The Accrual Accounting Principle and its Implications for Portuguese Tax Courts Decisions

Table of Contents

1. Introduction

2. Accounting and tax implications of the accrual principle

3. Methodology

4. The application of the accrual principle by tax courts

   1. Depreciations

   2. Interest expenses

   3. Provisions

   4. Impairments in receivables

   5. Revenue reversals

5. Final remarks, policy implications and limitations

6. References

1 Introduction

Similar to many other countries, in Portugal, corporate income is taxable (Portuguese corporate income tax code – CITC). Accounting plays an important role in corporate taxation, since accounting profit is the basis for determining taxable income. However, accounting principles are not the sole set of rules used for establishing taxable income, since adjustments (i. e. including and/or excluding some entries) are performed by complying with the CITC. From this process a tax base is obtained, reflecting the application of both accounting rules and the tax code. This solution is consistent with article 104 § 2 of the Portuguese Constitution, which states that real income is the basis of corporate taxation. This constitutional demand realises the ability-to-pay and equality principles (Nabais, 2019). In effect, the use of accounting is important towards quantifying real income but does not have a monopolistic role (Sanches, 2007).

In a simplified way, the tax base is obtained by removing any tax-exempt revenues and tax-deductible expenses from revenues during a given fiscal period. Tax-deductible expenses are usually related to the purposes of the business, generating or securing income. This link between accounting and taxation, established by the adjustments introduced by the tax code to the accounting income, is called the partial dependence model, a mixed and balanced solution between a one-book system (dependence model) and a two-book system (autonomy model). Schmiel and Wetiz (2019) analysed the adequacy of the one-book system that takes the accounting profit as a basis for taxable income. Since the former is ruled by accounting principles, the relationship between financial accounting and taxation is called authoritative principle. Considering that equality of taxation, grounded on the ability-to-pay principle, is an adequate tax goal from an evolutionary perspective (based on uncertainty), they concluded that the authoritative principle is an adequate form of achieving it.

The determination of accounting income follows the generally accepted accounting principles but, under the partial dependence model, is also a first step to assess the corporate income tax base. When the extent and nature of accounting irregularities calls its reliability into question, accounting income fails to be the starting point of taxable income, requiring the use of indirect methods or presumptions, which are allowed under article 88 of the Portuguese General Taxation Law. None of such methods enables the accounting income to be removed from the computation of the taxable income. In this sense, real income persists as the basis for taxation and therefore what is at stake are technical corrections to the tax base in order to obtain it.

Intertemporal income shifting is a practice that directly affects taxable income. It is a tax planning method based on deferring book and taxable income between periods, aimed at obtaining tax savings (Shackelford & Shevlin, 2001). This remains a current problem. For instance, studies carried out by Höglund and Sundvic (2019) suggest that small Finnish companies engaged in discretionary accrual behaviour, decreasing the taxable income before a tax reduction anticipation. Evidence from literature highlights that, under the partial dependence model, managers have incentives to engage in income manipulation. Accounting policies, in particular discretionary estimations and judgments, may be used to transform financial accounts to derive some tax advantages (Niskanen & Keloharju, 2000).

Some accrual actions are outside accounting and tax rules and may have several implications in litigation between taxpayers and the tax authority (TA). Subsequently, tax decisions apply the tax rules, following the principle of justice prescribed in tax law in order to reach a fair solution to all the concerned parties. Focusing on legal decisions, this paper addresses the main accrual issues under litigation and aims to discuss the following research question: under which circumstances the principle of justice may affect the strict application of the accrual principle?

Since the accrual principle is common to the fields of accounting and tax law, legal research is done in both areas with the purpose of capturing its real nature and implications. Understanding the reasons behind the adoption of this accounting principle in tax law and its relations to other tax principles leads to suggestions for improvements and becomes useful for a wider group of agents, like taxpayers, tax practitioners and policymakers. Therefore, addressing the research question formulated above has the potential for contributing towards an improved coherent framework for the application of the accrual principle in the field of taxation.

