IRC Fair Value Application Under Article 45 CIRC Transitional Regime – CAAD Arbitration 707/2016-T

ARBITRATION DECISION

I. Report

1. The company A..., SGPS, S.A. (hereinafter referred to as the "Claimant"), with tax identification number..., with registered address at Rua..., no...–..., ...-... Lisbon, filed on 29 November 2016, in accordance with the combined provisions of Articles 2 and 10 of Decree-Law no. 10/2011 of 20 January, i.e., the Legal Regime of Arbitration in Tax Matters ("RJAT"), a request for the establishment of an Arbitral Court, so as to declare illegal the additional assessment no. 2016..., for the tax year 2013, relating to Corporate Income Tax ("IRC"), in the total amount of €516,343.56, with the Tax and Customs Authority (the "Respondent" or "AT") being the defendant.

A) Establishment of the Collective Arbitral Court

1. In accordance with Article 6(2)(a) and Article 11(1)(b) of the RJAT, the Ethics Council of the Administrative Arbitration Centre ("CAAD") appointed as arbitrators of the Collective Arbitral Court the signatories hereto, who communicated their acceptance within the applicable time limit, and notified the parties of this appointment on 25 January 2017.

2. Thus, in compliance with the provisions of Article 11(1)(c) of the RJAT, and through communication from the Chairman of the Ethics Council of CAAD, the Collective Arbitral Court was constituted on 7 March 2017.

B) Procedural History

1. In the request for arbitral ruling, the Claimant petitioned for a declaration of illegality of the IRC assessment act previously referred to, which arose in the context of an inspection carried out by AT for the taxation period of 2013.

2. AT submitted its response, petitioning for the dismissal of the request for arbitral ruling, on the grounds that there was no violation of law, requesting that the assessment act under analysis, as it violated no legal or constitutional provision, be maintained in the legal order.

3. By order of 31 May 2017, the Collective Arbitral Court, pursuant to Article 16(c) of the RJAT, decided, without opposition from the parties, that it was not necessary to hold the hearing referred to in Article 18 of the RJAT.

4. Also within the scope of that order, the parties were invited to submit final arguments, with a successive period of 10 days.

5. Upon ascertaining that the Claimant had not accessed its email inbox, in order to make the aforementioned notification effective, the present Collective Arbitral Court sanctioned that such notification was to be considered effective, for all legal and procedural purposes, on 11 July 2017.

6. In this regard, the Claimant submitted its arguments on 12 July 2017.

7. On the other hand, the Respondent did not submit any arguments, but did request, on 14 July 2017, the withdrawal of the arguments presented by the Claimant, on the grounds that they were untimely, and also requested the partial revocation of the aforementioned arbitral order, namely as concerns the fixing of the date on which the notification was deemed to be effective.

8. On 16 August, by arbitral order, the present Collective Arbitral Court decided to repeat the notification to both parties to submit their arguments, within a successive period of 10 days, and also to extend the time limit for the arbitral decision by 2 months, in accordance with Article 21(1) of the RJAT, fixing as the final deadline for the issuance of the arbitral decision 3 November 2017.

9. The Collective Arbitral Court was duly constituted and is competent to review the issues indicated (Article 2(1)(a) of the RJAT); the parties have legal personality and capacity and have full standing (Articles 4 and 10(2) of the RJAT and Article 1 of Ordinance no. 112-A/2011 of 22 March). There are no nullities, and therefore nothing prevents the judgment on the merits.

10. The present proceedings are thus in a position for a final decision to be delivered.

II. Issue to be Decided

1. The present Court will first assess whether the exception raised by the Respondent, concerning partial lack of subject matter, should proceed, thereby terminating the present instance.

2. In parallel, and should this not be the case, the present Court will also decide on the merits of the case, which consists, namely, in assessing whether the losses resulting from the application of the fair value method, in accordance with Article 18(9) of the IRC Code, are, as the Claimant contends, considered at 100%, or, alternatively, at only 50% of their value, as argued by the Respondent.

