Deductibility of Financial Costs in Reverse Merger Under IRC – CAAD Decision 606/2016-T

ARBITRATION DECISION

1. Report

On 11-10-2016, the joint-stock company A…, S.A., collective person number…, with registered office at Avenue …, no…, …-… Lisbon, registered at the Commercial Registry Conservatory of Lisbon under number…, hereinafter referred to as the Claimant, submitted to the Administrative Arbitration Center (CAAD) a request for constitution of an arbitration tribunal with a view to the annulment of the corporate income tax assessment (IRC) no. 2016…, the interest assessment no. 2016… and the compensation act no. 2016…, for the year 2012, in the total amount of 52,121.33 €.

The request for constitution of the Arbitration Tribunal was accepted by His Excellency the President of CAAD on 13-10-2016 and notification thereof was served on the Respondent on the same date.

The Claimant did not proceed to appoint an arbitrator, whereby, in accordance with the provisions of article 6 no. 2 letter a) of the RJAT, Ms. Dr. Andrea Firmino was appointed as arbitrator by the President of the Deontological Council of CAAD on 30-11-2016, the appointment having been accepted within the timeframe and in the terms legally provided.

On the same date the parties were duly notified of this appointment and did not express their intention to refuse the appointment of the arbitrator, in accordance with the provisions of article 11 no. 1, letters a) and b) of the RJAT, in conjunction with articles 6 and 7 of the Deontological Code.

Therefore, in accordance with the provision in letter c), no. 1, article 11 of the RJAT, the Arbitration Tribunal was constituted on 19-12-2017.

An order was issued on 02-01-2017, to notify the Respondent to, within a period of 30 days, submit a reply and, if it so wishes, request the production of additional evidence, and to forward to the arbitration tribunal a copy of the administrative file within the timeframe for submission of the reply.

On 31-01-2017, the Respondent submitted its reply to the file, and on 09-02-2017 it submitted a copy of the administrative file.

On 03-05-2017, an order was issued dispensing with the meeting provided for in article 18 of the RJAT, as well as with the submission of arguments, taking into account that none of the purposes legally assigned thereto were present, the position of the parties in the proceedings, in accordance with the provisions of articles 16 letter c) and 29 no. 2 of the RJAT, as well as the principles of procedural economy and the prohibition of the performance of useless acts.

The Claimant submitted, on 10-05-2017, a request informing of the facts that it intended to prove with the witness evidence indicated, asserting that it did not waive the production of witness evidence, under penalty of violation of the principle of access to law and the necessity of ascertainment of the material truth of the facts. The Claimant further stated that final arguments could not but be produced.

On 19-05-2017, the Respondent submitted a request stating that the matter in the file was exclusively one of law and that the operations and loans in question were proven by documentary evidence. And it argued against the performance of the witness examination procedure.

On 09-06-2017, an order was issued scheduling 17-06-2017 for the pronouncement of the arbitration decision.

On 14-06-2017, the Claimant submitted the proof of payment of the subsequent arbitration fee.

On 19-06-2017, an order was issued extending to 17-08-2017 the deadline for issuance of the decision, on account of a period of excessive workload.

On 21-08-2017, a new order was issued in which the deadline for the arbitration decision was again extended to 17-09-2017, on the same grounds.

On 10-10-2017, an order was issued by His Excellency the President of the Deontological Council of CAAD, stating that on 03-10-2017 Ms. Dr. Andrea Firmino was notified to, within 48 hours, provide information on whether the deadline for the arbitration decision had been extended, and that Ms. Arbitrator did not respond. It was further stated in the same order that, given that there had not been compliance with the deadlines legally and regulatory fixed, it was determined that Ms. Dr. Andrea Firmino's mandate be terminated, and that she be replaced, in the same functions, by Ms. Prof. Dr. Suzana Fernandes da Costa.

Subsequently, the AT requested clarification on the circumstances that led to the removal of Ms. Dr. Andrea Firmino, as well as the legal basis that supports it.

