IRC Cost Deductibility and Financial Charges Indispensability – CAAD Arbitration 695/2015-T

ARBITRAL DECISION

The arbitrators Maria Fernanda Maçãs (presiding arbitrator), Ricardo Rodrigues Pereira and António Martins, designated by the Deontological Board of the Administrative Arbitration Centre to form the Arbitral Tribunal, agree as follows:

I. REPORT

1. On 23 November 2015, the commercial company A..., S.A., NIPC..., with registered office at Avenida..., ..., ..., Porto (hereinafter, the Claimant), filed a request for constitution of an arbitral tribunal, pursuant to the combined provisions of articles 2(1)(a) and 10(1)(a) and (2) of Decree-Law no. 10/2011 of 20 January, which approved the Legal Framework for Arbitration in Tax Matters, as amended by article 228 of Law no. 66-B/2012 of 31 December (hereinafter, abbreviated as RJAT).

1.1. The Claimant requests the declaration of illegality and consequent annulment of the Corporate Income Tax (IRC) assessment notice no. 2015..., relating to the fiscal year 2011, the assessment of compensatory interest no. 2015... and the respective statement of account adjustment no. 2015..., with a total amount to be paid of €247,761.28. For this purpose, it attached 13 (thirteen) documents and listed three witnesses, having not requested the production of any other evidence.

1.2. The Claimant did not proceed to appoint an arbitrator, wherefore, pursuant to the provisions of article 6(2)(a) and article 11(1)(a) of the RJAT, the President of the Deontological Board of the CAAD appointed as arbitrators of the collective Arbitral Tribunal Councillor Maria Fernanda Maçãs, Dr. Ricardo Rodrigues Pereira and Dr. Jorge Manuel Figueiredo, who communicated acceptance of the appointment within the applicable time period.

1.3. On 15 January 2016, the parties were duly notified of such appointment and did not manifest the intention to refuse the appointment of the arbitrators, in accordance with the combined provisions of article 11(1)(b) and (c) of the RJAT and articles 6 and 7 of the CAAD Code of Ethics.

1.4. Thus, in accordance with the provisions of article 11(1)(c) of the RJAT, the collective Arbitral Tribunal was constituted on 1 February 2016.

1.5. Due to the resignation of Dr. Jorge Manuel Figueiredo from his duties as arbitrator in this proceeding, Prof. Dr. António Martins was appointed in his replacement, who accepted the appointment.

1. To support the claim, the Claimant alleged, in summary, the following:

The Claimant's corporate purpose is to promote the rational use of energy and the diversification of energy sources through the identification, study, design and execution, using own resources or in association, of installations for the production of electrical energy and/or recovery of residual heat and its subsequent operation and sale of energy, under the form of financing by third parties.

Following tax inspection in respect of the fiscal years 2011 and 2012, the Tax Inspection Services alleged that the Claimant "(…) is financing itself at rates higher than those at which it will subsequently finance its associated companies through the financing obtained, that is, it is bearing financial charges for financing that it is channelling to its associated companies and that are not being used in its activity as an autonomous entity, not passing on the entirety of such costs incurred to the beneficiary entities of such financing". Accordingly, the inspection concluded that "the financial charges corresponding to the loans obtained are not fiscally deductible, for the purposes of determining the taxable profit for the fiscal years 2011 and 2012, in the proportion of the amounts that were not recharged to the companies for which the loans were channelled".

The Claimant carries out its corporate purpose through the interaction it maintains with its subsidiaries and associates. Thus, the development of its activity – which is carried out both directly and indirectly (i.e. through its subsidiaries/associates and other investees) – necessarily presupposes the granting of intra-group loans, insofar as such financing proves essential for the pursuit of the activity developed by its investees and, consequently, for the activity carried out by the Claimant itself.

At inspection, the Claimant alleged and proved that:

(a) It is remunerated for the loans granted to its investee B... (consortium for the construction and operation of wind farms);

(b) To finance B..., multiple supply contracts were executed between the consortium companies and B..., according to the financing needs of this latter company;

(c) In 2011, the Claimant charged an average interest rate of 4.448%, resulting from the application of a fixed rate + Euribor 12M or Mid Swap 5Y value; and

(d) In 2012, the Claimant charged an average interest rate of 5.568%, resulting from the application of a fixed rate + Euribor 12M or Mid Swap 5Y value.

The Claimant notes the fact that article 23 of the IRC Code, and its concept of indispensability, is the only legal ground invoked by the Tax Authority for the correction made. However, in its view, expenses should be considered indispensable whenever they are aimed at the obtaining of profit by the taxpayers, that is, whenever, in abstract terms, they are capable of enhancing the profit of companies.

The Claimant emphasises that the Tax Authority itself, in the inspection report, states that "(…) the TP has as its corporate purpose the management, promotion, development, installation and operation of projects and activities of cogeneration and renewable energies, including participation in companies or complementary groupings of companies that pursue the same activities."

Thus, the aforementioned corporate purpose provides the necessary framework for the financing effected by the Claimant to its subsidiaries, insofar as it follows from the object that it may carry out its activity – indirectly – through investees, associates and subsidiaries, which pursue activities in the energy sector.

From the Claimant's perspective, as results from the facts exposed, the costs incurred with the financing whose fiscal deductibility is contested in the present proceedings have already produced and enhanced profits. For this reason the Tax Authority would be contesting only and solely the differential between the interest borne and the interest earned, recognising that there was a generation of gains.

The financing granted by the Claimant is fundamental to the activity of the investees, enabling them to obtain profits that will subsequently be distributed to the Claimant/will enhance the Claimant's investment – i.e. there is a potential for the costs incurred with the loan to have a mediated return for the Claimant, influencing its results positively.

The Claimant contests the Tax Authority's argumentative approach when, on one hand, it questions the necessity of the cost but, on the other hand, appears to focus only on the interest amount, a matter that goes beyond deductibility and should be analysed solely from the perspective of transfer pricing, in particular, when the objection presented centres on the excess of interest borne compared to the interest earned.

And the Claimant further states that the difference in spreads and variable components in a loan may exist without the operations not being perfectly justifiable and classifiable under market conditions, namely by virtue of the different capacity to produce sufficient guarantees between the companies or even by virtue of the duration of the credit.

2.1. The Claimant concludes its initial pleading by requesting the following:

"A) The annulment of the 2011 IRC assessment and respective compensatory interest, in the amount of EUR 247,761.28, on the ground that such correction incurs a defect of violation of law, due to errors in legal and factual premises, translated in the erroneous application of article 23 of the IRC Code;

B) The declaration of unconstitutionality of article 23(1)(c) of the IRC Code, due to violation of article 61 of the Constitution of the Portuguese Republic;

C) The condemnation of the Tax Authority to pay compensation for undue guarantee, pursuant to article 53 of the General Tax Law and 171 of the Code of Tax and Customs Procedure,

All with the legal consequences."

1. On 4 March 2016, the Defendant, duly notified for such purpose, filed its Reply in which it specifically challenged the arguments put forward by the Claimant, concluding that the present action is unfounded, with its consequent dismissal of the claim.

3.1. In essence and also briefly, it is important to extract the most relevant arguments upon which the Defendant grounded its Reply:

For the Tax Authority, and in the context of the analysis of the interest values at issue, it was verified that the loans granted are superior to those obtained, which means that the company is financing itself from financial institutions and from the holders of capital, and in turn is financing its associates using both the financing obtained and the use of own resources, since it grants more financing than it obtains.

