The majority of discussions held to this day on the tax consequences have primarily related to the transfer pricing setup. As a result, the intercompany pricing setup in line with the arm’s length principle has become the norm and it has become customary for many groups to adhere to it.

Therefore, the major issue is the allocation ratio among individual entities and proving the actual provision of the services and whether they serve the purpose of attaining, securing and retaining taxable income generated by the company. These days, only a small portion of companies have a robust and perfect “defence file” in place that would serve as detailed evidence of what services were specifically provided (eg preparation of budgets, acquisition-related advisory etc), in what scope (number of days, hours, when specifically etc), by whom (a specific employee the company providing the service) and with what deliverables (meeting minutes, e-mails, comments etc).

The precedent as to the scope in which the services received should be documented was set by a ruling of the Regional Court in České Budějovice (No. 10 Af 5/2016). In the ruling, the Regional Court sided with the tax administrator, confirming an additional tax assessment in excess of CZK 14 million including fines for failing to substantiate services from a related party.

However, the dispute has two levels. On the one hand, the tax audit contested the tax deductibility of the costs of advisory services received from the parent company. On the other hand, it contested the tax deductibility of legal services provided by a third party through the parent company, which subsequently rebilled the costs to the taxable entity.

As part of its defence, the taxable entity submitted a large amount of evidence which was intended to substantiate the provision of services by the parent company. For example, the evidence included presentations from training sessions, action plans, e-mail discussions and other records of communication with the parent company’s representatives. Furthermore, the company submitted a series of invoices in respect of which the taxable entity also submitted, following the tax authority’s call, the calculation of remuneration including a summary of the monthly payroll costs of the parent company’s employees participating in the provision of the service.

However, the tax administrator ruled that the evidence contained but a general description of the services, with none of the evidence submitted by the taxable entity showing the specific number of hours worked or the actual fee for the services provided and with individual appendices only referring to the specific invoice received without quantifying what proportion of the total amount invoiced is represented by the specific service. Furthermore, the tax administrator argues that it is primarily impossible to allocate a specific expense (the fee for the service) to a specific service provided and, as a result, to deduct the expense for tax purposes.

In respect of the calculation of remuneration to the parent company’s employees, submitted additionally as appendices to the invoices, the court agreed with the tax administrator’s conclusion in that the calculations submitted were prepared by the tax entity retrospectively, for which reason they are not credible and eligible evidence of the facts presented in them. The court also made similar comments on the retrospective conclusion of contracts, recalling the conclusion of Ruling of the Supreme Administrative Court Ref. No. Afs 8/2014-174, according to which it is insufficient to retrospectively assert that the entity’s past actions were in line with a contract concluded later without substantiating the specific expenses relating to the specific provision of services.

As for the rebilling of costs for legal services, the court agreed with the tax administrator’s opinion in that the taxable entity failed to prove that it had ordered the legal services, what individual meetings specifically addressed, in what manner work was assigned and what deliverables were produced for it.

Although the entity provided, during the audit, for example a memorandum prepared by the external provider of the legal services which showed that certain services were explicitly related to the activities of the given entity, the tax administrator stated that the entity failed to bear the burden of proof in substantiating what specific contribution was made by the deliverable to the entity’s activities and what benefits it had. The ruling specifically refers to a legal service relating to a change to the entity’s repayment schedule in respect of the bank which did not result in any changes to the schedule. The tax administrator argues that if the service were to be acknowledged as a tax-deductible expense, the repayment schedule would actually have to have been changed.

In its ruling, the regional court notes that it is only up to the taxable entity what evidence it submits to substantiate its assertions; however, at the same time, it points out that if, on the one hand, the cost incurred is not specified, and, on the other hand, it is not associated with a precisely specified provision of a service, the expense cannot be assessed to be tax deductible.

So far, this has only been stipulated by a regional court ruling. As the dispute has been advanced to the Supreme Administrative Court, there are still several months before we will know the ruling. However, other rulings on the provision of intercompany services have already been issued, containing similar arguments as the ones described above.

If the trend is upheld by the Supreme Administrative Court, it is high time for businesses to carefully prepare for this new era. It seems that contracts, invoices, samples of e-mail communication or unsigned meeting minutes will not be sufficient in substantiating services from related parties and it will be necessary to have many more documents at your disposal.

If you would like to learn more about the topic, come and join us for our presentation on 20 June 2018 from 11 a.m. to 1 p.m. as part of the debate Management Fees – The Current Perspective and Judicature hosted by the Construction Forum in cooperation with Deloitte.

The article is part of dReport – July 2018, Tax news; Grants and investment Incentives.