Following this request from the AT, on 16-10-2017, His Excellency the President of the Deontological Council of CAAD issued a decision declaring the incident raised by the AT to be without merit.

On 16-10-2017 the undersigned was appointed arbitrator in the present proceedings.

On 21-11-2017, an order was issued scheduling 13-12-2017 for the examination of witnesses and for the submission of oral arguments, so as to comply with the deadline stipulated in article 21 of the RJAT.

On 30-11-2017, the AT submitted a request to the file requesting that arguments be submitted in writing and in successive form, in light of the production of witness evidence. On 04-12-2017, an order was issued rejecting the request for written arguments submitted by the AT, so as to comply with the one-year deadline stipulated in article 21 of the RJAT (in this case: 19-12-2017), and bearing in mind that the law expressly provides for the possibility of oral arguments in article 18 of the RJAT.

On 13-12-2017, at 14:30 hours, the meeting of the arbitration tribunal took place. There appeared Her Excellency Dr. B… and Her Excellency Dr. C…, in the capacity of representatives of the Claimant, and His Excellency Dr. D… and His Excellency Dr. E…, jurists in representation of the Director-General of the AT.

The witnesses listed by the Claimant, F… and G…, were examined. After the examination, the parties submitted their respective oral arguments.

17-06-2017 was further scheduled for the pronouncement of the arbitration decision, and the parties were requested to send the procedural documents in word format.

2. Cause of Action

The Claimant begins by stating that two reverse merger operations occurred, that is, mergers in which the subsidiary company incorporates the parent company:

The first occurred on 17-04-2007, and consisted of the incorporation by the company H…, Lda of the company I…, Lda.

Following this merger, a global transfer of the assets and liabilities of the incorporated company to the incorporating company took place, the company having assumed responsibility for payment of the charges inherent in the loan agreement no. … concluded between the incorporated company (I…, Lda) and Bank J….

On 06-03-2008 the Claimant, previously designated K…, Lda, was transformed into a joint-stock company, becoming designated A…, SA, with share capital of 200,000 €.

The second merger occurred on 31-12-2008, through which the Claimant incorporated the company H…, Lda, there occurring a global transfer of the assets and liabilities of that company to the sphere of the Claimant, the latter having assumed responsibility for payment of the charges inherent in the loan agreement no. … concluded between the incorporated company and Bank J…, SA.

The Claimant alleges that its assets increased substantially as a consequence of the merger with the company H…, Lda, in particular with respect to financial investments, tangible fixed assets and intangible fixed assets, the Claimant's assets having risen from 1,517,196.38 € to 7,925,038.00 €.

In addition to the increase in assets, the Claimant states that there was a considerable increase in sales volume recorded with the merger and consequently a considerable increase in profits subject to tax.

The Claimant states that it was the subject of a tax inspection carried out by the Tax Authority of Lisbon, for declarative control of expenses recorded with financial charges, an inspection that concluded that "the two financings had as their purpose the acquisition of capital, with no connection being verified with the activity of exploitation nor with the obtaining of profit or the maintenance of the source of production". And it considered the financial charges associated with the loan agreements concluded with Bank J…, SA as not fulfilling the requirements provided for in article 23 of the IRC Code.

The Claimant points to the IRC assessment in question the defect of violation of law, in that it is not properly reasoned in the terms of the law, in that the reasons that motivated the AT to consider the financial charges associated with the said bank loans as not deductible for tax purposes are not stated in the inspection report.

The Claimant further states, in accordance with article 74 no. 1 of the LGT, that it is on the AT that the duty falls to prove the right to effect the correction to the Claimant's taxable base, given that the latter places in issue the elements declared by it which enjoy the presumption of truthfulness, in accordance with article 75 of the LGT.

As to the deductibility of financial costs, the Claimant alleges that, in accordance with article 23 of the IRC Code, there are two essential requirements for the accounting cost to be valued and accepted as a tax cost: being properly documented (proof) and being indispensable for the realization of profits or gains subject to tax or for the maintenance of the source of production (indispensability). In the concrete case, the Claimant states that the AT did not challenge the first requirement – that of proof.