On the other hand, it was found that the income obtained from the loans granted are lower than the expenses incurred to finance itself, a situation which derives from the fact that the company is financing its associates at an interest rate lower, and in some cases even without interest, than that which it itself is bearing in its financing.

From the facts ascertained during inspection, the essential question in the present proceedings is whether the financial charges resulting from the financing which the Claimant obtained and with which it financed its associated companies, not passing on the entirety of such costs to the beneficiary entities, could be classified under article 23 of the CIRC, or whether, on the contrary, they did not meet the requirements for admissibility of costs established in this provision.

And from the reasoning of the challenged act it results, for the Tax Authority, manifestly demonstrated that the Tax Administration could not accept as a fiscal cost the financial charges relating to the financing of the Claimant's associated entities that were not being used in its activity, as an autonomous entity. In the Tax Authority's view, the argumentation put forward by the Claimant, both at inspection and in the present proceedings, fails to overcome the judgment made by the Defendant to the effect of excluding from the normative scope of art. 23 of the CIRC, the financial charges which were thus disregarded for fiscal purposes, which determined the corrections made.

Thus, notwithstanding the relevance assumed by the legal-economic reality underlying the fiscal norms, the law requires the demonstration of the indispensability of the expense in the obtaining of income and not merely the demonstration of the possibility of obtaining such income. That is, in order for a certain amount to be considered as a cost, it is necessary that it relate to the activity carried out by it itself and not by another company, even if belonging to the same economic group.

The indispensability referred to in art. 23 of the CIRC, as a condition for an expense to be deductible for the purposes of determining taxable profit, does not refer to necessity (expenses as a condition sine qua non of income), nor even to convenience (the expense as convenient for business organization), but requires, only, a relationship of economic causality.

The Tax Authority alleges that the essential expense is equivalent to any cost incurred in order to obtain income and which represents an economic decline for the company. Thus, the expenses provided for in that article 23 must relate, from the outset, to the contributing company itself, that is, in order for a certain amount to be considered an expense of that company it is necessary that the respective activity be carried out by it itself, not by other companies. And it is absolutely consistent that the financing is obtained for the benefit of the activity of the investees and not of it itself, now the fiscal costs have the company's own activity as a prerequisite, and costs of the exercise of the activity of another with which it had some relationship cannot, for this purpose, be imputed to it.

And the premise from which the Claimant starts to ground its claim is, for the Tax Authority, manifestly erroneous, insofar as the indispensability criterion created by the legislator is intended to prevent the fiscal consideration of expenses that, although accounted for as costs, do not fall within the scope of the company's activity, having been incurred for the pursuit of other foreign interests.

The fact that the Claimant is an intermediate holding of the C... Group does not mean that the activities carried out by the companies within the group lose their autonomy, all the more so that among the services it provides within this structure, where the contributions it makes are identified, there is a clear definition of the counterparts received, concretised in the management fee and the maintenance fee, there is no reference whatsoever to the financial charges sub judice.

Not being inscribed in the company's activity, the expenses were incurred not for the pursuit of its interests, but for foreign interests, they cannot be classified within the scope of its corporate purpose. The financial costs incurred by the Claimant are not directly related to any activity inscribed in its corporate purpose, nor do they refer, even indirectly, to its activity.

Consequently, interest borne by a company cannot be accepted as deductible in relation to loans in which it is manifestly demonstrated that the funds obtained are diverted from its own operation to that of another entity with which it is related. The mere possibility of possibly having future profits resulting from the application of such capital in its associate, or their actual existence, does not by itself determine that such investments can be classified under the concept of fiscal expenses, because for that it would be necessary that such charges were indispensable for the realisation of income or gains subject to tax or for the maintenance of the productive source, and the Claimant failed to make such demonstration.

Since all the reasoning of the corrections, which concludes that the financial charges borne by the Claimant are not a fiscal cost classifiable under art. 23 of the CIRC, clearly demonstrates that they do not derive from the business activity carried out.

Consequently, interest borne by a company cannot be accepted as deductible in relation to loans in which it was manifestly demonstrated that the funds obtained are diverted from the operation and applied to purposes foreign to it.

Thus, the costs associated with financing that is being used by other companies, not the Claimant, should be fiscally disregarded, in relation to the differential existing between the costs and the income derived from the financing obtained and granted. It being true that there was recharged interest, those were lower than those borne, a fact for which only the financial charges that were borne and not recharged to the actual beneficiary entities of the financing were fiscally disregarded.

The Defendant concludes its pleading as follows:

"In these terms, and in those others which Your Excellency shall duly supply, the present request for arbitral pronouncement should be judged unfounded, maintaining in the legal system the impugned tax assessment act and accordingly absolving the Defendant of the claim."

3.2. On 24 March 2016, the Defendant attached to the record the respective administrative file (hereinafter, abbreviated as PA).

1. On 13 April 2016, the meeting referred to in article 18 of the RJAT took place – in which the contents of the respective minutes were dealt with which are here reproduced – and the examination of two of the witnesses listed by the Claimant was also carried out, with the latter dispensing with the third which it had listed in its list. At that meeting, 1 August 2016 was also set as the deadline for the rendering of the arbitral award.

2. Both parties submitted written submissions, in which they reiterated the positions previously assumed in their respective pleadings.

II. SANITATION

The Arbitral Tribunal was duly constituted and is competent.

The proceeding is not affected by any nullities.

The parties have legal personality and capacity, are duly represented and are properly interested.

There are no exceptions or preliminary matters that prevent the adjudication on the merits and which must be dealt with.

III. REASONING

III.1. ON FACTS

§1. PROVEN FACTS

The following facts are considered proven:

a) The Claimant was constituted in July 1991, having as its corporate purpose to promote the rational use of energy and the diversification of energy sources through the identification, study, design and execution, using own resources or in association, of installations for the production of electrical energy and/or recovery of residual heat and its subsequent operation and sale of energy, under the form of financing by third parties. [cf. document no. 5 attached to Initial Pleading]

b) The Claimant's capital structure was altered in mid-2011, becoming 100% owned by "Group D...", as it being then already held 50% by "C... España, SL", the latter acquired the 50% that belonged to the previous shareholder, "E...". [cf. PA attached to the record]

c) The Claimant has since fully integrated into the "C..." universe, a global leading economic group in the sector of electricity production through the use of renewable resources. [cf. PA attached to the record]

d) Which had an impact on its financing structure, as it ceased to be financed by third parties and began to be financed by intra-group loans, having ended in 2011 the external financing it had obtained through commercial paper programmes. [cf. PA attached to the record]

e) The Claimant is an intermediate holding of the "C..." Group which, in addition to equity interests in various companies in the energy sector, has resources and technical and human structures that allow for synergies and the enhancement of operational activity development by its respective subsidiaries.

f) In the year 2011, the Claimant was related to the entities and held the equity interests identified below [cf. PA attached to the record]:

g) The investee B..." constitutes a consortium for the construction and operation of wind farms.

h) The development of the Claimant's activity – which is carried out both directly and indirectly, through its subsidiaries/associates and other investees – necessarily presupposes the granting of intra-group loans, insofar as such financing proves essential for the pursuit of the activity developed by its investees and, consequently, for the activity carried out by the Claimant itself, enabling them to obtain profits that will subsequently be distributed to the Claimant and which will enhance the Claimant's equity interests.

i) The services provided by the Claimant break down as follows [cf. PA attached to the record]:

(1) A management fee, insofar as the companies that develop energy projects resort to resources in the Claimant's sphere, with a view to their exploitation, namely in the administrative, technical, financial and commercial areas.

