Reverse Merger Tax Deductibility of Financing Costs Under IRC – CAAD Case 93/2015-T

ARBITRAL DECISION

The Arbitrators José Pedro Carvalho (Presiding Arbitrator), Tomás Castro Tavares and João Menezes Leitão (who voted against the main decision, as per his attached dissenting opinion), appointed as arbitrators at the Centre for Administrative Arbitration, in order to constitute an Arbitral Court:

I – REPORT

On 13 February 2015, A…, S.A., NIF …, from the Finance Office of …, with registered office in …, …, filed a request for constitution of an arbitral tribunal, under the combined provisions of Articles 2 and 10 of Decree-Law No. 10/2011, of 20 January, which approved the Legal Regime of Arbitration in Taxation Matters, as amended by Article 228 of Law No. 66-B/2012, of 31 December (hereinafter, abbreviated as RJAT), seeking the declaration of illegality of the following tax acts:

Self-assessment of Corporate Income Tax (IRC) for the fiscal year 2011, corresponding to the Model 22 substitute return identified by No. …, filed on 19 December 2013 and accepted, from which resulted tax payable in the amount of € 716,174.11; and

Self-assessment of Corporate Income Tax (IRC) for the fiscal year 2012, corresponding to the Model 22 substitute return identified by No. …, filed on 19 December 2013 and accepted, from which resulted tax payable in the amount of € 647,305.27.

To substantiate its request, the Applicant alleges, in summary, that, by means of a merger by incorporation, the incorporating entity (Applicant) assumed, by operation of law and immediately, the entirety of the assets of the incorporated companies, including the financing costs incurred by the incorporated company to acquire its shareholdings, whereby the deductibility of such costs in the legal sphere of the Applicant cannot be questioned, unless there is proof of fraud or abuse.

On 16-02-2015, the request for constitution of the arbitral tribunal was accepted and automatically notified to the Tax Authority (AT).

The Applicant proceeded to the appointment of an arbitrator, having designated Prof. Dr. Tomás Castro Tavares, pursuant to Article 11(2) of RJAT. Under Article 11(3) of the same provision, the Respondent appointed Dr. João Menezes Leitão as arbitrator.

The Applicant raised an incident of refusal of the appointment of the arbitrator designated by the Respondent, which incident was dismissed by order of the Presiding Judge of the Ethics Council of CAAD, dated 29-04-2015.

The arbitrators appointed by the parties were appointed and accepted their respective duties. Pursuant to Article 6(2)(b) of RJAT and Article 5 of the Regulation on Selection and Appointment of Arbitrators in Tax Matters, the present Rapporteur was appointed to preside over this Arbitral Court, who, within the applicable time period, also accepted the duty.

On 15-05-2015, the parties were notified of this latter appointment and did not manifest any desire to refuse it.

In accordance with the provision in paragraph (c) of Article 11(1) of RJAT, the collective Arbitral Court was constituted on 01-06-2015.

On 03-07-2015, the Respondent, duly notified for this purpose, filed its response defending itself solely through challenge, alleging, in summary, that the deduction by the Applicant of financial charges related to its own acquisition, arising from the merger with the company that acquired it, cannot be fiscally accepted, as they are not indispensable for the achievement of income or gains subject to tax or for the maintenance of the income-generating source, under the terms of Article 23(1) of the Corporate Income Tax Code (CIRC).

On 25-09-2015, the meeting referred to in Article 18 of RJAT took place, where oral arguments were presented by the parties, pronouncing on the evidence produced and reiterating and developing their respective legal positions.

A period of 45 days was set for the delivery of final decision, which was extended, under legal terms, with parties being notified thereof, given the complexity and vastness of the subject matter. For the same reasons, the period referred to in Article 21(1) of RJAT was extended by 60 days.

The Arbitral Court is materially competent and is regularly constituted, under Articles 2(1)(a), 5 and 6(1) of RJAT.

The parties have legal capacity and standing, are legitimate and are legally represented, under Articles 4 and 10 of RJAT and Article 1 of Ordinance No. 112-A/2011, of 22 March.

The proceeding does not suffer from any vices.

Thus, there is no obstacle to consideration of the merits of the case.

All considered, it is necessary to deliver:

II. DECISION

A. FACTUAL MATTER

A.1. Facts Found to be Proven

1- Until 19 September 2008 the Applicant was part of Group B…, with its share capital entirely held by B… - Social Participation Management Company, S.A.

2- Having been decided by Fund "C… - …" to acquire the Applicant, with the expectation that it could generate sufficient cash-flow to pay off the financing debt and still remunerate investors, the company D…, SA was established in September 2008.

3- The company D…, SA raised financial resources from banking institutions and from its sole shareholder to acquire all shares of the Applicant, completed this acquisition in 2009 and began to share with the acquired company the corporate purpose and administrators, while also having direct interference in the management of the target.

4- In the complex of companies involved in the operation, the one that had the assets, know-how, client base, market position and that developed an activity capable of generating sufficient cash-flow to cover the costs of investment incurred and serve as guarantee to creditors was the Applicant, whereas the acquirer (D…) had as its main asset the shares of the Applicant and its revenues resulted almost entirely from management services rendered to the latter, whereby it did not meet sufficient conditions to serve as guarantee to the banking creditor.

5- It was absolutely determinant in the completion of the merger by incorporation (reverse merger) that the banking entity that granted the loan to D… imposed, as consideration for the loan, that the Applicant be the beneficiary of the merger.

6- In compliance with the Service Orders with numbers OI2013…, OI2013… and OI2013…, a general inspection action was conducted at the Applicant, by reference to the fiscal years 2010, 2011 and 2012.

7- The said inspection action was triggered following a previous general inspection action, by reference to fiscal year 2009, credited by Service Order with No. OI2013…, supplemented by External Orders Nos. DI2013…, DI2013… and DI2013….

8- Within the scope of the inspection procedure, the following was ascertained, in summary:

i. On 19-09-2008, through a purchase and sale contract executed for this purpose, the entities "B… - Social Participation Management Company, S.A.", in the position of seller, the Fund "C… - …", represented by Management Company "E… - …, S.A", in the position of "buyer-to-be" and "D…, SA", in the position of "buyer", celebrated a purchase and sale contract of shares.

ii. In accordance with the said contract, the buyer-to-be ("C…"), indicated "D…", company dominated by "C…", in which it holds an indirect participation of 100% of its share capital, as the purchasing entity of the shares representing 100% of the share capital of "A…", here Applicant.

iii. The said contract also established the company "F…-…, SGPS, SA", a company entirely held by "A…", as buyer of a quota representing 0.003% of the share capital of "G…" of which "B…" was also a holder.

iv. "A…", at the date of the said contract, was holder of quotas representing 99.997% of the share capital of "G…", shares representing 100% of "H…, Inc", a North American company, shares representing "I…, Ltd", an English company and shares representing 100% of the share capital of "F…", whereby all such shareholdings were also acquired by "D…" through the said contract.

v. The companies "J…" and "D…" were established in 2008, the same year in which "A…" was acquired by Venture Capital Fund C…, through the company "D…" (see shareholding structure diagram). As a result of that acquisition, it resulted that:

• Company "A…" came to be held 100% by company "D…";

• Company "D…" was held 100% by a company called "J…" which, in turn, was also held 100% by "E…";

• The administrators/managers were common to the various companies that subsequently participated in the merger process that was to be carried out.

vi. With regard specifically to company "A…", it was found that:

