X..., S.A., Tax Number...;
13. Y..., S.A., Tax Number...;
14. Z..., S.A., Tax Number...;

It also held partial capital in company AA..., LDA., with Tax Number...;

v) In December 2009, the Applicant (now A..., Lda. – Tax Number....) proceeded to merge, through incorporation, with the group companies, and from that date dedicated itself to the provision of medical services;

w) L..., Lda. (Tax Number...) ceased its activity due to the merger through incorporation with the Applicant;

x) The Tax Administration initiated an inspection action of the Applicant relating to the tax years 2013 and 2014, which originated from a declaratory control action, through which the necessity was proposed and officially sanctioned to control the interest recorded by the company relating mostly to expenses for its own acquisition.

y) The inspection action was carried out through service orders OI2016... and OI2016... of 6 January 2016;

z) Within the inspection action, the Tax Authority found that in the years 2013 and 2014, the Applicant incurred and recorded in its accounts costs (interest) with a bond loan and shareholder contributions, costs which the Tax and Customs Authority understood were not related to its business activity, nor served to maintain its income-generating source, but instead benefited a third party (F..., S.A.R.L., former E... S.A.R.L.), and were not deductible for the purposes of calculating taxable profit, pursuant to Article 23(1)(c) of the Corporate Income Tax Code;

aa) In the tax year 2013, the amount of interest recorded and paid to the parent company in the current company is approximately €11,664,656.99;

bb) The correction of the IRC assessment covers the disregard of interest paid relating to the bond loan and interest paid relating to shareholder contributions intended to settle interest on the bond loan;

cc) On 17 July 2014, the Applicant was notified by the Tax Authority to prove the indispensability of the costs and/or expenses incurred with the interest supported with the bond loan for the generation of income, with the Applicant submitting its reply on 14 August following (Annex 15 to the Tax Inspection Report);

dd) The Applicant was notified of the Draft Tax Inspection Report, and exercised its right to reply in a prior hearing, by means of a request sent on 11 November 2013 (Annex 21 to the Tax Inspection Report);

ee) On 26 April 2016, the Applicant was notified of the Tax Inspection Report, which determined the correction of the IRC assessment that is being challenged;

ff) The content of the documents referred to in the preceding items dd), ee) and ff) is hereby reproduced;

gg) The Applicant filed an administrative appeal against the tax assessment acts for additional IRC, which was dismissed.

hh) The Applicant provided a bank guarantee to obtain the suspension of the coercive collection proceedings instituted for the coercive recovery of the amounts stated in the tax assessment acts.

The Tribunal formed its conviction as to the proven facts based on the documents attached to the petition and those contained in the administrative proceedings presented by the Tax Authority with its reply.

III - Legal Matters

1. The Tax Authority proceeded to correct the IRC assessment for the tax year 2013 on the grounds that, pursuant to Article 23 of the CIRC, the interest incurred and recorded by the challenger arising from a bond loan and shareholder contributions, both subscribed and made by parent company F... (former E...), and which the Applicant came to assume as its liability as a result of the incorporation of the borrower C... (former B...), are not fiscally deductible.

The issue of the bond loan was intended to permit the acquisition of the H... Group business in Portugal, with this entity becoming designated as A..., Lda., and it was this entity that bore the costs resulting from the financing established between C... and F.... With the later merger operation that occurred between C... and A... Lda., C... adopted the name of the incorporated company and came to hold directly the financial shareholdings in the various healthcare service provider entities.

Under these circumstances, the Tax Authority considers that, with the merger, the income generated by the activity of the incorporated company came to bear the costs of its own acquisition, and in that sense, the funds are not being utilized in its respective operation nor do they constitute a source generating the income or gains resulting from its activity, and therefore they do not meet the requirements of indispensability and correlation required by Article 23 of the CIRC.

In opposition, the Applicant maintains that without the charges it bears, it could not have acquired L..., Lda. (former I...) and would not achieve the size and economic structure it presently has, thereby concluding that, with the merger, there occurred a genuine acquisition of assets and liabilities, distinct from capital interests, and generating operating results. Thus, the interest paid results from operations that, upon their completion, brought into the Applicant's sphere the assets (means of generating income) and the debts (financial support for such means) within a framework of clear economic rationality.

