CAAD 844/2014-T: IRC Transfer Pricing & Royalties to Non-Resident Entities Ruling

Case no. 844/2014-T

The arbitrators Dr. Jorge Lopes de Sousa (arbitrator-president), Dr. Ricardo Jorge Rodrigues Pereira and Prof. Doctor Jorge Júlio Landeiro Vaz, designated by the Deontological Council of the Centre for Administrative Arbitration to form the Arbitral Tribunal, constituted on 10-05-2015, agree as follows:

1. Report

A…, S.A., Legal Entity no. …, with registered office at Rua do …, no. …, … (hereinafter "A..." or "Claimant"), presented, pursuant to the terms and for the purposes of the provisions of Article 10, of Decree-Law no. 10/2011, of 20 January (hereinafter RJAT) a request for constitution of a collective arbitral tribunal, in which the Tax and Customs Authority is the Respondent.

The Claimant requests that the illegality of assessment no. 2014 …, relating to the CIT for the fiscal year 2010, be declared, and from which, after proper compensation, results a value to be paid of € 96,935.03, an assessment that is based on an increase to the taxable base in the amount of € 847,616.75, which results, among others, from the following corrections with which the Claimant disagrees:

i) Correction in the amount of € 601,282.73, to the taxable profit of company B…, S.A. (B...), a company that belongs to the group of companies subject to the Special Regime for Group Taxation, of which the Claimant is the dominant company, by application of the transfer pricing rules, Article 63, nos. 1 and 8 of the CIT Code;

ii) Correction in the amount of € 5,953.33, to the taxable profit of B..., relating to payments to non-resident entities subject to a privileged tax regime, in violation of the provisions of Article 65, no. 1 of the CIT Code.

Following the correction made on the basis of the provisions of Article 65 of the CIT Code, the Tax Authority, by this assessment act, additionally levied and assessed under the heading of autonomous taxation the amount of € 2,083.67.

The request for constitution of the arbitral tribunal was accepted by the President of CAAD and notified to the Tax and Customs Authority on 30-12-2014.

Pursuant to the terms of subparagraph a) of no. 2 of Article 6 and subparagraph b) of no. 1 of Article 11 of the RJAT, the Deontological Council designated as arbitrators of the collective arbitral tribunal the undersigned, who communicated their acceptance of the appointment within the applicable time period.

On 23-02-2015 the parties were duly notified of this designation, having not manifested their intention to refuse the designation of arbitrators, pursuant to the combined terms of Article 11, no. 1, subparagraphs a) and b) of the RJAT and Articles 6 and 7 of the Deontological Code.

In accordance with the provisions of subparagraph c) of no. 1 of Article 11 of the RJAT, the collective arbitral tribunal was constituted on 10-03-2015.

The Tax and Customs Authority responded, disagreeing with the value of the dispute indicated by the Claimant, of €106,055.43, understanding that it should be changed to €96,395.03, and argues that the request for arbitral decision should be judged unfounded and the Tax and Customs Authority absolved of the claims.

On 26-05-2015 and 02-06-2015, meetings were held, in which testimonial evidence was produced and it was agreed that the case would proceed with successive written submissions.

The parties submitted statements.

The parties enjoy legal personality and capacity, are legitimate and are duly represented (Articles 4 and 10, no. 2, of the same diploma and Article 1 of Ordinance no. 112-A/2011, of 22 March).

The Tribunal is competent and the case does not suffer from nullities and no obstacle arises to the consideration of the merits of the case.

1. Factual Matters

2.1. Established Facts

The following facts are considered established:

a) In compliance with Service Order no. OI … a tax inspection action was determined on the taxpayer B..., S.A. (hereinafter, B...) relating to the fiscal year 2010;

b) The Claimant, in the fiscal year 2010, was the dominant company of Group C…, in which B... was inserted, of which the Claimant holds 100% of the capital;

c) Entity B... began its activity of "Production of common and fortified wines" (CAE 11021) on 13-06-1996;

d) Since the beginning of the second quarter of 2002, the activity developed by B... has consisted of the acquisition, warehousing, preparation, treatment, aging, bottling and commercialization of Port Wine;

e) B... is engaged in a commercial activity, which includes not only the sale and commercialization, but also the production of the goods in question;

f) Approximately 50% of Port Wine acquisitions are made by B... from an entity belonging to the same Group "Company D…, Lda.", which is held directly by B... in 89%;

g) B... markets various brands of Port Wine, namely E…, F…, G…, H… and I…;

h) B... sent the Annual Declaration of Accounting and Tax Information/IES for the year 2010, pursuant to no. 7 of Article 63, subparagraph c) of no. 1 of Article 117 and no. 1 of Article 121, all of the CIT Code, having declared in the field "H70" [operations with entities subject to privileged tax regime] of Annex H, the value of €915,823.00;

i) That value is related in the amount of €906,986.97 to the sales of special categories of Port Wine ("…" and "…") made in 2010 to the entity "J… LTD" (hereinafter "J..." or "J...");

j) J... has its seat in …, …, Jersey, …, Channel Islands, with Jersey being an integral part of the "Channel Islands";

k) According to consultation with the website of … (www...org) J... has its seat in …, …, …, address coinciding with that of entity E…, which constitutes the holding company of group C…, with the telephone (…) … and fax (…) … being common to both companies;

l) B... indicated that there is a verbal exclusivity agreement with J..., pursuant to which the latter holds the exclusive right to sell vintage wines for the markets of the United Kingdom and the United States of America;

m) Despite the said exclusivity agreement never having been reduced to writing, B... indicated the conditions in force, which are as follows:

– B... has an agreement with J... (the abbreviation J... refers to J...) that allows it to sell future goods in large quantities anticipating financial flows that would otherwise occur later.

– Additionally, B... also does not incur the commercial risk inherent in the future sale of these wines.

– In return, J... has exclusivity in the sale of wines acquired from B... in some countries, fundamentally the United Kingdom and the United States.

– B... incurs promotional costs relating to the worldwide launch of its vintages.

– These promotional actions serve the interests of B... and J... in the countries where the latter has exclusive sales rights for these products. Thus, J... agrees to pay a certain value per year as a contribution to the costs incurred by B....

– The process relating to the sale of future goods can be summarized as follows:

– In the first quarter of year n+1, B... carries out a selection of the vintage lots of year n and assesses their potential for a future vintage declaration;

– B... informs J... if it recognizes that vintage potential in the selected lots. J... and B... agree on the sale of a certain quantity of that future good which is generally sold in May of year n+1;

– In April of year n+2, if confirmed and vintage is declared, B... and J... may still agree on a price adjustment on the value invoiced and received in year n+1, as well as a quantity adjustment;

– From the moment the vintage is bottled, which generally happens in July of year n+2, J... may at any time give instructions to B... regarding the volumes (which are already its property) to be shipped;

– Additionally, J... may at any time acquire other vintages (and only vintages) relating to years prior to year n, provided it reaches agreement with B... on quantities and prices";

n) Despite the large quantities of Port Wine transacted with destination to J... in 2010, the Tax and Customs Authority could not obtain any external information on the activity developed by it, since it does not even have a website that could be consulted;

o) B... prepared the transfer pricing file for the year 2010, which is attached as document no. 3 with the request for arbitral decision, whose content is given as reproduced, from which appears, among other things, the following:

8 Economic Analysis – Identification of Comparables

8.1. Framework

As mentioned, B... activity essentially consists of the commercialization of Port Wine. During the fiscal year 2010, the Company carried out various related transactions, the most significant for purposes of analysis in this file being the sales of Port Wine and trademark licensing (royalties).