With regard to the indispensability of financial-nature costs deducted in 2012, the Claimant states that the financial operations identified are not only related to its activity but are relevant to the increase in income subject to tax and, as such, should be considered costs deductible for tax purposes in 2012.

To support its position, the Claimant transcribes some doctrine and case law.

The Claimant states that the financial costs in question result from the normal exercise of its activity, with no view to any indirect, extra-business or illicit benefit in favor of a third party.

For the Claimant, these operations appear indispensable for the maintenance of the source of production in that they enabled it to meet its own expenses and ensure the growth of the company's activities, from which the Claimant derived the corresponding profit and increasing the value subject to tax.

Finally, the Claimant requests the examination of two witnesses.

3. Reply of the Respondent

The Respondent, in its reply, alleges in summary that:

As to the lack of reasoning invoked by the Claimant, the corrections set forth in the inspection report would be properly reasoned, with the reasons being listed by which the AT decided that the operations in question and the legal norms under which the costs incurred by the Claimant could not be accepted for tax purposes.

The AT states that the operation in question is characterized by the acquisition financed predominantly with debt, as a rule through a vehicle company, of a total or majority participation in the capital of an operating company, followed by a transfer, by merger, of the indebtedness incurred to the acquired company itself, so that it is this company that bears the economic-financial cost of its acquisition, resulting from this a significant increase in its coefficient of indebtedness with the consequent result of financial leverage on its social patrimony.

The Respondent reports that in the present case, the vehicle company I… and H…, Lda were terminated within the scope of the merger operation, by incorporation in the Claimant, although it had been established with a corporate purpose identical to that of the acquired company.

For the AT, we are faced with a "leveraged merger", in that its development occurs in two phases, in a first moment an existing company or newly created (vehicle company) incurs indebtedness to acquire control of another, carrying out a leveraged acquisition, and in a second moment, there takes place the merger between the acquired company and the acquiring company, with a view to that the financial cost of the operation falls, in whole or in part, on the patrimony of the acquired company.

The AT concluded that after the two merger operations, only one company exists, the Claimant, which receives the costs concerning the acquisition of its own share capital, and these costs lead to a diminution of results.

According to the AT's position, it was found that the financial charges in question related to financings the funds of which were neither injected nor applied in the exploitation or activity developed by the Claimant, as they served only to satisfy the payment of the cost of acquisition of its shareholdings to the former holders of the capital of I… and H…, Lda. For the AT, the costs did not serve, provably, to acquire goods or rights necessary to the development of the Claimant's normal activity, not least because the company I… did not evidence the exercise of the activity for which it was established, but constituted a mere vehicle with the purpose of obtaining a loan for the acquisition of shareholdings in company H…, Lda, being subsequently merged into that company.

The AT concludes by stating that the performance of witness evidence would lack meaning, given that the questions to be decided would be exclusively ones of law.

4. Case Management Order

The present request for arbitration pronouncement was submitted in a timely manner, in accordance with article 10 no. 1 letter a) of Decree-Law no. 10/2011 of 20 January.

The Tribunal is competent as to the appreciation of the request for arbitration pronouncement formulated by the Claimant.

The parties enjoy legal personality and capacity and are legitimated (articles 4 and 10 no. 1 and 2 of the RJAT and article 1 of Order no. 112-A/2011 of 22 March).

The proceedings do not suffer from nullities and no preliminary matters were raised.

5. Factual Findings

5.1. Facts Proven:

Having analyzed the documentary evidence produced, the following facts are considered proven and of interest for the resolution of the case:

1. The Claimant has as its corporate purpose the commercialization of pharmaceutical, hygienic and related products, purchase and sale of medical items and other products of medicinal use, purchase and sale of medicines.

