Autonomous Taxation on Undocumented Expenses Under IRC – CAAD Decision 795/2014-T

ENGLISH TRANSLATION

Case No. 795/2014-T

The arbitrators Dr. Jorge Lopes de Sousa (chair-arbitrator), Dr. A. Sérgio de Matos and Prof. Dr. Leonor Fernandes Ferreira, appointed by the Ethics Council of the Administrative Arbitration Centre to form the Arbitral Tribunal, constituted on 16-02-2015, hereby agree as follows:

1. REPORT

A… - SOCIEDADE DE COSMÉTICA, LDA, Tax ID No. …, submitted on 30-11-2014 a petition for constitution of the collective arbitral tribunal, pursuant to the combined provisions of Articles 2 and 10 of Decree-Law No. 10/2011 of 20 January (Legal Regime for Arbitration in Tax Matters, hereinafter referred to as RJAT), against the Tax and Customs Authority.

The Petitioner requests the declaration of illegality and annulment of the Corporate Income Tax (IRC) and compensatory interest assessment acts numbered 2013 … and 2013 …, relating to the tax years 2009 and 2010, respectively, and the tacit rejections of the hierarchical appeals it filed against the decisions rendered in the administrative objections Nos. … 2014 … and … 2014 … which addressed those assessments, respectively.

The Petitioner further requests reimbursement of the tax paid and payment of compensatory interest.

The petition for constitution of the arbitral tribunal was accepted by the President of CAAD on 01-12-2014 and notified to the Tax and Customs Authority on the same date.

Pursuant to the provisions of subparagraph a) of paragraph 2 of Article 6 and subparagraph b) of paragraph 1 of Article 11 of the RJAT, the Ethics Council appointed as arbitrators of the collective arbitral tribunal the undersigned, who communicated acceptance of the assignment within the applicable period.

On 28-01-2015 the Parties were duly notified of this appointment, and expressed no intention to refuse the appointment of the arbitrators, in accordance with the combined provisions of Article 11, paragraph 1, subparagraphs a) and b) of the RJAT and Articles 6 and 7 of the Code of Ethics.

In accordance with the provision of subparagraph c) of paragraph 1 of Article 11 of the RJAT, the collective arbitral tribunal was constituted on 16-02-2015.

The Tax and Customs Authority responded, contending that the petition for arbitral decision should be rejected.

On 19-05-2015, a hearing was held at which witnesses were examined and it was agreed that the proceedings would continue with written submissions.

The Parties submitted their arguments.

The Arbitral Tribunal was regularly constituted and is competent.

The parties are duly represented, possess legal capacity and standing (Articles 4 and 10, paragraph 2 of the same statute and Article 1 of Ordinance No. 112-A/2011 of 22 March).

The proceedings contain no defects and no obstacle exists to consideration of the merits of the case.

2. FACTS

2.1 Proven Facts

The following facts are considered proven:

a) An external tax inspection was conducted on the Petitioner by the Tax Inspection Services of the Lisbon Finance Directorate, pursuant to Service Order No. OI 20120 …, concerning the 2009 tax year;

b) In that tax inspection, a Tax Inspection Report was prepared, a copy of which is attached as document No. 15 with the petition for arbitral decision, whose contents are reproduced herein, which refers, inter alia, to the following:

III.1 – Corrections to Taxable Income under IRC

III.1.1 Personnel Expenses

In 2009, there was a restructuring following:

• Acquisition of the equity interests previously held by former managers B… and C… by D…Europe INC.;

• Resignation and replacement of managers B… and C…F…

The restructuring aimed at:

• Closure of A…'s warehouse on national territory, …, relocating it to Madrid, D1… Group warehouse.

• Reduction in the number of employees, warehouse workers and account managers.

The Management Report states: - "b) Following the restructuring plan announced during the previous year by D2… International, the subsidiary reduced 42 jobs which resulted in severance payments of €3,271,583.00."

This is the fact that explains the variation in results occurring in 2009, an expense recorded in account 634001 Personnel Severance Indemnities.

In the analysis of this item, the following irregularities/omissions were detected:

On 4 March 2010, an agreement terminating the employment contract was signed between C… and A… - Sociedade de Cosmética, Lda.

This agreement provided for the termination of the employment relationship and the functions of manager of C… in A…, Lda., in exchange for payment by way of severance indemnity of €296,100.00 and pecuniary compensation for a non-competition covenant valued at €140,000.00, for a total of €436,100.00.

Personnel expenses in the amount of €436,100.00, relating to the employment contract termination agreement signed with the former manager, were recorded by A…, Lda., in account 634001 on 30/06/2010, under entry No. …-…-…. The termination of the employment relationship as well as payment of the amounts due occurred on 30/09/2010. (see Annex 4)

Pursuant to paragraph 13 (added by Law No. 3-B/2010 of 28/04) of Article 88 of the Corporate Income Tax Code (CIRC), expenses or charges for indemnities or any compensation not related to productivity objectives, when there is termination of the functions of manager, administrator or director, are subject to autonomous taxation at the rate of 35%. Thus the expenses recorded in account 634001 Personnel Indemnities, on 30/06/2010, under entry No. …-….-…, for the manager C…, connected to the employment contract termination agreement, by way of indemnity, €296,100.00 and pecuniary compensation for the non-competition covenant, €140,000.00, for a total of €436,100.00 are subject to autonomous taxation calculated at the rate of 35% (€436,100.00 x 35%), or €152,635.00.

III.1.2 Non-deductible Costs - Article 23 of CIRC

III.1.2.1 Personnel Expenses

There is recorded under entry …-…-…, an invoice from supplier G..., S.A., Tax ID No. …, No. … and …/2009, dated 2009/10/15, in the amount of €11,377.80 plus VAT at the standard rate.

This invoice was recorded on 2009/10/23 as personnel expenses (account 638002, personnel training) and VAT deduction of €2,275.56 was claimed (account 243237). When questioned in point 4 of the notification of 2013/06/19, the taxpayer clarified that it was an Event they called "Mission Impossible," held for the sales department. (see Annex 5)

Although the expenses deducted by the taxpayer are properly recorded and supported by invoices and receipt documents evidencing their origin, nature and amount, the taxpayer did not prove their indispensability for the realization of revenues or gains subject to tax or for the maintenance of the productive source of A…, as provided for in Article 23 of CIRC.

Pursuant to Article 23, paragraph 1 of CIRC, they are not considered "provably indispensable for the realization of revenues or gains subject to tax or for the maintenance of the productive source," since the concept of costs not indispensable to the activity is essentially associated with the need to prevent abuses that may arise from the existence of expenses that may be unnecessary, and thus may not be considered as "provably indispensable for the realization of revenues or gains subject to tax or for the maintenance of the productive source."

The qualification of costs as deductible implies that they are related to the activity exercised by the company in terms of their economic adequacy relative to the purpose of obtaining results.

The following is transcribed from the judgment of 29/03/2006 of the Supreme Court of Justice, rendered in case No. 01236/05, which holds that "the criterion of indispensability was created by the legislator, not to allow the Administration to interfere in the management of the company, dictating how it should apply its resources, but to prevent the tax consideration of expenses that, although recorded as costs, do not fall within the scope of the company's activity, were incurred not for its pursuit but for other outside interests."

In this regard, the following excerpt from the judgment of the Central Administrative Court of 10/03/2009, rendered in case No. 02608/08, is also transcribed, which, "Drawing on the Study by Tomás de Castro Tavares (On the Relationship 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 CTF, No. 396, pp. 7-177)" concludes that "The indispensability referred to in Article 23 of CIRC as a condition for a cost to be deductible does not refer to necessity (the expense as a sine qua non condition of revenues), nor even to convenience (the expense as convenient for business organization), under penalty of intolerable interference by the Tax Authority in the autonomy and freedom of management of the taxpayer, but requires only an economic causal relationship, in the sense that it suffices that the cost be incurred in the interest of the company, in order, directly or indirectly, to obtain profits. The legal notion of indispensability is therefore defined from an economic-business perspective, by direct or indirect fulfillment of the ultimate motivation of contributing to profit generation."