(2) A maintenance fee, since the ACE's "S..." and "T...", in the context of their energy production activity in their cogeneration plants, resort to resources available in the Claimant's sphere, with a view to the operation of projects, namely in the area of equipment maintenance.

j) Regarding the year 2011, the Claimant declared the following values for IRC purposes [cf. PA attached to the record]: [values in document]

k) In the year 2011, the Claimant presents the following balances with respect to financing, both obtained and granted [cf. PA attached to the record]:

• Loans obtained: €103,836,584.00;
• Loans granted: €113,852,159.00.

l) With regard to financing costs and income recognised in 2011, these amount to the following [cf. PA attached to the record]:

• Costs: €4,781,874.00;
• Income: €3,437,136.00;
• Net costs: €1,344,738.00.

m) By virtue of holding an equity interest of 17.98% in its investee "B...", both the Claimant and the "C..." Group in which it is integrated were deprived of the power to impose on "B..." an interest rate in the financing different from that which was contractually agreed and practised (in the year 2011, an average rate of 4.448%).

n) All contracts and agreements underlying the definition of the interest rates practised were unanimously approved by the consortium members of "B...", not being dependent on a unilateral declaration of will by the Claimant.

o) The discrepancy between the interest rate at which the Claimant obtained financing and the interest rate it practised in the financing granted is explained by the fact that the former are tendentially long-term loans, contrary to what occurs with reference to the latter. [cf. documents no. 11 and 12 attached to Initial Pleading]

p) The objective was that the investee "B..." would come to be financed through project finance, with loans obtained from third parties, which only failed to happen due to the severe financial crisis that set in from the year 2011. [cf. document no. 13 attached to Initial Pleading]

q) Under service order no. OI2014..., the Claimant was subject to an external general scope inspection action, covering the fiscal years 2011 and 2012, which was carried out by the Tax Inspection Division –... of the Porto Finance Directorate, having begun on 08/01/2014 and concluded on 05/05/2015. [cf. PA attached to the record]

r) In the course of said inspection procedure, the Tax Inspection Services requested that the Claimant indicate, with respect to the fiscal years 2011 and 2012, which interest rates were practised in the loans it obtained and granted. [cf. PA attached to the record].

s) Following this request, the Claimant provided the following clarification to the Tax Inspection Services [cf. PA attached to the record]:

"Interest on loans obtained (5% + Euribor 6M)
[details in document]"

t) Through letter no. .../..., dated 06/05/2015, from the Tax Inspection Services of the Finance Directorate... sent by registered mail, the Claimant was notified of the Draft Tax Inspection Report and, if it so wished, to exercise its right to hearing, with the following corrections being proposed in IRC, regarding the fiscal year 2011 [cf. document no. 6 attached to Initial Pleading and PA attached to the record]: [details in document]

u) On 02/06/2015, the Claimant exercised its right to hearing on that Draft Tax Inspection Report, having advocated there that the financing it granted to its associates is justified and fully admissible in light of the provisions of art. 23, no. 1 of the IRC Code (applicable at the date of the facts), whereby the maintenance of the proposed corrections appear manifestly illegal. [cf. document no. 7 attached to Initial Pleading and PA attached to the record]

v) The corrections to the Claimant's IRC, relating to the fiscal year 2011, mentioned in t), were fully maintained in the Tax Inspection Report, with the Claimant's exercise of the right to hearing being subject to appreciation by the Tax Inspection Services, in accordance with what is contained in that Report and which are here reproduced. [cf. PA attached to the record]

w) The aforementioned corrections relating to the taxable matter of IRC for the fiscal year 2011 had the following reasoning set out in the Tax Inspection Report [cf. PA attached to the record]: [reasoning details in document]

x) The Claimant was notified of the Tax Inspection Report, through letter no. .../..., dated 09/06/2015, from the Tax Inspection Division –... of the Finance Directorate… sent by registered mail with acknowledgement of receipt. [cf. document no. 4 attached to Initial Pleading and PA attached to the record]

y) Due to the aforementioned corrections, the following were issued: an additional IRC assessment no. 2015..., dated 24/06/2015, relating to the fiscal year 2011, in the amount of €92,997.89, a compensatory interest assessment no. 2015..., in the amount of €25,348.91, as well as the offsetting no. 2015..., dated 29/06/2015, and the statement of account adjustment no. 2015..., in which a total amount to be paid of €247,761.28 was determined, with a voluntary payment deadline of 27/08/2015. [cf. documents no. 1, 2 and 3 attached to Initial Pleading]

z) The Claimant did not make the payment of the amount of €247,761.28, resulting from the aforementioned statement of account adjustment no. 2015....

aa) As a consequence of this failure to pay, the tax enforcement proceeding no. ...2015..., in the amount of €248,805.06 was initiated. [cf. document no. 8 attached to Initial Pleading]

ab) The Claimant, with a view to obtaining the suspension of that tax enforcement proceeding, provided a bank guarantee, issued by Bank Z... and to which was assigned the number..., in the amount of €314,628.21. [cf. document no. 9 attached to Initial Pleading]

ac) On 23 November 2015, the Claimant filed the request for constitution of an arbitral tribunal which gave rise to the present proceeding. [cf. procedural management computer system of the CAAD]

§2. UNPROVEN FACTS

With relevance to the appraisal and decision of the case, there are no facts that have not been proven.

§3. REASONING ON FACTS

With regard to the facts proven, the Tribunal's conviction was based on the facts alleged by the parties, whose correspondence to reality was not called into question, on the documents and the respective administrative file attached to the record and also on the witness evidence produced.

Regarding the statements given by the witnesses listed by the Claimant – AA... and BB... who testified in a clear, objective and impartial manner on the facts to which they were examined, revealing unequivocal direct knowledge of the same, whereby their statements merited full credibility – they corroborated, in essence, the facts alleged by the Claimant, with respect to which they were examined.

III.2. ON LAW

The Claimant grounds its request for declaration of illegality and consequent annulment of the 2011 IRC assessment and other contested tax acts on the alleged violation of art. 23(1)(c) of the IRC Code, also arguing the unconstitutionality of this same legal norm due to violation of the principle of private initiative, set out in art. 61 of the Constitution of the Portuguese Republic.

Article 124 of the Code of Tax and Customs Procedure (CPPT), applicable ex vi article 29(1)(a) of the RJAT, provides that the tribunal must prioritarily appreciate the defects that lead to the declaration of non-existence or nullity of the challenged act and, subsequently, the defects that lead to its annulment (no. 1). With regard to defects that constitute non-existence or nullity, the judge must prioritarily know of the defects whose success determines, according to his prudent judgment, more stable or effective protection of the offended interests. As for defects that constitute annullability, the same criterion is established, which shall only not apply if the challenger has established a relationship of subsidiarity between the defects imputed to the act – which is permitted by article 101 of the CPPT – in which case priority is given to his will (provided that the Public Prosecutor has not argued other defects) (no. 2).