8.2. Sales of Port Wine

8.2.1. Description of Related Entities

B... sells Port Wine to six related entities resident in national territory (K…, L…, M…, N… Hotel, O… and P…), as well as to other entities resident in territories listed in Ordinance no. 150/2004, of 13 February.

8.2.2. Detailed Description of the Transaction

As mentioned, B... is a company integrated into Group Q…, which is essentially dedicated to the commercialization of Port Wine.

In 2010, the value of Port Wine sales to related entities amounted to € 4,095,564.

8.2.3. Methodology for Price Setting

The agreed prices are determined in accordance with market principles, naturally taking into account quantitative and qualitative criteria.

8.2.4. Method of Determining Market Prices

For the reasons set out in section 7.5.1, it is not possible to obtain adequate information for the use of MPCM, whereby it was deemed appropriate to use MCM.

In order to apply this method, a benchmark of functionally comparable companies to B... will be carried out, in order to calculate a range of arm's length profitability for the transaction in question. The search process can be described through the scheme presented in the following sections.

Additionally, and notwithstanding the identical characteristics of the tested entity and the entities to be searched, essentially distributors of alcoholic beverages, it is found, however, that B... also performs slight transformation functions (bottling) of the products marketed.

Given the differences in cost structures that may result between the tested party and comparable entities, it was deemed appropriate to complement the evaluation of compliance with the arm's length principle with the use of MMLO, comparing for this purpose the operational profitability of the Company and the market pattern.

8.2.5. Search Process in the SABI Database

In order to find a set of comparable companies, essentially distributors of alcoholic beverages, the search was initiated through the use of the SABI database, of Bureau van Dijk's, version 142, of June 2011, which contains approximately 1 million and 630 thousand companies located in Portugal and Spain. The search in SABI involved the development of a strategy, based on a set of criteria, allowing in a first phase automatic filters, which is presented below.

CAE Code (Rev.3)

The application of this filter aimed to accept potential comparables to B.... Only companies classified according to the main economic activity code CAE (Rev.3) 46341 – Wholesale trade of alcoholic beverages were accepted.

Status of Activity

Only companies in operation ("active") were accepted, ensuring that they are not in liquidation or inactive.

Consolidation

With the application of this criterion, only companies that had unconsolidated accounts were accepted, given that the existence of consolidated accounts implies membership in an economic group.

Legal Form

With this filter it is intended mainly to reject associations and cooperatives, since they constitute entities with statutory purposes different from those of commercial companies.

Independence

In order to reject from the sample companies integrated in economic groups, susceptible to establishing related transactions between themselves, the following exclusion criteria were inserted:

• Companies held in a percentage equal to or greater than 10% by other companies; and

• Companies that held other companies in a percentage equal to or greater than 10%.

Location

All companies that did not have their registered office in Portugal were rejected.

Operating Income

Companies whose level of operating income did not exceed € 3,000,000 in the last available year were rejected.

The application of this criterion intended to reject small companies (using the level of operating income of the company as a proxy for its size) which, as a result of this characteristic, may perform different functions.

It is noted that the impact of size on the functions performed by the company and consequently on its profitability constitutes a result that is theoretically and empirically grounded.

In fact, economic theory reveals the existence of signal effects of opposite sign associated with company size. On one hand, larger companies will have higher profitability due to the greater efficiency associated with the exploitation of economies of scale, exploitation of economies of scope and faster exploitation of learning curves.

On the other hand, larger companies have a heavier organizational structure, supporting diseconomies associated with management resulting from the complexity of the organizational structure and therefore associated with the performance of different functions.

The final effect of company size on its profitability is therefore indeterminate and depends on the comparison of the two previous effects. In any case, regardless of the sign of the impact on company profitability, economic theory makes it clear that the functions performed by a small company will tend to be different from the functions performed by a large company.

There is thus a need to operationalize the criterion for distinguishing between small companies and large companies. For purposes of this study, it was assumed that all companies whose level of operating income was less than € 3,000,000 could be considered small companies (consequently with different functions from those performed by B...).

The choice of this limit resulted from a concern to harmonize the criterion adopted with the criterion assumed in the Ordinance regarding the scope of the obligation to prepare a transfer pricing file, as well as with the criterion assumed in commercial law regarding the obligation of official accounting audits.

The search described above identified 6,512 companies as potential comparables, which were exported from the SABI database and worked individually in proprietary search tools.

8.2.6. Use of Filters (Processing of Information Collected from SABI)

In order to perform a more detailed analysis, the data from the 65 companies exported from SABI were analyzed in an Excel spreadsheet, in order to reject non-comparable companies.

Availability of Information

The first filter used relates to the availability of information regarding the operating income of each entity, having opted to reject those companies that did not have information available for this item in at least two of the last three years (with reference to the period 2007 – 2009).

Since the processing of financial data of comparable entities is carried out on the basis of average values earned in a given period, it would not make sense to accept companies for which information was available for only one year of that same period.

Manual Review

Through manual review of activity descriptions, companies that presented differences from the products sold and functions performed by B... and companies that showed signs of having special relationships were rejected. After this review, the sample was reduced to 46 companies.

The 46 companies resulting from the review process were subjected to an additional search step, carried out by analyzing the information contained in their respective websites or relevant information obtained from other Internet sources.

8.2.7. Review of Websites Available on the Internet

In this phase, an individualized analysis was carried out of the information contained in the web pages (website) of the 46 companies that apparently meet the comparability requirements. Through this step, 33 more companies were excluded for being included in economic groups or which, based on information obtained on the Internet, revealed they performed different functions or marketed different products from B....

Thus, after reviewing the websites available on the Internet, the universe of independent companies, selected as the best comparables of B..., consisted of 13 companies.

8.2.8. Independent Companies Considered as Best Comparables

The final result of the crossing of all the filters mentioned above and subsequent analyses resulted in the exclusion of 52 companies exported from the SABI database, arriving at a final result of 13 independent companies, presented in the following table:

[TABLE - DD…]

8.2.9. Results Obtained in the Benchmark – Selection of IR

The financial data used from comparable entities correspond to the fiscal years 2007, 2008 and 2009, since for the vast majority of companies information relating to the fiscal year 2010 was not yet available in the SABI database. In this sense, an average of the results obtained in those three fiscal years was calculated, considering that the result of this calculation is supported in the medium/long term, not being thereby influenced by possible exceptional fiscal years.

To verify compliance with the arm's length principle in the transactions in question, one of the selected methods was MCM, using the indicators Gross Margin/COGS and Gross Margin/Net Sales.

The option to use Net Sales in the calculation formula, rather than Sales, relates to the difficulty in obtaining this information in the database used.

As such, it was opted to use Net Sales, considering it to be the best approximation to Sales, insofar as Services Rendered assume a null or marginal weight within the sample companies.

To complement this method, MMLO was also selected, using the indicators Operating Result/Operating Expenses and Operating Result/Operating Income.

The table below presented includes the results corresponding to the benchmark carried out (average values for the analyzed period):

[RESULTS TABLE]

The benchmark results present ranges of values for the different selected profitability indicators, with a view to validating compliance with the arm's length principle in the sales of Port Wine by B... to its related entities.