These are therefore expenses of a purely recreational nature, and accordingly the cost recorded is not accepted for the formation of taxable profit, pursuant to Article 23 of CIRC, in the amount of €11,377.80.

The quantification of corrections in VAT will be addressed below, in section III.2.1.

III.1.2.2 Undocumented Expenses: H… Cards, I… Cheques, J… Gift Cheques, K… Gift Cards and L… Vouchers

Purchases of cards designated as:

1. H… Card - Operation Success Campaign: The supplier M.., Lda., Tax ID No. …, defines this product it sells on its website as pre-paid debit cards (visa/electron). Also invoiced were the design and production of brochures, letters, production of H… Cards and monthly campaign monitoring. When the financial director N… was questioned, she clarified that the beneficiaries of this campaign were saleswomen of perfumeries, which are A…'s clients, with the objective of promoting sales. She further explained that the letters to the saleswomen and assignment of amounts to be debited to the debit cards was effected by supplier M…, Lda. (see Annex 6)

These purchases were recorded as costs by A… with the nature of advertising and promotional costs (account 622002) or promotional materials (account 623005) and are supported by the invoices indicated below and assume the following values:

[TABLE]

Pursuant to Article 81, paragraph 1 (currently 88) of CIRC, confidential or undocumented expenses, as is the case here, since they are payments in relation to which the taxpayer did not identify the charge to which such payment is related or the entity benefiting from such payment, are subject to autonomous taxation at the rate of 50% (€64,996.24 x 50% = €32,498.12), and the costs recorded are not accepted pursuant to Article 23 of CIRC, in the amount of €64,996.24.

1. I… Cheques, J… Gift Cheques, K… Gift Cards

Purchases of cards/cheques are recorded in A…. When the websites of suppliers were consulted, the products are defined: (see Annex 7)

– J… Gift Cheques are multistore gift cheques, sold by O… Portugal, Lda., with diverse offerings, face values: €10, €15, €25, €30 and €50, validity period of 6 to 18 months, accepted at more than 600 stores nationwide.

Recorded on 2009/09/17, document No. …-…-…, invoice/receipt No. 2009663 from O… Portugal, Lda., for the purchase of J… Gift Cheques, totaling €4,650.00.

– I… - There are available to our clients gift cheques, which are valid for the entire range of I… and I…Service products. Their unit value is €5, €10, €20 and €30. The holder of the gift cheque may exchange it for the product he wishes in the establishment itself.

I… gift cheques are likewise valid for green price products and accepted at any I…, I…Service, P…, Q… or R… store.

Recorded:

i. On 2009/09/17, document No. FCR-10-000595, invoice No. 20090739 of 2009/08/19 from I… Portugal, for the purchase of Cheques, totaling €2,000.00;

ii. On 2010/05/12, document …-…-…, invoice/receipt 13670 from I… Portugal, for the purchase of 21 gift cards, totaling €2,100.00.

– K… - The card, once loaded, represents a monetary value to the bearer.

With reference to supplier …, the following invoices are recorded, in accounts 623004 and 622108, totaling €16,321.90,

[TABLE]

1. L… Vouchers

Recorded on 2010/05/21 under entry No. DP-10-01316, a bank transfer of €810.00, effected from A…'s demand deposit account at BES to NIB …. When notified on 2012/04/19 to present supporting documents for this transaction, they exhibited an email referring to the purchase of L… vouchers and a copy of the BES bank statement extract showing this transfer (see Annex 8)

No invoice or equivalent document was exhibited, and furthermore, vouchers are means of payment and not an actual cost.

1. Various gift cards, etc., recorded in account 623004 articles for gifts, all with the nature of means of payment and not actual costs: (see Annex 9)

[ENTRIES]

The taxpayer was notified on 19 June 2013 to, with respect to suppliers M…, Lda., K… Hypermarkets, S.A., O… Portugal, Lda., I… Portugal and L… and the purchase of H… Cards, K… gift cards, J… Gift Cheques, I… cheques, and L… Vouchers, other cheques and gift card/cheques T…, respectively, recorded in the course of 2009, identify the beneficiaries with their tax identification number and amounts attributed and to demonstrate the indispensability of such costs pursuant to Article 23 of CIRC. (see Annex 10)

The taxpayer stated that:

In order to increase sales at A… (Sell Out objectives), A… developed incentive campaigns, delivering cheques to saleswomen of perfumery clients based on sales achieved.

Gift Continent cheques and L… vouchers were also attributed to A… workers as an incentive and recognition of their work.

In summary,

The elements presented by the taxpayer did not allow identification of charges and/or beneficiaries of the said payments and/or amounts assigned.

The acquisition and distribution of H… Cards (totaling €64,996.24), pre-paid debit cards, I… Cheques, J… Gift Cheques, K… gift cards, T… gift card/cheques and Vouchers, constitute monetary values payable to bearer, represent mere exchanges of means of payment and not actual costs, since the expense only occurs when the document (invoice/receipt) is recorded.

The taxpayer could and should have documented the expense corresponding to each acquisition of the goods/services underlying each cash outflow. If such cash outflows correspond to payment for acquisitions of goods/services, or if they had any other destination, it was not possible to determine, and accordingly they are classified as confidential expenses.

Pursuant to Article 88 of CIRC, confidential or undocumented expenses, as is the case here, since they are payments in relation to which the taxpayer did not identify the charge to which such payment is related or the entity benefiting from such payment, are subject to autonomous taxation at the rate of 50%, totaling €50,029.07, and the costs recorded are not accepted pursuant to Article 23 of CIRC, in the amount of €100,058.14.

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VIII - Right to Be Heard

In compliance with Article 60 of the General Tax Law and Article 60 of the Complementary Tax Inspection Regime, a draft conclusion of the report was prepared, which accompanied the notification sent to the taxpayer through Official Communication No. … of 26/08/2013 with registration No. RC … PT, giving it a period of fifteen days to exercise the right to prior hearing.

The taxpayer exercised the right to be heard, through its representative – U…, by written petition, sent to this Finance Directorate by registered mail, which was received on 12/09/2013. (see annex 12)

In exercising the right to be heard, the taxpayer contests the arithmetic corrections proposed, of autonomous taxation under IRC, which result in tax in the amount of €152,635.00, described and justified in section III.1.1 Personnel Expenses, concentrating its defense on the following arguments:

• The amount paid to C… as indemnity or compensation in connection with the termination of the employment contract does not fall within the provision of Article 88, paragraph 13 of the Corporate Income Tax Code (CIRC), and attached the employment contract termination agreement (doc. 2);

• C…, ceased functions as director on 31/12/2009, when the indemnity was received she was not a director, presenting the declaration of resignation (doc. 4) submitted by her, the commercial registration certificate (doc. 3) showing the registration of said resignation and the salary receipts of C…, from July 2009 to August 2010 (doc. 6);

• From 31/12/2009 onwards, C…, began to exercise the functions of General Director, under a dependent employment relationship, submitted the Social Security form of February 2010 (doc. 5);

The taxpayer states that "the Tax Authority intends to interpret the concept of director to encompass all types of positions susceptible to presenting characteristics similar to those of an administrator or director" - Article 47.

Regarding the documents submitted in the right to be heard, it should be noted:

• The salary receipts of C… (attached to the Right to be heard - doc. 6) document that the base salary of €10,000.00, which she received as director, remained unchanged until 30/09/2010, the date on which she ceased functions at A…, Lda.;

• The "Employment Contract Termination Agreement" signed between A…, Lda., and C…, on 4 March 2010, states:

"A) The first and second parties entered into an employment contract between them on 1 July 1998, pursuant to which the second party has been performing the functions of General Director;"

"B) The parties intend to terminate, by mutual agreement, the employment relationship identified in the preceding clause;"

That is, despite the letter of resignation from the management position submitted on 31/12/2009 by C… to A…, Lda., it was agreed that she would maintain the functions she performed as director and which in the agreement are defined as "functions of General Director," until she terminated her employment relationship with A…, Lda., which occurred at the end of September 2010.

