The Problem
When the Portuguese tax authorities have reason to believe that there may be differences between the declared value and actual value of the transfer of shares by an individual shareholder, the tax authorities are entitled to proceed to their own determination of a value for tax purposes [Article 52(1) of the Portuguese Income Tax Code].
We may frame this provision with a heading “Divergence of values” as an anti-abuse clause which allows the tax authorities to question the value of a transaction.
The problem starts on the second moment, when the provision states that “In the case of shares or securities not listed on a stock exchange, their disposal value shall be determined by reference to the most recent balance sheet prior to their disposal” [Article 52(2)(b) of the Portuguese Income Tax Code].
The attentive reader will identify that the law does not define or limit the facts on which the Portuguese tax authorities can base itself to reasonably consider that there may be a discrepancy between the declared value and the real value of the transaction, to apply this specific provision. Seems to me a carte blanche rule…
Additionally, the same attentive reader is stunned to discover that the law does not define what it means by balance sheet value and specifically if certain adjustments to the book value should be considered to arrive to a fair market value. The law refers only to value calculated based on the last balance sheet, assuming likely that this provides an adequate snapshot of the company that reliably reflects the financial situation and hence its value to a third-party buyer and the value the seller should have received (and taxed).
This short note uses as example a recent Arbitration Court decision (Case 156/2021-T), where the final outcome was favourable to a correction of price by the tax authorities, to demonstrate the inequity of a blanket rule of adjustment of prices between two separate taxpayers that refers to undefined terms and provides, in my personal perspective, an old-fashioned perspective on valuation of companies and determination of fair market value.
The “fair market value” is the value that a particular asset would fetch on the open market on the assumption that adequate knowledge of the market is available to the buyer and seller, they are acting in their best interests without external pressures and a reasonable amount of time is allowed for the transaction to take place. As we will see with an example, the rebuttable presumption that the fair market value of an enterprise is given by the balance sheet value may in some cases lead to abnormal results and may not reflect the open market conditions.
The Arbitration Case
Mr A was the majority shareholder of a Portuguese unquoted company (BCo) with a stake of 92% in 2016. Mr. A had acquired initially shares of BCo in 2013 for nominal value of €1. Mr. A purchased in 2016 an additional stake of shares of BCo for €0.61 per share. Mr. A in the same year decided to sell a 20% stake to a new shareholder CCo for a price of €0.45 per share. The tax authorities considered the book value of BCo in the prior year was €4m (FY15) that evidenced a “significant robustness” and hence considered there was a founded divergence between the values declared and the real value of the transfer and went on to apply the infamous Article 52. The tax authorities applied the equity value of the company based on the last balance sheet and determined a price of €2 per share. Instead of generating a tax loss as reported in the tax return, the tax adjustment performed to Mr. A resulted in €110k tax payable (28% rate on the capital gain) plus compensatory interest.
Mr. A alleged that this rule requires a demonstration of the existence or serious probability of divergence as a starting point, and this may not be extracted simply by looking at the last balance sheet. Mr. A also alleged that principles such as legal certainty and security, equality and tax capacity should lead to the conclusion that “balance sheet” should be interpreted as excluding components of credits from shareholders (e.g. supplementary capital contributions) and unrealized components that are merely potential or latent. Mr. A considered that equity value is not a trustworthy metric as it includes recognition of deferred taxes for future tax benefits not yet realized (and uncertain) and other variations such as subsidies that would also need to be adjusted from the value of the company.
But the arguments were without avail, as the Arbitration Court considered that the taxpayer failed to provide an adequate rebuttal to the legal presumption of valuation based on the balance sheet value. Therefore, the adjustment levied by the tax authorities was maintained and the fictional price per share taxed!
The Outcome
We all know that valuation is not an exact science but it is actually because the fair market value may be difficult to determine that tax law should be better equipped to handle with the many factors that may influence the valuation (e.g. nature/size of shareholding, profitability, future growth, etc.).
Using the company book value, or net worth, may lead to shortcomings as accounting criteria are subject to a certain degree of subjectivity and differ from market criteria when it comes to pricing. This may even work in some cases in favour of the taxpayer.
The discussion on the Arbitration Court decision on the relevance whether some balance sheet items should be priced or adjusted is demonstrative of those shortcomings. For example, experience indicates that the “economic value” of deferred tax assets arising from unused tax losses may be significantly less than the balance sheet figure. Due to limitations on maintaining tax losses in M&A transactions, the actual norm in majority stake acquisitions is even not to value any loss carry forwards (or corresponding DTAs).
In the case of Mr. A, perhaps both control issues and the preceding transaction value (if a comparable uncontrolled price) could also have been considered relevant points.
I also asked myself how this book value method would compare in a stock quoted company. We know that for quoted shares, the law provides that the disposal value is the quoted price at the date of transfer, but I wanted to use a real example to test. Using BCP Millennium bank (one of the Portuguese largest private banks) and compared the recent price per share in the market (€0.17) vs price per share determined based on last balance sheet value (€0.37). This basically corroborated my impression that balance sheet value for valuation and price of share is not revealing.
If we would call up a valuation expert, he will likely turn instead to other basic valuation methods. The first being a simple asset-based approach that calculates business value by subtracting liabilities from fair value of assets to determine a net asset value (best suited to holding companies). The second being a market approach using valuation multiples (such as price to earnings) derived from known sales or transactions involving comparable private companies. The third being an income approach that is generally known as Discounted Cash Flow Method which seeks to determine enterprise value based upon estimated future earnings. Why not the law referring to these alternative methods?
Finally, we should add that back in 2021, a transfer pricing provision in Article 43(7) was included providing that for determining capital gains/losses in transactions between an individual taxpayer and related party (entity), the terms should be substantially identical to those that would normally be accepted and practiced between independent entities in comparable transactions. This means that for related party transactions, the rule is fair market value determined by transfer pricing methods whilst non-related party transactions remain with a risk of the Sword of Damocles (book value) falling over the taxpayer head.
The tax law may be complicated, but life is even more so and it is wrong tax policy to try to anticipate every possible situation that lead to designing rules that lack statutory purpose and use presumptions that limit the capacity of the interpreter to apply normal valuation principles.
Before valuation becomes more an art rather than a science, it is time to reconsider the logic behind this inadequate legal presumption.
Tiago Cassiano Neves
Managing Partner of Kore Partners
maio de 2022