Regarding the gross margin indicators, the arm's length range is between the minimum of 11.03% and the maximum of 64.38%, for the Gross Margin/COGS ratio, and between the minimum of 9.94% and the maximum of 39.17%, for the Gross Margin/NS ratio.

Regarding the operating margin indicators, the arm's length range is between the minimum of -2.79% and the maximum of 17.96%, for the RO/OE ratio, and between the minimum of -2.87% and the maximum of 15.23%, for the RO/Op. Inc. ratio.

It should be noted that, in the absence of objective reasons to reject companies through the search strategy, the intervals between the minimum and maximum for the selected profitability indicators should be considered as arm's length.

8.2.10. Profitability Earned by B...

In 2010, in the development of its activity, as an entity that essentially commercializes Port Wine, B... earned a gross margin on COGS of 97.12% and a gross margin on NS of 49.27%.

Regarding net profitability indicators, B... earned margins that amounted to 19.56% and 16.36%, for the Operating Result/Operating Expenses and Operating Result/Operating Income ratios, respectively.

These values are always above the maximums of the respective arm's length ranges, whereby it is concluded that the sales of Port Wine made to related entities had no reducing effect on the taxable base of the Company.

Considering that, despite the introduction of SNC and the weighted average cost method for valuating inventories for accounting purposes, the basic stock continues to be used as the valuation model for tax purposes, it was also deemed relevant to determine B... profitability according to the latter valuation criterion.

Thus, in 2010, using the basic stock as the valuation criterion, B... earned a gross margin on COGS of 86.08% and a gross margin on NS of 46.26%.

Regarding net profitability indicators, B... earned margins that amounted to 15.06% and 13.09%, for the Operating Result/Operating Expenses and Operating Result/Operating Income ratios, respectively.

These values are above the maximums of the respective arm's length ranges, for the gross margin indicators, and very close to the maximums, for the net margin indicators, whereby it is concluded, once again, that the sales of Port Wine made to related entities had no reducing effect on the taxable base of the Company.

p) Following the inspection carried out on B..., the Tax and Customs Authority prepared the Tax Inspection Report contained in the administrative file, whose content is given as reproduced, from which appears, among other things, the following:

From the analysis of the invoices issued to J... in the fiscal year 2010, we verify that the wines contained in the same are embodied in bottles of "…" and "…" (special categories of wines of various denominations, solely from group C….). These are exclusive vintage wines of group C…, whereby it is not possible to obtain public information on transactions involving similar products conducted between two independent entities.

(...)

Comparing the selling prices of bottles of the same wines and vintage years practiced in transactions destined to J... and to independent customers, resident and non-resident in national territory, it is concluded that the former are substantially lower than those practiced in relation to independent customers, resident and non-resident in national territory, thus justifying a deeper analysis of the conditions underlying the transactions with J... with a view to ensuring their conformity with those that would be practiced with independent entities in comparable circumstances.

Among the characteristics of the transaction described in the conditions provided in the exclusivity contract, the following should be noted, as well as the aspects considered relevant resulting from complementary analyses and/or investigations conducted:

1. Sale of future goods in large quantities (noting that according to the description the sale would occur in May of year n+1 while generally the wine is only bottled in July of year n+2);

– B... clarified that with respect to harvests from 2008, 2009 and 2010, this situation did not occur since vintage potential was not unequivocally recognized and the vintage declaration only occurred in n+2, that is, in 2010, 2011 and 2012, whereby the parties only completed the sale of wine in the year of its bottling, without any price and quantity adjustment.

1. Anticipation of financial flows due to the large quantities transacted and prompt payment of issued invoices.

– It should be noted that most of the wine sold and paid remains at B... facilities awaiting instructions from J... regarding the volumes (which are already its property) to be dispatched. When dispatching to J... customers, B... issues a zero-value invoice to J... with the references and quantities dispatched making reference to the initial invoice, amounts associated with the quantities dispatched, and the respective payment.

– Furthermore, the sales invoices issued to J..., as well as shipping invoices, identify J... customers to whom they are associated (sub-client), thus resulting for products destined for the British market, the customer EE… Ltd (hereinafter EE…), and for products destined for the American market, the customer FF… Inc, (hereinafter FF…).

– This situation seems to have underlying that at the time of invoicing to J... there already was on the part of the latter a negotiation with its customers regarding the quantities and categories of wines to be supplied. These customers are only two, and it is unknown whether this negotiation resulted in any advance receipt in the sphere of J... (advance on account of sales) from the referred customers.

– From the analysis of shipping invoices, in terms of quantities shipped relating to harvests with greater weight in 2010 invoicing, that is, harvest of 2008, it results as evidenced in the table below, that the orders of J... customers of the wines in question are in a relatively low percentage, a situation that supports the aspect of anticipation of financial flows invoked since, for those harvests, if J... only acquired from B... the quantities shipped each year, B... financial receipt would be lower.

1. Transfer of commercial risk associated with responsibility for marketing a large part of B... vintage wine production.

2. Sharing of promotional costs - according to additional clarification provided, participation in promotional costs represents approximately 5% of J... sales volume.

(...)

... as will be evidenced (see section 3.1.3.3.6), in view of the available information the MPCM will not be the most appropriate revealing preference for MCM using internal comparables.

(...)

COST PLUS METHOD

MCM is based on the amount of costs borne by a supplier of a product or service supplied in a related transaction, to which is added the gross profit margin practiced in a comparable unrelated transaction (as per Article 8 of the Ordinance). The gross margin (or mark-up on production costs) constitutes an indirect indicator for assessing the transfer price.

The use of this method is recommended by the OECD essentially in the case of sales of semi-finished products between associated companies, in the context of agreements concluded between associated companies with a view to joint use of equipment or long-term supply, or when the related transaction consists of the provision of services (cf. paragraph 2.39 of the OECD Guidelines). In the case in question we are faced with an operation of continuous supply of goods (long-term supply).

The margin on cost price to be applied to the amount of supplier costs in the related transaction should preferably be established by reference to the margin obtained by the same supplier in comparable unrelated transactions (internal comparables, as per paragraph 2.40 of the OECD Guidelines). Alternatively, the margin may be determined based on the margin obtained by an independent company in comparable unrelated transactions (external comparables).

The transfer price sought to be validated is the selling price of the product/service to a related entity, by adding to the purchase price of raw materials and operating costs (production and commercialization) a gross profit margin practiced in a comparable unrelated transaction.

According to paragraph 2.41 of the OECD Guidelines, an unrelated transaction is comparable with a related transaction for purposes of applying the cost plus method if no difference (if any) between the transactions subject to comparison, or between the companies carrying out those transactions, is susceptible to having a significant impact on the cost price margin practiced in the open market, or if sufficiently accurate adjustments can be introduced to eliminate the material effects of these differences, similarly to what was already mentioned regarding MPCM.

It is therefore a transaction-based method, which requires a detailed comparison, not so much at the level of product characteristics, but above all at the level of functions exercised, risks assumed and intangible assets involved, between the related and unrelated transactions.

Given that the taxpayer carries out with independent entities transactions of the same nature as the related transactions in question, notwithstanding the existence of comparability differences between them which are clearly identified, it is possible, contrary to the taxpayer's allegations, to make comparability adjustments as will be illustrated and justified opportunely in the context of this analysis (see section 3.1.3.3.6)

(...)