Other documents worthy of analysis:

1. From 31 December 2009, with the legal resignation from management, C…, ceased to be able to bind the company. Thus so that she could continue to represent and bind A… before third parties, a power of attorney was executed on 13/01/2010, establishing as attorneys-in-fact of A…, Lda (represented by director B… on the day she resigned from management): (annex 13)

o C…;

o V…;

o W…;

With the company bound "jointly by C… with any one of the other attorneys-in-fact, but never the latter jointly without the intervention of the attorney-in-fact C…."

1. Regarding the functions exercised by C…, in A…., Lda., in the course of the tax inspection procedure for 2009, which included analysis of documents evidencing and supporting facts occurring between 01/07/2009 and 30/06/2010, we found that: - The documents we observed that bound the company before third parties were signed throughout that period by C…. Namely, means of payment and bank payment orders, employment contract termination agreements entered into between A…, Lda., and workers, facts which we documented in annex 14 of this report;

Finally, with reference to the last argument made by the taxpayer "the Tax Authority intends to interpret the concept of director," it should be clarified that we did not invoke this, since the functions exercised by C…ra were those of Director.

We conclude that:

o Until 31/12/2009, C…, was director de jure and de facto of A…, Lda., from that date until 30/09/2010, she continued to represent and to bind the company.

o In annex 14, we document that after 31/12/2009, C…, carried out the execution of A…, Lda's restructuring plan, executing on behalf of A…, Lda., the termination agreements that were entered into with workers.

o The termination of the functions of director, did not end on 31/12/2009, but on 30/09/2010, as expressly agreed between A… and C…, in the "Employment Contract Termination Agreement," between them concluded:

o Thus the autonomous taxation of this indemnity or compensation is provided for in paragraph 13 (added by Law No. 3-B/2010 of 28/04) of Article 88 of CIRC, expenses or charges for indemnities or any compensation not related to the achievement of previously defined productivity objectives, when there is termination of functions as director, are subject to autonomous taxation at the rate of 35%.

In light of the foregoing, the proposed corrections are maintained.

c) Following the inspection mentioned above, the Tax and Customs Authority issued the additional IRC assessment No. 2013 …, in the amount of €202,664.07, and the compensatory interest assessment, materialized in the compensation No. 2013 …, in the amount of €22,631.74, in the total amount to pay of €225,295.81, concerning the 2009 tax year (document No. 5 attached with the petition for arbitral decision, whose contents are reproduced herein);

d) In calculating the IRC amount for 2009, the Tax and Customs Authority included the amount of €202,664.07 in autonomous taxation, resulting from the corrections made;

e) The Petitioner filed an administrative objection to the aforementioned assessment, which was assigned No. … 2014 … and was rejected by decision of 29-05-2014, issued by the Deputy Director of Finance for Lisbon, a copy of which is attached as document No. 3 with the petition for arbitral decision, whose contents are reproduced herein, which refers to an opinion in which the following is stated, inter alia:

2.2. Personnel Expenses - indemnity (§ 57 to § 109)

Value of contested correction: €152,635.00

In her arguments, the objecting party states "the same employee ceased making management decisions from the date she resigned from the management position, from which time forward she resumed performing the functions of simple director... In autonomous taxation under IRC, the tax event is the expense itself, not a complex fact... but an instantaneous tax event. In the case at hand ... the creation of the expense for the indemnity and compensation to be paid to the former employee .... Occurs... before the publication of the new Law, which came into force on 29 April 2010.

Tax Inspection Report: "in the analysis of account 634001-Personnel Indemnities, the following was detected: "On 4 March 2010, an agreement terminating the employment contract was signed between C… and A… - Sociedade de Cosmética, Lda. In this agreement, the termination of the employment relationship and the functions of director of C… in A…, Lda., is provided for, in exchange for payment as indemnity of €296,100.00 and pecuniary compensation for the non-competition covenant valued at €140,000.00, for a total of €436,100.00...The termination of the employment relationship as well as payment of the amounts due occurred on 30/09/2010...Pursuant to paragraph 13 (added by Law No. 3-B/2010 of 28/04) of Article 88 of CIRC, expenses or charges for indemnities or any compensation not related to productivity objectives, when there is termination of the functions of director, administrator or manager, are subject to autonomous taxation at the rate of 35%. Thus the expenses ... totaling €436,100.00 are subject to autonomous taxation calculated at the rate of 35% (€436,100.00 x 35%), or €152,635.00.

First, regarding dates, to dispel any doubts, the following is clarified based on what is described in the Inspection Report:

• According to the Commercial Registry Certificate, "C…" appears as partner-director in the period between 2004-08-02 and 2009-12-31, having resigned from the management position on 2009-12-31 (cf. p. 72 attached);

• De facto management occurred in the course of the year under analysis (tax period 2009-07-01 to 2010-06-30), as evidenced by documentary proof presented in the preceding point

• The employment contract termination agreement between the objecting party and the employee in question was signed on 2010-03-04 (cf. pp. 73 attached);

• On 2010-01-13, a power of attorney was executed (cf. pp. 78,140 and 141 attached), "to whom are conferred ... all necessary powers"; with the objecting party bound "jointly by C… with any one of the other attorneys-in-fact, but never the latter jointly without the intervention of the attorney-in-fact C…."

In fact, the objective of autonomous taxation is to try to prevent these expenses, indemnities not related to the achievement of previously defined productivity objectives, from being accepted in full as expenses of the tax period.

These expenses are taxed autonomously at the rate of 35%, by legislative provision set forth in paragraph 13 of Article 88 of CIRC.

"Article 88

Autonomous Taxation Rates

(...)

13—Are taxed autonomously at the rate of 35%:

a) Expenses or charges relating to indemnities or any compensation due not related to the achievement of previously defined productivity objectives, when there is termination of functions as director, administrator or manager, as well as expenses relating to the portion exceeding the value of remuneration that would have been earned by the exercise of such positions until the end of the contract, when it is a contract termination before the end date, regardless of the payment method, whether made directly by the taxpayer or with transfer of the inherent responsibilities to another entity..."

We reaffirm what the objecting party stated: "the creation of the expense for the indemnity and compensation to be paid to the former employee .... Occurs... before the publication of the new Law, which came into force on 29 April 2010"

Now, according to the information available, the Tax Administration (TA) has maintained that the 35% rate should apply to all bonuses or variable remuneration attributed in the period they were recognized as an expense, provided that the conditions of incidence are met and the tax exclusion conditions in the standard under review do not apply.

In fact, the objecting party presented no concrete evidence serving as support for changing the initial correction, that is, no new element was presented, and accordingly it appears to us that the correction made by the Tax Inspection Services is correct.

2.3. Personnel Expenses and their indispensability ... (§ 110 to § 139)

Value of contested correction: €11,377.80

In her arguments, the objecting party states: "The Inspection Services ... claim that the expenses ... in the amount of €11,377.80 and relating to the conduct of the event intended for the sales department would have a recreational nature ...such actions prove to be essential and fundamental to proper business management"

Tax Inspection Report: "Recorded ... is an invoice from supplier G…, SA, Tax ID No. …, No. and 310/2009, dated 2009/10/15, in the amount of €11,377.80...account 638002, personnel training ... When questioned in point 4 of the notification of 2013/06/19, the taxpayer clarified that it was an Event they called "Mission Impossible," held for the sales department ...*

After analyzing the documents attached (cf. pp. 92, 93 and 150-167), we verified it was an event called "Mission Impossible," which took place from 30 September to 1 October, for middle and senior management, as described in the following manner:

"YOU HAVE BEEN CALLED FOR A SPECIAL MISSION.

REPORT AT L… (...) AT 10:00 ON 30 SEPTEMBER 2009.