Legal issues in the accounting and taxation fields are firstly presented in Section 2, followed by Section 3 describing the methodology adopted in this paper. Section 4 discusses the application of the accrual principle to corporate income taxation by tax courts, highlighting the role of the principle of justice restraining its rigid use. This paper concludes with a summary of findings based on the analysis of an extensive sample of court decisions.

2 Accounting and tax implications of the accrual principle

The main purpose of accounting information is to provide a true and fair view of the economic organisation of reporting entities in order to support economic decisions by their stakeholders. According to the IASB Conceptual Framework for Financial Reporting, the primary objective of financial reporting is to inform existing and potential investors and creditors. In this perspective, other parties, such as regulators and the public, are regarded as secondary. Despite the Portugal’s Conceptual Framework, included on Accounting Normalization System (SNC), being based on that by the IASB, it lists at the same level existing and potential investors, employees, lenders, suppliers, costumers, government and public departments and also society (public). This notion is in accordance with the 2006 version of the IASB Conceptual Framework. However, in 2010, the amendments made to the IASB Conceptual Framework categorised investors and creditors as key stakeholders, above all others. Zhang and Andrew (2014) observe that the importance given to investors and creditors reflects FASB’s influence in this amendment process, ensuring an increased commitment towards capital markets.

TA is an important stakeholder, included in government and public departments mentioned in Portuguese Conceptual Framework, though it does not have a privileged position above others. Accounting for income taxes, simply defined as the reporting on financial statements information about the firm’s taxes, includes the conciliation between book and taxable income. Graham, Raedy, and Shackelford (2012) observed that that the primary user of this information may be an adversarial party, such as the TA. Therefore, this type of accounting faces the challenge of balancing information provision to the TA and other stakeholders.

Moreover, the purpose of the tax system is to collect revenues, in addition to other economic and social roles, such as resource allocation, redistribution of income and economic stabilisation. Sheffrin (2018) emphasises that the intended role of taxation is to serve as a mechanism to correct market outcomes, introducing in the community principles of justice, fairness or desert (deservingness). However, Sheffrin (2018) found that often political preferences introduced into tax law were not consistent to a merit-based society.

Therefore, “tax accounting” and financial accounting have different motivations and cannot be unified (Molín & Jirásková, 2015). The adjustments prescribed by the CITC, according to which the accounting income recognised in the profit and loss statement can be increased or decreased, have become more extensive. This has increased the differences between accounting income and taxable income. According to International Accounting Standard 12 (Income Taxes), these differences may be recognised in financial statements. Brouwer and Naarding (2018) propose some changes to this standard in order to provide more value-relevant information to investors.

The introduction of fair value measurements in accounting rules has widened the gap with taxation rules. In effect, emphasising value relevance and decision usefulness for investors decreases the degree of reliability and objectivity usually pursued by taxation. There is a persistent effort from tax law towards the protection of tax revenues from variations in income resulting from the application of accounting standards, which contain assumptions and estimations, affected to a significant extent by professional judgment.

Income is generally defined as a residual variable, corresponding to the difference between revenues and expenses allocated to some stakeholders. However, measuring income remains the main goal for accountants (Littleton, 2011). Representing objectively the business firm is a complex task, due to the continuous changes in circumstances, both internal and external, that affect it. Accounting relativism results from the existence of several accounting theoretical approaches. Indeed, this is in addition to the underlying relativism that emerges at firm level, which is also a composite phenomenon (Zambon & Zan, 2000). Therefore, more than one alternative exists for a firm’s accounting representation. This pluralism manifests itself particularly through the existence of a variety of income measurements, as discussed in detail by Zambon and Zan (2000).

Additionally, tax law still fails to provide a clear definition for economic income, despite carefully regulating exclusions, deductions and exemptions. Regardless of its source, gross income net of related expenses is subject to taxation over a period of time. This broad conception of tax base can accept lower tax rates, without compromising tax revenues. In this context, Costello and Sanders (2016) assert that taxable income differs from the comprehensive income proposed by Haig and Simons. In order to simplify tax law, they suggest it should provide a clear definition of economic income. In effect a stable concept of economic income would allow clearer adjustments to be introduced in the tax law that would enable, over time, different tax policy goals to be met.