2. On 17-04-2007, a reverse merger occurred by which H…, Lda (incorporating company, held by the Incorporated) incorporated by merger the company I…, Lda (incorporated company).

3. With the merger there occurred a global transfer of the assets and liabilities of the incorporated company to the incorporating company, the company having assumed responsibility for payment of the charges inherent in the loan agreement no. … concluded between the incorporated company (I…, Lda) and Bank J…, SA, as per documents 1 and 2 attached to the arbitration request.

4. On 31-12-2008, another merger occurred in which the Claimant (in the meantime transformed into SA and with a new name) incorporated the company H…, Lda, there occurring a global transfer of the assets and liabilities of that company to the sphere of the Claimant, the latter having assumed responsibility for payment of the charges inherent in the loan agreement no. … concluded between the incorporated company and Bank J…, SA, as per document 4 attached to the arbitration request.

5. The reasons underlying the merger, contained in the merger proposal, were the correction of inefficiencies detected, as well as the elimination of unnecessary costs, namely through the integration of the administrative facilities of the two companies with the resulting cost reductions, the concentration of sales effort and investment in advertising, the global reduction of administrative and logistical structures of the two companies through the integration of all treasury, accounting, human resources management and general management activities of the incorporating company and the better utilization and rationalization of actual personnel.

6. Following the merger the Claimant company increased its assets, as to financial investments, intangible fixed assets and intangible fixed assets, the value of assets having risen from 1,517,196.38 to 7,925,038 euros.

7. And from 2008 to 2015 it recorded a gradual increase in sales volume.

8. The Claimant was the subject of a tax inspection action for the year 2012, carried out by the Tax Authority of Lisbon.

9. The inspection report states that "in the case under analysis, it is verified that the two financings had as their purpose the acquisition of capital with no connection being verified with the activity of exploitation nor with obtaining profit and or maintenance of the source of production", as per document 8 attached to the arbitration request.

10. The Claimant was notified of the corporate income tax assessment no. 2016…, of the interest assessment no. 2016… and the compensation act no. 2016…, for the year 2012, in the total amount of 52,121.33 €, with final payment date 01-09-2016, as per document 9 attached to the arbitration request.

No other facts with relevance to the resolution of the case were proven.

5.2. Reasoning of the Proven Factual Findings:

The factual findings were based on the documents attached to the file, the administrative file and the examination of the witnesses listed by the Claimant, and the facts admitted by agreement of the parties.

5.3. Facts Not Proven

There are no other facts of relevance to the appreciation of the merits of the case that have not been proven.

6. Legal Findings:

6.1. Object and Scope of the Present Proceedings

The question to be decided in the present proceedings is that of ascertaining what tax treatment is to be given to the financial charges borne in 2012 by the Claimant (incorporating company) following the so-called reverse merger, relating to financings contracted by the incorporated companies in the phase prior to the merger. It is sought to know, in particular, whether the expenses corresponding to the charges of the financings borne by the Claimant in 2012 meet or do not meet the requirements of article 23 no. 1 of the IRC Code, in the wording in force at the date.

It is also discussed whether the corrections effected in the sphere of the Claimant and which are at the basis of the assessment in question are affected by a defect of reasoning.

6.2. Legal Framework

a) On the deductibility of expenses with financial charges

Article 23 of the IRC Code, on expenses and losses, provided, in 2012, as follows:

"1 – Expenses or losses are those that are provably indispensable for the realization of income subject to tax or for the maintenance of the source of production (…)".

As to financial charges proper, the aforementioned article 23 no. 1 letter c) of the IRC Code provides that the following are considered costs:

"c) of a financial nature, such as interest on foreign capital applied in exploitation (…), expenses with credit operations (...)".

On the other hand, article 112 letter a) of the Companies Code provides that, with the merger of companies, the incorporated companies are terminated, their rights and obligations being transmitted to the incorporating company, under the so-called principle of neutrality of mergers.