MANDATORY USE OF SPORTS CLOTHING AND SWIMWEAR."

Now let us consider,

Taxpayers are free to manage their companies and bear the expenses they consider necessary. Different is their acceptance in tax terms.

Paragraph 1 of Article 23 of the Corporate Income Tax Code provides that only are considered costs or losses those "provably indispensable for the realization of revenues or gains subject to Tax or for the maintenance of the productive source," that is, the qualification of costs as deductible implies that they are related to the activity exercised by the company in terms of their economic adequacy relative to the purpose of obtaining results.

The question of substantiation of the expense required by Article 23 constitutes the proof of the actual realization of the constituent facts of the charges. In matters of expenses, the most important means of proof is documentary evidence.

Accordingly, these expenses are considered as abnormal and not essential to the maintenance of the productive source given the manifest and proven lack of adequacy and appropriateness to the company's activity.

Granting the law to the TA sufficient powers to refuse acceptance as a tax expense of expenditures that cannot be considered compatible with the purposes to be pursued by the company.

The Judgment of the Supreme Court of Justice, rendered in case No. 01236/05, of 2006-03-29, holds that "the criterion of indispensability was created by the legislator, not to allow the Administration to interfere in the management of companies, dictating how it should apply its resources, but to prevent the tax consideration of expenses that, although recorded as costs, do not fall within the scope of the company's activity, were incurred not for its pursuit but for other outside interests*.

In this regard, an excerpt from the judgment of the Central Administrative Court, rendered in case No. 02608/08, of 2009-03-10, is transcribed, which "Drawing on the Study by Tomás de Castro Tavares (On the Relationship 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 CTF, No. 396, pp. 7-177) concludes in the sense that "The indispensability referred to in Article 23 of CIRC as a condition for a cost to be deductible does not refer to necessity (the expense as a sine qua non condition of revenues), nor even to convenience (the expense as convenient for business organization), under penalty of intolerable interference by the TA in the autonomy and freedom of management of the taxpayer, but requires only an economic causal relationship, in the sense that it suffices that the cost be incurred in the interest of the company, in order, directly or indirectly, to obtain profits. The legal notion of indispensability is therefore defined from an economic-business perspective, by direct or indirect fulfillment of the ultimate motivation of contributing to profit generation.'

In light of the foregoing, given the fact that the objecting party has not proven the indispensability and the purpose of the expense for purposes of determining the taxable base under IRC, and moreover that such expenses exist, under penalty of the respective expense not being tax-deductible, and such proof was manifestly not achieved, the expenses in question should be disregarded as a tax expense, maintaining the correction made by the Tax Inspection Services.

2.4. Undocumented Expenses (§ 140 to § 163)*

Value of contested corrections: €100,056.14 and €50,029.07, by way of autonomous taxation

The objecting party states: "the entirety of these expenses were intended to reward and/or incentivize the Petitioner's employees and partners... the Petitioner has and delivered to the Inspection Services documents that enable it to control and prove the attribution of such cheques and vouchers*

It is mentioned in the inspection report:

"The elements presented by the taxpayer did not allow identification of charges and/or beneficiaries of the said payments and/or amounts assigned.

The acquisition and distribution of H… Cards (totaling €64,996.24), pre-paid debit cards, I… Cheques, J… Gift Cheques, K… gift cards, T… gift card/cheques and Vouchers, constitute monetary values payable to bearer, represent mere exchanges of means of payment and not actual costs, since the expense only occurs when the document (invoice/receipt) is recorded.

The taxpayer could and should have documented the expense corresponding to each acquisition of the goods/services underlying each cash outflow. If such cash outflows correspond to payment for acquisitions of goods/services, or if they had any other destination, it was not possible to determine, and accordingly they are classified as confidential expenses.

Pursuant to Article 88 of CIRC, confidential or undocumented expenses, as is the case here, since they are payments in relation to which "the taxpayer did not identify the charge to which such payment is related or the entity benefiting from such payment, are subject to autonomous taxation at the rate of 50%, totaling €50,029.07, and the costs recorded are not accepted pursuant to Article 23 of CIRC, in the amount of €100,058.14."

In fact, an expense is not properly documented when it is not supported by credible external documents and in the case at hand, after analyzing the documents attached (cf. pp. 94-104 and 168-215), we found they were only internal documents.

With the arguments now presented, we conclude that no additional external documents were presented as support for the accounting entries made, only internal documents already presented in the inspection procedure, so as to enable knowledge in a faithful, clear and precise manner of the respective transactions, demonstrating the cause, nature and amount.

Now, the Corporate Income Tax Code has long been clear regarding the obligation of commercial companies to maintain organized accounts in accordance with commercial and tax law.

Highlighting subparagraph a) of paragraph 3 of Article 17 of CIRC, which provides that accounting should "be organized in accordance with accounting standards and other legal provisions in force for the respective sector of activity (...)", with specific duties for company record-keeping being established in Article 115 of CIRC, namely in subparagraph a) of paragraph 3 - "In the execution of accounting (...) all entries must be supported by supporting documents, dated and capable of being presented whenever necessary".

And so it is, given the logic of the Corporate Income Tax Code, because the "supporting document" referred to in subparagraph a) of paragraph 3 of Article 115 of CIRC, in the case of an expense, is an external document that allows identification of its nature - namely, for the purpose of knowing whether it is indispensable for the realization of revenues or the maintenance of the productive source, as provided in paragraph 1 of Article 23 of CIRC - of the beneficiary, of its realization and of the respective temporal allocation, for the essential purpose of income periodization, as provided in Article 18 of CIRC.

In light of the law, it is concluded that, to be deductible, and, beyond the other requirements already mentioned, costs will necessarily be proven by valid documents, understanding as, in general, a valid document one whose external origin - which is the general rule for those justifying acquisitions of goods and services--- demonstrates unequivocally the truthfulness of the economic transaction underlying the accounting entry made, as well as the other essential elements for quantifying the respective consequences.

The requirement for substantiation required in Article 23 of CIRC relates to the effectiveness of the realization of costs. Within the scope of this issue, the requirement for substantiation is relevant and the connection of this requirement with other duties of the taxpayer, such as the issuance of an invoice and the means of proof to be used.

In the same sense, the jurisprudence of the Central Administrative Court South expressed its understanding through Judgment No. 01486/06 of 30 January 2007, in holding that "In light of the principles presented, they do not constitute deductible charges for purposes of determining taxable profit, charges not properly documented (existing when they are not supported by external documents in terms of enabling knowledge easily, clearly and precisely of the transaction, showing the cause, nature and amount) and ..."

The causal nexus of "indispensability" must exist between costs and the realization of revenues or gains and, not being documented, they cannot be accepted for tax purposes.

The facts presented by us are in line with the opinion of Freitas Pereira expressed in his Opinion issued in CEF No. 3/92 of 6/1/1992, published in CTF No. 365, pp. 343-352, "The absence of an external document intended to substantiate a transaction for which it should exist necessarily affects, in principle, the evidentiary value of the accounting and this lack cannot be supplied by presenting an internal document. This is because the evidentiary value of accounting is based essentially on its supporting documents and, as for those that should be, it is the external origin that confers on them a character that can be designated as a presumption of authenticity ..."

Accordingly, we do not confirm the arguments presented by the objecting party and it appears to us that the corrections made by the Tax Inspection Services are correct.

f) The Petitioner filed a hierarchical appeal of the decision rejecting the administrative objection for 2009, an appeal which was assigned No. … 2014 …, filed on 04-07-2014 and was not decided until the date the petition for arbitral decision was submitted (document No. 1, attached with the petition for arbitral decision, whose contents are reproduced herein);

g) As the Petitioner had a tax loss in 2010, it deducted it in calculating the IRC for 2010;

h) The Tax and Customs Authority conducted an external tax inspection by the Tax Inspection Services of the Lisbon Finance Directorate, pursuant to Service Order No. OI 2013 …, for the 2010 tax year, having made a correction that resulted in disallowing the tax losses that had been deducted, in the total amount of €111,435.94, as stated in the Tax Inspection Report attached with the petition for arbitral decision as document No. 16, whose contents are reproduced herein, which states, inter alia, the following:

III - Description of Facts and Basis of Purely Arithmetic Corrections

From the inspection action under Service Order No. …, conducted on taxpayer A… - Sociedade de Cosmética, Lda., Tax ID: …, for 2009, resulted technical corrections, IRC taxable base, in the amount of €111,435.94, altering the fiscal result determined by the taxpayer from €-1,304,476.62 to €-1,193,040.68.