• The company always had considerable operational activity in the sector of production and commercialization of plastic products and processed materials;

• The financial statements as of 31-12-2008, and those relating to earlier fiscal years, reflected this reality, as they presented quite significant positive net results;

• Medium and long-term liabilities and debts to credit institutions presented a value balanced with current assets.

vii. With regard to company "D…", the following was verified:

• The company was established with the corporate purpose "Production and Commercialization of Chemical and Plastic Products";

• In its results structure, in operational terms it only presented operations at the level of service provision, which corresponded entirely to provision of administration and management services to "A…" and, especially, at the financial level;

• Model 10 statement was submitted, and the personnel costs presented did not evidence employees in its service related to its corporate purpose;

• In the financial statements prepared with reference to 31-12-2008, assets consisted essentially of "Financial Investments", corresponding to the value of acquisition of 100% of the shares of company "A…", for €56,086,000.00;

• Own capital included the amount of €4,750,000.00 of supplementary contributions and liabilities the amount of the banking financing, in the total amount of €23,200,000.00 contracted from BES and supply contracts granted by its sole shareholder "J…", in the amounts of €19,200,000.00 and €10,500,000.00.

viii. With regard to "J…", the following was verified:

• Entity "J…" was established on 21-07-2008, at the same time as the establishment of company "D…" (11-09-2008) and the purchase of shares of "A…" by "D…" (19-09-2008);

• Its corporate purpose was also "Production and Commercialization of Chemical and Plastic Products", with no evidence of operational activity or structure for the declared corporate purpose;

• In assets were Financial Investments - loans to group companies: €34,450,000.00 (for financing part of the price of shares of "A…");

• In own capital were Supplementary Contributions of €4,750,000.00;

• In Liabilities were loans granted to "D…" in the amounts of €19,200,000.00 and €10,500,000.00.

ix. In the year 2009, a merger by incorporation process of companies "F…" and "D…" into "A…" was verified, as a result of which the incorporated companies "F…" and "D…" were extinguished.

x. As a result of this process, the financial statements of "A…" came to reflect the assets, liabilities and results obtained by the various companies throughout 2009, as the merger operation project was registered with the Commercial Registry Office of …, on 22-12-2009, with effects, from an accounting standpoint, dated back to 01-01-2009.

xi. The shareholding structure at the date of the said merger was as follows:

[diagram referenced in original]

xii. In the text of the "Merger Project", the intervening companies had the following corporate purposes:

• Company "F…", the management of shareholdings in other companies, as an indirect form of conducting economic activities;

• Companies "A…" and "D…", the production and commercialization of plastic products and processed materials.

xiii. In the text of the "Merger Project", the following reasons for the operation carried out were pointed out:

• Companies A… and D… had as their corporate purpose the production and commercialization of plastic products and processed materials;

• F… was a company entirely held by A…;

• The existence of the three separate companies was implying a set of efforts (administrative and service costs), with added expenses;

• The management of companies with the same corporate purpose and centralized in a single company would generate considerable synergies, through greater management flexibility and planning;

• The companies participating in the merger process were, directly and indirectly, dependent on the company called J…, SA, with registered office on Avenue …, …, …, in Lisbon;

• The INCORPORATING company was held 100% by the incorporated company D…, which in turn held 100% of the share capital of the incorporated company F….

xiv. Given the accounting for the merger by incorporation operation, the balance sheet of company "A…" as of 31-12-2009, came to evidence "the sum of assets and liabilities", where it was verified that:

• In Assets was the heading Intangible Fixed Assets "goodwill", in the amount of € 37,395,166.00, to which corresponds the difference in assets and liabilities transferred to the legal sphere of "A…" in the merger operations previously referred to;

• In Liabilities was the heading debts to credit institutions (BES), and within this the amount of €23,200,000.00, of which €1,660,000.00, accounted in the heading Short-Term Loans, account "23114 Senior Debt Tranche A", and €21,540,000.00, in the account Medium/Long-Term Loans "Account 23124 - Senior Debt Tranche A", corresponding to the banking loan previously contracted by "D…", in the total amount of €23,200,000.00. Also recorded was the debt to shareholder "J…", in the amount of €19,200,000.00, relating to supply contracts.

xv. The profit and loss statement came to evidence, in addition to operating result, which recorded an increase of about 20% compared to the previous year (OR 2009 = €2,013,640.00 and OR 2008 = €1,673,665.00), also a negative financial result of (€-5,269,325.00), compared with that obtained in 2008 (€-629,968.00), which resulted essentially from financial charges related to interest borne, resulting from the accounting by company "D…" of financial charges arising from the banking loan contracted from BES and supply contracts celebrated in 2008, with the shareholder ("J…"), in the amounts of €19,200,000.00 and €10,500,000.00.

xvi. From the financial statements of "A…" it resulted that the costs with interest in 2009 amounted to €5,963,438.00, compared to an amount of interest borne in the year 2008 of €1,433,111.00.

xvii. As a result of the merger operation that occurred in 2009, the now Applicant came to present from then until 2011 tax losses, which departs significantly from a history of tax profits presented by the company in the three-year period prior to 2009, according to the following table:

[table referenced in original]

9- Within the scope of the reverse merger, in which the Applicant was the incorporating entity, its shares, which formed part of the assets of D…, were delivered, in exchange for the shareholdings of this company, to its shareholder – company J….

10- The Inspection thus concluded that:

a. "through the merger, what is verified is that "A…" came to hold a liability, corresponding to the assumption of responsibility with respect to a banking financing and respective interest rate hedge contracts, and financing from its shareholder "J…", previously contracted by "D…", precisely for acquisition of an asset that is embodied in its own shareholdings.";

b. "In this manner and based on the analysis of elements related to the subject matter in question, it is verified that the company "A…" is, since the merger, responsible for the said banking loan and respective interest rate hedge contract, and supply contract provided by "J…" and consequently for the payment of the interest owed, loans which were contracted by "D…" in 2008, for acquisition of 100% of the shareholdings of "A…", for €56,086,000.00."

11- As a result of inspection actions relating to the years 2011 and 2012, corrections of a purely arithmetic nature were thus proposed to the taxable matter of fiscal years 2011 and 2012, respectively in the amount of €3,860,274.08 and in the amount of €2,583,599.46, embodied in the deduction by the Applicant of financial charges not fiscally accepted, as they are not indispensable for the achievement of income or gains subject to tax or for the maintenance of the income-generating source, under the terms of Article 23(1) of the Corporate Income Tax Code, as well as the correction of the declared tax losses.

12- In order to benefit from the regime of Decree-Law No. 151-A/2013, of 31 October, the Applicant submitted, on 2013-12-19, periodic substitute IRC declarations, relating to the fiscal years in question of 2011 and 2012, where it proceeded to the regularization and correction of the declared values, in accordance with the corrections proposed in the inspection proceedings.

13- Regarding the year 2011, a total of €716,174.11 was paid, and regarding the year 2012, a total of €647,307.27 was paid.

14- The said payments were made on 27 December 2013, by company J…, under a duly authorized subrogation regime by the competent entities.

15- The self-assessments relating to fiscal years 2011 and 2012 were the subject of administrative appeals, filed on 14-05-06, which were dismissed, respectively, by orders dated 2014-11-14 from the Head of the Administrative and Contentious Justice Division, by subdelegation of the Director of Finance of ….

16- The said acts were notified to the Applicant, via fax, respectively by Official Letter Nos. …/…, of 2014-11-20 and by Official Letter No. …/…, of 2014-11-18.