In addressing the matter, it should first be noted that the inspection procedure that gave rise to the tax correction also covered the tax year 2014, and procedures of identical nature have been applied to the years 2009, 2010, 2011 and 2012.

And in all such cases, the arbitral tribunal, called upon to rule on the corresponding requests to challenge the additional IRC assessments, has consistently decided that the financial charges incurred with the acquisition of I... (later designated as L..., Lda., and which is integrated into the currently existing company) are still inscribed in the interest and economic activity of the Applicant and cannot be disregarded as fiscally relevant costs (decisions issued in Proceedings Nos. 42/2015, 337/2016, 480/2016, 508/2016 and 607/2017).

And there is no reason to alter that understanding now.

The pivotal point concerns the criterion of indispensability of expenses referred to in Article 23 of the CIRC.

In the wording in force at the date of the events, the provision, in the part which is now most relevant to consider, provided as follows:

Article 23
Costs or losses

1 — Those that are demonstrably indispensable for the generation of income or gains subject to tax or for the maintenance of the income-generating source are considered costs or losses, in particular the following:

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

b) Distribution and sales expenses, including those for transport, advertising and placement of goods and products;

c) Financial expenses, such as interest on borrowed capital applied in the operation, discounts, premiums, transfers, exchange differences, credit operation expenses, debt collection and issuance of shares, bonds and other securities, redemption premiums;

(…)".

It follows from this provision that the consideration of costs or losses for tax purposes depends on a requirement of indispensability for the generation of income or gains that are subject to tax.

In filling the indeterminate concept of indispensability, there is firm case law understanding to the effect that the legal notion of cost provided by Article 23 of the CIRC does not result in the Tax Administration being able to call into question the principle of management freedom, reviewing the soundness and appropriateness of the company's economic management decisions and considering that only those from which directly generate income for the company or prove advantageous to the company can be assumed fiscally. The indispensability referred to in Article 23 requires only an economic causal relationship, in the sense that it is sufficient that the cost is incurred in the interest of the company, in order, directly or indirectly, to generate profits. And outside the concept of indispensability will fall only acts that are inconsistent with the social purpose, those that do not fit within the company's interest, especially because they do not aim at profit" (cf. decision of the Administrative Court of the South (TCA Sul) of 6 October 2009, Proceedings 03022/09 and, in the same sense, decision of the Administrative Court of the North (TCA Norte) of 12 January 2012, Proceedings 00624/05).

In the same line of understanding, the Supreme Administrative Court (STA), drawing attention to the casuistic character of filling the concept of indispensability, formulates the following criterion:

"The rule is that correctly recorded expenses are fiscal costs; the criterion of indispensability was created by the legislator, not to allow the Administration to meddle in the company's management, dictating how it should apply its means, but to prevent the fiscal consideration of expenses which, even though recorded 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 costs of the company, but expenses which, in light of their object, were abusively recorded as such. Without the Administration being able to assess the indispensability of costs in light of criteria concerning their appropriateness and merit".

The same decision goes on to conclude that, "under penalty of violation of the principle of contributive capacity, the Administration can only exclude expenses not directly ruled out by law under strong justification that convinces that they were incurred beyond the social objective, or, at least, with clear excess, deviant, in the face of the objective needs and capacities of the company" (decision of 29.03.2006, Proceedings No. 1236/05).

In this sense, legal scholarship has also positioned itself.

Rui Morais states that "the invocation of the rule of indispensability of costs can never be made to replace the judgment of convenience and appropriateness of the charges assumed, as they resulted from the decision of the company's bodies, by another judgment, also of a business nature made by the tax administration or courts". And he proceeds to say that "we cannot regard as sound the orientation of certain case law that refuses the tax recognition of certain costs because it is not possible to establish a direct correlation with the generation of concrete income. Taken to the extreme, such an understanding would mean that expenses with research would only be fiscally deductible when such research was successful, when, as a result, the company began to sell new goods and services (…)."

To conclude in the following manner:

"We argue that the question of whether a cost should be considered indispensable should be resolved from the objective purpose of the transaction, that is, the business purpose test. We believe it is fairly clear what the norm seeks: to refuse tax participation in some of the charges incurred by the taxpayer (…). If the assumption of the charge was preceded by a genuine business motivation (…) the cost is indispensable. When one must conclude that the charge was determined by other motivations (personal interest of shareholders, administrators, creditors, other companies in the same group, business partners, etc.) then such cost should not be considered indispensable" (Notes on the IRC, Coimbra, 2007, pp. 86-87).

