Abuse of right in taxes

20. April 2021
  • Petr Němec

We would like to draw your attention to a judgment, which brings a further shift in the application of abuse of right in taxes.

This is judgment of the Prague Municipal Court from 22 February 2021 file no. 10 Af 29/2019 - 123 in the matter of assessing tax eligibility of interests on a loan on grounds of restructuring. Assessment of the above-mentioned case by the Supreme Administrative Court (SAC) will of course be important.

The series of judgments in the matter of abuse of right began in the year 2015 with a judgment of the SAC file no. 9 Afs 57/2015 – 120 in the matter of assessing tax eligibility of interests on a loan. A Czech company acquired a loan as part of restructuring within a group, when ownership interests in companies in the group were bought, among other things. The purchase price for these stakes was paid by means of a loan from an affiliated company. A merger of the acquired companies with the buyer took place subsequently and the merged (successor) company assessed the interests on the loan as tax-eligible costs. In its judgment, the SAC noted abuse od right, adding that the loan to finance restructuring did not have a clear economically rationally justified meaning, other than a tax one (or more precisely, the economic justification claimed by the taxpayer was not accepted/proven). It needs to be accentuated that in this ground-breaking judgment, what harmed the taxpayer was the fact that the interests were practically not taxed abroad.

In many respects, the new judgment of the Prague Municipal Court is very similar to the above-mentioned judgment. This was again a loan within a group and again a loan from an affiliated company for restructuring, or a purchase of a stake in companies, which were already part of the group earlier. The difference here is that no merger occurred (but the purchased company was transformed into a limited partnership) and the interests were probably taxed at the foreign provider of the loan. In its new judgment, however, the Prague Municipal Court clearly notes that:

The circumstance of taxation of interest revenues abroad is, according to the court, not capable of fundamentally revising legal assessment of the situation, when within a certain group, a change occurs from direct control of a profitable limited liability company into indirect control of the same party transformed into a limited partnership by means of an artificially created intermediary – general partner, whose only meaning, in effect, is to

  • lower the tax base generated by the activity of the controlled party by a significant amount represented by interests on a loan, which the general partner basically had to accept following a decision of the controlling party, in combination with
  • a change of the current uncertain cash-flow in the form of the taxed profit/loss of the target controlled party into a certain contractual obligation of instalments of interests from a principal of a loan in the amount basically corresponding to the market value of the controlled party, while the principle was immediately returned to the controlling party to dispose of and the income, which served for the instalments (i.e. revenues from the activity of the controlled party), was no longer subject to taxation.

Regardless of the location of taxation of the accepted instalments on the loan, the court sees this arrangement as an illegitimate transaction, or irrelevant from the perspective of tax eligible costs on grounds of abuse of right.”

This is another judgment, which accentuates the importance of business and other reasons (legal, regulatory etc.) for significant transactions, where tax motivation should not “prevail”. Setting a certain limit, when tax reasons will (not) prevail over economic reasons, will, according to our opinion, be a painful process corrected by the SAC judicature during many years to come. Needless to accentuate that the view of the tax administrator (due to the nature of his work) a priori magnifies the significance of tax aspects, while business or other reasons may often be perceived as negligible. It is therefore quite fundamentally up to independent courts (and the unifying SAC) to gradually set the limits of abuse of right in taxes with their case-law, and to approve the concept of abuse of right only in extreme cases of “tax injustice”. Otherwise, taxpayers will be forced to examine – for every transaction – if the relevant economic opportunity or relevant benefit for maintaining achieved income is “at least in a proportion that from the perspective of judicatory starting points would seem comparable to the achieved tax advantage”.   

The effects of abuse of right may occur and be controlled after a long time and we therefore consider it essential to carefully document the due economic reasons for all more significant transactions, especially for any restructuring within a group (including transactions that appear neutral for the group at first sight).

In case you are interested in more detailed information, please, turn to your partner or GT manager.

Author: Petr Němec