Interest on a loan and the prohibition of abuse of law in the judgment of a Regional Court
Following the letter of the law may not always be sufficient to defend the tax regime applied. Increasingly, the tax authorities are applying the principle of the prohibition of abuse of law, the primary premise of which is that the law has been followed. However, if a tax advantage has been obtained which is contrary to the meaning and purpose of the law and this was the main purpose of the transaction, the tax administrator may disregard such transactions and, for example, exclude the expense as not tax deductible.
Since 2016, we have been assisting our client with tax audits in subsequent tax proceedings. A dispute regarding the tax deductibility of interest from acquisition financing reached a Regional Court, which has recently ruled in our favour. There were valid economic reasons for the transactions under review and the tax authorities failed to prove that the conditions for the application of the prohibition of abuse of law had been met.
What was the case?
The situation was as follows: An investment group took over a group of companies (including a Czech operating company) engaged in the repair of electronic equipment. The takeover was financed by a bank loan. As part of the transaction, a Czech SPV (the “Successor Company”) was established to acquire the assets of the Czech operating company. The Successor Company entered a line of credit, acquired the shares, and subsequently merged with the Czech operating company. The loan for the share purchase was provided by an independent consortium of banks, which required the loan to be pushed down through the merger to the level of the Czech operating company.
The tax authorities did not recognise the post-merger interest as taxable, citing the prohibition of abuse of law. According to the tax authorities, the merger did not make sense from an economic point of view because the transaction could have been carried out without the purchase of the shares (and therefore without the additional credit burden).
Limits of the application of the prohibition of abuse of law are set out in the case law of administrative courts. It makes it clear that this institute should be applied only in extreme cases. At the same time, it is the tax administrator who proves the conditions for its application. Thus, the tax administrator must primarily prove that a tax advantage has been obtained which is contrary to the purpose of the law (objective criterion), and at the same time that the main objective of the transaction was to obtain such an advantage (subjective criterion); i.e. the transaction is artificial. Both conditions must be met simultaneously. If, for example, a tax advantage was obtained which was not intended by the law but was not the main reason for the transaction, the prohibition of abuse of law cannot be applied and the standard provisions must be followed.
Decision of the Regional Court
The Regional Court in Prague first admitted that the objective criterion had been met but then agreed with the Successor Company’s argument that the main economic reason for the transaction was to enable the acquisition of the entire group by the new owner. Thus, all the steps were taken with that economic objective in mind (i.e. to enable a new investor to take over the group). The merger of the companies was demonstrably requested by the financing bank. Thus, the Court considered it to be a key factor that the conditions under which the takeover of the group took place originated with an external financier. From the point of view of the Successor Company, therefore, there was nothing purposeful about the transactions. From an economic point of view, it makes sense that the loan was pushed down to the level of the operating company that generates active business income and holds assets. The bank clearly wanted to ensure maximum efficiency in the repayment of the loan, and it can hardly be assumed that the bank deliberately set the terms in such a way as to create an artificial structure.
Obtaining the advantage of the tax deductibility of interest was therefore not the main objective of the transaction. The Court thus ruled in favour of the Successor Company and held that the tax authorities had failed to prove that the subjective criterion for the application of the prohibition of abuse of law was met.