The rules emanating from this legal norm on the order of knowledge of defects are intended to protect the challenger's interest with maximum procedural efficiency, omitting pronouncement on defects invoked when the defect or defects already recognised prevent the renewal of the act with the same sense. Indeed, the establishment of this order of knowledge of defects presupposes that, knowing of a defect that leads to the legal elimination of the challenged act, the tribunal will cease to know of the rest, for if the judge had to know all defects imputed to the act, the order of knowledge would be indifferent.

The protection of offended interests is more stable when the decision prevents the renewal of the harmful act affecting the interests of the challenger and will be more effective when it allows the interested party, in execution of the judgment, to obtain a better satisfaction of its interests, affected by the annulled act.

Thus, for example, if it is a defect of violation of law, the annulment of the act will prevent the practice of a new tax act in which the same norm that was at issue in the previous act is applied or not applied, which will result in the impossibility of practising a new act that imposes taxation on the challenger.

As it follows from what has just been said, it is having regard to the execution of the annulment judgment and the influence it has on the type of defect that grounded the annulment that the establishment of an order of knowledge of the defects of the challenged act is justified.

In this framework, returning to the concrete case, it is thus necessary to begin with the appraisal of the defect of violation of art. 23(1)(c) of the IRC Code, for if verified, it will definitively rule out the possibility of imposing on the Claimant a new tax assessment act, thereby achieving more stable and effective protection of its interests. Moreover, only if and to the extent that it is concluded that the interpretation and implementation of the normative solution resulting from it precludes the subsumption of the situation sub judice to the respective legal provision will it be important to proceed to the appraisal of the question of unconstitutionality of that same legal norm, as alleged.

§1. ON THE INTERPRETATION OF ARTICLE 23 OF THE IRC CODE, IN PARTICULAR THE CONCEPT OF "INDISPENSABILITY"

In the process of structuring the decision rendered herein, the Tribunal will begin by presenting the general grounds it considers applicable to the subject matter at issue.

Subsequently, the Tribunal will invoke such grounds to reach the decision relating to the concrete case.

Thus, in this part, the following key questions will be particularly analysed:

i) the interpretation of article 23 of the CIRC and the question of "indispensability" of expenses;

ii) the concept of "activity" of business entities;

iii) the concept of asset and productive source; the notion of financial asset and the nature of its income;

iv) where a participed company becomes indebted and transfers those funds to participed entities, charging them with interest none or lower than paid, is it developing its own activity or others' activity (i.e., carrying out acts of management alien to its interest)?

i) On the interpretation of article 23 of the CIRC and the question of "indispensability" of expenses

Article 23 of the CIRC provided, at the time (2011) to which the contested facts relate (of which the respective no. 1 is transcribed below):

"Article 23

Expenses

1 — Expenses are those that are demonstrably indispensable for the realisation of income subject to tax or for the maintenance of the productive source, in particular:

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) Those relating to distribution and sale, including transport, advertising and placement of goods and products;

c) Of a financial nature, such as interest on foreign capital applied in the operation, discounts, premiums, transfers, exchange differences, costs with credit operations, debt collection and issuance of bonds and other securities, redemption premiums and those resulting from the application of the effective interest method to financial instruments valued at amortised cost;

d) Of an administrative nature, such as remuneration, including those attributed as participation in profits, allowances, current consumption materials, transport and communications, rent, litigation, insurance, including life and "Life" class operations, contributions to savings-retirement funds, contributions to pension funds and to any supplementary social security schemes, as well as expenses with employment termination benefits and other post-employment or long-term employee benefits;

e) Those relating to analysis, rationalisation, research and consultation;

f) Of a fiscal and parafiscal nature;

g) Depreciation and amortisation;

h) Adjustments in inventories, impairment losses and provisions;

i) Expenses resulting from the application of fair value in financial instruments;

j) Expenses resulting from the application of fair value in biological assets that are not multi-annual forestry operations;

l) Realised losses;

m) Compensation resulting from events whose risk is not insurable.

Thus arises in this provision a core requirement in the admissibility of expenses for fiscal purposes: their indispensability. What should be understood by "indispensability"? Between us, two analyses are customarily invoked on which the appropriate interpretation of the concept of indispensability set out in article 23 of the CIRC should be.

They are authored by TOMÁS TAVARES, "On the relation of partial dependence between accounting and tax law in the determination of taxable income of legal entities: some reflections at the level of costs", in Science and Tax Technique, no. 396, 1999, p.7-180; and ANTÓNIO M. PORTUGAL, "The deductibility of costs in Portuguese tax case law", Coimbra Editora, 2004.

Doctrine and case law frequently draw on these works (see, with regard to these references, among others, the Award of the Supreme Administrative Court (STA), of 30-05-2012, in Case 0171/119, as well as other awards therein referenced. In doctrine see, among others, RUI MORAIS, Notes on IRC, Almedina, Coimbra, 2007 and J. L SALDANHA SANCHES, The limits of tax planning, Coimbra Editora, 2006).

In the first of the mentioned works, TOMÁS TAVARES extensively analyses the question relating to the interpretation of the concept of indispensability contained in article 23 of the CIRC. The author points out three possible interpretations, arguing that only one of them constitutes the correct solution. A first understanding would be translated into a necessary or obligatory relationship between costs incurred and income obtained. Such an understanding of indispensability would mean that only the "absolute necessity" of an expense to obtain income would allow it to be deducted as a negative component of taxable profit. The author qualifies such an interpretation as absurd. He does so in the following terms: "…the narrowing proposed by this conception would lead to the fiscal disregard of certain declines actually borne by the organisation, in clear and flagrant violation of the principle of contributory capacity….Secondly, given that, at the limit, the deductibility of costs connected with businesses that proved ruinous for the company would never be accepted, given the absence (or insufficiency) of income derived therefrom. Yet the truth is that Tax Law cannot censure an unfruitful business policy…Tax Law must recognise the right to error of the business owner."

A second interpretation of the concept of indispensability – meaning "convenience" – is treated by the author in the following terms: "…this goal does not arise as a yardstick for interpretation, both in view of the numerous practical problems it raises, and above all, because it also allows administrative control over the merit of business decisions. Indeed, convenience is a fragile concept, with an open and undefined significance, which is conducive to administrative interference in the economic choices of taxpayers".

Finally, the author follows the thesis that the correct interpretation of the concept of indispensability is the one that equates essential expenses to costs incurred in the interest of the company, in the pursuit of activities resulting from its corporate purpose.

This thesis is expressed in the following terms: "The legal notion of indispensability is therefore carved out from an economic-business perspective, through direct or indirect fulfilment of the ultimate motivation for obtaining profit. Essential costs are equivalent to expenses incurred in the interest of the company or, in other words, in all acts abstractly subsumable in a profit-generating profile. This objective brings, purposefully, economic and fiscal categories closer together, through an interpretation primarily logical and economic in nature of legal causality. The essential expense is equivalent to any cost incurred in order to obtain income and which represents an economic decline for the company. As a rule, therefore, the fiscal deductibility of the cost depends only on a causal and justified relationship with the company's productive activity".

And it continues: "…Indispensability subsumes all and any act carried out in the interest of the company…The legal notion of indispensability thus suppresses acts non-conformable with the purpose of the company, not to be inserted in the corporate interest, above all because they do not aim at profit…".

