Judgment of the Supreme Administrative Court on disguised legal acts in connection with dividend payments

On 31 October 2022, the Supreme Administrative Court issued its judgment No. 2 Afs 94/2021-48, which addressed the issue of a disguised legal act in connection with the payment of a profit share and the concept of the beneficial owner.

What were the circumstances of the case?

As often happens in practice, the circumstances of a case are never entirely straightforward, and so we will take the liberty of simplifying the initial situation for the purposes of this article. In the case at hand, a Czech limited liability company originally had a sole owner who was a Czech individual. This sole shareholder subsequently decided to transfer 25% of company’s share capital to a newly established Cypriot company. This share sale was exempted by the Czech individual in accordance with the Czech Income Taxes Act.

To understand the broader context, we would like to point out that the conditions of the payment of the purchase price were agreed between the parties only in very general terms. The purchase price was to be paid up to ten years without further specification as to the amount or timing of the individual instalments, which is rather rare in common business relationships. Another unusual practice is that, by agreement of the owners, i.e. the Czech individual and the new Cypriot owner, the company subsequently paid out the whole profit share to the Cypriot owner. This is despite the fact that the Cypriot owner had no participation in the creation of the previous profits and had a smaller share in the company compared to the individual.

The payment of the profit share was then exempted by the Czech company in accordance with the Czech Income Taxes Act and the relevant double taxation treaty between the Czech Republic and the Republic of Cyprus. The entire procedure of the company as a taxable entity was then based on the argument that the Cypriot company was the beneficial owner of the income.

However, within a few days after the payment of the profit share, the Cypriot company used the money to pay the purchase price to the Czech owner for the transfer of the share. The amount paid, or rather the instalment of the purchase price, roughly corresponded to the amount of the profit share paid.

Reasoning of the Tax Administrator and Assessment by the Supreme Administrative Court

After completing a tax audit focused specifically on the payment of the profit share to the Cypriot company, the tax administrator concluded that the entire transaction (and not just its partial steps) disguised the true state of affairs. According to the tax administrator, the real purpose of the whole procedure was to pay the share to the Czech owner, but with the benefit of a tax advantage that could not have been obtained if the payment had been made directly. That is because the payment of a profit share to a Czech individual is generally subject to a withholding tax of 15%. The tax administrator, therefore, concluded that the transaction was disguised by a formal situation, in which the share was first purchased by the Cypriot company, which subsequently received all the profits but had to use them as an instalment of the purchase price of the share to the individual.

In its decision (No. 2 Afs 94/2021-48), the Supreme Administrative Court confirmed the tax administrator’s view that the Czech owner was in fact the beneficial owner of the profit share; primarily because the amounts paid merely “passed” through the accounts of the Cypriot company. According to the Supreme Administrative Court, the main purpose of the legal acts was therefore the intention of the majority owner to avoid taxation in the Czech Republic when paying out the profit share.

According to the Supreme Administrative Court, the tax administrator acted correctly in assessing withholding tax on the company, which it was supposed to have withheld when paying the profit share to the individual as the beneficial owner of the income.

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