3.1.3.2 ANALYSIS OF THE TRANSFER PRICING "FILE"

Given that, pursuant to subparagraph h) of no. 4 of Article 63 of the CIT Code, there are special relationships between B... and J... the taxpayer was requested to present the documentation process on transfer pricing, provided for in no. 9 of Article 63 of the CIT Code and in Ordinance no. 1446-C/2001 of 21/12.

In the part of the transfer pricing file provided by the taxpayer relating to the year 2010 and relating to transactions with J..., the following aspects stand out:

• "There are significant differences between the volumes transacted (in liters) with J... and with independent entities which, naturally, also imply divergences in the average prices of the transacted products, and it is not possible to introduce adjustments, since (i) the price reduction criterion, based on quantities transacted with J..., has no parallel with any other client of B..., for the same type of categories, and (ii) it is essentially due to a situation of supply and demand, in which the demand of J... ensures B... the disposal of a significant part of its supply of those categories, transferring to J... the responsibility for commercialization of those types of products";

• "In the case of J..., it is a distributor (wholesaler) that sells to other distributors and which, given the volumes it acquires from B..., removes from B... the responsibility for commercialization of those types of products, i.e., market risks, losses and damage risks (of inventory), exchange risks and credit risks of the transacted products. Regarding independent entities, it is, as a rule, retail distributors that sell directly to the public and that, individually, acquire insignificant quantities, whereby it cannot be considered that, given the volumes transacted, there is a transfer of the same degree of risk from B... to these entities";

"For the same goods sold to J..., there is no other representative independent customer located in the United Kingdom which, as is common knowledge, constitutes a traditional market and the main market of destination for special categories of Port Wine companies (...). Citing official data from the Institute of Douro and Port Wines (IVDP), I concluded that "the United Kingdom market, in addition to being the main consumer of special categories, is the location for which the average price per liter of those special categories is the lowest";

• The transactions with J... and with other customers (independent) are at different stages of the commercialization circuit, since J... is a wholesale distributor that sells to other distributors and that removes from B... the responsibility for commercialization of the types of products it acquires, whereas the other customers are, for the most part, retailers that sell to the general public, not removing from B... any type of risk. Such differences in the stage of the commercialization circuit, implying the exercise of different functions, the use of different assets and the assumption of different risks, also require equally different remuneration, whereby it is consistent with the arm's length principle that the prices practiced with J... are proportionally lower than those practiced with other customers";

• "J... is an anchor customer of B..., which by virtue of its own distribution channels, ensures to B... that the market of the United Kingdom, the main market for Port Wine, represents a fairly significant share of the respective sales of special categories, as well as a constant and prominent presence in that market";

• "J... pays with order (at the time of order), while other customers pay at 30/60/90 days. Moreover, annually and contrary to what occurs with any other customer of B..., J... pays to B... a value, as promotional funding, for the advertising efforts developed by B... and which, in 2010, amounted to € 61,857".

For all the above, the taxpayer concludes that "the applicability of MPCM to the operations in question does not prove appropriate, since; B... does not practice similar transactions with independent entities; within Group Q… there are no similar transactions conducted with independent entities; it was not possible to obtain public information on transactions involving similar products, conducted between two independent entities. The taxpayer points out, however, that "there are transactions with independent entities of the products transacted with J.... Nevertheless, in such cases (.. ) the transactions are not comparable, because the various comparability requirements necessary for the use of MPCM are not met, which requires the highest degree of comparability with focus both on the object and other terms and conditions of the operation as on the functional analysis of the intervening entities".

In view of the analysis conducted and the arguments invoked, which will next be subject to examination, the taxpayer concluded for the use of MCM, using a publicly available database (SABI), complemented with MMLO due to the different cost structure potentially existing between the entities selected as comparable and B... by the fact that this entity, unlike them, contemplates production functions in addition to commercialization.

The comparables selected relate to independent active entities, with registered office in Portugal, whose operating income exceeds € 3 M, in the last available year, and whose main economic activity corresponds to wholesale trade of alcoholic beverages (CAE Ver.3-46341).

The analysis indicators used were Gross Margin/Cost of Merchandise Sold and Material Consumed, Gross Margin/Sales, Operating Results/Operating Expenses and Operating Results/Operating Income. The positioning of B... in the comparability intervals obtained was always above the maximums of the intervals, either for gross margin indicators or for net margin indicators. It thus concluded that "the sales of Port Wine made to related entities had no reducing effect on the taxable base of the Company".

In this context, the following comments should be made:

• In the application of MCM & MMLO the indicators measured in the sphere of B..., the tested entity, for purposes of positioning in the obtained comparability intervals, were based on the entire universe of its operations and not just those conducted with J..., related transactions whose materiality justified the analysis.

• The taxpayer justified this procedure on the grounds that the inventory valuation criterion used (basic stock) does not differentiate the COGS of special categories (inherent to the transaction with J...) from other categories, further reinforcing that if it individualized the transactions with J..., the calculated margin would increase, whereby, if in terms of aggregate analysis it concludes in favor of conformity with APP, in individualized terms the conclusion would be equally favorable;

• It should be noted that, in the year 2010, the taxpayer uses accountingly the weighted average cost method in the valuation of inventories, a method that allows differentiation of the COGS of special categories from other categories, whereby the taxpayer's allegations and justifications as to conformity with APP set forth in the previous section do not merit acceptance;

• Furthermore, despite its materiality in the context of related transactions on product sales, the transactions with J... are little representative in B... total sales volume, assuming approximately 2% of sales volume in 2010, whereby the aggregate analysis of operations conducted by the taxpayer tends to dilute the impact of non-conformity of transactions relating to J... with APP, in the set of all operations;

• In the transfer pricing file, it is stated that the application of MCM "requires a detailed comparison of (...) transmitted goods (...), functions developed, risks borne, cost structure and intangibles between the related transaction and the unrelated transaction" (underlined by us). Additionally, it states that "B... acquires wine from SAN in market conditions (...) and adds to the product essentially commercial intangibles of high representativeness, supporting the preference for adopting MCM but without justifying or proving in what measure the value added potentiated by the referred intangibles, that is, the margin added to the cost price, is comparable with the margin earned by the selected independent entities, whether measured in net or gross terms;

• In this way, in the choice of MCM/MMLO based on external comparables (entities exercising wholesale trade of diversified alcoholic beverages), the taxpayer ignored the specificities inherent to the wines sold to J..., that is, vintage Port Wines which constitute special wine categories recognized by Group C… in relation to which the following references are made in the transfer pricing file:

"Most major connoisseurs classify the Group as being the best Port Wine house, in particular for its Vintages of great longevity, which frequently achieve the highest prices at auctions",

"Although B... does not hold economic value intangibles, notably brands and patents, it should be noted that B... ability to produce high quality Port Wine results from specialized know-how, arising from the involvement and collaboration of different company departments, namely production, research and development, quality control and marketing."

• It is thus found that, whether the margin indicators measured in the sphere of B... for the aggregate set of the taxpayer's operations are considered, or only the operations conducted with J... are considered, the comparability study conducted by the taxpayer does not guarantee the comparability associated with intangible assets of value existing in the sphere of the products sold by B...;

Given the above, it is to be concluded that the application of MCM/MMLO as carried out by B... does not ensure the validation of the conditions practiced in the related transactions with J... with those that would be established between independent entities.