It should be noted, for now, that the quoted text leaves us in no doubt as to the author's position (essential costs are equivalent to expenses incurred in the interest of the company). However, the fact is that an excerpt from that text, in particular the relationship between expenses and productive activity, has served interpretive purposes of the concept of indispensability that even the author himself has clearly eliminated, in the award relating to case no. 12/2013-T, of the CAAD, as will be seen below.

A. MOURA PORTUGAL, discussing the same concept, deals above all with the history of the judicial interpretation made of it from the time of Industrial Contribution until 2001. In any case, this author, and regarding the question of knowing which is the best interpretation of the concept of indispensability, adopts the following position:

"The solution adopted among us (at least in doctrine), following the understandings put forward by Italian doctrine, has been to interpret indispensability according to the corporate purpose. This position is present from the outset in the writings of Vítor Faveiro, who reduces the indispensability of the expense to its appraisal as an act of management in accordance with the concrete corporate purpose, refusing that this indispensability can be assessed freely from any subjective judgment of the law applier".

See also what T. TAVARES refers to regarding intra-group loans, already in 1999:

"These operations (free supply from a participant to a participed company) correspond, therefore, to normal acts of management, notwithstanding the apparent non-conformity with the interest of the sacrificed entity (...) The ratio of these legal options lies in the fact that with them, the company pursues its business activity with a lucrative aim…".

And in note 427, p. 150 of the aforementioned work, the author supports the following: "In our opinion, this operation (paying interest for obtaining a loan, whose product is lent, without interest, to another entity) can fit within the lucrative scope of the sacrificed entity…".

In summary: the most frequently invoked doctrinal works on this question exclude the interpretation of the concept of indispensability as meaning a necessary causal link between costs and income. Both sustain that any economic decline (cost) that has a relationship with the corporate purpose, whether incurred within the framework of the activity or in the interest of the company, will meet the requirement of indispensability, and for this reason should not be denied fiscal acceptance under article 23 of the CIRC.

The doctrinal anchor which the Tax Authority, and some case law, have extracted from the work of TOMÁS TAVARES on the subject under examination here – according to which the obtaining of funds by a participant transferred without remuneration to a participed company does not constitute activity or interest of the former – was widely undone by the author himself, as follows. In case no. 12/2013-T, within the CAAD scope, where he was sole arbitrator, T. TAVARES decides on the deductibility of these expenses with the following grounds (bold by the Tribunal):

"Indispensability between costs and income is assessed in an economic sense: essential costs are those incurred in the interest of the company, which are linked to its capacity, by insertion in its lucrative scope (mediately or immediately) and in the exercise of its concrete activity.

The Tax Authority cannot scrutinise the soundness and opportunity of the company's business management decisions. It cannot interfere in the freedom and autonomy of the company's management. A cost will be fiscally accepted if it is adequate to the company's productive structure and to the obtaining of profits, even if it turns out to be an economically unfruitful or economically ruinous operation.

The essential expense is equivalent to any expense incurred in order to obtain the income and which represents an economic decline for the company. Article 23 of the CIRC requires not only an adequate causal connection between the cost and the income (in the aforementioned economic terms), but also alternatively connects (as the word "or" indicates) with the maintenance of the productive source – in the sense of an economic link between the expense and the existence and maintenance of the company and its activity.

A company may obtain funds (and pay interest) and then deliver those funds to a subsidiary without any causal and direct remuneration – and still properly exercise its activity, within its capacity and lucrative scope: it may effect an increase of capital (art. 25 of the Commercial Code), supplementary or accessory contributions without interest (art. 210 and 287 of the Commercial Code) or free supplies (art. 243 of the Commercial Code) – and in any of these cases it acts fully within its exercise capacity and with a lucrative intent and in the exercise of its activity".

In the view of this Tribunal, equating the notion of indispensability to a relationship with productive activity or to a mandatory nexus of causality with the obtaining of income is therefore not a position supported by reference doctrine.

Beyond what has already been said, and still on this nexus of causality, see the position of DIOGO LEITE DE CAMPOS AND MÓNICA LEITE DE CAMPOS: "To admit a posteriori administrative judgment on the company's financial, commercial, etc., management would involve the constant risk of this judgment being based on supplementary elements that did not exist, or did not exist clearly, at the moment of decision-making and which could not have been taken into account. The tax administration does not have to judge whether a company was well or poorly managed".

See also RUI MORAIS, who sustains: "The invocation of the rule of indispensability of costs can never be made to substitute judgment on the convenience and opportunity of the costs assumed, as resulted from the decision of the corporate bodies, for another judgment, also of a business nature made by the tax administration or the courts".

And it continues: "We cannot consider good the orientation of certain case law that refuses fiscal accreditation of certain costs because it is not possible to establish a direct correlation with the obtaining of concrete income. Carried to extremes, such an understanding would mean that research expenses would only be fiscally deductible when such investigations were successful, when as a result the company began to sell new goods and services…"

To conclude as follows: "We argue that the question of knowing whether a cost should or should not be deemed indispensable should be resolved from the objective intent of the transaction, that is the business purpose test… We believe it is relatively clear what the norm is seeking: to refuse fiscal participation in some of the expenses borne by the taxpayer… If the assumption of the expense was presided by a genuine business motivation… the cost is indispensable. When it should be concluded that the expense was determined by other motivations (personal interest of partners, administrators, creditors, other companies in the same group, business partners, etc., then such cost should not be deemed indispensable."

Conclude this doctrinal digression with J. L. SALDANHA SANCHES, who states: "…knowing whether a certain cost corresponds, or not, to the most effective defence of the company's interests is a question that cannot be resolved by granting a power of State intervention…in order to conduct a judgment of merit on a certain management choice, just as it cannot validate the qualification of the expense as a cost by subjecting it to the condition of the ex post verification of the actual generation of income".

Let us now look at case law on the question, in general terms, relating to indispensability and its meaning, that is, without yet dealing with financial charges and the operations being assessed in this case.

In case 03022/09 – Award of 6 October 2009 – of the South Administrative Court of Appeal (TCA Sul) the following dispute was judged. A company (A) transferred to another (B) its own machinery commercialisation activity. In the context of this transfer, the personnel of A also moved to company B, and A ceased to carry out commercial activity, limiting itself to receiving rent from a property. However, at the time of said transfer, it had been agreed between A and B that the first would bear any charges with compensation to personnel in case rescissions were negotiated.

In a given fiscal year such negotiations occurred and A bore a certain amount of costs related to said compensation that its accounts recorded. The tax inspection disregarded these costs, on the grounds that "the company is without activity and without personnel (having as income only the rent received), considering that this cost does not become necessary for the formation of income, in accordance with article 23 of the CIRC".

In the award handed down, the South Administrative Court of Appeal treats the concept of indispensability at length and does so in the following terms: "But how should the concept of indispensability be assessed? Accepting that we are faced with a vague concept requiring completion and accepting that we are not, as to such completion, faced with any power of discretion (in terms of technical discretionarity) on the part of the Tax Administration, it is important to then note how the law frames such concept. (…)

Appealing to the study of TOMÁS TAVARES (…) we will say, as the author points out, it seems evident that from the legal notion of cost provided by article 23 of the CIRC it does not result that the Tax Administration can question the principle of freedom of management, scrutinising the soundness and opportunity of the company's business management decisions and considering that only those from which income directly derives or which prove convenient for the company can be fiscally assumed.