Article 52 of the Corporate Income Tax Code regulates the regime for the deduction of tax losses.

Thus tax losses determined in a given fiscal year shall be deducted from taxable profits, if any, in one or more of the four following years.

In 2010, the taxpayer declared a taxable profit of €2,144,336.95 to which it deducted the tax loss it had declared for 2009 in the amount of €-1,304,476.62, determining a taxable base of €839,860.33.

Paragraph 4 provides that when corrections are made to tax losses declared by the taxpayer, the deductions made shall be correspondingly altered.

Thus, we will make the correction in determining the taxable base for 2010, altering the amount of tax losses deducted from 2009 from €-1,304,476.62 to €-1,193,040.68.

This will result in the alteration of the taxable base determined for 2010, from €839,860.33 to €951,296.27.

i) Following the correction made by the Tax and Customs Authority regarding 2010, an additional IRC and compensatory interest assessment No. 2013 … was issued, with reference to 2010, in which the Tax Authority determined the amount of tax of €27,856.98 to be paid by the Petitioner and €2,178.81 of compensatory interest, for a total of €30,035.79 (document No. 6, attached with the petition for arbitral decision, whose contents are reproduced herein);

j) The Petitioner filed an administrative objection to the aforementioned assessment for 2010, which was assigned No. … 2014 … and was rejected by decision of 18-07-2014, by the Head of Division, acting for the Lisbon Finance Directorate (document No. 4 attached with the petition for arbitral decision, whose contents are reproduced herein);

k) The Petitioner filed a hierarchical appeal of the decision rejecting the administrative objection for 2010, an appeal which was assigned No. … 2014 …, filed on 11-08-2014 and was not decided until the date the petition for arbitral decision was submitted (document No. 2 attached with the petition for arbitral decision, whose contents are reproduced herein);

l) The Petitioner proceeded to pay the amount of €27,858.98, relating to the assessment for 2010, under the Exceptional Regime for Regularization of Tax and Social Security Debts, provided for in Decree-Law No. 151-A/2013 of 31 October, which enabled it to be relieved of payment of the compensatory interest (document No. 17 attached with the petition for arbitral decision, whose contents are reproduced herein);

m) The Petitioner engages in the business of sales of perfumes, hair products, cosmetics, jewelry and decorative items and similar hygiene and cleaning activities (document No. 8 attached with the petition for arbitral decision, whose contents are reproduced herein);

n) In the context of this activity, the Petitioner is the exclusive importer of various products from the international economic group, namely D3… Companies;

o) In 2009, the Petitioner underwent a restructuring process, which proved necessary considering the international structure in which the Petitioner operates;

p) As part of said restructuring process, various employees terminated their relationship with the Petitioner;

q) In 2009, C… held the functions of director of the Petitioner company;

r) In December 2009, C… resigned from the management position of the company, with effect from 31-12-2009, disagreeing with the restructuring being undertaken (documents Nos. 9 and 10 attached with the petition for arbitral decision, whose contents are reproduced herein);

s) After resigning from the functions of director and until ceasing functions, C… continued to receive the remuneration she received as director;

t) From January 2010 onwards, the management of the Petitioner was conducted from an integrated perspective, essentially with Y… exercising the functions of director of the Petitioner (document No. 10 attached with the petition for arbitral decision, whose contents are reproduced herein);

u) It was the management of the Petitioner, which C… was not part of, that decided all steps to be taken in the development of the restructuring in question, with the then employee C… limited to executing the decisions being made;

v) From the date the resignation from the functions of director took effect, the then employee C… ceased to have any real involvement in management decision-making;

w) From the date of effectiveness of the resignation from the functions of director, the then employee C… was registered with Social Security as a dependent employee from 04-02-2010 (document No. 11 attached with the petition for arbitral decision, whose contents are reproduced herein);

x) Disagreeing with C… the sacrifices resulting from the Petitioner's restructuring, it became unviable, in March 2010, to maintain the functional relationship;

y) On 04-03-2010, C... concluded with the Petitioner an employment contract termination agreement, which resulted in the termination of her employment relationship, with payment by way of severance indemnity of €296,100.00 and pecuniary compensation for a non-competition covenant valued at €140,000.00, for a total of €436,100.00 (document No. 12 attached with the petition for arbitral decision, whose contents are reproduced herein);

z) In arbitral case No. 297/2014-T, which was decided at CAAD, it was decided by judgment of 30-10-2014, now final, that from the resignation from the position of director in December 2009, C... limited herself to exercising functions as a dependent employee, complying with the orders and management decisions taken by the management of the Petitioner, of which she no longer was part (document No. 7 attached with the petition for arbitral decision, whose contents are reproduced herein);

aa) In October 2009, the Petitioner organized, through G… -, S.A., an event called "Mission Impossible" in which, inter alia, the matters referred to in the documents attached to the petition for arbitral decision as document No. 19, whose contents are reproduced herein, were addressed;

bb) In 2009, the Petitioner developed certain campaigns in which it rewarded employees and partners for sales made and objectives achieved, having made offers of H… Cards, I… cheques, J… Gift Cheques, K… gift cards and L… Vouchers, as referred to in section III.1.2.2 of the Tax Inspection Report, in the global amount of €100,058.14;

cc) On 30-11-2014, the Petitioner submitted the petition for arbitral decision which gave rise to the present case.

2.2 Unproven Facts

It was not proven that C..., between 01-01-2010 and 30-09-2010, exercised, de facto or de jure, the functions of director of A… Lda.

The testimony of witness W… was clarifying in a sense contrary to the exercise of the functions of director by C..., after 01-01-2010.

2.3 Substantiation of Facts

The determination of facts is based, in general, on the documents attached with the petition for arbitral decision and, as for the remaining points, on the testimony of witnesses W…, E… and E….

The witnesses appeared to testify with impartiality and with knowledge of the facts they related.

3. LAW

The Petitioner attributes several defects to the act of IRC and compensatory interest assessment, the annulment of which it requests.

Article 124 of the Code of Tax Procedure (CPPT), subsidiarily applicable by virtue of Article 29, paragraph 1 of the RJAT, establishes an order of examination of defects, which presupposes that, upon finding one defect that ensures effective protection of the rights of the challenging party, there is no need to examine the remainder, since, if it were always necessary to examine all defects attributed to the challenged act, the order of examination would be irrelevant.

Under subparagraph b) of paragraph 2 of said Article 124, when defects of form and defects of violation of substantive law are attributed to an act, one should begin by examining the defect of error regarding the factual presuppositions, as the possible annulment based thereon would provide the Petitioner with stable and effective protection of its interests.

In the case at hand, the Petitioner invokes, first, the defect of lack of substantiation of the decisions on administrative objections, maintained by the tacit rejections.

However, since this is a defect of a formal nature, the protection provided by its possible establishment is less stable than that which can result from the establishment of defects of violation of law.

Therefore, defects of violation of law will be examined first, and then, if examination thereof would not prejudice knowledge of other matters, defects of lack of substantiation of the decisions on administrative objections will be examined.