With respect to the duties of reasoning of tax acts, article 77 of the LGT provides that:

"1. - The procedural decision is always reasoned by means of a brief exposition of the facts and law reasons that motivated it, the reasoning being able to consist of mere declaration of agreement with the grounds of prior opinions, information or proposals, including those forming part of the tax inspection report.

2 - The reasoning of tax acts may be effected in summary form, and must always contain the legal provisions applicable, the qualification and quantification of tax facts and the operations for ascertainment of taxable income and of the tax".

6.3. Application to the Concrete Situation

The legislator adopts an indeterminate concept of cost, which must comply with two requirements: proof and indispensability.

The proof of costs with financial charges was not challenged by the AT. It is indispensability that is the crux of the question discussed in these proceedings.

With regard to the indispensability of expenses, the doctrine highlights the work of António Portugal entitled "The Deductibility of Costs in Portuguese Tax Case Law", Coimbra Publisher, 2004.

For his part Tomás Cantista Tavares (The Deductibility of Costs in the IRC", Tax Review, 101-102, January 2002), states that indispensability should be interpreted broadly, which "leads to considering as indispensable costs all genuine and real business costs, even if linked to ruinous transactions", only denying the quality of tax cost to abusively recorded expenses in the accounts.

To proceed with the application to the case at hand of the requirement of indispensability of costs, it is necessary to verify, on the basis of all relevant facts and circumstances, the actual and concrete allocation of the loan of which the interest borne is the remuneration, in other words, it is necessary to consider the destination or use of the funds obtained in relation to which the taxpayer intends to deduct for tax purposes, for purposes of ascertaining its taxable profit, the financial charges that it bore.

The AT alleges that the two financings had as their purpose the acquisition of capital, with no connection being verified with the activity of exploitation nor with obtaining profit and/or maintaining a source of production.

The Claimant, on the other hand, states that the acquisition of the shareholdings enabled the increase of its assets and had as a consequence the increase of its sales volume, through expansion by acquisition of new businesses. And it alleges that by acquiring shareholdings and by incorporating the company, the Claimant increased its potential for generating income and profits, which it then incorporated through distributed dividends, made decisions in accordance with its interest or its business purpose. According to the Claimant, its sales volume and the results subject to tax increased considerably as a consequence of the merger operations and the consequent incorporation of all the assets and liabilities, facts which are considered proven.

As to the summary of case law and national doctrine on the indispensability of expenses, we transcribe part of the decision of CAAD delivered by majority in process no. 110/2017-T, a process with factual and legal situation similar to that of the present proceedings:

• "The judgment on the indispensability of the expenses borne implies that its contribution to the obtaining of profits or gains subject to tax or to the maintenance of the source of production is verified";

  The legal notion of indispensability is thus carved out, over an economic-business perspective, by direct or indirect fulfillment, of the ultimate motivation of contribution to the obtaining of profit" and "the fiscal deductibility of the cost depends, only, on a causal and justified relationship with the company's activity." (Decision of the Higher Administrative Court, delivered on 30-11-2011, in process no. 0107/111);
  

• the costs (...) cannot but respect, from the outset, the taxpayer company itself. That is, for a certain sum to be considered a cost of that company it is necessary that the respective activity be developed by it itself, not by other companies." (Decision of the Higher Administrative Court, delivered on 30-05-2012, in process no. 0171/11);

• a concept of indispensability which, moving definitively away from the idea of causality between expenses and income, puts the emphasis on the relationship of expenses with the activity pursued by the taxpayer, that is, considering that the said concept of indispensability is verified whenever expenses are incurred in the interest of the company, in the pursuit of its respective activities." (Decision of the Higher Administrative Court, delivered on 04-09-2013, in process no. 0164/12);

• the concept of indispensability is one of case-by-case determination, and the nexus of economic causality cannot be disconnected from the factuality of the concrete case;