In identical terms, Saldanha Sanches notes that "determining whether a certain cost corresponds, or not, to the most effective protection of the company's interests is a question that cannot be resolved by granting the State (…) a power of intervention so as to make a judgment of merit about a certain business management option, just as it cannot validate the characterization of the expense as a cost by subjecting it to the condition of subsequent verification of the actual generation of income" (The Limits of Tax Planning, Coimbra, 2006, p. 215).

In conclusive summary, in light of the principles just expounded, it should be understood that business activity that generates deductible costs must be that which translates into operations that have a purpose, an intent (and not a necessary immediate causal nexus) of generating income or the purpose of maintaining the potential of an income-generating source. In that sense, productive activity should not be understood in a restrictive sense, but rather in a broad sense, meaning activity related to an income-generating source of the entity that incurs the expenses. When seeking the meaning of the concept of activity of companies, it cannot be confined to mere or simple operations of production of goods or services. To say that a cost must reflect a relationship with the activity can only mean that there must be a relationship with the overall economic operations of operation or with the operations or management acts that are part of the pursuit of the entity's own interest that assumes such costs (cf. in this sense, the arbitral decision issued in Proceedings No. 480/2016).

1. In the present case, the Tax Administration understands that the financing provided to a company devoid of operational content (B..., later designated as C...), and which served only as a vehicle company for the acquisition of I..., determined, following the reorganization of the A... group, the obtainment of a tax advantage, materialized in the reduction of taxable profit through the deduction of financing costs.

In that sense, it considers that the costs incurred with the bond loan are not related to the Applicant's business activity, nor served to maintain the income-generating source and, even though recorded in its accounts, do not benefit its activity or respective business interest, but instead benefit a third party (F..., former E...).

In reaching this conclusion, the Tax Administration proceeds from the idea that costs cannot fail to relate to the contributing company itself, and in the case of interest, the funds to which they relate must be applied in its own operation, so that the productive activity is developed by the company that incurs the charges and not by third parties.

However, as has been seen, the concept of indispensability is consensually interpreted as implying that the expenses relate to the company's activity or interest. Thus, financial charges that fall within this framework, even if not applied in activities considered operational or exploitation, may meet conditions of indispensability.

And, moreover, Article 23 of the CIRC, when referring to financial charges susceptible of being deductible as costs, such as interest on capital applied in the operation, does not intend to restrict deductibility to that type of charges—indicated therein merely by way of example—and nothing prevents other charges from being considered provided they meet the general requirement of indispensability.

And the fact is that the charges in question are related to the Applicant's activity, as they result from the financing of assets held by it and which generate income of an operational nature.

Indeed, as a result of the merger operations, the same company (the Applicant) came to hold, as patrimonial elements recorded or recognized in its balance sheet, the assets and liabilities of operative companies and continued to record, also in its balance sheet, the equity and financial liabilities that supported the shareholdings that previously represented this set of patrimonial elements.

This means that, before the merger, L... Lda. (former I...) held, on the right side of the balance sheet, sources of financing from C... (former B...), paying interest on those sources which constituted debt; and, in its assets, shareholdings in operative entities. With the merger, the same entity (Applicant) continues to hold the aforementioned liabilities (debts to participant F..., SARL), thereby coming to recognize the assets and liabilities of the operative companies whose acquisition constituted the essential cause of C...'s (former B...) indebtedness to F..., SARL.

In sum, the merger maintains in the Applicant the financing for which it paid interest, and had as its patrimonial consequence the joining, in the same balance sheet, of the assets that such debt financed and continued to finance. Not just financial assets, but their real translation into assets and liabilities of an operational nature.

It is therefore clear that the Applicant's debt to the parent company—and the interest resulting therefrom—is inscribed in its interest and economic activity. There is even an economic nexus between income and expenses. The income derived from the business is related to the interest paid for its acquisition. And from a patrimonial perspective, there is greater approximation between assets and the capital that finances them which are now recorded in the same entity. Without the Tax Authority calling into question the economic purpose of the reorganization operations carried out, the disregard of interest paid has no support in Article 23 of the CIRC.