The taxpayer downplayed a comparability factor of paramount importance and which relates to intangible assets, of widely recognized value, inseparable from the products sold by B... to J..., which have impact not only on price but also on the margin obtained.

Comparability at the level of intangible assets of value, inseparable from the products sold by B... to J..., will only be ensured if the comparability study with a view to determining arm's length conditions is carried out based on internal comparables, without prejudice to the performance of comparability adjustments that prove necessary given the differences existing between the related transaction in question and the transactions conducted with independent entities.

In this way, we next proceed to evidencing the arguments invoked in the transfer pricing file when analyzing comparability factors, making the corresponding counter-argument in order to conclude for the possibility of performing comparability adjustments at the level of related transactions with J... and allow the comparison thereof with transactions of the same nature and object conducted with independent entities.

(...)

3.1.3.3 ANALYSIS OF COMPARABILITY FACTORS

In accordance with the provisions of paragraphs 1.33 and 1.34 of the OECD Guidelines, the application of APP is based, in general, on the comparison between the conditions practiced in a related transaction, and the conditions practiced in a transaction between independent companies. To determine the degree of comparability between operations, this source of doctrine states that it is necessary to understand how independent companies evaluate the terms of potential operations and, when considering the conditions of a potential operation, one should bear in mind that independent companies will compare that operation with other options that are realistically available to them, and only conclude an operation if they do not have another more advantageous alternative. This article materializes the parallelism existing between APP and the sound business purpose principle which should assist effective and efficient business management.

At the same time, and as provided in Article 5 of the Ordinance, to ensure the highest degree of comparability between related and unrelated transactions, the most appropriate method should be adopted, based on the comparability factors analyzed below.

3.1.3.3.1 CHARACTERISTICS OF GOODS - QUANTITIES SOLD (subparagraph a) of Article 5 of the Ordinance)

Considering the specific case under analysis relating to goods sales transactions, attention should be paid to the specific characteristics thereof which are susceptible to influencing the price of the operations, in particular, the physical characteristics, quality, quantity, reliability, availability and volume of supply of the goods.

In this regard, the taxpayer alleged the following (underlined by us):

There are significant differences between the volumes transacted (in liters) with J... and with independent entities which, naturally, also imply divergences in the average prices of the transacted products, and it is not possible to introduce adjustments, since (i) the price reduction criterion, based on quantities transacted with J..., has no parallel with any other customer of B..., for the same type of categories, and (ii) it is essentially due to a situation of supply and demand, in which the demand of J... ensures B... the disposal of a significant part of its supply of those categories, transferring to itself a very substantial part of the responsibility for commercialization of those types of products.

It is to be recognized indeed the representativeness of J..., both in terms of volume of vintage Port Wine sales, as evidenced above, and in terms of quantities transacted. Nevertheless, the taxpayer did not materialize, at the level of the discount policy adopted in its commercial activity, the price reduction criteria applied based on the quantities transacted with J... and with other customers, nor did it demonstrate the impossibility of comparability adjustments being made.

Furthermore, in view of the facts established in the course of the inspection action which are evidenced below, the allegations of the taxpayer that the demand of J... ensures B... the disposal of a significant part of its supply of those categories, removing from it any responsibility for commercialization of those types of products (as well as the assumption of the commercial risks inherent thereto; the risk of non-disposal of products, the inventory risk, the exchange risk and the credit risk) are questionable.

In fact, in the periods analyzed, the only customers of J... in the British and American markets mentioned above - EE… and FF…, respectively - are equally direct customers of B... in the non-vintage wine segment (NON VTG) holding in this segment exclusive commercialization rights for the brands of group C… in those markets. Also noteworthy:

• It is the taxpayer itself which, on its website (www.C....pt/importers) identifies the entities EE… Ltd and FF…, as exclusive importers and distributors in the United Kingdom and United States of America, respectively;

• It is verified by analysis of the invoices issued to J... that they reference, in the field "sub-client", the final recipient of the goods, which is the entity EE… Ltd, when the goods are intended for the United Kingdom, and the entity FF…, when the goods are intended for the United States of America;

• Since the taxpayer issues an invoice (with zero value) to account for the exit of goods acquired by J... intended for its customers – EE… Ltd and FF… - it is possible to verify that these latter entities also frequently acquire Port Wine vintages, having done so in the year 2010;

• The referred customers – EE… Ltd and FF… - are long-standing customers of the taxpayer (relations with EE… date back to 1977 and with FF… to 1987);

• On the website of FF… (www.FF....com) it is stated that in 1987 "FF… becomes the exclusive importer of the great Ports of E…", in 1989, "F…, a second Port Wine house sister brand of E…, is welcomed in the portfolio" and, finally, in 2002, "E… and F… joined together with the respected house I… in a new Corporate entity A…, which FF… represents in its entirety'';

• On the website of EE… Ltd (www.EE....co.uk) it is stated that the representation of the F… brand was ensured in 1977, and it is added that "the representation of Port F…. led to the formation of what could be called 'modern EE…' when E… (owners of F…) acquired a minority stake in the company in 1990 and introduced Ports E… in the portfolio";

In the case of the United Kingdom, it is noted that group C… is a minority shareholder of EE… Ltd and, in this way, may influence the volumes of purchases of Port Wines from the companies that comprise the group. Indeed, on the website of that company it clearly states that the acquisition of a minority stake in the company in 1990 by "E…" led to the introduction of Port Wines E… in its portfolio;

It should be noted that, on the websites of EE… Ltd and FF…, no reference is made to J..., only reference being made to the relationships with E…, which, in turn, clearly indicates that J... belongs to group C…;

The volume of sales of B... with those customers in the non-vintage segment, compared to that achieved in the vintage segment through J..., is substantially higher and materially relevant, being equally representative in the total volume of sales of the segment (first and second largest customers), as illustrated in the following table:

[TABLE]

Therefore, the vintage customers in the British and American markets are identified and, being customers of B... in the non-vintage segment, could perfectly be direct customers of B... in the vintage segment, taking into account also the fact that they are markets of tradition of consumption of special categories of Port Wine, as per statistical information from the Institute of Douro and Port Wines which the taxpayer includes in the transfer pricing file (information relating to quantities and amounts). The assertion of the taxpayer to the effect that the disposal of vintage wine for those markets is guaranteed by J..., does not merit acceptance.

Considering further the greater volume of operations in the non-vintage segment, in relation to which the taxpayer already incurs credit and exchange risk, those of the vintage segment do not reflect a transfer of materially relevant risk.

In any case, since vintage sales to J... are intended for customers EE… and FF…, customers which are also of high significance in the non-vintage segment, we consider there to be sufficient elements to reliably estimate the quantity discount present in the prices practiced with J... and thereby eliminate the comparability difference relating to the quantities transacted, in parallel with the differences associated with the geographical market destination of the goods (see section 3.1.3.3.3).

Concretely, through the comparison between the conditions practiced in sales of wine references in the non-vintage segment to EE…, and those conducted with other customers in other markets, the implicit quantity-market discount with respect to the British market can be determined, and the same reasoning will be promoted for the American market, with respect to references sold to FF…. The most appropriate form of carrying out this comparison with a view to determining the comparability adjustment will be the subject of explanation in section 3.1.4.1 of this report.

It should be noted that after elimination of the quantity differences, the characteristics of the goods, in physical, quality and reliability terms, are comparable in operations with J... and with other customers.

(...)