Income is shaped by the accrual principle, which is advocated under both International Financial Reporting Standards and US Generally Accepted Accounting Principles. The accrual principle is an alternative to cash-based accounting, stating that revenues should be recorded when earned and expenses when incurred. Both must be included in the financial statements of the periods to which they relate to, regardless of the time of their receipt or payment. This principle is considered to be more appropriate for providing reliable information about the firm’s incomes and expenses, financial position and cash-flows. Indeed, in order to fulfil its mission, accounting records must guarantee the periodical determination of several financial statement elements, such as assets, equity, liabilities, expenses, revenues and cash flows.

The accrual-based system has been introduced in a variety of contexts, including government accounting, following the rise of New Public Management (NPM). Cash-based accounting was heavily criticised by NPM as it prevented the matching between consumed resources and accomplished activities. This limitation misled public management accountability. Despite the advantages of the accrual-based system, particularly in terms of measuring the costs of public activities, the absence of a profit motive justifies the need to maintain, at least in part, the “old system” (i. e. cash-based). Therefore, a dual-system option appears suitable, namely in the European Union accounting and financial reporting system (Biondi & Soverchia, 2014).

The measurement of periodic income requires the reporting and matching of expenses and revenues. Under this principle, expenses incurred in relation to a certain transaction shall be recognised in the period when revenues derived from them occurs (i. e. matching principle). Allocating costs to different time periods remains a central issue under debate for nearly a century (Brief & Owen, 1970). Matching requires unclear allocations, which may be refutable (Thomas, 1975). In fact, periodic reporting of income is often arbitrary and influenced by estimations and uncertainty. However, evidence obtained by Alhadab and Clacher (2018) supports that the appointment of high-quality auditors limits the manipulation of discretionary accruals.

The fair value perspective introduced some changes to the matching principle, which, along with the going concern and invested cost and generated revenue principles, belongs to the historical cost approach (Biondi, 2011). According to the matching principle, the revenues generated by the firm are linked to stakeholders’ compensation during historical time. Conversely, under the fair value approach, the accounting system focuses on changes of capital values and shareholders’ wealth, leading to an earlier recognition of profits. Therefore, the value discounting technique has been challenging the matching of (historical) costs and revenues, compromising accounting’s commitment to public interest (Biondi, 2011). Nevertheless, the historical review carried out by Zimmerman and Bloom (2016, p. 114) show that the matching principle is “alive and well in practice, having a significant body of current empirical research in favour of its retention”. Matching is a reliable form of measuring operating performance to support informed decisions by the stakeholders and is consistent with accrual-based accounting.

The measurement of periodic income carries several consequences. Bartov and Mohanram (2004) and Cheng and Warfield (2005) studied the relation between earnings management and the manipulation of accounting accruals, while results from Chowdhury, Mollak, and Farooque (2018) show a positive relationship between discretionary accruals and insider trading. Earnings management theories are grounded on the attempts by managers to smooth periodic income by shifting its items intertemporally. Smoothing earnings has several purposes, such as to signal firm quality, attract investors, or to influence financial rating to lower debt costs (Barnea, Ronen, & Sadan, 1975; Goel & Thakor, 2003; Trueman & Titman, 1988).

The separation of firm’s life into periods is justified under the impossibility of waiting until its dissolution to capture the total amount of income generated. Assessing both accounting and tax income requires the measurement of income obtained in specified periods, i. e. the temporal allocation of revenues and expenses to be reflected in the income statement. This computation enables the calculation of tax liabilities (Austin, Surrey, Warren, & Winokur, 1954). Pereira (1988) states that one of the main practical problems arising from determining real income in each taxable period is the need to allocate revenues and expenses over time. Results from Watrin, Pott, and Ullmann (2012) suggest that earnings management is influenced by tax accounting incentives in a setting of a strong book-tax-conformity. Under this context, Andries, Cools, and Uytbergen (2017) highlight that firms engage in profit shifting, reacting to the introduction of a tax allowance for corporate equity.