The indispensability referred to in article 23 (…) 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 indirectly, to obtain profits. (…) And outside the concept of indispensability will remain only the acts non-conformable with the social purpose, those that do not fit within the interest of the company, above all because they do not aim at profit".

Also on this subject, and with reference to a decision of the North Administrative Court of Appeal - case 00624/05.OBEPRT, award of 12 January 2012 – it is stated there: "In the consideration and completion of this indeterminate concept – indispensability – the analysis of a concrete cost must be made according to corporate activity, that is, according to its objective within the framework of the company's activity; essential costs will be equivalent to expenses incurred in the interest of the company. The criterion of indispensability was created by the legislator precisely to prevent the fiscal consideration of expenses that, despite being accounted for as costs, do not fall within the scope of the company's activity, that were incurred not for its pursuit but for other foreign interests".

Finally, in an award of 29/3/2006 – case no. 1236/05 – the Supreme Administrative Court sustains that: "The concept of indispensability, being indeterminate, has been filled in by case law casuistically (…). The rule is that expenses correctly accounted for are fiscal costs; the criterion of indispensability was created by the legislator, not to allow the Administration to interfere in the company's management, dictating how it should apply its means, but to prevent the fiscal consideration of expenses that, although accounted for as costs, do not fall within the scope of the company's activity, were incurred not for its pursuit but for other foreign interests. Strictly speaking, they are not true company costs, but expenses that, having regard to their purpose, were abusively accounted for as such. Without the Administration being able to assess the indispensability of costs in light of criteria incidenting on their opportunity and merit".

And, further on, this award states "that, under penalty of violation of the principle of contributory capacity, the Administration can only exclude expenses not directly ruled out by law under strong motivation that convinces that they were incurred beyond the corporate objective, or, at least, with clear excess, deviant, in the face of the objective needs and capacities of the company".

The legal interpretation of the concept of "indispensability" contained in article 23 of the CIRC has been, as doctrine and case law show, equated to costs incurred in the interest of the company; to expenses borne within the framework of activities resulting from its corporate purpose. Only when costs result from decisions that do not meet such requirements should they then be disregarded.

There has thus been ruled out a necessary link to income; a mandatory nexus of causality. Equally ruled out has been the possibility of the tax administration judging the correctness of management decisions regarding the actual obtaining of income (scrutinised ex post), provided that such decisions are taken within the framework of business interest.

At this point, the Tribunal understands that it should address at length the notion of business activity. This interpretation has often been used by the Tax Authority and the courts, whereby it deserves careful analysis.

ii) On the concept of "activity" of business entities

According to what can be consulted in the Universal Dictionary of the Portuguese Language, Text Editora, Lisbon, 1995, "activity" means: quality of being active, diligence, readiness. For its part, "active" means: that acts, laborious, diligent. Finally, "act" has the meaning of: to exercise action, to determine, to influence.

From this it follows, in our understanding, that activity must mean the set of actions or acts that determine or influence the life of the business. Having collective entities a scope or social objective defined in their statutes, with a view to achieving the purpose for which such collective entities are formed – the obtaining of a surplus to be distributed among partners – then the acts of management that contribute to such purpose must constitute the activity of the companies.

Should this activity be assimilated to "productive activity"? This Tribunal understands that it should not. No legal provision authorises such an identity of concepts, the economic interpretation of business operations entirely rejects such equation, and doctrine (where, supposedly, there would exist an interpretive base that would justify such assimilation) not only does not sustain it but has already rejected it.

The activity of a company, in the sense that only from it would derive essential costs, could never be assimilated to productive activity, in the context where it is translated into the set of operations of transformation or production of goods and services. The exploitation cycle of companies comprises pre-productive activities: legal formation of the entity, pre-investment studies, research, development, supply and others. And, as is obvious, it also encompasses post-productive activities: commercial, after-sales assistance, etc. Moreover, it also includes administrative and financial activities, which are concomitant to these pre and post-productive phases. Such is an economic evidence that does not require, as we judge, further substantiation.

Productive activity should not be understood in a restrictive sense, but rather in a broad sense, meaning activity related to a source of income generation of the entity bearing the expenses. We believe this is the appropriate sense of the expression "productive activity", both in the work of T. TAVARES and in the fiscal sense used by the Tax Authority and some case law.

Indeed, if it were otherwise, article 23 would certainly not admit as deductible costs administrative expenses, financing and even losses. These expenses do not directly relate to productive activities, strictly speaking, and yet they are provided for in law. Also, for example, the destruction of inventories or the financing of certain assets that were withdrawn from production (which may be designated, under certain conditions, as "non-current assets held for sale") would be excluded from the activity of companies, understood in that restrictive sense, which would be unacceptable.

In seeking the sense of the concept of activity of companies, it cannot be limited to mere or simple operations of production of goods or services. To say that a cost must verify a relationship with productive activity can only mean verifying a relationship with the overall economic operations and exploitation, or with the operations or acts of management that fit into the pursuit of the proper interest of the entity assuming such costs.

In that sense, the activity of a company will consist of operations resulting from the use of its assets, in particular its assets and the management of its liabilities. That is, the way in which its management will use the business assets in the context of the various operations (productive, commercial, investment and disinvestment, general financing, acquisition of financial interests and others) which, taken together, allow the entity in question to meet its economic purpose: the pursuit (immediately or in the long term) of an economic surplus (profit).

The point this Tribunal underlines is the following: the "activity" of a company is not exhausted, as often seems to emerge from some interpretations, in the set of productive or operational operations. "Activity" is also the set of operations that have as their purpose the realisation of investments or the alienation of assets, the acquisition of financial interests and their subsequent sale, the application of liquidity to investments or short-term securities and their management, the receipts and payments resulting from operational or non-operational income and expenses, and many others not expressly referred to here.

The management of companies has, essentially, as its purpose to obtain a surplus from the use of assets that are held by economic-business entities. Such assets are, even through their classification in normative-accounting terms, divided into different types. Tangible fixed assets/fixed assets (e.g., machines used in production), intangible assets (e.g., manufacturing patents), financial assets (e.g., equity interests), non-current assets held for sale (e.g., a machine that was no longer used in production and is intended to be sold short-term), inventories/stock (e.g., raw materials) and so on.

Constituting this vast array of assets the means which management has available to generate income and surpluses, it is natural that the purchase of physical assets for investments and their possible sale (disinvestment), the purchase and sale of financial interests, the application of liquidity, the receipts and payments of the activity, all of this is part of what is considered normal or appropriate acts of a company's management.

The meaning and economic scope of such operations depend on the economic-financial characteristics of the entities but, in a general sense, all of them subsume into objectives and instruments of business management, because they all fall within the scope or purpose of the activity carried out.

Business activity that has a relationship with essential costs extends to all acts of management that aim at the interest of companies. This set of operations encompasses, in the understanding of this Tribunal, the acts of management of the assets and liabilities that constitute the means at the disposal of business entities, provided that such acts conform to the scope, purpose or objective of these collective entities.

In summary conclusion of this point, business activity that generates deductible costs must be that which is translated into operations that have a purpose, an intent (and never a mandatory immediate nexus of causality) of obtaining income or the purpose of maintaining the potential of a source of income generation.