III. Decision on the Facts and its Reasoning

1. Having examined the documentary evidence produced, the present Court finds as proven, with relevance to the decision of the case, the following facts:

I. The Claimant is a company managing shareholdings;

II. The Claimant adopted the Accounting Standard and Financial Reporting ("NCRF") 27, following the transition from the Official Accounting Plan ("POC") to the Accounting Standardisation System ("SNC") in Portugal, altering its accounting policy for the recognition of financial instruments traded on a regulated market, namely equity instruments, from the cost model to the fair value model;

III. In this sense, the Claimant, under Decree-Law no. 159/2009 of 13 July, fiscally recognized the losses resulting from the aforementioned adoption (in full), distributing that impact, as indicated by the applicable legislation, over 5 tax years.

IV. The Claimant, on 29 May 2014, submitted electronically its income tax return (Form 22 of IRC), for the tax year 2013, determining a taxable profit of €582,650.11.

V. On 29 July 2016, AT notified the Claimant that it had made corrections to the taxable profit of the aforementioned year (2013) to €6,037,375.43.

VI. For such correction, AT essentially argued that the Claimant "altered the values relating to negative equity variations (...)", concluding that the Claimant should have deducted "(...) 50% of the value of 1/5 of the loss determined as a result of the application of the fair value measurement model (...)"

VII. Consequently, AT issued an additional IRC assessment for 2013 (Document 3, attached to the request for arbitral ruling).

VIII. In its return referred to above in IV, the Claimant considered a deduction of 100% of the loss of 1/5 determined by the application of the fair value measurement model in the tax year 2013, relating to the value of its shares in company B..., SGPS, SA (currently C..., SGPS, SA), acquired at the price of €84,868,590.00 and with a balance sheet value of €30,321,336.00 on 31 December 2009.

Reasoning

1. The Court's conviction concerning the facts found resulted from critical examination of the copy of the administrative investigation file submitted by AT in conjunction with the position of the parties in the proceedings, reflected in the pleadings and documents attached to the case file by the parties, as specified in the points of the facts stated above.

IV. On the Law

A) Legal Framework

1. Given that the legal issue to be decided in the present proceedings requires the interpretation of the relevant legal texts, it is important, firstly, to set out the norms that compose the relevant legal framework, as at the date of the occurrence of the facts (2013).

2. First, it is necessary to cite Decree-Law no. 159/2009 of 13 July, which established a transitional regime, in respect of IRC, for the effects arising from the adoption, for the first time, of International Accounting Standards, as follows:

"Article 5

(Transitional regime)

1. The effects on equity resulting from the adoption, for the first time, of international accounting standards adopted in accordance with Article 3 of Regulation no. 1606/2002 of the European Parliament and of the Council of 19 July, which are considered fiscally relevant in accordance with the IRC Code and supplementary legislation, resulting from the recognition or non-recognition of assets or liabilities, or from changes in their measurement, contribute, in equal parts, to the formation of taxable profit of the first tax period in which such standards apply and the four following tax periods.

2. (...).

3. The adjustments referred to in the preceding paragraphs shall be duly evidenced in the tax documentation process provided for in Article 130 of the IRC Code, in accordance with the new numbering.

4. (...).

5. The transitional regime established in the preceding paragraphs is also applicable to the adoption, for the first time, of the Accounting Standardisation System, approved by Decree-Law no. 158/2009 of 13 July, of the Adjusted Accounting Standards, approved by Bank of Portugal Notice no. 1/2005, or of the Chart of Accounts for Insurance Companies, approved by Regulatory Standard no. 4/2007-R of 27 April of the Institute of Insurance of Portugal, without prejudice to the fact that, with respect to entities that were already applying these new accounting frameworks, the period referred to in no. 1 shall be counted from the tax period in which they were adopted for the first time.

6. With respect to entities that have chosen, in accordance with Decree-Law no. 35/2005 of 17 February, to prepare their individual accounts in accordance with international accounting standards adopted in accordance with Article 3 of Regulation (EC) no. 1606/2002 of the European Parliament and of the Council of 19 July, the effects referred to in no. 1 of this article shall be determined by reference to the individual accounts, organized in accordance with national accounting standardization, provided for in Article 14 of that decree-law".

7. Additionally, we also list the relevant norms, for the purposes of the present decision, set out in the IRC Code, as at the date of the facts (2013).

