What were the circumstances of the case?

There was a company (let us call it “A, Ltd.”) which was owned directly by several individuals. During the period in question, the majority shareholder decided to leave A, Ltd. Upon the shareholder’s resignation, mutual relations were settled through the following transactions:

• Establishment of a holding company

The remaining minority shareholders established a holding company to which they sold their shares in A, Ltd. and another directly owned company. The retiring majority shareholder also sold his shares to the holding company. The shareholders thus incurred a claim against the holding company for the purchase price of the individual shares, the key aspect being that the income from the sale of the shares was tax-exempt income for the shareholders.

• Payment of profit share

The holding company subsequently decided to pay the profit shares from its newly acquired subsidiaries, including A, Ltd. Since the statutory conditions for exemption were met, A, Ltd. did not apply withholding tax on the payment of the profit shares to the holding company (as would be the case if they were paid directly to the individual shareholders).

• Settlement of liabilities in respect of purchase price for shares in subsidiaries

The holding company then used the untaxed profit shares primarily to settle the liability to the resigning majority shareholder and to repay the purchase price to the remaining shareholders.

In the tax administrator’s opinion, this represented an abuse of the law, i.e. the purposeful creation of a holding structure so that the shareholders could obtain otherwise taxable shares in the profits of company A, Ltd., in the form of exempt income from the sale of shares. During the tax audit, A, Ltd. defended the rationality of the entire setup by (i) the necessity to sell the share of the majority shareholder, (ii) the effort to equalise the shares among the remaining shareholders, (iii) the effort to bring in a new shareholder, and (iv) the planned expansion of the business. However, none of these were accepted by the tax administrator.

What was the issue for the tax administrator?

In the tax administrator’s view, the above situation was artificially created and lacked any economic ratio. The tax administrator reached this conclusion primarily from the involvement of related persons who decided on all the essential transactions and from the temporal sequence and immediacy of the individual steps. Another important aspect was that the newly established holding company was an empty shell that did not actually carry out any activity. Its sole purpose, therefore, according to the tax administrator, was to ensure that the shareholders received the untaxed shares of the profits of their companies for payment to the resigning majority shareholder.

In fact, a situation arose where the newly created holding company received the profits of its subsidiaries. Those profits from A, Ltd. to the holding company were not taxed as they met the conditions for exemption from withholding tax, and the amount was then used to finance the buyout of the resigning shareholder’s interest. In other words, the shareholders used the untaxed profit shares to pay off the majority shareholder and settle their relationships. An aggravating factor was the fact that the purchase price of the majority shareholder’s share was determined by an expert opinion to be almost the same amount as the amount of retained earnings that the holding company had drawn from its subsidiaries.

How did the Regional Court decide the case?

In its judgment No 63 Af 5/2022-67, the Regional Court upheld the conclusions of the tax administrator. The court also did not consider the argumentation regarding the necessity of establishing a holding company relevant. It added that other possibilities were also offered, such as the distribution of the share of the resigning shareholder among the other shareholders. This option would also allow the entry of a new shareholder.

The settlement of the relationship with the retiring shareholder could be financed in the same way in such a case, i.e. through profit shares. The undistributed profits of A, Ltd. would be duly distributed to the shareholders and subject to withholding tax. The remaining shareholders would then buy out the share of the retiring majority shareholder in a specified proportion. Alternatively, the entire undistributed profit could be paid to the majority shareholder and taxed, with A, Ltd. incurring a future liability to the remaining shareholders.

The Regional Court thus confirmed that the tax administrator had acted correctly in not granting exemption status to the payment of profit shares and in assessing the related withholding tax on the paying A, Ltd. as if it had distributed its profits directly to the shareholders. In the event of a proven abuse of the law, it is necessary to proceed on the basis of the situation that would have existed if there had been no abuse. Consequently, purposeful transactions (in our case, in particular, the establishment of the holding company) are not considered.

The Supreme Administrative Court, which will be ruling on the cassation complaint, may still intervene in the case and we will continue to keep you informed of further developments.