3.1 Question of the Correction Relating to the Termination of C...'s Employment Contract

The substantiation of the tax act consists only of what is stated in the act itself and the elements to which it refers, since the tax arbitration procedure, as an alternative to the judicial challenge procedure (paragraph 2 of Article 124 of Law No. 3-B/2010 of 28 April), is, like this, a procedural remedy based on legality, aimed at eliminating the effects produced by illegal acts, by annulling them or declaring them null or non-existent [Articles 2 of the RJAT and 99 and 124 of the CPPT, applicable by virtue of Article 29, paragraph 1, subparagraph a), thereof]. Therefore, the acts that are the object of the procedure must be examined as they were adopted, and the tribunal cannot, upon finding that an illegal basis was invoked as the foundation of the administrative decision, examine whether its action could be based on other grounds, nor attend to those which were invoked only later, particularly in the arbitration procedure.

The Tax and Customs Authority understood that the total amount of €436,100.00, paid by the Petitioner to its former employee C... connected with the termination of her employment contract (€296,000.00 by way of severance indemnity and €140,000.00 as pecuniary compensation for a non-competition covenant) is subject to autonomous taxation at the rate of 35%, provided for in paragraph 13 of Article 88 of the CIRC, added by Law No. 3-B/2010 of 28 April.

The said paragraph 13 of Article 88, as amended by Law No. 3-B/2010 of 28 April, establishes the following, in its subparagraph a), which was applied by the Tax and Customs Authority:

13 - Are taxed autonomously at the rate of 35%:

a) Expenses or charges relating to indemnities or any compensation due not related to the achievement of previously defined productivity objectives, when there is termination of functions as director, administrator or manager, as well as expenses relating to the portion exceeding the value of remuneration that would have been earned by the exercise of such positions until the end of the contract, when it is a contract termination before the end date, regardless of the payment method, whether made directly by the taxpayer or with transfer of the inherent responsibilities to another entity;

As can be seen, this standard only applies in situations of termination of functions as director, administrator or manager.

The Tax and Customs Authority understood in the Tax Inspection Report that C... was director when she concluded the agreement on termination of functions with the Petitioner.

However, in the case at hand, it is documented by the commercial registry certificate that C... ceased to exercise the functions of director from 31-12-2009 (page 4 of document No. 10 attached with the petition for arbitral decision, whose contents are reproduced herein).

Therefore, only the de facto exercise of managerial functions can be relevant for the classification of C...'s situation under the standard referred to.

In section 2.2 of the decision on the administrative objection, "to dispel any doubts, the following is clarified based on what is described in the Inspection Report:

• According to the Commercial Registry Certificate, "C…" appears as partner-director in the period between 2004-08-02 and 2009-12-31, having resigned from the management position on 2009-12-31 (cf. p. 72 attached);

• De facto management occurred in the course of the year under analysis (tax period 2009-07-01 to 2010-06-30), as evidenced by documentary proof presented in the preceding point

• The employment contract termination agreement between the objecting party and the employee in question was signed on 2010-03-04 (cf. p. 73 attached);

• On 2010-01-13, a power of attorney was executed (cf. pp. 78,140 and 141 attached), "to whom are conferred ... all necessary powers"; with the objecting party bound "jointly by C… with any one of the other attorneys-in-fact, but never the latter jointly without the intervention of the attorney-in-fact C…"

The first of these facts proves precisely the opposite, since the certificate states that the termination of the functions of director occurred on 31-12-2009, and therefore they would not be exercised on 04-03-2010, when the employment contract termination agreement was concluded.

The third, which is the signing of the contract on 04-03-2010, likewise does not prove the exercise of management, since nothing in it refers to such exercise.

Thus remain the facts indicated in the second and fourth places; the power of attorney executed on 13-01-2010 provides support for the adoption of the acts that are indicated as follows:

In truth, it is stated in the power of attorney that to bind the company in court or outside it, the signatures of two directors, one director and one designated agent, or one or more designated agents are necessary and sufficient pursuant to their respective powers of attorney, and that for acts of mere routine, the signature of any of the directors will suffice.

From this it can be seen that to bind the company it was not necessary to have the status of director, since the possibility was provided for the company to be bound through agents, even only one, designated pursuant to their respective powers of attorney.

Therefore, the fact that the Petitioner signed documents binding the company does not imply that the Petitioner was exercising de facto management, as the status of agent-in-fact allowed her to do so.

On the other hand, the testimony of witness W… clarified, unequivocally and coherently, that the management of the Petitioner in 2010 was carried out from abroad, that C... ceased to exercise de facto management functions from 01-01-2010, and that the sums paid to her do not relate to the termination of management functions, but rather to the functions as an employee, which she began to exercise after ceasing to exercise those of director.

As for the fact that the former remuneration was maintained after the resignation, this does not imply that the functions were the same, signifying only that she began to exercise functions remunerated in the same manner, for whatever reason, which was not determined, but could even be a contractual obligation or agreement of the interested parties. In particular, in this context, one cannot fail to bear in mind that one is dealing with the exercise of special functions, with unusually high remuneration (€10,000 per month), certainly justified by exceptional skills in the area in question, and the company's concern with protecting its interests after the termination of functions even justified an unusually high severance indemnity (€436,100.00). This indemnity, which includes compensation for a non-competition covenant, reveals that the company had more important concerns regarding the termination of management functions by C... than lowering her remuneration, as it substantially even paid her for inactivity after ceasing to exercise functions in the area in which the company operates.

Therefore, the fact that remuneration was not reduced cannot be considered an indication that C... continued to exercise the same functions after the resignation.

Thus, it must be concluded that the correction in question is based on an error regarding the factual presuppositions (incorrect understanding that C... exercised management functions and that the amount she received was related to the termination of exercise of those functions), which constitutes a defect of violation of law and justifies its annulment.

Error regarding the factual presuppositions constitutes a defect of violation of law, since, as the legal powers exercised in the administrative act are attributed to be exercised under certain conditions, their use in factual situations that do not correspond to those that underlay the attribution of such powers is in conflict with the law. ([1])

The petition for arbitral decision thus succeeds in this regard, both as to the correction to the taxable base and as to the autonomous taxation of 35%, leaving prejudiced by being moot the examination of the remaining questions raised by the Petitioner regarding this correction, in particular that relating to the temporal application of paragraph 13 of Article 88 of the CIRC.

3.2 Indispensability of Expenses

Article 17 of the CIRC provides that "the taxable profit of legal entities and other entities referred to in subparagraph a) of paragraph 1 of Article 3 is constituted by the algebraic sum of the net profit for the period and the positive and negative patrimonial variations verified in the same period and not reflected in that profit, determined on the basis of accounting and eventually corrected pursuant to this Code."

Article 23 of the CIRC, in the version prior to Decree-Law No. 159/2009 of 13 July (in force until the end of 2009), provides that "only are considered costs or losses those provably indispensable for the realization of revenues or gains subject to tax or for the maintenance of the productive source."

The Tax and Customs Authority made a correction relating to the expense documented by an invoice from supplier G…, S.A., dated 2009/10/15, in the amount of €11,377.80 plus VAT at the standard rate.

It is stated in the Tax Inspection Report that "this invoice was recorded on 2009/10/23 as personnel expenses (account 638002, personnel training) and VAT deduction of €2,275.56 was claimed (account 243237). When questioned in point 4 of the notification of 2013/06/19, the taxpayer clarified that it was an Event they called 'Mission Impossible,' held for the sales department. (see Annex 5)."

The Tax and Customs Authority understood that "although the expenses deducted by the taxpayer are properly recorded and supported by invoices and receipt documents evidencing their origin, nature and amount, the taxpayer did not prove their indispensability for the realization of revenues or gains subject to tax or for the maintenance of the productive source of A…, as provided for in Article 23 of CIRC" and concluded by stating that "these are expenses of a purely recreational nature, and accordingly the cost recorded is not accepted for the formation of taxable profit, pursuant to Article 23 of CIRC, in the amount of €11,377.80."

The deficiency in the substantiation of this point of the Tax Inspection Report is manifest, as it does not clarify what the activity consisted of that was concluded to have "a purely recreational nature."