"Article 18

(Period of taxable profit)

(…)

9 — Adjustments resulting from the application of fair value do not contribute to the formation of taxable profit, being attributed as income or expenses in the tax period in which the elements or rights that gave rise to them are disposed of, exercised, extinguished or liquidated, except when:

a) They relate to financial instruments recognized at fair value through profit or loss, provided that, in the case of equity instruments, they have a price formed in a regulated market and the taxpayer does not hold, directly or indirectly, a shareholding in the capital exceeding 5% of the respective share capital; or

b) This is expressly provided for in this Code.

Article 21

(Positive equity variations)

1. Positive equity variations not reflected in the net result of the tax period also contribute to the formation of taxable profit, except:

a) Capital contributions, including share premiums, cover of losses, in any form, made by holders of capital, as well as other positive equity variations resulting from transactions involving equity instruments of the issuing entity, including those resulting from the attribution of derivative financial instruments to be recognized as equity instruments;

b) Potential or latent capital gains, even if expressed in the accounts, including revaluation reserves under tax legislation;

c) Contributions, including participation in the losses of the associate to the associant, in the context of partnership or participation in quota;

d) Those relating to income taxes.

(…)

Article 45

(Non-deductible expenses for tax purposes)

(…)

1. The negative difference between capital gains and capital losses realized through the transfer of shareholdings, including their redemption and amortization with capital reduction, as well as other losses or negative equity variations relating to shareholdings or other components of equity, namely supplementary contributions, contribute to the formation of taxable profit in only half of their value.

(…)"

1. Thus, it is within this legal framework that it is important to assess whether the correction made by the Respondent to the Claimant's taxable profit, by reference to the tax period of 2013, suffers from any illegality (as contended by the latter).

B) Arguments of the Parties

1. For the Claimant, the issue sub judice consists in determining what fiscal treatment should be given to losses arising from the application of the fair value model in financial instruments, whose counterpart is recognized through profit or loss,

Influencing the determination of the IRC taxable profit of the Claimant, and, whether to losses with that specific nature, the norm of Article 45(3) of the IRC Code is applicable or not".

1. And, in that sense, the Claimant considers that "the expression 'other losses or negative equity variations' used in Article 45(3) of the IRC Code does not have an indiscriminately comprehensive sense, but rather a precise sense, defined in Articles 23 and 24(b), both of the IRC Code.

And also expressed in Article 46(1) of the same Code (...) when it stipulates '(...) financial instruments, with the exception of those recognized at fair value in accordance with paragraphs (a) and (b) of no. 9 of Article 18'".

1. Indeed, the Claimant argues that "a literal interpretation of Article 45(3) of the IRC Code that admitted, within its scope of application, not only losses (defined in Article 23) but also negative equity variations (as defined in Article 24), as well as expenses (as defined in Article 23) would lead to the fact that, e.g., the acquisition cost of shareholdings would only contribute half of its value to the determination of taxable profit, which would be, obviously and logically, inconceivable for a minimally reasonable legislator (...)".

2. Therefore, the Claimant understands that "the aforementioned norm of Article 45(3) was designed for the realization of capital losses and other situations therein listed 'stricto sensu', dependent on a voluntary action by the taxpayer corresponding to the realization thereof".

3. The Claimant also makes a reference to Article 104 of the Constitution of the Portuguese Republic ("CRP"), considering that, "in light of the imperative (...) that underlies the taxation of companies fundamentally on their real income", no other understanding could be drawn from that fiscal framework.

4. It should be noted that the Claimant, in the course of its exposition, relies especially on the arbitration decision regarding Process no. 108/2013-T.

5. The Claimant concludes by saying that, "in the interpretation of what is established in Article 45(3) of the IRC Code, expenses/losses resulting from the application of fair value in financial instruments, which are relevant to the formation of taxable profit in accordance with the terms and scope of paragraph (a) of no. 9 of Article 18 of the IRC Code, cannot be included".

6. Thus requesting a declaration of illegality of the aforementioned additional IRC assessment act.

7. In its final arguments, the Claimant sought, above all, to reinforce the understanding previously set out in the initial petition, also arguing that, from its perspective, the value of the case was appropriate.

8. For its part, the Respondent, after being duly notified to that effect, presented its response in which it first requested its dismissal from the claim, as there was a peremptory exception.

9. Indeed, in the understanding of the Respondent, there was "lack of subject matter with respect to the part that exceeds the value of assessment no. 2016..., in the amount of €336,686.27, which constitutes a peremptory exception, which is invoked for all legal purposes (...) which gives rise to the dismissal of the Respondent from the claim (...)".

