Judgment summary
This case concerns an appeal by the Portuguese Tax Authority (AT) against a first instance decision that annulled an additional IRC assessment made against the Portuguese branch (sucursal) of Banco 1..., a French credit institution, for the 2006 tax year.
The AT had corrected the branch's taxable profit by adding back €1,108,441.37, representing interest paid to the Madrid branch of the same bank, on the basis that the Portuguese branch had insufficient 'free capital' and that part of the loan should be treated, for tax purposes, as an equity contribution rather than debt (paras I-IV of the summary and I).
The Supreme Administrative Court unanimously dismissed the AT's appeal, confirming the first instance judgment and annulling the assessment and compensatory interest.
Background
The Respondent is the Portuguese branch of Banco 1..., a credit institution headquartered in France and supervised by the Banco de Portugal (facts A and B).
In early 2001, the parent bank requested and obtained the Banco de Portugal's non-opposition to the cancellation and repatriation of capital allocated to the branch, in the amount of €21.982.721,64 (fact C).
In 2006, the branch obtained medium-term and overnight funding from the Madrid branch of Banco 1..., and assessed the arm's length nature of the interest paid using the Comparable Uncontrolled Price Method, referencing Euro interbank market (MMI) rates, concluding that the interest rates were consistent with the arm's length principle under Article 58(1) of the CIRC (fact I).
Following a tax inspection in 2008-2009 covering the 2006 financial year, the Tax Inspection Services (Divisão de Inspecção a Bancos e outras Instituições de Crédito) issued a Final Inspection Report on 20.04.2009, concluding that the branch's own funds represented only about 0,314% of its total assets, a proportion the AT considered inconsistent with the arm's length principle, and calculated a 'free capital' deficit of €1.108.441,37, which it added back to taxable profit under Article 58(1) of the CIRC (facts F to I).
An additional IRC assessment (no. ...70) of €49.876,57, including compensatory interest, was issued on 17.06.2009, together with a separate compensatory interest assessment of €78.749,76 and a statement of account showing €288.632,73 payable (facts K and L).
Core dispute
The dispute concerned whether the correction made by the AT to the branch's 2006 taxable profit, adding back €1.108.441,37 of interest paid as non-deductible on the basis that the branch should have held a higher level of 'free capital' under the arm's length principle, was lawful under Article 58 of the CIRC as then in force.
The AT argued that the arm's length principle, embodied in Article 58 of the CIRC, Article 9 of the OECD Model Convention, the Portugal-France Double Taxation Convention, and OECD Guidelines and Commentaries, justified attributing a level of 'free capital' to permanent establishments, and that OECD soft law materials were not subject to the non-retroactivity rules of Article 12 of the LGT.
The Respondent argued that no provision of the CIRC or of Portaria 1446-C/2001 in force in 2006 required non-deductibility of interest linked to notional free capital, that OECD Reports and Commentaries have no direct legal effect in Portugal, that the 2008 Report on the Attribution of Profits to Permanent Establishments introduced a substantially new approach that could not be applied retroactively, and that the assessment breached the constitutional principles of legality, non-retroactivity, proportionality and legal certainty.
Court findings
The Court held that Article 58 of the CIRC, in the version applicable at the time, is a classic transfer pricing provision with a circumscribed and clearly delimited scope, which does not address the situation relied upon by the AT, namely the recharacterisation of part of a loan (and associated interest) as a free capital contribution.
The Court found that there was no rule, either in Portuguese domestic law or in the Portugal/France Convention as applicable at the time, dealing specifically with the allocation of free capital to permanent establishments. Article 58 of the CIRC concerns the correction of prices of transactions actually carried out, not the requalification of transactions for subsequent correction.
The Court noted that no procedure had been initiated that could have permitted a requalification of the financial operation for tax purposes, such as reliance on simulation (Article 39 of the LGT) or the general anti-abuse clause (Article 63 of the CPPT and Article 38(2) of the LGT). In substance, however, this is what the AT had done by disregarding part of the credit granted and requalifying it as a free capital allocation, using transfer pricing rules to derive an average free capital figure and then justifying the correction by reference to Article 58 of the CIRC together with various international instruments, commentaries and reports.
The Court also addressed the temporal question, agreeing with the first instance court that the 'new approach' allocating free capital to permanent establishments only began to be reflected in the 2008 OECD Commentaries to Article 7, following the July 2008 Report on the Attribution of Profits to Permanent Establishments, and that this could not be applied to double taxation conventions, or to interpretive purposes, in respect of a tax year (2006) predating that development, given the substantial nature of the changes introduced.
The Court further observed that OECD Guidelines, Reports and Commentaries constitute soft law, lacking binding force, and cannot substitute for or anticipate positive domestic or treaty law, particularly where they bear on the determination of a component of taxable profit engaging the principle of legality.
Outcome
The Supreme Administrative Court unanimously dismissed the Tax Authority's appeal, confirmed the first instance judgment, and annulled the additional IRC assessment and the associated compensatory interest assessment. Costs were ordered against the Appellant (AT).
Tp method highlighted
The Respondent branch applied the Comparable Uncontrolled Price Method (Método do Preço Comparável de Mercado) to assess the arm's length nature of interest paid to the Madrid branch, using external comparable data in the form of Euro Area interbank money market (MMI) rates, and concluded that the interest rates charged were consistent with the arm's length principle under Article 58(1) of the CIRC.
The Tax Authority, by contrast, compared the ratio of own funds to total assets of the Portuguese branch with the equivalent ratio at the head office level, and on the basis of the disparity found, calculated a 'free capital' deficit of €1.108.441,37 by reference to the proportion that the branch's assets represented within the bank's total assets, drawing on paragraph 83 of the OECD's 1984 Report. The Court held that this method of requalifying part of the loan as free capital could not be grounded in Article 58 of the CIRC.
Major issues / areas of contention
- Whether Article 58 of the CIRC permits the Tax Authority to requalify part of an interest-bearing loan from a parent bank to its branch as a 'free capital' contribution, rather than merely correcting the price of an existing transaction.
- Whether the Portugal/France Double Taxation Convention, as in force in 2006, contained any rule requiring the allocation of free capital to a permanent establishment.
- Whether the 2008 OECD Report on the Attribution of Profits to Permanent Establishments and the resulting 2008/2010 Commentaries to Article 7 of the OECD Model Convention could be applied, retroactively or through dynamic interpretation, to the 2006 tax year.
- The legal status of OECD Reports, Guidelines and Commentaries as soft law, and their inability to substitute for positive domestic or treaty law.
- Whether the correction should instead have been pursued through a specific anti-abuse rule, simulation under Article 39 of the LGT, or the general anti-abuse clause under Article 38(2) of the LGT and Article 63 of the CPPT.
- Whether the interest rates actually charged on the branch's financing complied with the arm's length principle under the Comparable Uncontrolled Price Method.