If business activity has as one of its salient traits the use and management of assets, what should then be understood by assets and what functions do they perform in the context of the pursuit of activity, exploitation, or business purpose?

iii) Concept of asset and productive source; the notion of financial asset and the nature of its income

Let us first see the definition that the accounting system contains for "asset". It is as follows: "it is a resource controlled by an entity as a result of past events, and from which it is expected that future economic benefits will flow to the entity".

This definition makes it clear that if an entity possesses a resource controlled by it (tangible, intangible, biological, financial or otherwise) from which future economic benefits are expected, such element will constitute an asset that should be recorded in the balance sheet. It is thus on the basis of these elements that the activity of companies develops, which, obviously, can present various facets or aspects of implementation (e.g., productive, commercial, financial, administrative) depending on the nature of the assets that sustain it.

The conceptual framework of the accounting system – which forms the theoretical-normative basis of financial accounting – goes even further in developing the characterisation of assets used by business entities. Let us see the respective §§ 52, and 54 to 56:

"52 — The future economic benefits incorporated in an asset are the potential to contribute, directly or indirectly, to the cash flow and cash equivalents for the entity. The potential may be a productive potential that forms part of the entity's operational activities. It may also take the form of convertibility to cash or cash equivalents or the ability to reduce cash outflows, such as when an alternative manufacturing process lowers production costs.

54 — The future economic benefits incorporated in an asset may flow to the entity in different ways. For example, an asset may be:

(a) Used alone or in combination with other assets in the production of goods or services for sale by the entity;

(b) Exchanged for other assets;

(c) Used to settle a liability; or

(d) Distributed to the owners of the entity.

55 — Many assets, for example, tangible fixed assets, have a physical form. However, physical form is not essential to the existence of an asset; hence patents and copyrights, for example, are assets if it is expected that future economic benefits will flow to the entity from them and if they are controlled by the entity.

56 — Many assets, for example, amounts receivable and property, are associated with legal rights, including the right of ownership."

And, embodying the concepts that have just been transcribed, the chart of accounts of the SNC, which does not diverge significantly from what was contained in the POC for what matters here, identifies, among others, the following assets:

"4- INVESTMENTS

41 Financial investments

42 Investment properties

43 Tangible fixed assets

44 Intangible assets

45 Investments in progress

46 Non-current assets held for sale"

The breadth of assets recorded in the balance sheet is very significant. We have physical assets (e.g., merchandise, tangible fixed assets), incorporeal assets (intangibles), money and equivalents (e.g., cash and deposits), long-term financial assets (e.g., financial investments); contractual rights (e.g., customers, loans granted, other accounts receivable).

An element of assets, of a financial nature, embodied in an equity instrument of another entity, in a contractual right to receive money or other financial asset of another entity, or to exchange financial assets or financial liabilities under conditions that may be favourable, constitutes an asset, bearing in mind its characteristic of (expected) generation of future economic benefits. If such characteristic is not present, it will not even be recognised accountingly as such.

The fact that it is potential or expected income does not disqualify an asset: from an asset it is expected, estimated, that future economic benefits will flow from it.

The acquisition of physical assets (such as buildings or machines) is also carried out expecting that the expected rate of return for those assets will exceed the cost of capital that finances them. We are, in the field of investments, physical or financial, in the situation of comparing expectations of profitability with the cost of capital that finances the assets. The potential nature of the generation of results is inherent to any type of investment, and not only to financial assets. And what will govern the acquisition of some and others will be the interest of the company, which always derives from a prior evaluation of its expected or prospective profitability.

Risk constitutes an element present in economic activity, making uncertain the obtaining of income from many investments carried out. Moreover, with equity instruments (e.g., quotas, shares, supplementary contributions) are associated contingent income, and not contractualised or certain flows.

This means that a financial asset which is translated into an interest of capital in a certain entity will have income subject to the variability (standard deviation or volatility) of the performance of the entities in which it was invested, and not to the nature of a pre-fixed or deterministic remuneration.

iv) Where a participed company becomes indebted and transfers those funds to participed entities, charging them with interest none or lower than those paid, is it developing its own activity or that of others (i.e., carrying out management acts alien to its interest)?

To analyse this point, suppose that a participant (let us call it ALFA, SA) becomes indebted and transfers the funds thus obtained, for which it pays interest at the rate of 5%, to its participed company which we will call here BETA. Such transfer of funds is made in the form of loans, for which it is charged, let us admit in a first hypothesis nil interest, and in a second situation, interest of 4%.

The financing coming from the participant will be made in the interest of this one if it serves to generate an expectation of future income directly resulting from it. Or, still, that such funds contribute to keeping BETA operating, that is, allowing to maintain or sustain the financial asset of the participant as a patrimonial element from which advantages are expected, albeit future and not immediately quantifiable. This independent of the interest charged being nil or positive. As will be seen below, the interest rate charged may be appraised in light of other provisions of the CIRC, but it is not believed that it should be in light of article 23 of the same code.

In a company that, hypothetically, acquires machines for production and, due to factors external or internal to the undertaking, such machines do not generate taxable results, repairs, depreciations and other expenses inherent to its operation must be admitted as costs. Also in a general sense, the purchase of stock that subsequently deteriorates has no causal nexus with income, but, as is obvious, such acquisitions must be fiscal costs, provided that such deterioration is inherent to the business risk.

It will be said that the machine and the stock contribute to the activity of the entity that incurs those costs, or that at least they were acquired with the aim or intent of maintaining or reinforcing the productive source. But if that is so, then if the financing which, in the example presented here, ALFA carries out for BETA has a relationship with expected income for ALFA, or contributes to maintaining the financial asset (interest in BETA) as a productive source, or enhances that potential for benefits for the participant, the condition for the deductibility of interest in ALFA does not differ from that required for the machine or the stock referred to above.

In any case there is a relationship with the activity of the company carrying out such operations: the purchase of the machine, the acquisition of stock or the acquisition of financial assets. The difference may lie in the fact that the machine and the stock have economic implications within the company that acquired them, and the financial interest, being an asset whose management constitutes activity of the participant, will generate income according to the expected evolution of the investee's business. But this does not remove from the financial investment the qualification of an asset managed in the interest of the entity (participant) that acquired and holds it.

Thus, in the question discussed in this point, the deductibility of interest borne by the participant will depend on the fact that such financing contributed to, according to normal management rules, enhance the expectation of future benefits or to maintain the productive source (financial asset) of ALFA.

This means that the expenses resulting from the financing obtained by ALFA and which was subsequently applied in financing BETA must satisfy one (or both) of the following conditions:

a) Being associated with the expectation of enhancement of the benefits of the participant;

b) Allowing the maintenance of the productive source of income (that is, contributing to the continuity of the activity of the participeds and of the consequent continued recognition of the financial asset in the sphere of the participant).

With an equity interest of ALFA in BETA, many of the decisions of ALFA that affect the patrimonial sphere of BETA (e.g., investments, financing) are determined by the interest of the participant in the light of the economic-financial situation of the participed. Consequently, the management, by ALFA, of said interest is a condition required for obtaining from that financial investment immediate or future income.