In any case, the documents comprising document No. 19 attached with the petition for arbitral decision demonstrate that at that event matters of potential interest to the Petitioner's activity were addressed, such as competition issues, company structure, product lifecycle, business model and, in general, business strategy, in particular ways of acting to achieve the company's objectives.

The testimony of witness F… confirms that the event did not have a purely recreational nature and was clarifying regarding its relevance to company efficiency.

Therefore, it must be concluded that the presupposition on which the correction made was based is erroneous, as it is manifest that the event did not have "a purely recreational nature" and, therefore, the act adopted contains a defect of error regarding the factual presuppositions, which alone justifies the annulment of the assessment in that respect.

On the other hand, as has been understood, the concept of indispensability of costs under Article 23, paragraph 1 of the CIRC does not require a causal connection between costs and revenues, sufficing that the expenses have a relationship with the object of the company, are incurred in the course of its activity or evidence a business purpose. ([2])

In the case at hand, the connection between the event referred to and the Petitioner's interest is proven by the content of the documents attached as document No. 19, beyond the aforementioned testimony.

Therefore, the interpretation of Article 23, paragraph 1 of the CIRC adopted by the Tax and Customs Authority is not correct, in excluding from the scope of cost indispensability expenses with events at which matters of the types referred to were addressed.

Therefore, the correction made contains a defect of violation of law due to error regarding the factual presuppositions regarding the law.

3.3 Undocumented Expenses

The Tax and Customs Authority considered confidential or undocumented expenses indicated in the Petitioner's accounting relating to campaigns in which it rewarded employees and partners for sales made and objectives achieved, having made offers of H… Cards, I… cheques, J… Gift Cheques, K… gift cards and L… Vouchers, as referred to in section III.1.2.2 of the Tax Inspection Report, in the global amount of €100,058.14.

Beyond not considering such expenses as deductible costs due to lack of proof of their indispensability for obtaining revenues, the Tax and Customs Authority applied autonomous taxation of 50%, provided for in Article 88, paragraph 1 of the CIRC, in the amount of €50,029.07.

The Tax and Customs Authority understood that:

"The elements presented by the taxpayer did not allow identification of charges and/or beneficiaries of the said payments and/or amounts assigned.

The acquisition and distribution of H… Cards (totaling €64,996.24), pre-paid debit cards, I… Cheques, J… Gift Cheques, K… gift cards, T… gift card/cheques and Vouchers, constitute monetary values payable to bearer, represent mere exchanges of means of payment and not actual costs, since the expense only occurs when the document (invoice/receipt) is recorded.

The taxpayer could and should have documented the expense corresponding to each acquisition of the goods/services underlying each cash outflow. If such cash outflows correspond to payment for acquisitions of goods/services, or if they had any other destination, it was not possible to determine, and accordingly they are classified as confidential expenses.

Pursuant to Article 88 of CIRC, confidential or undocumented expenses, as is the case here, since they are payments in relation to which the taxpayer did not identify the charge to which such payment is related or the entity benefiting from such payment, are subject to autonomous taxation at the rate of 50%, totaling €50,029.07, and the costs recorded are not accepted pursuant to Article 23 of CIRC, in the amount of €100,058.14."

3.3.1 Confidential and Undocumented Expenses

Article 81, paragraph 1 of the CIRC, in the version prior to Law No. 67-A/2007 of 31 December, which currently corresponds to Article 88, provided as follows:

1 - Confidential or undocumented expenses are taxed autonomously at the rate of 50%, without prejudice to the provisions of subparagraph g) of paragraph 1 of Article 42

With the version introduced by Law No. 67-A/2007, the wording of this standard now provides as follows:

1 - Undocumented expenses are taxed autonomously at the rate of 50%, without prejudice to their non-consideration as a cost pursuant to Article 23

As can be seen, in the version prior to Law No. 67-A/2007, the concepts of "confidential expenses" and "undocumented expenses" were used cumulatively, the reference to the former being removed in the new version.

The Plenary of the Supreme Administrative Court in judgment of 28-1-2009, rendered in case No. 575/08, defined the two concepts:

Confidential expenses are expenses that, "as their very designation indicates, are not specified or identified as to their nature, origin and purpose." ([3]) These are expenses that, by their very nature, are not documented. ([4])

In the context of these statutes, in view of the cumulative reference to confidential and undocumented expenses, the former would be those as to which their nature, origin and purpose are not revealed, while the latter would be expenses as to which there is no documentary evidence, although there is no concealment of their nature, origin or purpose. All of them, however, would be expenses not substantiated documentarily.

(...)

The assessment of the existence or not of proper documentation and confidentiality of the expense is made having as its object the act through which the taxpayer bears the charge or expense that is capable of affecting the net profit of the fiscal year, for purposes of determining the taxable base for IRC.

That is, the expense will not be properly documented when there is not the documentary evidence required by law demonstrating that it was effectively borne by the taxpayer and the expense will be confidential when it is not disclosed who received the sum embodying the expense.

In said judgment of the Supreme Administrative Court, the case involved expenses with so-called "cheques-auto," which were "payment vouchers for fuel or other products made available by the same suppliers, since, after being acquired, such cheques could both be used for the acquisition of those products or could be exchanged again, at least in part, for cash."

The Supreme Administrative Court understood that acquisition of cheques-auto by companies represented only an exchange of means of payment, considering that, with the destination of the said cheques being unknown, one was dealing with confidential expenses, as one was dealing with "expenses not identified as to their nature, origin and purpose." ([5])

However, as was stated, in the version of Article 81 of the CIRC (current Article 88) in force in 2009, there was no reference to confidential expenses, and accordingly autonomous taxation could only be based on the possible qualification of expenses as undocumented.

Moreover, the relevance of the expenses in question for purposes of determining taxable profit must be assessed in light of Article 23 of the CIRC.

First, it is necessary to specify what these expenses consist of and the evidence that was made regarding them.

3.3.2.1 H… Cards

As is stated in the Tax Inspection Report, H… Cards are pre-paid debit cards, the beneficiaries of which were saleswomen of perfumeries that are A…'s clients, with the objective of promoting sales. The design and production of brochures, letters, production of cards and monitoring were invoiced, and the invoices were found in the Petitioner's accounting.

Moreover, the saleswomen of the perfumeries to whom the debit cards were delivered are identified by the Petitioner in the list in document No. 20 attached with the petition for arbitral decision, whose contents are reproduced herein, with no question being raised as to its correspondence to reality.

3.3.2.2 J… Gift Cheques

It is stated in the Tax Inspection Report that J… gift cheques are multistore gift cheques, sold by O… Portugal, Lda., with diverse offerings, face values: €10, €15, €25, €30 and €50, validity period of 6 to 18 months, accepted at more than 600 stores nationwide.

The acquisition of such cheques is recorded on 17-09-2009, through invoice No. 2009663 from O… Portugal, Lda., totaling €4,650.00.

The Petitioner in document No. 21 attached with the petition for arbitral decision, whose contents are reproduced herein, identifies the perfumeries to which the cheques were delivered and their values.

3.3.2.3 I… Cheques

It is stated in the Tax Inspection Report that I… provides gift cheques, which are valid for the entire range of I… and I…Service products. Their unit value is €5, €10, €20 and €30. The holder of the gift cheque may exchange it for the product he wishes in the establishment itself. I… gift cheques are likewise valid for green price products and accepted at any I…, I…Service, P…, Q… or R… store.

The Petitioner did not indicate to whom these cheques were delivered.

3.3.2.4 K… Cards (Z…, S… and T…)

These are cards that, once loaded, represent a monetary value to the bearer.

The acquisition of such cards is documented in the Petitioner's accounting and document No. 22 attached with the petition for arbitral decision indicates the perfumeries to whom they were delivered.

3.3.2.5 L… Vouchers

A transfer of €810.00 was made, with the Petitioner having informed that it is a purchase of L… vouchers, but no invoice or equivalent document was exhibited.

In the present case the Petitioner states, in Article 228 of the petition for arbitral decision, that the documents evidencing the nature, purposes and beneficiaries are contained in annexes 8 and 9 to the Tax Inspection Report and in document No. 23 attached with the petition for arbitral decision.