• the Tax Authority cannot evaluate the indispensability of costs in the light of criteria focused on the opportunity and merit of the expense. A cost is indispensable when it relates to the company's activity, with costs foreign to the company's activity being only those in which it is not possible to discern any causal nexus with the profits or gains (or with the income, in the current expression of the code - cfr. art. 23, no. 1, of the CIRC), explained in terms of normality, necessity, congruence and economic rationality." (Decision of the Superior Administrative Court of the South, delivered on 16-10-2014, process no. 06754/13);

• The indispensability of the cost must result simply from its connection with business activity. If the cost is not foreign 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 (one is not faced with an apparent or simulated cost), the cost is indispensable." (Decision of the Superior Administrative Court of the North, delivered on 20-11-2011, process no. 01747/06.3BEVIS);

• from the legal notion of cost provided by art. 23° of the CIRC does not result that the AT can put in question the principle of freedom of management, censuring the soundness and opportunity of the business decisions of company management and considering that only those from which directly accrue profits to the company or which prove convenient for the company can be assumed fiscally. The indispensability to which art. 23° of the CIRC refers as a condition for a cost to be deductible does not refer to necessity (the expense as a condition sine qua non of profits), nor even to convenience (the expense as convenient for business organization), under penalty of intolerable intrusion of the AT in the autonomy and freedom of management of the taxpayer, but requires, only, a relationship of economic causality, in the sense that it suffices that the cost be incurred in the interest of the company, in order, direct or indirect, to the obtaining of profits. The legal notion of indispensability is thus carved out, over an economic-business perspective, by direct or indirect fulfillment, of the ultimate motivation of contribution to the obtaining of profit. The indispensable costs are equivalent to expenses incurred in the interest of the company or, in other words, in all acts abstractly subsumed under a lucrative profile. This desideratum brings, purposefully, the economic and tax categories closer, through a primarily logical and economic interpretation of legal causality. The indispensable expense is equivalent to all costs incurred in order to obtain income and which represent an economic decline for the company. As a rule, therefore, the fiscal deductibility of the cost depends, only, on a causal and justified relationship with the company's activity. And outside the concept of indispensability will remain only the acts inconsistent with the corporate purpose, those that are not inserted in the interest of the company, especially because they do not aim at profit." (Decision of the Higher Administrative Court, delivered on 30-11-2011, process no. 0107/11);

• The rule is that correctly recorded expenses are tax costs; the criterion of indispensability was created by the legislator, not to allow the Administration to intrude in company management, dictating how it must apply its means, but to prevent the tax consideration of expenses which, even if recorded as costs, do not fall within the scope of the company's activity, were incurred not for its pursuit but for other interests unrelated thereto. Strictly speaking, they are not true costs of the company, but expenses which, having regard to their object, were abusively recorded as such. Without the Administration being able to evaluate the indispensability of costs in the light of criteria focused on their opportunity and merit. The concept of indispensability cannot only not be made equivalent to a strict judgment of imperative necessity, as has been said, but also cannot be based on a judgment about the convenience of the expense, necessarily made a posteriori. For example, expenses made with an advertising campaign that proved fruitless cannot, solely on the basis of that result, be asserted to be dispensable.

The judgment on the opportunity and convenience of expenses is exclusive to the businessman. If he decides to make expenses with a view to pursuing the company's purpose but is unsuccessful and those expenses prove, ultimately, unproductive, they do not cease to be tax costs. But every expense that is recorded as a cost and shows itself foreign to the company's purpose is not a tax cost, because not indispensable. We understand (...) that, under penalty of violation of the principle of tax capacity, the Administration can only exclude expenses not directly ruled out by law under strong motivation that convinces of that they were incurred beyond the corporate objective, that is, in pursuit of another interest than the business one, or, at least, with clear excess, deviating, in face of the objective needs and capacities of the company." (Decision of the Higher Administrative Court, delivered on 29-03-2006, process no. 01236/05);" (end of quotation).

On the fiscal deductibility of financial charges borne by the incorporating company after the merger, the following CAAD decisions have already pronounced: 120/2017-T, 110/2017-T, 560/2016-T, 537/2016-T, 508/2016-T, 491/2016-T, 88/2016-T, 93/2015-T, 92/2015-T, 42/2015-T and 87/2014-T.