10. Subsequently, and as regards the merits of the action, the Respondent considered that the Claimant has no grounds, as set out below.

11. For the Respondent, "as a result of the adoption, for the first time, of the SNC, approved by Decree-Law no. 159/2009 of 13 July, significant changes occurred in the valuation policy of financial investments, whereby, in certain situations, financial instruments had to be measured in the accounts at fair market value (...)".

12. Thus, in the words of the Respondent, "the legislator understood the need to create transitional mechanisms that would protect against the (strong) impact resulting from the introduction of fair value (to the detriment of historical cost), having been established in Article 5 of Decree-Law no. 159/2009 of 13 July that 'the effects on equity resulting from adoption (...) contribute, in equal parts, to the formation of taxable profit of the first tax period in which such standards apply and the four following tax periods'".

13. Thus, "if negative adjustments had occurred, their value should, in the same way, be taxed, in equal parts, over 5 years (...), commencing in 2010".

14. In view of the foregoing, the Respondent understands that, "in accordance with what is legally provided, only half the value of the total losses verified in shareholdings is deductible from taxable profit, which is why, and having regard to what is provided in Article 5 of Decree-Law no. 159/2009, in conjunction with Article 45(3) of the IRC Code, the deductible value in each of the five years shall correspond to half of 1/5 of the total value of the loss verified".

15. With respect specifically to Article 45(3) of the IRC Code, the Respondent cites the view advocated by André A. Vasconcelos, "by reading that provision, and given its broad scope, we are led to conclude that all losses relating to shareholdings, where these financial assets are included, shall only be relevant for tax purposes in half of their value".

16. The Respondent continues, arguing that "in view of what is stipulated in the literal element of Article 45(3) of the IRC Code, losses or negative equity variations (...) contribute to the formation of taxable profit in only half of their value.

Note that the legislator and, above all, the law itself, made a clear choice in no. 3 of Article 45 of the IRC Code (...) and this despite successive legislative amendments made to the IRC Code, the legislator did not establish in Article 45(3) of the IRC Code any exception relating to either the losses determined by the transitional adjustments resulting from the change in the accounting framework, or the losses accepted fiscally resulting from the reduction of fair value through profit or loss.

On the contrary, the same statutory provision continued to apply to all losses, with fiscal relevance, verified in shareholdings, namely potential losses, as would be the case with variations in fair value in half of their value".

1. Consequently, for the Respondent, "if it had been the legislator's intention to exclude the losses in question from the scope of application of Article 45(3) of the IRC Code, amended by Decree-Law no. 159/2009, it would certainly have made that clear in the law, by making the due amendment to the norm in question.

In view of the foregoing, it follows that, in the case of financial instruments (...) measured at fair value to profit or loss, the loss reflected in the accounts will only be considered for tax purposes in half of its value (...)".

1. As to the constitutional question raised by the Claimant, the Respondent recalled that "the Constitutional Court has already ruled on this question (...) 'as concerns the question of the prohibition of taxation on presumed income, it is the very wording of Article 104(3) of the CRP that provides a clear answer: the taxation of companies fundamentally incurs on its real income'.

(...)

It is thus to be concluded, also, that the solution established in no. 3 of Article 45 of the IRC Code does not suffer from any unconstitutionality".

1. In conclusion, AT requests that the claim be judged to lack merit and, consequently, that it be dismissed from the claim, in the terms previously referred to.

2. In its final arguments, the Respondent sought to reinforce the understanding previously advocated in its response.

3. Nevertheless, the Respondent notes that the understanding of the present Court, as regards time limits, underwent an abrupt modification.

4. Additionally, the Respondent emphasized, once again, that the value of the case was incorrectly calculated, and that therefore it should be dismissed from the claim.

C) Assessment of the Collective Arbitral Court

1. As a preliminary matter, it is incumbent on the Collective Arbitral Court to assess the peremptory exception raised by the Respondent.

2. Now, the Respondent considers that the value stated in the request for arbitral ruling, €516,434.56, has no basis, since the value of the assessment that it seeks to contest is fixed at €336,686.27.