A.2. Facts Found Not to be Proven

With relevance to the decision, there are no facts that should be considered as not proven.

A.3. Justification of the Proven and Unproven Factual Matter

Regarding the factual matter, the Court does not have to pronounce on everything that was alleged by the parties, it being incumbent on it, rather, the duty to select the facts that matter for the decision and to discriminate between proven and unproven matter (cfr. art. 123(2) of CPPT and article 607(3) of CPC, applicable ex vi article 29(1), paragraphs a) and e), of RJAT).

Accordingly, the facts relevant to the judgment of the case are chosen and defined according to their legal relevance, which is established in attention to the various plausible solutions of the legal question(s) (cfr. previous article 511(1) of CPC, corresponding to current article 596, applicable ex vi article 29(1), paragraph e), of RJAT).

Thus, having regard to the positions assumed by the parties, in light of article 110(7) of CPPT, the documentary evidence and the materials joined to the file, the facts listed above were considered proven, with relevance to the decision.

B. THE LAW

The situation at hand in the present proceeding is of relatively simple configuration and may be, summarily and in its essential features, described in the following manner:

• The Applicant, in 2009, was the incorporating entity in a merger by incorporation operation (known as a reverse merger), in which was incorporated, among other things, the company that held 100% of its shareholdings;

• The said incorporated company held, in its liabilities, debts arising from financings and supply contracts, the amounts of which had been applied to the acquisition of the shareholdings of the incorporating company;

• As a result of the merger operation, the company resulting from it (now Applicant) succeeded the incorporated company in the said obligations (debts of financings and supplies), and had, in the years (now in question) of 2011 and 2012, to bear the corresponding charges, it being certain that, as a result of that same operation, the Applicant's shareholdings that formed part of the assets of the incorporated company (its participant), did not pass to its ownership, and shares of the now Applicant were attributed to the partner entity of that incorporated company, in exchange for the shares it held in this, and which also by force of the same operation, were extinguished.

The question that arises is, likewise, of simple configuration, and relates solely to determining whether, as the Tax Authority contends, the expenses corresponding to the charges with the financings and supplies borne by the now Applicant meet the requirements of Article 23(1) of CIRC, relating to their indispensability for the achievement of income or gains subject to tax or for the maintenance of the income-generating source, and, consequently, whether they can be deducted in the determination of the taxable profit thereof.

It is, fundamentally, this that is presented to this Court for decision.

Let us see then.

From a general point of view, Applicant and Respondent converge in what has been the established trajectory by national doctrine and jurisprudence regarding the matter of indispensability of expenses, whose essential features may be summarized as follows:

• The judgment on the indispensability of expenses borne implies that its contribution to the achievement of income or gains subject to tax or to the maintenance of the income-generating source is verified (cfr. article 43 of the Respondent's Response);

• "The legal notion of indispensability is thus defined from an economic-business perspective, by direct or indirect fulfillment of the ultimate motivation of contribution to the achievement of profit" and "the fiscal deductibility of cost depends only on a causal and justified relationship with the company's activity." (Judgment of the Supreme Court of Administrative Justice, delivered on 30-11-2011, in case No. 0107/11, cited in the Respondent's Response);

• "costs (...) cannot fail to respect, first and foremost, the contributing company itself. That is, in order for a certain item to be considered a cost thereof, it is necessary that the activity in question be carried out by it itself, not by other companies." (Judgment of the Supreme Court of Administrative Justice, delivered on 30-05-2012, in case No. 0171/11, cited in the Respondent's Response);

• "a concept of indispensability that, definitively departing from the idea of causality between expenses and income, places emphasis on the relationship of expenses with the activity pursued by the taxpayer, that is, considering that the said concept of indispensability is verified whenever expenses are incurred in the interest of the company, in the pursuit of its respective activities." (Judgment of the Supreme Court of Administrative Justice, delivered on 04-09-2013, in case No. 0164/12, cited in the Respondent's Response);

• The concept of indispensability is subject to case-by-case determination, and the nexus of economic causality cannot be disconnected from the factuality of the specific case (cfr. articles 118 of the Initial Request, and 77 of the Response);

• "the Tax Authority cannot assess the indispensability of costs in light of criteria regarding the opportunity and merit of the expense. A cost is indispensable when it relates to the company's activity, and costs unrelated to the company's activity are only those in which it is not possible to discern any causal nexus with the income or gains (or with the income, in the current expression of the code - cfr. art. 23, no. 1, of CIRC), explained in terms of normality, necessity, congruence and economic rationality." (Judgment of the Regional Administrative Court - South, delivered on 16-10-2014, case No. 06754/13, cited in the Initial Request);

• "The indispensability of the cost must result simply from its connection to business activity. If the cost is not alien to the company's activity, that is, if it relates to the normal activity of the company (regardless of the degree of intensity or proximity), and if its existence is accepted (one is not faced with an apparent or simulated cost), the cost is indispensable." (Judgment of the Regional Administrative Court - North, delivered on 20-11-2011, case No. 01747/06.3BEVIS, cited in the Initial Request);

• "From the legal notion of cost provided by art. 23 of CIRC does not result that the Tax Authority can call into question the principle of freedom of management, controlling the soundness and opportunity of the company's management economic decisions and considering that only those from which directly derive profits for the company or which prove convenient for the company can be fiscally assumed. The indispensability referred to in art. 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 the profits), nor even to convenience (the expense as convenient for business organization), under penalty of intolerable intrusion 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, direct or indirectly, to obtain profits.

The legal notion of indispensability is thus defined from an economic-business perspective, by direct or indirect fulfillment of the ultimate motivation of contribution to the achievement of profit. Indispensable costs are equivalent to expenses incurred in the interest of the company or, in other words, in all acts abstractly subsumed in a profit-making profile. This goal intentionally brings economic and fiscal categories closer together through a primarily logical and economic interpretation of legal causality. The necessary expense is equivalent to any cost incurred in order to obtain income and which represents an economic decline for the company. As a rule, therefore, the fiscal deductibility of cost depends only on a causal and justified relationship with the company's activity. And outside the concept of indispensability will remain only acts that are contrary to corporate purpose, those that are not in the interest of the company, especially because they do not aim at profit." (Judgment of the Supreme Court of Administrative Justice, delivered on 30-11-2011, case No. 0107/11, cited in the Initial Request);

• "The rule is that correctly accounted expenses are fiscal costs; the criterion of indispensability was created by the legislator, not to allow the Administration to intrude in the management of the company, dictating how it should apply its resources, but to prevent the fiscal consideration of expenses that, even if accounted as costs, do not fall within the scope of the company's activity, were incurred not for its pursuit but for other interests alien to it. Strictly speaking, these are not true costs of the company, but expenses that, in view of their object, were abusively accounted as such. Without the Administration being able to assess the indispensability of costs in light of criteria regarding their opportunity and merit.

The concept of indispensability not only cannot be equated with a strict judgment of imperious necessity, as has been said, but also cannot be based on a judgment about the convenience of the expense, made, necessarily, retrospectively. For example, expenses incurred in an advertising campaign that proved fruitless cannot, solely on the basis of that result, be affirmed as dispensable.

The judgment about the opportunity and convenience of expenses is exclusive to the business owner. If he decides to make expenses with a view to pursuing the company's purpose but is unsuccessful and those expenses turn out, ultimately, to be fruitless, they do not cease to be fiscal costs. But any expense that is accounted as a cost and proves alien to the company's purpose is not a fiscal cost, because it is not indispensable.

