A large number of Czech businesses that are part of multinational groups already have first-hand experience that the Czech tax administration’s approach has undergone a fundamental change in recent years as regards tax audits focusing on related party transactions. The lack of any form of communication with the tax administrator (such as on-the-spot inspections) concerning related party transactions is rather an exception at present. Contrarily, regular contact with tax payers or directly a tax audit of intragroup transactions is becoming common practice.
With the information which is available to the Czech tax administration, either based on statutory reporting as part of income tax returns, information exchange with foreign tax administrations or disclosures made by the tax payer itself, the tax administrator already has a wealth of data and a clear objective prior to initiating the tax audit. Our advisory practice indicates that it is very often the audited taxable entity which is taken by surprise by the tax administrator’s approach and requirements.
Tax administrators being cautious about “management services”
Among other things, tax offices pay increased attention to intragroup services rendered by the parent or another group company which are referred to as (usually not entirely accurately) “management services”. These may involve a broad variety of advisory and ancillary services, ranging from general administrative, financial and legal services to technical and more specialised ones. Such services are frequently ensured for most group entities in a centralised manner. Even though the provision of such services in multinational groups has economic substantiation, tax administrators are rather cautious and distrustful in respect of them in tax audits. An increasingly greater emphasis is given to the detailed demonstration of all relating facts. Tax administrators place demanding requirements on means of evidence, primarily as regards their convincingness, formal elements and authenticity. What was accepted by the tax administrator in the past is usually no longer sufficient at present.
In assessing the tax deductibility of expenses relating to intragroup services, it is usually initially demonstrated that the expenses were incurred by the tax payer in achieving, ensuring and retaining taxable income (Section 24 (1) of Act No. 586/1992 Coll., on Income Taxes). It is the taxable entity that must bear the burden of proof in this discovery stage. Only subsequently, when the evidence supplied by the taxable entity is successful, the transfer pricing of the respective transaction is tested. It is, however, no exception that in the event of the tax payer’s failure to bear the burden of proof, the second stage will not take place.
Example: Legal dispute concerning the deductibility of expenses
As an example, a legal dispute has been recently closed which dealt with, inter alia, the deductibility of expenses for advisory services provided by the parent company and expenses for legal services provided by an external law office whereby 50% of those expenses was allocated to the taxable entity. The Supreme Administrative Court (the “SAC”) rejected the taxable entity’s cassation complaint (8 Afs 216/2017-75) and thus acknowledged the previous decision of the Regional Court in České Budějovice (10Af 5/2016-80) confirming an additional tax assessment exceeding CZK 14 million, which was assessed by the tax administrator using auxiliary tools, due to a failure to demonstrate the services received from a related party.
Although the taxable entity provided the tax administrator with a great deal of evidence including hundreds of various documents, the tax administrator rejected the presented means of evidence emphasising that the taxable entity only provided a general description of services, does not show the specific time spent, the actual cost of provided services or in which amount the respective service contributes to the aggregate value invoiced. The SAC agreed with the tax administrator’s course of action and, similarly as the Regional Court, has not found any deficiencies in this respect.
Nevertheless, it may be more important for taxable entities in a similar situation as the tax payer in the above-specified legal dispute that neither the Regional Court nor the SAC give any indication in their decisions as to which means of evidence would be sufficient in such a case.
Thorough preparation a necessary prerequisite
Although tax payers may be considered to show uncertainty as to which document will or will not serve as sufficient evidence in a tax audit, the situation is not entirely hopeless. It is highly advisable to prepare for the tax administrator’s potential questions in advance. How?
- Collect regularly, already in providing services, all paper documents demonstrating facts relating to the services provided, starting from orders of particular services (including the relevant communication concerning the scope and costs of services and anticipated outputs);
- Collect all outcomes of the services provided (such as presentations, analyses, overviews, calculations etc);
- Collect all documents confirming the receipt of outcomes and the recipient’s feedback as regards the services provided;
- Identify specific persons on the part of the provider who are rendering the services to the specific taxable entity, including, for example, as a list of tasks or an overview of the time spent with respect to the services in question;
- Collect all means of evidence demonstrating who prepared the outputs and individual documents and when; and
- Review or reset processes with regard to the circulation and archiving of documents.
It should also be noted that in the event of intragroup services, it is possible or advisable to draw inspiration from similar relations among independent entities. In such situations, business relations are not established automatically. Services without orders or agreements and a pre-arranged scope and cost would not be provided. In return for payment, recipients expect required, previously agreed outputs. This should also be the case of services rendered within a group. It is therefore necessary that the service provider (eg a parent or another service company) already cooperate with the taxable entity before and during the provision of services. Such cooperation is an essential prerequisite of success.
The article is part of dReport – September 2018, Tax news; Grants and investment Incentives.