The fact that such decisions, made in the sphere of ALFA, influence the assets of BETA, does not mean that they are realised in the interest of third parties; that is, that they can be classified as alien to the activity of the participant, ALFA. They are taken from the interest of the participant (ALFA) in ensuring the operationalisation and profitability of its investment (in BETA). Obviously such investment translates into the ownership of a third entity; but the interest and its respective management are included in the interest and activity of the participant.

For this reason this Tribunal understands that the financing operation which we have seen, for now in general theory, scalpel-like does not translate into a pursuit solely or even predominantly of the interest of the participed, having nothing to do with the management of the participant. The management (in this case, the strengthening of the financial asset) which the participant carries out is of its interest. The participed uses funds that are provided to it, but this provision of funds is made in the interest of the participant, that is, in the context of normal management acts that can be encompassed in its scope or lucrative purpose.

This notion is well illustrated by GEOFFREY HOLMES and ALAN SUGDEN, "Interpreting company reports and accounts", Prentice Hall, 1999, p. 64, when they write (underline by the Tribunal):

"A participating interest is an interest held by the investing company on a long term basis to secure a contribution to its activities by the exercise of control or influence…A participating interest is only an interest in an associated undertaking where a significant influence is exercised over its operating and financial policy".

NCRF 13 expresses an equal concept, according to which an investment in an investee fits within the interest of the investor, and does so in the following terms (underline by the Tribunal):

"Associate: is an entity (here including entities that are not constituted as companies, such as, for example, partnerships) over which the investor has significant influence and which is neither a subsidiary nor an interest in a joint venture.

Subsidiary: is an entity (here including entities not constituted as companies, such as, for example, partnerships) that is controlled by another entity (designated by parent company).

Control: is the power to manage the financial and operational policies of an entity or of an economic activity in order to obtain benefits from it.

1. If the investor holds, directly or indirectly (for example, through subsidiaries), 20% or more of the voting power in the investee, it is presumed that it has significant influence, unless the contrary can be clearly demonstrated. If the investor holds, directly or indirectly (for example, through subsidiaries), less than 20% of the voting power in the investee, it is presumed that it does not have significant influence, unless the contrary can be clearly demonstrated. The existence of another investor, who holds a majority or substantial interest, does not necessarily prevent significant influence from being exercised.

2. The existence of significant influence by an investor is generally evidenced by one or more of the following:

(a) representation on the board of directors or equivalent management body of the investee;

(b) participation in policy decision processes, including participation in decisions about dividends and other distributions;

(c) material transactions between the investor and the investee;

(d) interchange of management personnel; or

(e) provision of essential technical information.

(…)"

If, as has been seen, the holding of significant influence implies, at least, the participation of the investing company in defining the operational and financial policies of the participed, then the financing of the participed by the investor will be of its interest or economic-legal purpose, fitting within the scope of normal management operations of the participant.

In the realm of corporate legislation, article 486 of the Commercial Code, in defining the relationship of dominance, establishes:

"Article 486

Companies in a relationship of dominance

1 - Two companies are considered to be in a relationship of dominance when one of them, called dominant, can exercise, directly or through companies or persons meeting the requirements indicated in article 483, no. 2, over the other, called dependent, a dominant influence.

2 - It is presumed that a company is dependent on another if this one, directly or indirectly:

a) Holds a majority interest in the capital;

b) Has more than half of the votes;

c) Has the possibility of appointing more than half of the members of the board of administration or the supervisory body."

Now the dominant influence must lead the participant to influence, act decisively in the management of the participed, taking into account, as seems evident, the interest of the investor. It would be strange if it were otherwise. The operations or decisions of the participant regarding the participed fit within the interest of the former. These operations, relating to the pursuit of purposes relating to assets embodied in financial investments, include their acquisition, financing, sale, maintenance of the asset, among others.

Having thus traced the general line of interpretation which this Tribunal adopts regarding the subject matter at issue, let us proceed to the appraisal of the concrete case.

§2. ON THE SUBSUMPTION OF THE CASE SUB JUDICE TO ARTICLE 23 OF THE IRC CODE

In the light of the facts fixed and the divergent positions of the parties, each grounded in law, doctrine and case law, the following presents the analysis and appraisal of the tribunal in the concrete case, dealing with the following aspects which, so we believe, encompass the various theses in confrontation:

A - Nexus of causality with income

B - The insertion in the activity of the participant or of the participeds. Which interest is pursued?

C - Productive source in the case at issue

D - The confusion of accounts and the assumption of another company's activity by one

E - Income subject to tax in the case at issue

F - The differential of interest and transfer pricing: brief note

It is worth recalling that, as already mentioned, the Tax Authority invokes that the Claimant "(…) is financing itself at rates higher than those at which it will subsequently finance its associated companies through the financing obtained, that is, it is bearing financial charges for financing that it is channelling to its associated companies and that are not being used in its activity as an autonomous entity, not passing on the entirety of such costs incurred to the beneficiary entities of such financing".

Examining the procedural documents it is verified that the Claimant finances itself from third parties, subsequently financing its participeds in turn, but charging interest to only one of them: B.... That is, of the various financing granted, the interest charged relates to a participed entity that benefits from the loans.

A - Nexus of causality with income

Economic business activity involves, to a greater or lesser degree, risk and uncertainty. If this were not the case, we would not observe so many business initiatives that fall short of the success their promoters would expect. In truth, the realisation of investments is carried out based on expectations or predictions of future income; but it is not possible to determine with absolute certainty that such application of funds (investment) will generate return for the capital invested in the measure of estimates made.

There will be cases where the return can even exceed such estimates. Others will occur in which such return is nil, or possibly negative, either by vicissitudes of the environment external to companies (economic and financial crises), or by poor management decisions by business entities, or a combination of both causes.

In business life the evaluation of an investment (real or financial) is made by confronting present outlays with expectations or predictions of future income or inflows. It could not be otherwise, for no economic agent controls all the variables on which the expected evolution of income, expenses, profit and cash flows resulting from a certain investment depends. Economic decisions are, as a general rule, made on the basis of future expectations; but such expectations rest on mere estimates and may prove to be quite different when their realisation comes about. Such potential deviation constitutes the notion of risk in economic activities.

The Supreme Administrative Court, in the context of case no. 0779/12, in an award of 24-09-2014, expresses this idea clearly, by saying (underline by the Tribunal):

"I - In the understanding which doctrine and case law have been adopting to ascertain the indispensability of a cost (cfr. art. 23 of the CIRC in the wording in force in 2001), the Tax Authority cannot scrutinise the soundness and opportunity of the company's business management decisions, under penalty of interfering in the freedom and autonomy of the company's management.

II - Thus, a cost will be fiscally accepted if, in a judgment reported to the moment when it was effected, it is adequate to the company's productive structure and to the obtaining of profits, even if it proves to be an economically unfruitful or economically ruinous operation, and the Tax Authority can only disregard as fiscal costs those that do not fit within the scope of the contributor's activity and were incurred, not in its interest, but for the pursuit of foreign objectives (when it is to be concluded, on the face of the rules of common experience that it had no potential to generate income).

III - Being the contributor a company dedicated to the construction of buildings, the Tax Authority cannot disregard the costs relating to the acquisition of two properties on the grounds of failure to demonstrate indispensability, even if this business proves to be economically unprofitable due to its sale at a price six times lower than that at which they were acquired having generated a loss."

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