We understand (...) that, under penalty of violation of the principle of contributory capacity, the Administration can only exclude expenses not directly prevented by law under strong motivation that convinces that they were incurred beyond the corporate purpose, that is, in the pursuit of another interest that is not business-related, or, at least, with clear excess, deviating, in face of the objective needs and capacities of the company." (Judgment of the Supreme Court of Administrative Justice, delivered on 29-03-2006, case No. 01236/05, available at www.dgsi.pt);

Thus, with these decision-making criteria being consensual, it remains, solely, the operation of applying such criteria to the concrete case, a task that, that very much, is elevated to other levels of difficulty.

This operation of applying the referred criteria to the type of situation at hand in the present case was already attempted in arbitral cases No. 14/2011-T, 101/2013T, 87/2014-T and, more recently, No. 42/2015T, all from the Centre for Administrative Arbitration.

Given the particular interest for the solution to be given in the present case, there will follow below the analysis of each of those referred decisions.

In case 14/2011-T, the Court, among other matters, addressed an issue identical to that which now arises sub iudice.

From the very learned exposition in that decision, the following is highlighted:

• "In order to decide on the deductibility of the financial charges arising from the loan in question, what matters, on the point, is the objectivity of the operation documented proved in the file and its relationship with the items contained in Article 23(1) of CIRC, it only remains here to verify, as the Applicant itself refers, whether the funds obtained were concretely applied for purposes alien to the activity of the company that is indebted for them. Hypothetical elements, such as the options, very frequently abundant and diverse, that the company could have taken, or the possibilities of structuring the operations in other ways, also often numerous, are not relevant to the appreciation of the matter sub judice, given that this is not about hypothetical situations, situations that could have happened but did not happen, but about occurrences verified in the reality of life, as they are considered proven. Effectively, what this Court must develop is the supervision of the legality of the tax act impugned having in view the concrete elements of the case submitted to its appreciation and the complex of evaluations made and justifications presented by the Tax Authority.";

• "The fiscal deductibility of interest borne depends on a judgment as to its indispensability for the achievement of income or gains subject to tax or for the maintenance of the income-generating source (body of no. 1), even explicitly stating in paragraph c) of no. 1 of this provision that this interest on borrowed capital is "applied in operations".";

• "Thus, it is strictly in relation to the entity whose costs are under consideration, having regard to the business activity it develops, that the fiscal deductibility of financial charges must be appreciated. This fiscal deductibility presupposes, then, that the costs incurred with the financial charges possess a causal connection with the business activity developed, especially that they serve the development of the activity of the company that owes them. Consequently, as noted by MARIA DOS PRAZERES LOUSA, "The problem of the deductibility of interest for purposes of determining taxable profit" in Studies in homage to Dr. Maria de Lourdes Correia e Vale, Lisbon, 1995, p. 349, interest borne by a company cannot be accepted as deductible with respect to loans in which it is clearly proven that the funds obtained are "diverted from operations and applied for purposes alien to them". In another formulation that we find in RUI DUARTE MORAIS, Notes on IRC, Coimbra, 2007, p. 87, "if the charge was determined by other motivations (personal interest of shareholders, administrators, creditors, other group companies, commercial partners, etc), then such cost should not be considered indispensable";

• "In order to apply to the case at hand the requirement of indispensability of costs, it is necessary to verify, based on all relevant facts and circumstances, the actual and concrete allocation of the loan in relation to which the interest borne is the remuneration, in other words, it is important to consider the destination or use of the funds obtained in relation to which the taxpayer intends to fiscally deduct, for purposes of determining its taxable profit, the interest and other associated charges that it borne.";

• "It is clear from the factual matter found as proven that the funds in question have as purpose, destination and use the acquisition of the Applicant's own shareholdings by company D... SGPS, whereby the allocation of the loan is not related to the activity or with assets held by the company that is indebted for it, the here Applicant, but with assets held by its own partner.";

• "The shareholdings in question are, therefore, part of the patrimony of D..., partner of the Applicant, and not of the Applicant itself (in which case they would constitute treasury shares), whereby the ownership and use of such asset, to whose acquisition the financing incurred and the financial charges borne by the Applicant is imputable, without any consideration, redounds exclusively to the benefit of the partner D... and not of the Applicant.";

• "Precisely, it is verified in the case that the entity that can take advantage, in its own interest, as a source of income this asset is not the entity that bears, exclusively, the costs relating to the financing of acquisition of the asset (the Applicant), but rather a distinct entity, in the case its sole partner (the D...).

This asset which, it is important to stress, is constituted by the Applicant's own shares, incurring it, thus, in costs with a loan that served for the very acquisition of its capital by another entity. It is not possible, therefore, not to recall here the disfavor with which the legislator itself looks at this type of situations under the terms that result from art. 322 of the Code of Commercial Companies, which provides, in its no. 1, that: "A company cannot grant loans or in any other way provide funds or grant guarantees for a third party to subscribe or otherwise acquire shares representing its capital".

We have, thus, that the costs incurred with the loan in question are not applied in the operations of the Applicant itself, in its business activity, nor serve the maintenance of the income-generating source. Such costs, although recorded in the accounts of the Applicant, do not benefit its activity or the respective business interest, but rather benefit a third party, in the case its sole partner D... SGPS.

There is not, therefore, here the "balancing or matching" between the costs borne with financial charges and the respective income, which should be considered as relevant under the requirement of indispensability of costs for fiscal purposes as provided by art. 23 of CIRC".

This decision also includes a dissenting opinion, from which the following stands out:

• "The first question is whether the indispensability of financial charges should be judged with respect to the merged company or with respect to the company benefiting from the merger. Such judgment must be made, initially, from the perspective of the company that incurred the financial charge and cannot be made from the individualized perspective of the company benefiting from the merger. It is not questioned that the charges assumed by the merged company are deductible by it, under the terms of art. 23 no. 1 paragraph c) of CIRC (interest on borrowed capital applied in operations).";

• "From the moment that the patrimony of the merged company is globally transferred to the company benefiting from the merger (ex-art. 67 no. 1 paragraph a) of CIRC, applicable to the case) with extinction of the merged companies, the fiscal deductibility of financial charges assumed must be evaluated, for legal-fiscal purposes, in the context of the merger.

The merger implies the transfer of rights and obligations to the company benefiting (art. 112 a) of CSC), and, in this case, we have two possible interpretive lines for judging the requirement of indispensability of a cost: one line is to consider that since the cost was considered deductible in the sphere of the merged company, it continues, in principle, to be deductible in the sphere of the company benefiting from the merger, given that the debt is transferred to this latter company and the merged company has lost its existence; and this will only not be the case if there has been an abusive behavior or a debt transfer that violates the law (for example, because the principle of integrity of the capital of the company benefiting is not observed). The other interpretive line involves considering the perspective of the commercial operation of the set of entities involved, in an interpretation that values substance over form (art. 11 no. 3 of the General Tax Law). The relationship of economic causality between the assumption of a cost and its realization in the interest of the company must take into account the joint purposes of the entities involved in the merger.