Article 23 no. 1 letter c) of the IRC Code provides, moreover and insofar as it is relevant here, that "Expenses (...) are considered, in particular: c) interest on foreign capital applied in exploitation".

We now remain to apply these doctrinal and jurisprudential pointers to the concrete case.

In the case here presented, the first reverse merger operation occurred on 17-04-2007. In this operation, H…, Lda (incorporating company) incorporated by merger the company I…, Lda (incorporated company). Following this merger, a global transfer of the assets and liabilities of the incorporated company to the incorporating company occurred, the company having assumed responsibility for payment of the charges inherent in the loan agreement no. … concluded between the incorporated company (I…, Lda) and Bank J…, SA. As results from common sense and was reaffirmed by the witnesses listed, the incorporating company was the one that held at the date the license for operating a pharmacy.

On 06-03-2008 the Claimant, previously designated K…, Lda, was transformed into a joint-stock company, becoming designated A…, SA, with share capital of 200,000 €.

The second merger occurred on 31-12-2008, in which the Claimant incorporated the company H…, Lda, there occurring a global transfer of the assets and liabilities of that company to the sphere of the Claimant, the latter having assumed responsibility for payment of the charges inherent in the loan agreement no. … concluded between the incorporated company and Bank J…, SA.

As was written in the decision of the Higher Administrative Court of 13-04-2005, delivered in process 01265/04:

"The merger by incorporation, even though it implies that only the company into which the others are incorporated survives, with its own legal personality, does not have as a consequence, in the field of economic and business realities, the disappearance of the merged companies. Some commercial doctrine – see PINTO FURTADO, PINTO COELHO and PUPO CORREIA in the places cited in the appealed decision – points out that the merged company, losing its legal personality, nonetheless persists, modified, forming a whole with others, under conditions different from those that occurred before the merger. But the same economic reality continues to exist, the same set (now integrated in another more enlarged) of means devoted to a productive activity, which the partners, moreover, wanted to enhance with the merger.

That is, with the merger by incorporation a transformation of the company occurs, not an extinction, the integration not resulting in its disappearance, but in its alteration, even though it implies the loss of legal personality." (see also decision of the Superior Administrative Court of the South of 17-04-2012, delivered in process 04172/10)".

It is in relation to the entity whose costs are under consideration, having regard to the business activity that it develops, that the assessment of the fiscal deductibility of financial charges must be made. This fiscal deductibility presupposes that the costs incurred with financial charges possess a connection of causality with the business activity developed, that is, they serve the development of the activity of the company owing them.

It was proven that the reasons underlying the merger were the correction of inefficiencies detected, as well as the elimination of unnecessary costs, namely through the integration of the administrative facilities of the two companies with the resulting cost reductions, the concentration of sales effort and investment in advertising, the global reduction of administrative and logistical structures of the two companies through the integration of all treasury, accounting, human resources management and general management activities of the incorporating company and the better utilization and rationalization of actual personnel.

It was also proven that following the merger the Claimant company increased its assets, as to financial investments, intangible and intangible fixed assets, the value of assets having risen from 1,517,196.38 to 7,925,038 euros and from 2008 to 2015 it recorded a gradual increase in sales volume.

There is thus, in our view, a connection between the loan effected for the purchase of shareholdings and the strategy of growth and restructuring developed subsequently by the companies, which was carried out through two reverse mergers, as the entities intended to expand their business to new establishments.

The expenses with interest in question correspond to foreign capital which, by virtue of the merger, were recorded in the accounts and applied in the exploitation of the entity that bears them, as was concluded in the CAAD decision in process no. 120/2017-T. Indeed, properly understood the post-merger reality (non-fraudulent), one should accept that the entity resulting therefrom, although contained in the legal "shell" of the incorporating company, no longer corresponds to it, as it was configured before the said process of corporate reorganization, but is instead a synthesis between the incorporated and the incorporating company.