3.1.3.3.6 CONCLUSIONS REGARDING THE ANALYSIS OF COMPARABILITY FACTORS AND THE MOST APPROPRIATE METHOD

From the analysis conducted in section 3.1.3.2, it stands out that the vintage Port Wines sold by B... are special wines, recognized in the Port Wine sector, which give the transaction in question specific characteristics by the intangible elements involved, susceptible to influencing both the prices and margins of operations, making their comparison difficult from the outset with operations relating to other products than B... own products.

In fact, we are faced with special categories of wines of various denominations, solely from group C…, whereby it is not possible to obtain public information on transactions involving similar products conducted between two independent entities. As was previously highlighted, the transfer pricing file yields the following statement: ''Most major connoisseurs classify the Group as being the best Port Wine house, in particular for its Vintages of great longevity, which frequently achieve the highest prices at auctions."

The use of internal comparables is thus justified, that is, operations for the sale of vintage Port Wine from B... to independent entities, to validate conformity with APP of the related transactions conducted with J....

Nevertheless, and as evidenced in section 3.1.4, some comparability differences, susceptible to influencing the terms of the operations (both at the level of prices and at the level of margins), should be adjusted in order to ensure the highest degree of comparability between the operations with J... and with independent entities and allow the validation of APP.

The comparability differences considered relevant refer to:

o Quantities sold to J... much higher than those sold to independent entities;

o Specific characteristics of the markets of destination of products sold to J... (American and British) due to the tradition of Port Wine consumption;

o Payment conditions contracted, associated with the anticipation of financial flows allowed by operations with J....

We consider the performance of comparability adjustments in a context of use of the Cost Plus Method (MCM), which proves to be more appropriate than the Comparable Uncontrolled Price Method (MPCM), not only because there are references of vintage wine sold only to J..., prejudicing the comparison of the conditions practiced in those operations, but also and essentially, because of the fact that the emphasis in the analysis is that the margin to be obtained in operations with J... should only diverge from that of operations with independent entities to the extent that there are also divergences in the functions exercised and risks assumed by J..., which are summarized, in view of the analysis evidenced above, to the higher quantities transacted with J... and the anticipation of financial flows allowed to the benefit of B... financial sphere.

The adoption of a method that assigns lesser importance to the identity of the object of the operation (reference, vintage year) and greater importance to the functions exercised, in the comparability analysis to be performed, is thus justified, without nonetheless, in the specific case, failing to consider the type of products in question, that is, the vintage wines marketed by B..., whose singularity imposes the use of internal comparables.

3.1.4 NON-COMPLIANCE WITH APP AND IMPACT ON DETERMINING TAXABLE PROFIT

Following the analysis evidenced in the previous sections, in the use of the Cost Plus Method for validation of conformity of the operations with APP, the comparison of the gross margin earned in operations with J..., adjusted for the identified comparability differences, with the gross margin earned on average terms obtained in operations with the remaining independent entities in the vintage wine segment should be performed.

The performance of this test comprised the following stages:

1. All "…" and "…" wines sold in the year 2010 were identified in the SAF-T file provided by the company;

2. The selling price per bottle of wines mentioned in the previous section was determined;

3. The production cost of wines mentioned in section 1) was determined using the inventory of existing stock at the end of the year 2010 and, regarding wines that did not exist in final inventory, information on production cost was requested from the taxpayer, through notifications made on 2013/07/26 and 2013/10/16. Given the extent of the universe of wines in question and compliance with the proportionality principle provided in Article 7 of the Complementary Tax Inspection Procedure Regime and Article 55 of the General Tax Law, wines whose total sales in 2010 did not exceed 1,000 euros were excluded from the sample, which represented a large part of the references sold, but whose aggregated sales value was not significant;

4. Based on the elements mentioned in the previous sections, the gross margin on sales of the sales made to J... and to third entities was calculated.

From the operations conducted in the national market, sales with destination to related entities (L…; N… Hotel) as well as to the final consumer, that is, entities that do not meet the comparability requirements, should be excluded from the comparability analysis. Sales destined to related entities pursuant to subparagraph h) of no. 4 of Article 63 of the CIT Code, that is, entities subject to a clearly more favorable tax regime, identified by the taxpayer in the transfer pricing file, should also be excluded from the comparability analysis.

The gross margin constitutes thus a profitability indicator which, in transfer pricing and the application of APP, allows indirect validation of the prices of operations through the addition of an arm's length profit margin to the costs incurred in the production of goods sold in the related transactions in question.

In the case in question, the comparability adjustments evidenced thus show the remuneration components existing in the sphere of operations with J... and which reflect the functions exercised by this related entity, non-existent in the sphere of the remaining independent customers.

Considering the information provided by the taxpayer with respect to production costs, the following table evidences the gross margins obtained in operations with J..., in 2010, and the gross margins obtained in the remaining operations of the vintage segment, in the said taxation periods, it being emphasized that the latter are approximately three times the former:

[MARGIN TABLE]

The calculations of gross margins on the Cost of Merchandise Sold and Material Consumed in sales made to J... and to third entities (excluding related entities and final consumers) are demonstrated in annex (annex 1, remitted jointly with the draft tax inspection report).

For purposes of comparing margins and concluding whether or not there is conformity with APP of operations with J..., the performance of comparability adjustments, in the sphere of the said operations, should be based, in each taxation period, on the following procedures and justifications:

3.1.4.1 ADJUSTMENT OF QUANTITIES AND MARKETS

· The adjustment relating to quantities transacted with J... as well as to the destination markets underlying operations with this related entity (American and British market), can be estimated based on the implicit discounts in the sales of the non-vintage segment conducted directly with J... customers - EE... and FF... - which are also in the non-vintage segment representative in terms of quantities transacted, as previously evidenced.

· To note that, despite being notified to evidence the conditions agreed with EE... and FF..., in terms of discount policy, B... stated that "the normal procedure for defining the conditions to be practiced, passes through the holding of an annual meeting to take place in the course of the first quarter of each year, where the following matters are addressed among others: Definition of the price table to be practiced during that year; Approval by B..., of the promotional actions to be performed by the customer; Definition of the value of B... participation in those promotional actions; (...) There is no discount policy regarding any customer (...)."

· In this way, the quantification of the quantity and market discount inherent in sales to J... should be based on the central tendency, measured through the statistical indicator "median", of each of the discount intervals to be determined, for the universe EE... and universe FF....

· For each non-vintage wine reference sold to EE... and FF..., determine the average prices of sales conducted in the sphere of EE... and FF... as well as in the sphere of other customers, subsequently determining the average implicit discount in the sphere of EE... and FF... relating to each reference (in some references there may be no discount but these will not be excluded from the analysis).

· Determine the central tendency of the average discounts inherent in references sold to EE... through the statistical indicator median, performing the same procedure for the discounts inherent in references sold to FF...,

· The quantity-market adjustment, to be added to the volume of sales to J... for comparability purposes, will be obtained by considering the application of the discount rate determined in the EE... universe to the volume of sales to J... intended for EE... and, the discount rate determined in the FF... universe to the volume of sales to J... intended for FF....

Described the procedures adopted, the implicit discounts in the sales of the non-vintage segment conducted directly with J... customers - EE... and FF... - were calculated, which, as demonstrated in annex, present in 2010 a median of 17.72% and 15.97%, respectively (annex 2, remitted jointly with the draft tax inspection report).