1. The correction of the IRC assessment also covers charges with shareholder contributions which, together with the bond loan, were made by E... to I... for payment of financial charges of the bond loan to the parent company in the proportion of the total amount of €11,664,656.99.

The Tax Authority argues, on this point, that with the merger, the debts between Portuguese companies were cancelled, while maintaining the record of the debt to the parent company in the amount of €47,399,162.66 which includes the amount paid as interest, with there being grounds for the disregard of interest paid relating to shareholder contributions for tax purposes, pursuant to Article 23 of the CIRC.

In the request for arbitral pronouncement, the Applicant contests this interpretation, alleging that the amount of €11,664,656.99 represented a partial reduction of the debt of I... and is not included in the final balance of €47,399,656.99.

To this extent, the Tax Authority, in its reply, following the reasoning adopted in the Tax Inspection Report, merely states that "no evidence was found that unequivocally demonstrates that the amount of €11,664,656.99 is not included in the value of shareholder contributions, all the more so that company L..., Lda. (former I...) directly paid such interest on account of company C... (former B...) by virtue of the latter company not having financial means to proceed with the settlement of interest".

It is important to bear in mind, in this regard, the rule of material evidence law resulting from Article 74 of the LGT. It is incumbent upon the Tax Authority to prove the facts constituting the non-deductibility of costs for tax purposes, it not being sufficient to state that the taxpayer did not provide countervailing evidence to what is stated in the Inspection Report. In the face of probative uncertainty, the tribunal must rule against the party on whom rested the burden of proof and, therefore, in favor of the taxpayer.

Even if this were not so, the financial charges with shareholder contributions which were intended for the payment of interest owing from the issuance of the bond loan relate to the same financing that permitted the acquisition of the assets and liabilities that were concluded to be relevant for the generation of income, and therefore, for the same reasons already previously stated, there is no reason to disregard these costs for tax purposes.

Compensation for Improper Provision of Guarantee

1. The Applicant also requested payment of the corresponding compensation for improper provision of guarantee, invoking the provisions of Articles 171 of the CPPT and 53 of the LGT, having alleged that it provided a guarantee to obtain the suspension of the coercive collection proceedings instituted as a result of a tax assessment act.

Article 171 of the CPPT guarantees compensation in the case of a bank guarantee or equivalent improperly provided, which may be requested in the proceedings in which the legality of the exigible debt is contested, and it should be understood that arbitral proceedings are also the appropriate procedural means for submitting this request since it may address claims relating to the declaration of the legality of tax assessment acts (Article 2(1)(a) of the RJAT).

Article 53 of the LGT further provides that the debtor who offers a bank guarantee or equivalent to suspend coercive collection shall be compensated in whole or in part for the losses resulting from its provision, should he have maintained it for a period exceeding three years, except where it is found in the judicial challenge that there was error attributable to the services in the assessment of the tax, in which case the compensation is not dependent on the period for which the guarantee was in force.

In the present case, it is clear that the error from which the assessment acts suffer is attributable to the Tax Administration, and the Applicant has the right to compensation for losses resulting from the improper provision of guarantee.

However, the Applicant did not allege or prove the charges it incurred with the provision of guarantee, and therefore may only be recompensed in a separate liquidation incident to be deduced autonomously (in this sense, the decision of the arbitral tribunal of 12 February 2018, Proceedings No. 369/2017-T).

IV - Decision

They hereby decide:

a) To find the request for arbitral pronouncement fully meritorious and to annul the tax assessment acts for additional Corporate Income Tax (IRC) with No. 2016..., in the amount of €2,781,557.01, for demonstration of interest calculation with No. 2016... and for demonstration of accounts reconciliation No. 2016..., which resulted in tax payable in the amount of €2,910,756.02, relating to the tax year 2013;

b) To order the Tax Authority to pay compensation to the Applicant for the provision of guarantee owing in the terms to be set in a liquidation incident.

1. Value of the proceedings

The Applicant indicated as the value of the action the amount of €2,910,756.02, which was not contested by the Respondent, and corresponds to the value of the assessment that was sought to be opposed (Article 97(1)(a) of the CPPT).

Notify.

Lisbon, 24 May 2018

The President of the Arbitral Tribunal

Carlos Fernandes Cadilha

The Arbitrator Member

Luís Oliveira

The Arbitrator Member

Gustavo Lopes Courinha