As referred to in the CAAD decision in process no. 120/2017-T, "citing the case law that precedes, continues 'the same economic reality to exist', the 'same set (now integrated in another more enlarged) of means devoted to a productive activity', in the exploitation of which the foreign capital whose interest charges come to have their deductibility questioned was applied, since the integration did not result in its disappearance, but in its alteration, even though it involved the loss of legal personality".

Thus, in light of this understanding of the effects of merger by incorporation – including the reverse – one cannot conclude otherwise than by the fulfillment of the requirements of the aforementioned letter c) of no. 1 of article 23 of the CIRC.

In conclusion, in our view the Claimant's position is well-founded, determining the declaration of illegality of the assessment impugned, whereby the claim is upheld with the consequent annulment of the corporate income tax assessment for the year 2012, with the legal consequences.

b) As to the alleged lack of reasoning of the corrections effected by the AT

The Claimant alleges that the AT failed to comply with the duty of reasoning of tax acts, provided in art. 77 of the LGT. Specifically it asserts:

"The Claimant understands that, among other defects, the aforementioned corporate income tax assessment suffers from the defect of violation of law, in that it is not properly reasoned in the terms of the law, given that at no moment are the corrections resulting from internal analysis stated in the Report, the reasons that motivate the Tax Authority to consider the financial charges associated with the bank loans no. … and no. …, contracted with Bank J…, S.A. borne during the year 2012, as not deductible for tax purposes. That is, the Tax Authority limited itself to presuming and concluding, without more, as to the non-indispensability and lack of connection of the said charges with the obtaining of gains subject to tax, without the taxpayer being afforded the opportunity to ascertain the cognitive process that determined the position assumed by the Tax Authority and that led to the correction in question."

The AT, on the other hand, alleges that it complied with the duty of reasoning required by law and attempts to use the reply as a complement to that reasoning.

In the inspection report containing the reasoning underlying the corrections it is stated that "in the case under analysis, it is verified that the two financings had as their purpose the acquisition of capital with no connection being verified with the activity of exploitation nor with obtaining profit and/or maintenance of the source of production".

That statement is manifestly insufficient for the duty of reasoning of tax acts to be considered fulfilled.

We understand that the AT, in the reasoning of the tax act, did not invoke sufficiently valid arguments to justify the assessment, in substitution or cumulatively with article 23 of the CIRC.

Indeed, the AT did not support the tax correction on article 38 no. 2 of the LGT or on article 73 no. 10 of the CIRC or even on article 63 of the CIRC (invoking an excessive quantification of interest between companies in special relationships).

For all the foregoing, it is concluded that the assessment impugned suffers from the defect of lack of reasoning, whereby it is illegal and must be annulled.

7. Decision

In light of the foregoing, it is determined that the claim formulated by the Claimant in the present tax arbitration proceedings be held to be well-founded as to the illegality of the corporate income tax assessment (IRC) no. 2016…, the interest assessment no. 2016… and the compensation act no. 2016…, for the year 2012, in the total amount of 52,121.33 €.

8. Amount of the Case:

In accordance with the provisions of article 315 no. 2 of the CPC and 97-A no. 1 letter a) of the CPPT and 3 no. 2 of the Regulation of Costs in Tax Arbitration Proceedings, the value of the action is fixed at 52,121.33 €.

9. Costs:

In accordance with article 22 no. 4 of the RJAT, and the Table I attached to the Regulation of Costs in Tax Arbitration Proceedings, the amount of costs is fixed at 2,142.00 €, to be borne by the Respondent.

Notify.

Lisbon, 18 December 2017.

Text prepared by computer, in accordance with article 138 no. 5 of the Civil Procedure Code (CPC), applicable by referral of article 29 no. 1 letter e) of the Tax Arbitration Regime, by me reviewed.

The Arbitrator

(Suzana Fernandes da Costa)