Neither in annexes 8 and 9 to the Tax Inspection Report nor in document No. 23 attached with the petition for arbitral decision is there any invoice relating to payment of the amount of €810.00 referred to.

3.3.3 Decision on the Question of Expenses Considered by the Tax and Customs Authority as Undocumented

With respect to H… Cards, J… cheques and K… cards, beyond there being documents evidencing the expenses, its destination was proven, which allows the conclusion that one is dealing with activities of promoting sales of the Petitioner's products, which, beyond not coming within Article 81, paragraph 1 of the CIRC (current Article 88), should be considered costs for purposes of Article 23 of the CIRC, as they come within the concept of "advertising" expressly indicated in subparagraph b) of its paragraph 1.

With regard to I… cheques, the expenses are documented through invoices, and accordingly one is not dealing with a situation falling under Article 81, paragraph 1 of the CIRC (current Article 88). Moreover, unlike what occurred in the situation of cheques-auto, dealt with in the jurisprudence of the Supreme Administrative Court that was cited, one is not dealing with a mere exchange of means of payment, eventually reversible, and accordingly one is dealing with expenses definitively made by the Petitioner. In any event, not having proven the destination given to the cheques referred to, the amount spent cannot be relevant for purposes of determining taxable profit.

As to L… Vouchers, it is found that no invoice was presented, and accordingly one is dealing with undocumented expenses for purposes of Article 81, paragraph 1 of the CIRC (current Article 88), beyond the expense being unable to be relevant for purposes of determining taxable profit.

Accordingly, the petition for arbitral decision succeeds with respect to the corrections and autonomous taxation relating to H… Cards, J… cheques and K… cards.

The petition for arbitral decision does not succeed with respect to the correction relating to L… Vouchers, either as to autonomous taxation thereof (€405.00) or as to relevance for determining taxable profit (€810.00).

As to the correction relating to I… cheques (in the global amount of €4,100.00), the petition for arbitral decision succeeds as to the question of autonomous taxation and does not succeed as to the question of relevance for determining taxable profit.

The Petitioner argues that Articles 23 and 81, paragraph 1 of the CIRC (the latter, current Article 88) would be materially unconstitutional if interpreted to mean that for the qualification of certain expenses as confidential or undocumented it suffices to invoke the absence of external documents, when the taxpayer demonstrates that these have documentary support, establishing what their activity is, this implies a violation of the constitutional principle of proportionality.

However, the requirement to comply with accounting obligations, imposed by Article 115 of the CIRC, in the version in force in 2009, has an evident basis in the principle of practicability, indispensable for the Tax and Customs Authority to carry out the inspection activity, which, in pursuit of the public interest, it is incumbent upon it to conduct.

Therefore, it is appropriate that non-compliance with these obligations is associated with the irrelevance of undocumented expenses.

Moreover, with respect to autonomous taxation, their justification, despite being deviations in a system of taxation of business income, was adequately explained in the Preamble to Bill No. 46/VIII, which gave rise to Law No. 30-G/2000 of 29 December, which greatly expanded the situations of autonomous taxation, as it was understood that they were necessary, in short, to compensate for other distortions resulting from significant tax fraud and evasion, and thus to increase the fairness of the distribution of the fiscal burden among citizens and companies.

In truth, the said Bill states:

"The current model of taxation of income was established in 1988, based on the individual income tax (IRS) and the corporate income tax (IRC), and corresponded to the adoption of solutions with identical bases to those common in OECD countries, which obviously is not intended to be altered.

However, pragmatic considerations led immediately to some deviations from the defined principles, which the practice of subsequent years came, in numerous situations, to aggravate.

Furthermore, the evolution of the country has introduced changes in economic and social reality, partly as a result of the impact of the European Union and the very dynamic of deepening the integration process, with repercussion on the network of relationships and institutes that are the object of tax laws.

There is in Portuguese society a generalized feeling that the tax system does not fairly distribute the tax burden among citizens, falling on the most compliant, among them, employees, the greater share of the tax effort, while tax evasion and fraud maintain a significant presence that allows, frequently, that those who earn the most do not pay taxes or bear them in terms far below what is required of them.

1. Accordingly, the Government, following the elaboration of studies and technical reports produced under the auspices of previous Governments, in particular the XIII Government, as well as the work carried out by the Tax Reform Coordination Structure (ECORFI), which was created in January 2000, and beyond the debate these issues have raised, understood that it was time to submit to the National Assembly a broad reform of the Portuguese tax system.

It is intended with these measures to implement a fiscal justice pact with citizens, based on the broadening of the tax base, the intensification of the fight against tax fraud and evasion and the reduction of the fiscal burden of compliant taxpayers, within the framework of the general principles of equity, efficiency and simplicity that should frame the tax system."

In light of this explanation, it becomes clear that, from the legislative perspective, autonomous taxation directly affecting certain expenses, within taxes that originally applied only to income, are considered deviations from the system of direct taxation of income that was intended by the IRC.

But it also follows from this explanation that a value that legislatively was considered to be of greater importance than theoretical coherence of taxes, such as the implementation of fiscal justice, imposed a choice for these forms of taxation, as they are in consonance with the principles of equity, efficiency and simplicity.

That is, it was understood that the system of taxation of companies exclusively based on taxable profit generated situations of fiscal inequity that it was intended to attenuate or eliminate by implementing a "broadening of the tax base," through adding to direct taxation, which continues to be the essence of the system of taxation of companies, situations of indirect taxation, by way of application of tax also to certain expenses that it was understood would be causes of such inequity, by being presumably connected to situations of "tax evasion and fraud" "that allows, frequently, that those who earn the most do not pay taxes or bear them in terms far below what is required of them."

In this light, the autonomous taxation provided for in Article 81, paragraph 1 of the CIRC (current Article 88) does not appear to be disproportionate, and accordingly there is no unconstitutionality invoked, reason for which the assessment does not annul the act of assessment for 2009, in the part where it applied autonomous taxation of €405.00 on the correction relating to L… Vouchers.

3.4 Conclusion

In summary, as to 2009, the correction to the IRC taxable base for 2009 should have been €4,910.00 and not €111,435.94, and accordingly corrections in the amount of €106,525.94 are illegal.

As to autonomous taxation, only the autonomous taxation relating to L… Vouchers expenses is justified, in the amount of €405.00 (€810.00 x 50%), and accordingly autonomous taxation relating to 2009 in the amount of €202,259.07 (€202,664.07 – €405.00) is illegal.

4. ASSESSMENT FOR THE YEAR 2010

Since the correction underlying the assessment relating to 2010 is dependent on the losses incurred in 2009, the petition for arbitral decision succeeds to the extent that the petition for arbitral decision succeeds in the part where it challenges the assessment for 2009, in the part corresponding to the determination of taxable profit.

The assessment relating to 2010 was based on the following quantitative elements:

[CALCULATION TABLE]

As results from what was stated regarding 2009, the correction to the taxable base should have been €4,910.00 (expenses relating to I… cheques and L… Vouchers) and not €111,435.94 (whereby there is an illegal correction in the global amount of €106,525.94).

Accordingly, the tax losses to be deducted in 2010 are €1,299,566.62 (€1,304,476.62 – €4,910.00) and the taxable base for this year is €844,770.33 (€2,144,336.95 – €1,299,566.62).

Accordingly, the petition for arbitral decision for the assessment for 2010 partially succeeds, in the part where it was based on the illegal correction of the taxable base in the amount of €106,525.94.

5. QUESTION OF LACK OF SUBSTANTIATION

As the petition for arbitral decision succeeds regarding the part of the corrections based on violation of law, the examination of the defect of lack of substantiation attributed by the Petitioner becomes moot and unnecessary, being justified only if it exists regarding the corrections relating to I… cheques and L… Vouchers.

As the jurisprudence has been asserting, substantiation is a relative concept [continuing...]