Securing transfer of ownership rights to a business share

The first of the SAC judgments pertains to the existence of a relationship between related parties ‎according to § 23 paragraph 7 of Act No. 586/1992 Coll., as amended, (hereinafter referred to as ‎‎“Income Tax Act”) and the tax deductibility of interest according to § 25 paragraph 1 letter w) of the ‎Income Tax Act in the case where a securing transfer of ownership rights to a business share ‎contract was concluded between a bank as the lender and the company to which the loan was ‎granted.‎
The tax authority qualified the relationship between the company (debtor) and the bank as a ‎relationship of capital-related parties in the sense of § 23 paragraph 7 letter a) point 2 of the Income ‎Tax Act, as the bank became the sole partner of the company based on the securing transfer of ‎business share agreement. Since the debtor had negative equity, the tax administrator assessed all ‎interest from loans provided by the bank as tax non-deductible costs according to the rules of thin ‎capitalization (§ 25 paragraph 1 letter w) of the Income Tax Act).‎

In its decision, the SAC confirmed that the securing transfer of rights resulted in a complete transfer ‎of ownership rights to the business share. By this transfer, the bank became the real owner of the ‎company, and the fact that the exercise of shareholder rights on the part of the bank was limited ‎based on the concluded agreement does not change the essence of its position as owner. According ‎to the SAC, securing transfer of rights is not a “formal” transfer – the legal effects of the transfer of ‎the business share are fully valid, including participation in the registered capital. It is important to ‎note that the SAC based its decision on the legal framework of securing transfer of ownership rights ‎agreements according to the “old” Civil Code, but it is highly probable that the same conclusions ‎would be reached under the current wording of the “new” Civil Code. The SAC therefore stated that ‎the bank and the company became mutually capital-related parties according to § 23 paragraph 7 of ‎the Income Tax Act, thus fulfilling one of the basic conditions for excluding excessive interest from ‎tax-deductible expenses under § 25 paragraph 1 letter w) of the Income Tax Act.‎

Given the courts’ conclusions, we recommend paying increased attention to the securing ‎instruments agreed upon in a loan financing agreement, as some of them may affect the ‎assessment of the tax deductibility of costs.‎

Conditions for deductibility of interest expenses

The second SAC judgment, which we would like to highlight, dealt with the issue of so called “crown ‎bonds”, where interest from these bonds is paid to a person who does not maintain accounting ‎records. Specifically, it concerned the question of whether the tax deductibility of interest from ‎bonds should be assessed according to § 24 paragraph 2 letter zi) of the Income Tax Act, which ties ‎the deductibility of such interest to actual payment, or whether it should proceed according to the ‎general clause of tax deductibility of expenses listed in § 24 paragraph 1 of the Income Tax Act.‎

The extended Senate of the SAC confirmed that the deductibility of interest from bonds is not tied to ‎their actual payment as stipulated in § 24 paragraph 2 letter zi) of the Income Tax Act, neither in the ‎past nor currently. Therefore, when assessing the tax deductibility of bond interest, the general ‎clause mentioned in § 24 paragraph 1 of the Income Tax Act applies

This resolution of the extended Senate of the SAC brings additional aspects of the interpretation of ‎the Income Tax Act which are noteworthy. Firstly, the SAC summarized the key conclusions regarding ‎legislative abbreviations in legal regulations, stating that a legislative abbreviation is merely a ‎technical tool for clarification of legal text, i.e., a brief verbal designation that replaces a more ‎elaborate phrase or list in a legal regulation. A legislative abbreviation does not serve to define legal ‎concepts and its introduction does not factually affect their interpretation. It is also important to ‎recognize that according to the SAC, a legislative abbreviation “applies” from the point in the legal ‎regulation where it was used onward A legislative abbreviation must be used consistently and ‎precisely in the form in which it was introduced in the law. It cannot be substituted with a differently ‎phrased set of words (e.g., when the order of words is changed or additional meaningful words are ‎inserted).‎

Additionally, the extended Senate addressed the relationship between § 24 paragraph 1 and § 24 ‎paragraph 2 of the Income Tax Act and summarized the established SAC case law that § 24 ‎paragraph 2 of the Income Tax Act does not extend the range of tax-deductible expenses but ‎specifies or modifies the rules listed in § 24 paragraph 1 of the Income Tax Act. We remind that § 24 ‎paragraph 1 of the Income Tax Act states that an expense incurred to obtain, secure, and maintain ‎taxable income can be considered a tax-deductible expense. Expenses according to § 24 paragraph ‎‎2 of the Income Tax Act are expenses according to the first paragraph, which are listed illustratively ‎and which have special (often more lenient or technically different) regimes. Expenses listed in § 24 ‎paragraph 2 of the Income Tax Act are generally considered costs incurred to obtain, secure, and ‎maintain taxable income without the taxpayer explicitly proving it. The condition of substantive ‎connection with taxable income is “automatically” fulfilled if the expense is related to the taxpayer’s ‎activity. However, the SAC warns it is necessary to keep in mind that the listing of an expense in § 24 ‎paragraph 2 of the Income Tax Act does not always establish its automatic tax deductibility without ‎further ado. For certain expenses, paragraph 2 only sets supplementary or modifying conditions for ‎their deductibility, which do not exempt the taxpayer from the obligation of proving the fulfillment of ‎the general clause from § 24 paragraph 1 of the Income Tax Act. A typical example is the “payment ‎test” for interest on loans and interest on credits according to § 24 paragraph 2 letter zi) of the ‎Income Tax Act. In other words, even if the interest is on a loan provided by an individual who does ‎not keep accounting records, the condition of their deductibility is not solely payment, but the ‎purpose of such a loan and its connection to taxable income must be examined and proven.‎

Abuse of law

The final court decision mentioned in this article is the dismissal of the constitutional complaint ‎aimed at the actions of the tax administrator and administrative courts regarding the application of ‎interest from so-called “crown bonds” as tax-deductible expenses according to § 24 paragraph 1 of ‎the Income Tax Act. The tax administrator and administrative courts in this case assessed the ‎application of interest as an abuse of law, which the affected company contested at the ‎Constitutional Court.‎

The company’s objections focused partly on the violation of Article 11 paragraph 5 of the Charter of ‎the Fundamental rights and freedoms, according to which taxation can only occur based on law, and ‎further on the failure to apply the principle “in dubio mitius” (“in doubt, more leniently”). In the first ‎part of this objection, the Constitutional Court clearly stated that tax can be imposed based on the ‎interpretation of the law. The requirement “based on law” does not only mean a literal interpretation ‎of the promulgated wording of the law but also its interpretation that includes restrictive and ‎extensive interpretation and the so-called creation of law. The constitutional order does not prevent ‎restrictive or extensive interpretation of tax law provisions if generally accepted interpretive methods ‎are used. Regarding the requirement for applying the principle “in dubio mitius”, the Constitutional ‎Court stated that it can only be applied when there are fundamental interpretative doubts that ‎cannot be eliminated by common interpretative methods. The uncertainty of the law and the ‎possibility of alternative interpretation do not automatically establish a reason to prefer an ‎interpretation that is more lenient for the taxpayer.‎

These Constitutional Court conclusions thus confirm the legitimacy of the administrative courts’ ‎interpretation of the principle of abuse of law.‎