Considering the implicit discounts in the sales of the non-vintage segment conducted to EE... and FF..., the quantity-market adjustment was calculated, which will correspond to 17.36% of the value of sales to J..., as presented in the following table:

[CALCULATION TABLE]

3.1.4.2 ADJUSTMENT FOR ANTICIPATION OF FINANCIAL FLOWS

· The anticipation of financial flows allowed by J... confers a financial advantage to B... whereby the remuneration inherent in this financing function existing in operations with J... should be equivalent to the financing cost that B... would incur if it were to finance itself in the market.

· To measure the financial advantage, it is necessary to estimate, on one hand, the average period inherent in the anticipation of funds and, on the other hand, the market financing cost.

· Regarding the period of anticipation of funds, and in accordance with information provided by the taxpayer in the course of the inspection action, the same may be measured on average terms, through analysis of the behavior of shipments of each year in relation to the dates of their respective invoices (weighting the period by the associated amounts). That is, consider as the best estimate for the period of anticipation of financial flows inherent in sales carried out in the periods in question, the behavior of sales conducted in the past considering the period elapsed since them until their shipment in the period in question;

· Regarding the market financing cost, the financing conditions obtained by B... from independent entities should be considered.

· The application of the average annual funding rate actually incurred by the taxpayer, to the volume of operations with J... and for the average period determined will result in the sought adjustment, which should be added to the volume of operations with J... for comparability purposes.

In order to determine the market financing cost, the taxpayer was notified on 2014/02/14, to provide a copy of the "financing contracts obtained in force" in the period of 2010.

In the response, the taxpayer presented "a copy of the two medium/long-term contracts in force in the reference period:

CGD 15M - Mutual loan contract with pledge, mortgage and guarantee executed between B... and Caixa Geral de Depósitos

PPC 10M - Organization, domiciliation, placement, guarantee subscription and paying agent contract executed between B... and BST" (note: CGD - Caixa Geral de Depósitos; BST - Banco Santander Totta).

Considering the conditions provided in the financing contracts presented by the taxpayer and the value of the Euribor rate in force in the relevant periods for purposes of determining the interest rate in force, obtained from the website of the Bank of Portugal, the average financing rate of the taxpayer in the year 2010 was calculated, which, as determined in the following table, amounted to 1.91%:

[FINANCING RATE TABLE]

Then, as mentioned, considering the period elapsed between the date of sale of products to J..., contained in the respective invoices, and the date of delivery of goods dispatched in the course of the year 2010, the adjustment rate for anticipation of financial flows allowed by J... was estimated, which, as demonstrated in annex (annex 3, remitted jointly with the draft tax inspection report), amounts to 4.41%.

It should be noted that, in the calculations presented, since the goods shipment invoices refer to the sales value expressed in the currency of the final customer (pounds sterling when goods are intended for the British market (articles with reference [RP-GB]] and American dollars when goods are intended for the United States of America (articles with reference [RP-US])), the exchange rates in force on the date of the sales invoice were used, for purposes of determining the value in euros, obtained from the website of the Bank of Portugal. Exceptions occur in cases where the sales invoices are prior to 1999/01/04, in which case the exchange rates in force were not found on the website of the Bank of Portugal, and in this situation, the exchange rates indicated by the taxpayer in the response to item 5 of the notification made on 2014/04/08 were used, in which it was requested "a table with the following detailed information related to the reconciliation between the sales invoices issued to J... and the goods shipment invoices acquired by this with destination to its customers:

a. Number and Date of Invoices "outstanding" as of 1 January of each of the periods of 2010 and 2011, that is, invoices for which the full shipment of the sold products had not yet occurred;

b. Amount and global quantities of the respective invoices in the currency of the invoice, as well as the exchange rate used in its accounting;

c. Amount and quantities "outstanding"

Considering the combined effect of the comparability adjustments indicated in the sphere of operations with J..., and the exclusion of gross margins relating to non-J... operations with related entities, namely those of national territory, the adjusted gross margins in the sphere of J... will be obtained for purposes of comparison with the margins obtained in the sphere of independent customers in other markets.

The percentage total of adjustments to be performed amounts to 21.77% in 2010, as evidenced in the following table:

[TOTAL ADJUSTMENTS TABLE]

In this way, considering those adjustments, the adjusted value of sales to J... will amount to 1,159,385.11 euros (=906,986.97/(1-21.77%)). Thus, the adjusted gross margin in the sphere of J... for purposes of comparison with the margins obtained in the sphere of independent customers in other markets is the following:

[ADJUSTED GROSS MARGIN TABLE]

The difference in margins existing constitutes the violation of APP, and the corresponding adjustment should be promoted in the sphere of B... in determining taxable profit in CIT.

3.1.5 COMPLIANCE WITH THE REQUIREMENTS PROVIDED FOR IN NO. 3 OF ARTICLE 77 OF THE GENERAL TAX LAW (GTL)

No. 3 of Article 77 of the GTL provides that "in the case of existence of operations or series of operations on goods, rights or services, or of financial operations, conducted between a taxpayer subject to income tax and any other entity, subject or not to income tax, with which the former is in a situation of special relationships, and whenever there is non-compliance with any obligation established in law for that situation, the substantiation of the determination of the adjusted taxable base of the effects of special relationships must comply with the following requirements:

a) Description of special relationships;

b) Indication of the obligations not complied with by the taxpayer;

c) Application of the methods provided in law, with the Tax Directorate-General being able to use any elements at its disposal and considering its duty of substantiation of the comparison elements properly observed even if such elements are purged of data susceptible of identifying the entities to which they relate;

d) Quantification of the respective effects.

The description of special relationships is already conducted in section 3.1.2.1 of this report.

The indication of obligations not complied with by the taxpayer is conducted in section 3.1.3.2 of this report, with emphasis on the following:

• The taxpayer concluded for the use of MCM, using a publicly available database (SABI), complemented with MMLO. However, in the application of MCM and MMLO the indicators measured in the sphere of B..., the tested entity, for purposes of positioning in the obtained comparability intervals, were based on the entire universe of its operations and not just those conducted with J..., related transactions whose materiality justified the analysis;

It should be noted that in the justification of the methodology adopted by the taxpayer and contained in the transfer pricing file some incorrect facts are mentioned, namely, when it states that "the option for aggregate analysis of Port Wine sales by B... to related entities, rather than for disaggregated analysis of sales to its customer J..., is justified by the fact that the inventory valuation criterion used by B... (basic stock), in line with the criterion followed by the Port Wine sector in general, does not differentiate the COGS of special categories, which constitute the type of merchandise sold to J..., from the COGS of other categories". In fact, with the entry into force of the Accounting Standardization System on 2010/01/01, entities were prevented from using LIFO or special valuations for inventories considered as basic or normal, such as is the case of Basic Stock, with the taxpayer accounting for its operations, from that date, using the weighted average cost valuation criterion, although later, and only for tax purposes, it proceeded to adjust the COGS value, pursuant to official letter no. …/2012 of 2012/01/05 of the Tax Inspection Planning and Coordination Department;

Further on in the transfer pricing file, the taxpayer itself admits that "considering that, despite the introduction of SNC and the weighted average cost method for inventory valuation for accounting purposes, basic stock continues to be used as the valuation model for tax purposes, it was deemed likewise pertinent to determine B... profitability in accordance with the latter valuation criterion. It is concluded thus that the taxpayer uses accountingly the weighted average cost method in inventory valuation, and cannot justify the taking of a certain option based on the use of another valuation criterion. In fact, contrary to what the taxpayer states, the valuation criterion used (weighted average cost) allows differentiation of the COGS of special categories, which constitute the type of merchandise sold to J..., from the COGS of other categories;