3. It transpires that, from the documents sent by the Respondent to the Claimant, namely from the account reconciliation statement, the value of €516,343.55 appears with reference to payment and its respective due date.

4. Now, in accordance with Article 97-A(1)(a) of the Code of Procedure in Tax Matters ("CPPT"), "the values to be considered, for the purposes of costs or others provided for in law, for actions that take place in tax courts, are the following (...) when the assessment is contested, the amount whose cancellation is sought (...)".

5. It should be noted that the Claimant indeed seeks to contest the account reconciliation statement, with no. 2016..., and not the assessment, with no. 2016..., as referred to by the Respondent.

6. And from this arises that disparity of values.

7. However, the value of the assessment does not correspond to that of the account reconciliation statement only because there are reflected therein source deductions, in the amount of €179,657.28, a tax asset of the Claimant.

8. In view of the foregoing, the Court considers that the value of the case should be that presented by the Claimant, i.e., €516,434.56, since that is the financial impact, in terms of tax, that effectively occurs in its sphere[1].

9. In light of the foregoing, the exception raised by the Respondent lacks merit.

10. Entering now into the assessment of the merits of the case.

11. As a preliminary matter, it should be noted that it is considered that the issue sub judice is merely to determine whether the expenses fiscally relevant, by application of Article 18(9)(a) of the IRC Code, in this case, the losses from the reduction in fair value of shareholdings valued at fair value...

12. ...are, after all, only to be considered, for the purpose of determining taxable profit, in half of their value, by virtue of what follows from Article 45(3) of the IRC Code.

13. From a legal point of view, this framing is perhaps controversial, since there is a clear discrepancy in the treatment given to expenses and income resulting from the application of fair value, the former being accepted only at 50% of their value and the latter being taxed in full.

14. However, it is not for the Court to assess, except incidentally, the relevance or justice of the norms it applies, but solely to judge the case before it in accordance with what emanates from the aforementioned norms and in the interpretation it makes of these in light of the good rules of legal hermeneutics.

15. Now the position of the Claimant appears to support, in large part, what was stated in the arbitration decision delivered in the context of arbitration process no. 108/2013-T.

16. Without need for exhaustive dissection of the rules governing the legal interpretation of the norm, it will be said that, with respect to the teleological element of the law, or that is, broadly speaking, the purpose intended by the legislator with the norm, such a desideratum must be found, even if minimally or imperfectly, in the letter of the law.

17. Which is to say that the interpreter is barred from departing from the letter of the law to find the purposes intended by it.

18. As previously mentioned, the Court does not assess the merit of the norm except as concerns its constitutional framework, a matter on which the Constitutional Court will ultimately rule.

19. Indeed, it is for the legislator and not for the judge to restore or correct any eventual injustice that may emanate from the norm and which is not susceptible to correction in light of the good rules of interpretation.

20. Returning to the case sub judice: The legislator, later and through Law no. 2/2014 of 16 January, came to repeal the norm in question, in force at the date of the facts and thus applicable.

21. Therefore, in light of the legal regime then in force, to seek to exclude the losses in question from what is provided in Article 45(3) of the IRC Code is to go in the direction contrary to the Law, with mere support in conceptual inaccuracies.

22. Suffice it to say,

23. It follows from Article 18(9) of the IRC Code (as drafted at the date of the facts) that "adjustments resulting from the application of fair value do not contribute to the formation of taxable profit, being attributed as income or expenses in the tax period in which (...)" (emphasis ours).

24. "Expense", for the purposes of this norm, corresponds to all accounting items (which may or may not have fiscal relevance) considered as negatively affecting the net result of a company, which include, namely, losses, capital losses, depreciation, operating expenses, among others.

25. Now, to affirm that expense and loss are hermetic and distinct concepts is, in the understanding of the Court, fallacious. Indeed, loss is a type of expense.

26. Beyond the pertinent comments of André Vasconcelos, which the Respondent brought to bear, let us also consider the understanding expressed in the arbitration decision regarding process no. 25/2015-T, diametrically opposed to that referred to by the Claimant. To quote: "(...) Ana Maria Rodrigues accounts for the attempts to overcome these inaccuracies and hesitations as to the solutions for fear of increasing disturbance in the legal order. As an example, she cites the headings of Articles 20 and 23 of the IRC Code. As to the first (...), and as to the second, 'expenses and losses', she observes that expense is a concept which, in accounting, already includes losses".