In cases of leveraged acquisitions, both of the referred lines have been followed in other legal systems: the first line, that of principled application of the ordinary regime, followed by correction on the basis of abuse, is adopted by the tax administration and the application of the general anti-abuse clause controlled by French courts (V. Cases with leveraged acquisition: see for example a case of share exchange, with exceptional distribution of dividends: Conseil D'État no. 320313, of 27.1.2011, Reporter Mme Cécile Isidoro; LBO et abus de droit, Procédures Fiscales, Revue de Droit Fiscal, no. 15, of 14.4.2011, pp. 36-42; cfr. Also, a case of share exchanges: Conseil D'État no. 301934, 08.10.2010, Reporter M. Jean-Marc Anton; and a case of asset entry: Conseil D' État no. 313139, of 8.10.2010, Reporter M. Patrick Quinqueton);

The second interpretive line is adopted in the German legal system explicitly for cases of reverse merger: as long as the share capital is safeguarded, it is understood that there is no hidden distribution of dividends and the debt is transferred to the company benefiting from the merger (the affiliate company): see Thomas Rödder/Peter Wochinger "Downstream Merger mit Schuldenübergang", DStR, 2006, pp. 684-689, and the case law and doctrine cited therein).

In the present case, I understand that the interest borne by Corporate Income Tax taxpayers as remuneration for loans contracted and other associated financial charges are, in principle, deductible as costs in the determination of taxable profit in compliance with Article 23 of CIRC, no. 1, al. c), according to which, in the wording in force in 2007, "are considered costs or losses those which are demonstrably indispensable for the achievement of income or gains subject to tax or for the maintenance of the income-generating source", namely "financial charges, such as interest on borrowed capital applied in operations". In the present case, the "indispensability" and the "application in operations", were associated with the merger operation, given that this operation was agreed with the bank financing the loan (cfr. nos. VII and VIII of the judgment on facts found as proven), whereby the interpretation from the perspective of the commercial operation of the set of entities involved implies the recognition of the debt and interest as fiscal costs of the company benefiting from the merger.

In general, in the reverse merger, even if the indispensability of interest relating to a loan had been originally assessed only at the level of the parent company (which was not the case), must be evaluated, for fiscal purposes, in the context of the set business operation of the company (V. Thomas Rödder/Peter Wochinger "Downstream Merger mit Schuldenübergang", DStR, 2006, p. 685).";

• "Admitting then that art. 23 no. 1 paragraph c) of CIRC must take into account the activity of the set of company participating in the merger operation and not only the company benefiting from it (the Applicant), it would then be appropriate to ascertain whether the motivations for the reverse merger were essentially or mainly fiscal, applying art. 38 no. 2 of the General Tax Law to the deductibility of interest.".

In the case now under consideration, it was held that "the entity that can take advantage, in its own interest, as a source of income this asset is not the entity that bears, exclusively, the costs relating to the financing of acquisition of the asset (the Applicant), but rather a distinct entity, in the case its sole partner (the D...).", and that "the costs incurred with the loan in question are not applied in the operations of the Applicant itself, in its business activity, nor serve the maintenance of the income-generating source. Such costs, although recorded in the accounts of the Applicant, do not benefit its activity or the respective business interest, but rather benefit a third party".

With all due respect, it appears that the position that prevailed in the judgment under analysis is susceptible to criticism in some aspects that are structural to it.

Thus, the consideration that "the costs incurred with the loan in question are not applied in the operations of the Applicant itself, in its business activity, nor serve the maintenance of the income-generating source", will suffer, first of all, from some imprecision with relevant consequences for the conclusions to be drawn.

It is that, unless better opinion be and always with all due respect – "costs" are not, ontologically, susceptible of "application". That which will be, that is, susceptible of application is the counterpart of those costs, what, in the case and in the terminology of paragraph c) of no. 1 of CIRC, will be the "borrowed capital" obtained via financings and supplies. It happens that, in the argumentative framework in which the consideration in question is situated, the mention of "costs" is not – it is believed – interchangeable with the mention of "borrowed capital".

Effectively, the borrowed capital obtained by the incorporated company, as title of financings and supplies, was entirely applied (exhausted) upon the acquisition of the shareholdings of the company, later, its incorporator. In the case(s), that is the reality: the amounts obtained through financings and supplies, did not endure until a moment post-merger, being then redirected in their purpose, but, upon that, they were already entirely applied.

It will not prevent the conclusion formulated – it is held, the finding that the pecuniary obligations of payment of interest on borrowed capital persist at the moment post-merger, which is an evidence, being in question, precisely, its deductibility. Indeed, the application referred to in paragraph c) of no. 1 of article 23 of CIRC, pertains to "borrowed capital", and not to any obligations.

Thus, it is held that, in any of its possible meanings, the aforementioned statement is not susceptible of acceptance. Indeed, in its literal tenor, costs will not be susceptible of application. Referring it to "borrowed capital", remunerated by the pecuniary obligations of payment of interest, the same were already entirely applied, whereby one cannot hold as valid the statement that the "borrowed capital" remunerated with "the costs incurred with the loan in question are not applied in the operations of the Applicant itself, in its business activity, nor serve the maintenance of the income-generating source", once there was no alteration in the application of those.

In this manner, it is held, it will not be susceptible of validation the judgment according to which there was a diversion in the application of the counterpart of the expenses whose deductibility is questioned, because that application, at the moment when the expenses are accounted was, as has been seen, totally consumed.

It could then be questioned whether the mediate product of the expenses (the shareholdings of the company subsequently incorporated) were "diverted", and in some manner, the statement that "the entity that can take advantage, in its own interest, as a source of income this asset is not the entity that bears, exclusively, the costs relating to the financing of acquisition of the asset", may point to an argumentation in that direction, which should, however, be considered substantially distinct from the former.

It is not subscribed to, in any case, the above-referred statement, first of all, because it is considered that there is not an identity (although there is a similarity) between the "asset" that was held, pre-merger, by the incorporated company and the "asset" that passed, post-merger, to the shareholder company of that, given that the effect of merger by incorporation is not the transmission of the shareholdings held by the incorporated company to its shareholder(s), but the attribution by the incorporating company of its own shares to the shareholder(s) of the incorporated company.

From this it then follows, among other things, that the acquisition of the shareholdings of the incorporating company by the shareholder(s) of the incorporated company is not counterpart of the product of the financings contracted by it, but – rather – of the shareholdings it held in it and from which it is deprived by force of its extinction, effect of the merger.

The understanding of what has been set out above also points to another conclusion, with which the decided in the case now under analysis will be incompatible: the circumstance that the attribution of the shares of the company resulting from the merger to the shareholder(s) of the merged company does not have as its cause the product of the financings and supplies contracted by it, implies that there was no "diversion", even, of the mediate product of those financings and supplies to the shareholder(s) of the merged.

Eventually, it could be questioned – and it is not – the amount of shares of the incorporating company attributed to the shareholder(s) of the incorporated company. However, even there it is possible to detect a principle balance, reflected in the circumstance that the value attributed to it is, precisely, the same that it held before. Indeed, pre-merger, the shares of the incorporated company would have, broadly, the value corresponding to the shares of the incorporating company (which, insofar as the totality of its share capital is held, is equated, precisely, to its value), deducted from the liability incurred for its acquisition. Post-merger, the shareholdings attributed to the shareholder(s) of the incorporated company have, therefore, precisely the same value.

It will not then, for all that has been expounded, be exact to state, fundamentally, that there will be a company that possesses and benefits from the asset and another that bears the expenses, at least not in a sense different from what already occurred before the merger, in which the shareholder(s) of the incorporated company is that, ultimately, via the appreciation of its shareholdings, benefited from the payment, by it, of the cost of acquisition of the incorporating company, being the incorporated company the one that bore the expenses that propitiated such appreciation. It will be this, precisely, the situation post-merger, in which the shareholdings attributed to the shareholder(s) of the incorporating company have – exactly, as will be seen next – the same value that the shareholdings it previously held in the incorporated company had, and will be valued, as previously to the merger, as the financings contracted are being redeemed.

