In 2005 “B Lender S.A” transferred a supplementary capital contributions to company C. The capital was to be paid back in 31 October 2009 and was provided interest-free.
Tax Authorities adjusted the taxable income of “B Lender S.A” with an amount of EUR 1,586,272.23, of which EUR 1,575,958.86 was attributable to interest on capital transactions, which it reclassified as interest-bearing loan under the arm’s length provisions of article 58 of the CIRC.
The assessment of additional income was upheld by a decision from the tax court.
An appeal was then filed by “B Lender S.A.”
Decision of Supreme Administrative Court
The Supreme Administrative Court set aside the decision of the tax court and decided in favour of A “B Lender S.A.”
Experts
“The question translates, in short, into knowing whether the arm’s length principle requires or imposes that a transaction of performance of ancillary services, within the scope of a group of companies be taxed as if it earned interest, even if, in fact, it has been agreed that it does not earn interest.
This is not a simple matter to be clarified and requires a prior conceptual and legal framework, which it is important to follow.
…
It is clear from the above that the tax authorities will act in accordance with the general rule allowing the reclassification of the transaction carried out by the parties, under the terms of the provisions of the above-mentioned rule.
The defendant’s action, on the specific point of the material reclassification of the transaction in question, is not only not illegal, but is also anchored in this basic parameter of action, permitted and imposed by the law “which sets out and defines the general principles governing Portuguese tax law and the powers of the tax authorities and guarantees of taxpayers” [see LGT, preamble].
On the other hand, what the appellant foresees as a requalification of the transaction is nothing more than the association of the transaction to the typical contract in which it may be subsumed, in accordance with the command contained in the legal rule which regulates the figure of accessory payments (cf. the said Art 287(1) of the CSC).
The classification of the “transfer of funds” operation, through the provision of ancillary services, as a loan therefore appears legitimate and the tax facts at issue herein do not involve any error of factual or legal assumptions.
Going forward, what is important to decipher at this point is whether s 58 is such as to require or impose that the transaction in question be interest-bearing for tax purposes.
…
In the section dedicated to “guidance on the application of the arm’s length principle” (“C.”), one can read, with relevance to the solution of the present case: “The application of the arm’s length principle is generally based on a comparison between the conditions applied in a linked transaction and the conditions applied in a transaction between independent enterprises. For that comparison to be meaningful, the economic characteristics of the situations considered must be sufficiently comparable. (…) In order to determine the degree of comparability, and in particular the adjustments to be made in order to achieve that comparability, it is necessary to understand the way in which independent companies assess the terms of possible transactions. When weighing the terms of a possible transaction, independent companies will compare it with other options realistically available to them and will only conclude the transaction if they have no other clearly more advantageous alternative. For example, a company is unlikely to accept a price offered for one of its products by an independent company if it knows that other potential customers are willing to pay more under similar conditions. This element is relevant to the issue of comparability since independent firms generally take into account all economically significant differences between the options realistically available to them (…) when considering those options. Consequently, when making comparisons arising from the application of the arm’s length principle, the tax administration must also take such differences into account when defining whether the situations considered are comparable and what adjustments may be necessary for the purposes of such comparability.” [paragraph 1.15 of the document].
The same summary of the OECD guidelines on the matter reveals, in paragraph 1.36, as to the recognition of transactions actually carried out (ii.), and with particular acuity for the issue we are dealing with:
“1.36.. The identification by the Tax Administration of a connected transaction should be based on the transaction that has actually taken place between the parties and on the way it has been structured by the parties, in accordance with the methods used by the taxpayer insofar as they are consistent with the methods set out in Chapters II and III. Save in exceptional cases, the tax administration shall not abstract from or substitute other transactions for the actual transactions. Restructuring legitimate business operations would amount to a wholly arbitrary procedure, the iniquity of which would be further aggravated by double taxation if the other tax administration involved took a different view on how the operation should be structured.
1.37. There are, however, two specific cases where, exceptionally, the tax authorities may be justified in disregarding the structure adopted by a taxpayer to carry out the linked transaction. The first case arises where there is a disagreement between the form of the transaction and its economic substance. The tax authorities may then disregard the qualification made by the parties and reclassify it according to its substance. This first case can be illustrated by the example of a company investing in an associated company in the form of an interest-bearing loan when, at arm’s length, given the economic situation of the borrowing company, the investment would not normally take that form. The tax authorities will then be entitled to qualify the investment by reference to its economic substance and to treat the loan as a capital subscription”.
From the excerpts transcribed it is clear the guideline to be adopted in the treatment of the issue we are dealing with.
And, in advance, it is already possible to make the following assertion:
If the purpose of the transfer pricing mechanism is to materially treat each company, inserted in a group of companies, and beneficiary of the special relations created within it, as a “separate entity”, an “independent company”, not inserted in the scope of special relations, and if, in concrete terms, the neutralization of the effects associated with such relations involves namely the qualification of the investment according to its economic substance, then it is clear that the defendant’s option, proposed by the inspection services and materialized in the assessment acts under analysis, is legitimate.
….
Now, besides the fact that we do not agree with the judgment under appeal in the interpretation of the sufficiency of the facts established and, consequently, in the extrapolation or definitive conclusion that it draws – it should be noted that there is no factual evidence in the evidence that it should be noted that there is no factual evidence that, in isolation or in conjunction, enables us to conclude that it was foreseeable that the refund of the supplementary instalments would be anticipated or that the parties intended to transfer results with the aim of reducing the tax burden and that the clauses contained in the contract entered into and accompanying the deferral of the price also entailed high financial risks for the purchaser, which both the Tax Administration and the Tribunal a quo have absolutely disregarded, Even if they admit the unpredictability of this anticipated refund – in this part, everything we have explained in relation to the legality of the action of the Tax Administration or the procedural conformation of the corrections in the light of the scope of application of the transfer pricing regime applies.
In short, it is clear to us that the corrections recommended, and which substantiate the assessment contested in this part, cannot be implemented by resorting to the transfer pricing regime or institute enshrined in article 58 of the CIRC. The Appellant is once again right when it defends (as the doctrine already cited and transcribed also affirms) that it is not possible to equate the assignment of the credit on additional services, even with the benefit of its restitution in relation to the deadline for payment, with a simple concession of credit, a concealed financial loan, since we are dealing with realities that are not comparable.
The conclusions 20 to 33 of the grounds of appeal are, therefore, upheld, or, in other words, that the assessment is also vitiated, in this part, by an error of fact and law and, consequently, because it is illegal, it must be annulled, the other questions raised in this regard concerning the method of comparison selected and used by the tax authorities (set out in conclusions 35 and following of the grounds of appeal) being also dismissed.”
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