27. Note that that is not the only decision in that sense, see, for example, the arbitration decision relating to process no. 90/2016-T, in which the panel of arbitrators also considered that the adjustments in question would contribute to the formation of taxable profit, in accordance with Article 45(3) of the IRC Code, only in half of their value.

28. In view of the foregoing, it is clear that the deductibility of that loss, which is naturally an expense, should be analyzed in light of Article 45(3) of the IRC Code, in order to ascertain to what extent it may fall within the scope of that norm.

29. The norm in question provides that "the negative difference between capital gains and capital losses realized through the transfer of shareholdings, including their redemption and amortization with capital reduction, as well as other losses or negative equity variations relating to shareholdings or other components of equity (...) contribute to the formation of taxable profit in only half of their value" (emphasis ours).

30. Now, from the mere interpretation of the relevant statutory texts, in their wording at the time, it can be peacefully concluded that the losses arising from the reduction in fair value of financial instruments, namely shareholdings, fall within the scope of Article 45(3) of the IRC Code, and therefore should only be considered, for the purpose of determining taxable profit, in half of their value (in the tax period under analysis).

31. This Court supports, in essence, what was argued in the arbitration decisions delivered in processes nos. 25/2015 and 90/2016 and the doctrine of the dissenting vote of arbitrator Dr. Manuela Roseiro in the judgment delivered in process no. 30/2015.

32. In conclusion: there is nothing to censure in the correction made by the Respondent and this arbitration request shall, consequently, lack merit.

33. The incidental invocation of unconstitutionality of Article 45(3) of the IRC Code (as drafted at the date of the facts) for alleged violation of Article 104 of the Constitution will equally lack merit.

34. Indeed, not only is it not constitutionally imperative that taxable income always and only consists of real income, as apparently follows from business accounts, but also such income is not, in itself, a reality of physically apprehensible value, rather being a normatively modeled concept.

35. In these terms, a fiscal regime that translates into lesser consideration, for tax purposes, of certain capital losses recorded by companies does not violate the cited constitutional provision.

36. Moreover, the impossibility of full deduction of some costs or losses, as such recorded by taxpayers, for the purposes of determining the taxable base, not only results from various provisions of the current Article 45 of the IRC Code, but has already been the subject of recourse to the Constitutional Court, namely in cases decided by Judgments nos. 418/2000 and 451/2002 (available on the Constitutional Court's website at http://www.tribunalconstitucional.pt/), which did not judge unconstitutional the solution found.

37. In this same line of understanding are found, e.g., the judgments of the Constitutional Court nos. 162/2004 and 85/2010, published on the aforementioned website.

V. Decision

1. In these terms, this Collective Arbitral Court decides:

A) To judge the request for arbitral ruling to be wholly without merit and, consequently,

B) To maintain in the legal order and declare legal the aforementioned additional assessment, by reference to 2013, from which resulted tax to pay (and compensatory interest) in the total amount of €516,343.56 and

C) To condemn the Claimant to bear the costs of the proceedings.

VI. Value of the Case

1. The value of the case is fixed at €516,343.56, in accordance with Article 97-A(1)(a) of the CPPT, applicable by virtue of paragraphs (a) and (b) of Article 29(1) of the RJAT and of Article 3(2) of the Regulation of Costs in Tax Arbitration Proceedings ("RCPAT").

VII. Costs

1. In accordance with the provisions of Article 22(4) of the RJAT, the value of the arbitration fee is fixed at €7,956.00 in accordance with Table I of the aforementioned Regulation, to be borne by the Claimant, given the total lack of merit of the request.

Let it be notified.

Lisbon and CAAD, 13 October 2017

The Collective Arbitral Court

(Dr. Judge José Poças Falcão – Presiding Arbitrator)

(Dr. Maria Cristina Aragão Seia – Adjunct Arbitrator)

(Dr. Gonçalo Cid Peixeiro – Adjunct Arbitrator)

[1] It is noted that the value of the economic utility of the arbitration request follows the rules provided for in Article 97-A of the CPPT – when there is a challenge to assessment, self-assessment, withholding at source or payment on account acts – and Article 3(3) of the Regulation of Costs – when there is an act of fixing equity values or determination of taxable or chargeable matter.