Furthermore, despite its materiality in the context of related transactions on product sales, the transactions with J... are little representative in B... total sales volume, assuming approximately 2% of sales volume in 2010, whereby the aggregate analysis of operations conducted by the taxpayer tends to dilute the impact of non-compliance of transactions relating to J... with APP, in the set of all operations;

The wines transacted with destination to J... consist of bottles of "…" and "…", which have profit margins (gross margin on sales) significantly higher than sales of other types of Port Wine. In this respect, reference is made to news published in the Business Journal on 2013/10/23, entitled "'Vintage' of group Q… nearly exhausted after two months on the shelf", in which it is stated that an official source of group Q… (referring to group C… of which the taxpayer is part) stated that "if, on one hand, we can say that a ['Vintage'] declaration is not financial, as it depends on Nature, it is also true that it is financial since, for us, it is worth about 7.5 million euros", with the news adding that "the effect of these harvests on the company's accounts is not new: the '2009 Vintages' also had contributed to almost doubling profits (then to 4.5 million euros) two years later, when they were put on sale". That is, it is clearly demonstrated that vintage sales have margins clearly higher than sales of other types of Port Wine, whereby the aggregate analysis intended by the taxpayer does not make sense in not considering the different margins obtained in the sale of different types of product, namely vintages;

In the choice of MCM/MMLO based on external comparables (entities exercising wholesale trade of diversified alcoholic beverages), the taxpayer ignored the specificities inherent to wines sold to J..., that is, vintage Port Wines which constitute special wine categories recognized by Group C… in relation to which it is affirmed, in the transfer pricing file, that "most major connoisseurs classify the Group as being the best Port Wine house, in particular for its Vintages of great longevity, which frequently achieve the highest prices at auctions" and that "B... ability to produce high quality Port Wine results from specialized know-how, arising from the involvement and collaboration of different company departments, namely production, research and development, quality control and marketing";

It is thus found that, whether the margin indicators measured in the sphere of B... for the aggregate set of the taxpayer's operations are considered, or only the operations conducted with J... are considered, the comparability study conducted by the taxpayer does not guarantee the comparability associated with intangible assets of value existing in the sphere of the products sold by B....

Given the above, it is to be concluded that the application of MCM/MMLO as carried out by B... does not ensure the validation of the conditions practiced in the related transactions with J… with those that would be established between independent entities, that is, it is considered that it is not fully demonstrated that there is compliance with the arm's length principle. In fact, the taxpayer downplayed a comparability factor of paramount importance and which relates to intangible assets, of widely recognized value, inseparable from the products sold by B... to J..., which have impact not only on price but also on the margin obtained. Comparability at the level of intangible assets of value, inseparable from the products sold by B... to J..., will only be ensured if the comparability study with a view to determining arm's length conditions is carried out based on internal comparables, without prejudice to the performance of comparability adjustments that prove necessary given the differences existing between the related transaction in question and the transactions conducted with independent entities.

The application of the methods provided in law is conducted in sections 3.1, 3.1 and 3.1.4 of this report, having concluded that "in view of the available information the MPCM will not be the most appropriate revealing preference for MCM using internal comparables", although in an "adjusted manner of the identified comparability differences".

Let us next proceed to quantification of the respective effects. For this, we will estimate the value of sales to J... considering the gross margin obtained by the taxpayer in sales of vintage wines to third entities, excluding related entities and final consumers, using the following formula:

VND = COGS × (1 + GM / COGS)

Where:

VND - Sales of Merchandise;

COGS - Cost of Merchandise Sold and Material Consumed;

GM / COGS - Gross Margin on Cost of Merchandise Sold and Material Consumed.

As was mentioned in section 3.1.4, the gross margin on the COGS obtained in sales of vintage wines to J... amounts to 134.19%, while the same indicator relating to sales of the same type of products to third entities, excluding related entities and final consumers, amounts to 397.82%.

From the estimated sales value, the percentage corresponding to adjustments of quantities and markets and anticipation of financial flows will be deducted, which, taken together, as mentioned, amounts to 21.77%.

In this way, the estimated value of sales made to J... in 2010, considering the indicated adjustments, amounts to 1,508,269.70 euros, as evidenced in the following table:

[ESTIMATED SALES TABLE]

3.1.6 CONCLUSION (TRANSFER PRICING ARTICLE 63 OF THE CIT CODE)

From the application of the criterion mentioned in the previous section, results, as evidenced in the table above, the correction, in the fiscal year 2010, of the revenues declared for purposes of CIT and, consequently, of the taxable profit, likewise declared, in the total value of 601,282.73 euros, given the failure to comply with the provisions of no. 1 (non-compliance with arm's length rules) and no. 8 (positive corrections to the declared net result were not made), both of Article 63 of the CIT Code.

3.2 - PAYMENTS TO NON-RESIDENT ENTITIES SUBJECT TO A PRIVILEGED TAX REGIME

In fields H78 and H81 of table 031 of Annex H of the annual declaration of accounting and tax information/IES for the year 2010, the taxpayer declared the payment of royalties and other income to entities resident in countries with a privileged tax regime in the amount of 1,334,814 euros and 61,857 euros, respectively. On the other hand, through consultation with the Statement Model 38 provided for in no. 2 of Article 63D-A of the General Tax Law, it is verified that transfers were made in favor of the entity E… LTD, with registered office in the Island of Jersey, which is part of the denominated Channel Islands provided for in no. 14 of Ordinance no. 150/2004 of 13/02, which establishes the list of territories subject to a clearly more favorable tax regime, pursuant to no. 2 of Article 65 of the CIT Code, in the amount of 922,535.76 euros.

Pursuant to no. 1 of Article 65 of the CIT Code "amounts paid or owing, whatever the title, to individual or legal persons resident outside Portuguese territory and there subject to a clearly more favorable tax regime, are not deductible for purposes of determining taxable profit, unless the taxpayer is able to prove that such expenses correspond to actually conducted operations and do not have an abnormal character or an excessive amount".

In this way, pursuant to nos. 1 and 4 of Article 65 of the CIT Code, in the version in force before the re-publication effected by Decree-Law no. 159/2009, of 13 July, the taxpayer was notified on 2013/06/04 to prove that the expenses borne with the income paid, in 2010, to entity E… LTD and, if not included therein, those relating to income declared in fields H78 and H81 of table 031 of Annex H of the annual declaration of accounting and tax information/IES for the year 2010, correspond to actually conducted operations and do not have an abnormal character or an excessive amount.

In the response to the notification, the taxpayer presented articulated exposition in relation to which it was concluded as follows:

a) "(i) Relationships (shareholdings) between the CLAIMANT and E… " (ARTICLE 1)

Article 1 of the EXPOSITION states: "The company E… (E…) holds 100% of the share capital of the company A, SA., which in turn holds 100% of the capital of company B.., SA.".

Although the date of the beginning of the shareholding is omitted, it should be noted that, as was established in previous inspection procedures, in accordance with the respective "BYLAWS" (deed executed at the Sixth Notary Office of Porto), "GG…, SA" (now with the corporate name "B…. SA") was constituted, on 13/06/19

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