In the Portugal’s CITC, the accrual principle is ruled by article 18 § 1. It states that income and expenses, as well as other positive or negative components of taxable income – including some changes in net worth not reflected in that amount –, are attributable to the taxable period in which they are obtained or incurred, irrespective of the time of receiving or paying the cash or cash equivalents. The legislator has forbidden taxpayers from defining the timing when they opt to declare the income and expenses generated by their activity. Additionally, article 18 § 2 sets out that the positive or negative components considered as related to previous periods can only be attributed to a future period when they were unpredictable or manifestly unknown prior to the end of those respective fiscal years. The reinforcement of the accrual principle in tax law shows that the legislator is concerned with this matter, seeking to avoid tax avoidance by the taxpayers through the deferral of expenses and income between different years.

When – voluntary or involuntary – reporting of income occurs in the wrong period, thus violating the accrual principle, conflicts arise between the TA and taxpayers and litigation may follow. Frequently, the dispute between TA and taxpayers concerning this matter is caused by the corrections to the taxable income, as a result of tax auditing, leading to additional tax charges. When challenging the TA’s procedure, the taxpayer often invokes that the principle of justice has been disregarded. In effect, article 266 of the Portuguese Constitution establishes fundamental principles that need to be observed, stating that public entities and administrative agents are subordinated to the Constitution and the law. They shall act in the exercise of their functions respecting the principles of equality, proportionality, justice, impartiality and good faith.

The principle of justice is also referred to in article 55 of the Portuguese General Tax Law as one of the guiding principles of tax procedure, meaning that fair and impartial criteria should be observed in all acts carried out by the TA (Martins & Alves, 2015). In simpler terms, under the principle of justice, everyone should be treated as they deserve, i. e. give to each one what is due. This principle, in a broad sense, encompasses other principles such as equality, proportionality, good-faith and impartiality (Pires, Bulcão, Vidal, & Menezes, 2015).

In fact, tax as a mandatory, definitive, unilateral and non-equivalent payment to fund public purse, may interfere with property rights. According to the legality principle, the power of the State to collect revenues is limited by the law. Moreover, the fulfilment of the main taxation principles, such as the principle of justice, establishes boundaries to the administrative power by the TA.

The violation of article 18 of the CITC may be accepted if the taxpayer had no intent to transfer taxable income between periods (Tavares, 2011). In this way, this approach breaks with a strict interpretation, seeking a non-observance of an operational rule (accrual principle) in favour of a structural principle of the tax system (principle of justice). This view is not new. Indeed, Pereira (1988) observed that a more flexible interpretation of the accrual principle had been adopted by the TA, prior to the adoption of the CITC in 1989. In certain circumstances, expenses and revenues registered in the incorrect periods could be accepted by the TA, if it does not result from intentional actions seeking to transfer income. Intent may be presumed when a tax exemption period is starting, when reducing tax losses are fabricated to take advantage of the carry forward losses mechanism and when the operation attempts to decrease the taxable income in a certain period (Tavares, 2011).

Another problem emerges when the TA refuses to apply a symmetric correction to the reported income. In practice, TA’s amendments leading to additional tax in a certain period are not combined with the corresponding rectification in favour of the taxpayer in other period(s). Morais (2009) argues that the TA has the duty to make a symmetric correction. By ignoring an actual expense, the taxpayer will be taxed for an income which was never obtained, leading to the violation of the ability-to-pay principle. For example, if the expense was wrongly deducted in fiscal year N, because is related to N-1, the increase in taxable income in fiscal year N should be compensated by the reduction in the tax income for N-1. Such a procedure aims to determine the real income in each of the two periods (and not only in period N).

If a symmetric correction does not occur, the taxpayer is doubly affected, as it loses the deduction of an expense in the incorrect period (according to article 18 of the CITC) and in the correct one. As a result, if it is no longer possible for the taxpayer to amend this situation, due to legal expiration dates, the TA, according to Campos, Rodrigues, and Sousa (2012), should not proceed with the correction at all.