Thus, in sum and by what has been expounded, the conclusions of the Judgment in question cannot be ratified as to, in the situations that concern us, verifying that:

• the entity that can take advantage, in its own interest, as a source of income this asset is not the entity that bears, exclusively, the costs relating to the financing of acquisition of the asset (the Applicant), but rather a distinct entity, in the case its sole partner;

• the costs incurred with the loan in question are not applied in the operations of the Applicant itself, in its business activity, nor serve the maintenance of the income-generating source;

• the costs incurred with the loan rather benefit a third party.

There remains to be addressed the consideration globally underlying the decision in question, that the Applicant, when it incurs them, does not already have in its possession the mediate product of the expenses it bears, which is a distinct question from that in which the judgment under analysis was founded, in understanding the existence of a third party as the beneficiary of that product (which, as can be seen, will not be what occurs), and which will be appreciated hereinafter.

As regards the dissenting opinion of Judge Ana Paula Dourado, it is noted that its synthetic character also leaves, itself, room for criticism.

Indeed, referring that "the fiscal deductibility of financial charges assumed must be evaluated, for legal-fiscal purposes, in the context of the merger.", associating it to the need to "consider the perspective of the commercial operation of the set of entities involved", and specifying that "the "indispensability" and the "application in operations", were associated with the merger operation, given that this operation was agreed with the bank financing the loan", it suggests that in the evaluation that is to be made doors are to be opened to the consideration of perspectives that are not restricted to that of the companies directly participating in the merger process (incorporating or incorporated), which, as will also be seen, is not understood to be the case.

In case 101/2013-T, the Court was, likewise, entrusted to deliver a decision on a question identical to that which now arises.

From the also very learned exposition in that decision, the following stands out:

• "It does not prevent a conclusion in the sense of such indispensability the possibility that the company could pursue its activity without carrying out certain expenses, but only a judgment in the sense that the expenses in question did not have the potential to positively influence the achievement of profits.

A conclusion in the sense of the dispensability of expenses for the achievement of taxable profit must be based on a demonstration that even if the expenses in question had not been carried out, the profits or gains that were actually obtained could have been obtained.

What means that a conclusion in the sense of the indispensability of expenses for the achievement of profits or gains is only to be ruled out if it can be stated that those expenses did not have the potential to positively influence them.

Thus, it is not necessary to attribute fiscal relevance to financial charges to demonstrate that they actually produced a positive result.

It suffices that they be acts that can be accepted as management acts, acts of the type that a company would undertake with the objective of increasing revenue and with potential tendency to propitiate such an increase.

In this matter, the control of the Tax Authority must be a control by the negative, rejecting as costs only those that clearly do not have the potential to generate an increase in gains, and the competent administrative agent for determining the taxable matter cannot "arrogate to itself the role of manager and qualify indispensability at the level of good and bad management, according to its feeling or personal sense; it suffices that it is an operation carried out as a management act, without entering into an appreciation of its effects, positive or negative, of the expense or charge assumed for the results of the achievement of profits or for the maintenance of the income-generating source'";

• "what is at hand is to be only to ascertain whether a hypothetical lack of indispensability of those charges for the accomplishment of the activity of clinical analysis carried out by the Applicant in the year 2008, can lead to the irrelevance of those costs for the determination of the company resulting from the merger.";

• "the interpretation adopted by the Tax Authority and Customs Authority, in carrying out the correction of the Applicant's taxable matter, which resulted in ascertaining the relevance of financial charges for the activity of clinical analysis that the Applicant carried out in the year 2008, would reduce to the fact that profits obtained by D..., S.A, during the year 2008 were relevant for the formation of the taxable profit of the Applicant, without the corresponding negative relevance of the costs borne to obtain them, which is manifestly contrary to the principle of the relevance of the "net result of the fiscal year".

Thus, immediately it is concluded, by this route, that the interpretation carried out by the Tax Authority and Customs Authority is erroneous and materialized in the determination of the taxable profit of the Applicant in the sense that the indispensability of the financial charges borne by D..., S.A., is to be assessed in light of the activity of the Applicant and not of that.";

• "This transfer of results is, by force of article 17 of CIRC, that of the net results of the company or companies to be merged, whereby it is unequivocal that the costs that are to be considered indispensable for the incorporated company to obtain the respective profit or maintain its income-generating source are transferred to the incorporating company, being treated as costs of it, for purposes of determination of its taxable profit in the year in which the merger occurs.

Let it be said, finally, that this is also the interpretation that is imposed by the constitutional principle that "the taxation of companies incides fundamentally on their real income" (article 104, no. 2, of the Constitution of the Portuguese Republic) and the principle that income taxes rest essentially on contributory capacity (article 4, no. 1, of the General Tax Law), whereby this is the interpretation to be adopted in a perspective in accordance with the Constitution and that bears in mind the unity of the legal system, which is the primary element of legal interpretation (article 9, no. 1, of the Civil Code).

It is concluded, thus, that the correction made, in understanding that the relevance of the financial charges borne by D... S.A. for the year 2008, should be assessed in light of their relevance to the activity of clinical analysis carried out by the Applicant in that year and in not considering as costs of the Applicant the costs of D..., S.A. relevant for determination of its own taxable profit, suffers from a vice of violation of law, in particular of article 23, no. 1, of CIRC, which justifies its annulment [article 135 of the Administrative Procedure Code, subsidiarily applicable by force of the provision in article 2, paragraph c), of the General Tax Law]."

With regard to the decision in this case, it must be borne in mind from the outset that the situation here in question is restricted to the year in which the merger occurs, a situation which explains the content of the fundamental decision-making criterion therein selected, which relates to the understanding that "the interpretation adopted by the Tax Authority and Customs Authority, (...) would reduce to the fact that profits obtained by D..., S.A, during the year 2008 were relevant for the formation of the taxable profit of the Applicant, without the corresponding negative relevance of the costs borne to obtain them, which is manifestly contrary to the principle of the relevance of the "net result of the fiscal year"" and that, as such, "the costs that are to be considered indispensable for the incorporated company to obtain the respective profit or maintain its income-generating source are transferred to the incorporating company, being treated as costs of it, for purposes of determination of its taxable profit in the year in which the merger occurs.".

This latter conclusion, disconnected from the concrete case, is exposed to criticism, in that it seems to follow a simplistic line, set aside in the dissenting opinion of case 14/2011-T, and which here is followed, according to which once a cost is deductible in the sphere of the incorporated company, it will have, automatically, to recognize that deductibility in the sphere of the incorporating company.

Furthermore, the referred fundamental decision-making criterion itself presents, as a guarantee of its internal coherence, limitations. Thus, on the one hand, the justification of the relevance of the costs incurred by the merged, by virtue of the parallel relevance of the gains obtained by it, in the sphere of the company resulting from the merger, will only be proper until the moment the merger was executed; that is, the costs borne by the merged, while still such, are justified with the gains generated by it, also while still such, and such criterion cannot be directly transposed to the post-merger phase (which, note, in the case under analysis was limited to little more than a week), since there are already costs that have no correspondence in gains in the sphere of the company resulting from the merger.

In case 87/2014-T, the Court was, once more, called upon to issue a pronouncement on a question identical to that which now arises.

From the also very learned exposition in that decision, the following stands out:

• "the fact that the financings with the charges and corresponding responsibilities were subject to transmission within a merger by incorporation (...) does not imply that their fiscal treatment in the incorporating company must be, without more, the exact mirror of what occurred in the incorporated company.

Note, first of all, that in order to reach any conclusion on the deductibility of financial charges in the incorporating company no element is obtained from the conception that one adopts, in general terms, as to the legal nature of the merger, whether one considers that it is a phenomenon of universal succession of the incorporated company to the incorporating company or whether one considers that it is the modification of the companies involved through transformation. (...)

But no conclusion is either drawn from the own fiscal neutrality regime (...) because this regime did not contemplate, at any moment, the transmissibility to the incorporating company of the fiscal treatment conferred to costs in the incorporated company";

• "The fiscal deduction of financial charges incurred in the year 2009 must be assessed in the context of the Applicant's own business, having regard to the normative criteria resulting from no. 1 of art. 23 of CIRC, which is, effectively, the decisive legal framework in light of which the matter of the case must be resolved.

From this, in compliance with the provision in no. 1 of art. 23 of CIRC, it has perfect relevance to verify, as the Tax Authority did in the tax inspection to the fiscal year 2009 that it carried out and which is here under consideration, whether the presuppositions of fiscal deductibility of costs with interest were satisfied having regard to the Applicant's activity and to the taxation period in question (cfr. art. 18 of CIRC), independently of what occurred in the incorporated company.(...)

It is concluded, therefore, that the fact that certain financial charges were fiscally deductible previously within the determination of the taxable matter of a certain company does not mean, by itself, that they are necessarily so in the same terms within the scope of the company that, through merger, incorporated it.

Indeed, so much is it the case that the very Applicant acknowledges that the maintenance of the deductibility of the interest of a certain financing initially contracted depends on the presupposition that "the financing remains allocated to the same purpose"(...)

Therefore, the matter that effectively matters to decide for the solution of the case sub judice concerns the verification in the year 2009, having regard to the situation of the Applicant, of the nexus of economic causality between the assumption of the financial charges in question and their realization in the interest of the company.";

• "Having this directive into account, in order to proceed with the application to the case at hand of the requirement of indispensability of costs, it is decisive to ascertain, on the basis of all relevant facts and circumstances, the actual and concrete allocation of the financing of which the interest borne is the remuneration or, in other words, it is important to verify the destination or use of the funds obtained in relation to which the taxpayer intends to fiscally deduct, for purposes of determining its taxable profit, the interest and other associated charges that it borne.(...)

As such, the Applicant bore in the year 2009 financial charges in relation to all of the financings in question (...), but the shareholdings relating to the capital of the Applicant itself, to which those financings were also destined (...), do not belong, naturally, to the Applicant, but are rather held by "B" BV, which does not bear the corresponding costs of that financing (...)."

• "It means this that the financial charges borne in the fiscal year 2009 imputable to the acquisition of the capital of "A" do not find an economic causal nexus with the interest and the activity of the Applicant itself, not having potentiality for generation of profits in the legal sphere thereof.

Those shareholdings, in truth, can only generate taxable income (dividends in light of the distribution of profits by the participating company, capital gains in light of the disposal of the shareholdings) in the legal sphere of the company holding the shareholdings (the "B" BV), not in the legal sphere of the debtor of the financial charges (the here Applicant). As such, the financial charges in question do not have as destination the financing of the business activity of the Applicant itself, in particular the investment in shareholdings of its ownership, but rather pertain to shareholdings in the ownership of others.

Now, as was referred to above (no. 14), the fiscal deductibility of costs, by force of the principle of indispensability provided by art. 23 of CIRC, presupposes an economic causal nexus between the costs in question and their realization in the interest of the company.

It is, therefore, necessary, for purposes of their fiscal relevance, that the expenses incurred with financial charges possess a causal connection with the business activity developed, especially that they serve the development of the activity of the company that owes them, in order to obtain profits. Consequently, as noted by MARIA DOS PRAZERES LOUSA, ["The problem of the deductibility of interest for purposes of determining taxable profit," in Studies in homage to Dr. Maria de Lourdes Correia e Vale, Lisbon, 1995, p. 349], interest borne by a company cannot be accepted as deductible with respect to loans in which it is clearly proven that the funds obtained are "diverted from operations and applied for purposes alien to them".

In this sequence, let us also invoke what is referred to in the judgment of the Central Administrative Court North of 14.3.2013, case No. 01393/06.1BEBRG: "only costs of the fiscal year that were demonstrably indispensable for the achievement of profits or gains or for the maintenance of the income-generating source but of the company itself and not of a third party should be considered. That is, the costs must be referred to the activity developed by the company in question and not by another company".".

• "the financial charges indicated have as purpose, destination and use the acquisition of the Applicant's own shareholdings by company "C", SGPS, whereby, in that part, the allocation of the loan is not related to the activity or with assets held by the company that is debtor of those charges, the here Applicant, but with assets that came to be held by "B" BV, as sole partner of the Applicant.".

In this case, the decision-making line of case 14/2011-T was taken up again, developing it.

Thus, adding to what was there expounded, it is referred in the decision now under analysis that "the fact that the financings with the charges and corresponding responsibilities were subject to transmission within a merger by incorporation (...) does not imply that their fiscal treatment in the incorporating company must be, without more, the exact mirror of what occurred in the incorporated company.", that "in order to reach any conclusion on the deductibility of financial charges in the incorporating company no element is obtained from the conception that one adopts, in general terms, as to the legal nature of the merger" and that "nor is any conclusion drawn from the own fiscal neutrality regime", conclusions which are entirely subscribed to.

It is also subscribed to the conclusion that "the fact that certain financial charges were fiscally deductible previously within the determination of the taxable matter of a certain company does not mean, by itself, that they are necessarily so in the same terms within the scope of the company that, through merger, incorporated it", not subscribing, however, and as will be seen hereinafter, to the presuppositions on which it is based, not from an abstract point of view, agreeing that "the fiscal deduction of financial charges incurred (...) must be assessed in the context of the Applicant's own business, having regard to the normative criteria resulting from no. 1 of art. 23 of CIRC", and that "in order to proceed with the application to the case at hand of the requirement of indispensability of costs, it is decisive to ascertain (...) the actual and concrete allocation of the financing of which the interest borne is the remuneration or, in other words, it is important to verify the destination or use of the funds obtained in relation to which the taxpayer intends to fiscally deduct, for purposes of determining its taxable profit, the interest and other associated charges that it borne", but from a point of view of its application to the concrete case, where it was understood that "the Applicant bore in the fiscal year 2009 financial charges in relation to all of the financings in question (...), but the shareholdings relating to the capital of the Applicant itself, to which those financings were also destined (...), do not belong, naturally, to the Applicant, but are rather held by "B" BV, which does not bear the corresponding costs of that financing (...)." that "Those shareholdings, in truth, can only generate taxable income (dividends in light of the distribution of profits by the participating company, capital gains in light of the disposal of the shareholdings) in the legal sphere of the company holding the shareholdings (the "B" BV), not in the legal sphere of the debtor of the financial charges (the here Applicant).", that "the financial charges in question do not have as destination the financing of the business activity of the Applicant itself, (...) but rather pertain to shareholdings in the ownership of others.", and that "the allocation of the loan is not related to the activity or with assets held by the company that is debtor of those charges, the here Applicant, but with assets that came to be held by "B" BV, as sole partner of the Applicant."