Therefore, as addressed in Section 4, courts’ rulings show that, in certain circumstances, the strict application of article 18 of the CITC is being restrained by resorting to the principle of justice defined in article 266 § 2 of the Portuguese Constitution, which is also mentioned in article 55 of the Portuguese General Tax Law.

3 Methodology

Empirical research grounds itself on evidence obtained from observing the real world. In particular, empirical legal research investigates the roles of legislation, legal policies and other kinds of legal arrangements ruling society. It can be both qualitative (non-numerical) and quantitative (numerical) and the abovementioned real world observations may be, among others, case law (Epstein & King, 2002).

Case law-based research is at the core of the work presented in this paper and, as such, is used to address the formulated research question. The arguments underpinning the legal decisions by the courts are difficult to summarise due to the diversity of the nature of the respective disputes, although they remain crucial to comprehend how legal principles were applied in the analysed cases. This weakness of this methodology is mitigated by this paper by critically selecting and grouping the cases by their central issue. Additionally, collecting critically, reading systematically and commenting the significance of legal decisions also constitutes an example of content analysis, forming the basis for a legal empirical methodology (Hall & Wright, 2008).

Principles are settled in law and are developed in legal writing performed by researchers. In previous sections, doctrinal research has been shown to frame the existing law in this specific topic. In the next section, from the analysis of judicial decisions of courts it can be seen how law is applied, offering insights into unresolved aspects of the law. This is useful to provide recommendations on how to interpret and employ the law, overcoming the flaws that currently affect it.

Conflicts between taxpayers and the TA can be solved by administrative decision, judicial courts or arbitration courts. This study was based on the analysis of twenty-four decisions made by the Portuguese tax courts – the Northern Central Administrative Court (NCAC), the Southern Central Administrative Court (SCAC), the Supreme Administrative Court (SAC) – judicial courts – and the Administrative Arbitration Centre (AAC).

Previously, the taxpayers and the TA were obliged to litigate in the judicial courts, respecting established limits and possible mechanisms for appeal. However, since 2011, with the Law Decree 10/2011 of 20th January, it became possible to seek the resolution of tax disputes through the Administrative Arbitration Centre for claims up to a limit of ten million euros. Additionally, the arbitration court expects that the arbitrators apply the tax law like any tax judicial court and the verdicts must be delivered within six months. Currently, in most cases, the taxpayer can decide between the judicial tax courts and the Administrative Arbitration Centre, with the TA being forced to accept this option.

The purpose of Central Administrative Courts (southern and northern) is to decide the appeals from first level courts (administrative and tax courts) where the first claim is decided. Their decisions can then be contested by appealing to the Supreme Administrative Court, which is the highest court for tax disputes.

Based on a representative sample of empirical research-based studies discussed in law reviews, Epstein and King (2002) highlighted some problems in this methodology, particularly those that result from the application of the rules of inference, i. e. the procedure through which sample observations are generalized in order to reach a broad conclusion. With these limitations identified, they provided some guidelines to improve empirical legal research, increasing its credibility and validity. One of such proposed measures is to collect as much data as feasible. In this paper, given the availability of electronic databases containing courts’ rulings, ^[1] a search based on selected keywords was made, aiming to identify those where the alleged violation of the accrual principle was argued by the TA while the taxpayers claimed that the principle of justice had been violated.

From this search, we found four rulings from the Central Administrative Courts, eight from the Supreme Administrative Court, and twelve from Administrative Arbitration Centre ^[2] (See Appendix for a comprehensive list). A wider search was also attempted by including the rulings by the Court of Justice of the European Union, in order to find appeals from Portuguese courts as well as those arising from other European countries. This search showed that the principle of justice had been rarely invoked and never under the context considered in this paper. It seems that this specific question has not been posed to the Court of Justice of the European Union, and it is entirely addressed domestically. Nevertheless, the principle of justice, encompassing proportionality and fairness, is applicable to a variety of contexts in the field of taxation. For example, in cases n.° C-352/08, 16/7/2009, and C-6/16, 19/1/2017, the Court of Justice of the European Union considered the importance of the principle of proportionality within the context of preventing fraud and tax evasion.