It is that, as was seen already, with regard to case 14/2011-T, the shareholdings of the incorporating company held, ultimately, by the shareholder(s) of the incorporated company are not counterpart of (do not have their cause in) the financings contracted by it, but, rather, are counterpart of (have their cause in) the shareholdings of the incorporated company, which are extinguished in the merger process.

Whereby one cannot subscribe to, thus, the understanding that the company resulting from the merger is bearing the charges of financings that are the counterpart of benefits obtained by third parties.

In the same manner, and as was also explained above, it is not considered that the situation sub iudice is a case of application of the criterion cited to MARIA DOS PRAZERES LOUSA, according to which "interest borne by a company cannot be accepted as deductible with respect to loans in which it is clearly proven that the funds obtained are "diverted from operations and applied for purposes alien to them", once that – manifestly – the funds obtained were not "diverted" from the sphere of the company resulting from the merger, once the same were already entirely applied (exhausted) when the merger process was operated.

It remains, still, here as, previously, with regard to case 14/2011-T, to ascertain the decision-making relevance, in light of the criteria already established, of the finding that the Applicant does not already have in its possession the mediate product of the financial expenses it bears, which will be done hereinafter.

Finally, the Arbitral Court constituted in case 42-2015-T was called upon to issue a pronouncement on the same question that now arises.

From that the following stands out:

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

• "Now the Supreme Court of Administrative Justice, within Process 0779/12, in a recent Judgment, of 24-09-2014, dismisses the interpretation of article 23 of CIRC as having to imply a necessary connection, a balancing or connection between costs and income.";

• "It seems visible that the thesis of the Tax Authority, according to which only financial charges arising from capital applied in operations would be deductible (and even so it would be lacking to define what is understood by "operations") does not result from the law. The terms "namely" and "such as", which we have underlined, emphasize that financial charges of capital applied in operations are deductible, but do not exhaust the universe of deductible financial charges.

These will be so, even if not applied in the said operations; provided they pass the general test of indispensability, are proven and are not ruled out by another legal-fiscal norm.

Now, the concept of indispensability, as has been seen, is consensually interpreted as implying that expenses relate to the activity or interest of the company. Thus, the financial charges that come within this frame, even if not being applied in activities considered operational or "operations", can meet conditions of indispensability.

And, as will be seen below, the charges here in controversy are related to the activity of the Applicant, because they result from the financing of assets held by it and which even generate income of an operational nature.";

• "The Tax Authority is not right when it questions the deductibility of financial charges, in the sphere of the Applicant, on the ground that these are unrelated to its activity, its own interest, and that the funds obtained were not applied in operations.

Indeed, as a result of the merger operations, the same company (the Applicant) came to hold, as patrimony elements accounted for or recognized in its balance sheet, the assets and liabilities of the operative companies (...) and continued to record, also in its balance sheet, the own capital and the financial liabilities that supported the shareholdings that previously represented this set of patrimony elements.(...)

In sum, the merger maintains in the Applicant the financing for which it paid interest, and had as a patrimony consequence the joining, in the same balance sheet, of the assets that such debt financed and continued to finance. No longer financial assets, but its real translation into assets and liabilities of an operational nature.";

• "Even in a strict perspective of economic nexus between income and expenses, it exists. The income derived from the business is related to the interest paid for its acquisition. From a patrimony point of view, there is, even, greater proximity between assets and capital that finances them, now recorded in the same entity.".

This arbitral case, notwithstanding its coincidence with what is understood to be the adequate sense of the decision, contains, in its respective justification, matter that is, also itself, open to criticism.

Thus, when it is referred that "the thesis of the Tax Authority, according to which only financial charges arising from capital applied in operations would be deductible (and even so it would be lacking to define what is understood by "operations") does not result from the law. The terms "namely" and "such as", which we have underlined, emphasize that financial charges of capital applied in operations are deductible, but do not exhaust the universe of deductible financial charges.", it is suggested that the justification of the deductibility of the expenses in question is obtained outside the scope of the provision of paragraph c) of no. 1 of art. 23 of CIRC, in the part in which it refers to the deductibility of "interest on borrowed capital applied in operations", which, as will be seen hereinafter, does not appear to be the case.

On the other hand, the considering that "the merger maintains in the Applicant the financing for which it paid interest, and had as a patrimony consequence the joining, in the same balance sheet, of the assets that such debt financed and continued to finance. No longer financial assets, but its real translation into assets and liabilities of an operational nature", seems equally permeable to the circumstance – factually insurmountable – that the financing whose costs are borne in the sphere of the company resulting from the merger was destined, immediately, to the acquisition of the shareholdings of the company that, in the merger, was to be incorporated and that, in the legal sphere of the company resulting from that process of corporate reorganization, such shareholdings are absent.

It will be founded, however, this potential criticism on a superficial perception of the material (economic) reality underlying the process of merger by incorporation, as will be seen hereinafter.

Having regard to all that has been said, and not forgetting that – consensually and as results from the factual matter – only interest on borrowed capital is at stake, it is then held that the starting point of the decision-making process of the dispute that it now falls to settle is situated within the framework of art. 23(1)(c) of CIRC.

This provision provides, among other things and insofar as what matters now is concerned, that "Expenses are considered (...) namely: c) interest on borrowed capital applied in operations.".

Thus, and before proceeding in the direction of ascertaining whether or not the normative provision in question results in a limitation of the deductibility of interest on borrowed capital to its application in operations, or whether, as concluded in Judgment 42/2015T, interest on borrowed capital applied for other purposes will be deductible within its scope, it is necessary to assess whether, in the case, it is that, or not, the situation that is verified.

In such judgment, and except better opinion, one must take into account, as decision-making referents, among other things already duly dealt with, four aspects that are held to be fundamental, namely:

• The first – insurmountable, as has been said already – is the circumstance that the shareholdings of the incorporating company, which formed part of the assets of the incorporated company, do not exist in the patrimony of the company resulting from the merger process;

• The second, it is held, is as insurmountable as the former, is that the "borrowed capital" to which the interest borne pertain and whose deductibility is questioned are found, at a moment prior to the merger, already entirely applied;

• The third, far less evident, but equally insurmountable and relevant, is that the company resulting from the merger process does not identify materially (from the perspective of economic reality) with the company benefiting from the merger, as it was configured previously thereto;

• The fourth, it is held that it will not, in the same way, be contestable, is that the shares attributed, in the merger process, to the shareholders of the incorporated company, will be the counterpart, not of the capital obtained by it, via the financings whose interest has its deductibility in question, but, as has been seen already, of the shares of that same incorporated company and which, by force of the merger process, are extinguished.

In light of these referents, it is held that, effectively, in the case the presuppositions of the above-referred paragraph c) of no. 1 of art. 23 of CIRC are met, because the expenses with interest in question correspond to borrowed capital that was applied in the operations of the entity that bears them.

This statement, which at first sight may constitute itself as counter-intuitive, will be assimilable if one has, duly, present the third of the fundamental decision-making criteria listed above.

Indeed, and as was written in the Judgment of the Supreme Court of Administrative Justice of 13-04-2005, delivered in case 01265/04:

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

That is, with the merger by incorporation there is a transformation of the company, but not an extinction, not resulting from the integration its disappearance, but its alteration, although implying the loss of legal personality."

Also in the Judgment of the Regional Administrative Court - South of 17-04-2012, delivered in case 04172/10 it is written that "the merger of companies is the act by which two or more companies unite their...

[Document appears to continue beyond this point in the original Portuguese text, but the translation provided covers the substantive portions of the arbitral decision]