In this paper, from the twenty-four cases selected from the abovementioned Portuguese courts, eleven are discussed in detail (one from the Central Administrative Court, four from the Supreme Administrative Court and six from the Administrative Arbitration Centre). The more controversial disputes were chosen in order to highlight the contrast between the perspectives of both parties and explain when the application of the principle of justice must prevail. We also selected cases where aspects of the more recent versions of the accounting and tax legislation were challenged. Particular emphasis was given to the period starting in 2010, when SNC took effect (Law Decree 158/2009 of 13th July).

4 The application of the accrual principle by tax courts

The main purpose of this section is to understand the various interpretations of the application of the accrual principle by the courts throughout recent years. This analysis includes the arguments put forward by both the TA and the taxpayers; the resulting court ruling and, when applicable, an opinion about that final ruling.

The cases are presented grouped according to the nature of the issues at the core of the disputes.

5 Final remarks, policy implications and limitations

Determining business performance is one of the purposes of accounting. Reflecting each year’s income appropriately involves the annual computation of expenses and revenues. The allocation of several items in annual periods represents, on a first level, an accounting issue. However, due to the partial dependence model, it influences the calculation of taxable income, which may impact eventual litigation. Moreover, the CITC explicitly establishes the accrual principle, reinforcing its importance in taxable income determination. Still, the existence of fundamental principles in tax law, such as the principle of justice, justifies in some cases a more flexible application of the accrual principle.

This paper shows that courts often apply the principle of justice, moderating the rigid use of the accrual principle. This happens mostly because the TA does not recognise a symmetric correction in favour of the taxpayer, focusing only on increasing taxable income. Indeed, if this adjustment is not recognised, some items may be omitted or duplicated in the overall taxable income, leading to an unfair solution for the taxpayer. Thus, when taxpayers do not purposefully omit or intend to shift income between years with the aim of gaining an advantage over the State, courts tend to adopt a more flexible interpretation of article 18 of the CITC.

From the twenty-four decisions selected, eleven were decided in favour of the taxpayer, ten in favour of the TA, while three can be characterised as mixed decisions. These generated about €30,6 million worth of corrections performed by the TA that were annulled by the court, while corrections of €17,9 million were accepted.

Focusing in particular on the eleven cases discussed in detail in Section 4, five decisions were in favour of the taxpayer, five in favour of the TA, while one was a mixed decision (Judgment from the Administrative Arbitration Centre in 20-11-2017, Process n.° 284/2017-T described in Section 4.4). In ten litigations, the taxpayer invoked the violation of the principle of justice (the exception was the mentioned Judgement). Among the decisions in favour of the taxpayer, the court agreed that the principle of justice should prevail over the violation of the accrual principle in three of them.

This paper has practical implications, providing useful guidelines for courts’ decisions, and also in terms of preventing tax litigation due to the application of the accrual principle between the TA and taxpayers. Despite the diversity of conflicts that can arise from different interpretations of the accrual principle in tax law, there is a persistent and coherent jurisprudential line that balances its application with that of the principle of justice. This involves a considerable degree of factual and circumstantial analysis during court proceedings. A case-by-case approach to the problem is fundamental in order to establish the real intentions of the taxpayer and achieve a fair decision.

Moreover, in order to prevent litigation, the TA must effectively distinguish the cases where taxpayer shifts income between periods disregarding the accrual principle to avoid taxes, from those where such an advantage is not obtained. On the other hand, taxpayers must avoid using the “principle of justice argument” as a protection shield against the intentional violation of the accrual principle. In effect, the decisions analysed in this paper revealed that the courts seem to be aware of this strategy.

The main limitation of this study is related to the selected sample of legal decisions, whose representativeness cannot, due to its nature, be ensured. Therefore, the conclusions derived from these decisions cannot (and should not) be generalised to all jurisprudence related to this issue. Moreover, some of the issues under dispute, if discussed under current legal regulations, could lead to a different conclusion. Finally, it should be noted that, by focusing on legal decisions, the analysis in this paper does not include any of the cases where, after the TA’s audit report, the taxpayer accepted the corrections proposed and reached an agreement, thus avoiding litigation.