Prepare to prove cross-border transactions
Where is the trend of tax audits for cross-border payments heading? Definitely to proving the fulfilment of the conditions for the application of preferential tax regimes, not only formally but also in practice. This is not an isolated trend. Globally, various instruments and measures of tax administrations have focused on achieving one thing in the last few years – preventing tax evasion and situations in which income is taxed in countries with lower or zero tax rates. And the easiest way to achieve this involves audits in companies, which pay the respective income abroad.
Trends in Tax Audit
Recently, we have been monitoring the growing trend in tax audits of Czech companies which pay income to other entities abroad. It is no secret that large entities, in particular so-called multinational companies, are in focus of tax audits. For several years now, the Czech financial administration itself has stated that the area of cross-border payments, intercompany transactions and transfer pricing is included in its priorities (also regarding the volume of such payments). In recent times, however, the financial administration has also focused on the originally Czech groups that run a part of their business activities abroad.
However, this trend is also followed by more frequent audits that focus on the application of potential WHT benefits, i.e. the correct withholding tax regime. Subject to the withholding tax regime is primarily the so-called passive income. This includes income that flows from Czech companies abroad – mostly interest, license fees profit shares (dividends).
While in the past the beneficial taxation on the taxpayer’s side was essentially applied automatically and withholding tax audit had long been a matter of chance rather than a targeted strategy, as various reporting obligations are introduced and international cooperation of tax administrations is strengthened, the identification of payers or payments in the focus of tax administrators is made easier.
The tax administration will not escape the trend of digitisation, either. Most submissions are already made electronically and other sources of information have been added to the tax return and financial statements: the so-called TP appendix to the corporate income tax return providing an overview of transactions with related parties, or alternatively country-by-country (CbC) reporting, and also reporting of income flowing abroad. Whereas previously only the income to which withholding tax was applied was subject to reporting, since April 2019, Czech taxpayers are required to report all income that is subject to withholding tax, i.e. including the income that is WHT exempt or not taxed on the basis of the application of the relevant provisions of double taxation treaties.
The above sources thus essentially disclose transactions or structures in which the tax administrator may subsequently examine the tax regime applied, and it is up to the taxpayers to properly demonstrate and defend their treatment.
Beneficial owner – condition required (not the only one)
In the case of passive income taxation, there is no clear instruction, procedure or “check-list” determining what is sufficient for the payer to bear the burden of proof. Confirmation of the recipient’s tax residence is already assumed. The aspect of “beneficial ownership” is also one of the conditions specified by the Czech legislation (or methodological guidelines) and double taxation treaties. It is also referred to by the courts in their rulings – however, in practice it is somewhat more difficult to assess the situation in the whole context. The tax administrator does not have to accept a mere declaration by the recipient that they are the beneficial owners of the income, but may (and often does) require proof of other matters. For example, how the recipient taxed the specific income, how they used it within their economic activity, whether the income was subsequently transferred to another entity, who has rights of disposal to the accounts, etc.
The issue of beneficial ownership and so-called flow-through entities is closely linked to another somewhat abstract aspect, which is the economic substance of transactions or the companies themselves, i.e. the recipients of interest, licence fees, dividends and other income.
In addition to the already established, relatively specific instruments, such as the method of taxation of controlled foreign corporations (so-called CFC rules) or the concept of abuse of rights, the European Commission announced the preparation of a proposal for uniform EU rules to prevent the abusive use of shell companies (companies without sufficient economic substance) for tax purposes. The proposal should be published later this year.
4 basic tips on how to prepare for proving cross-border transactions
- It is necessary to pay attention to the information that you provide to the tax administration in various reporting and to take it into account in overall context.
- Pay attention to the documentation and archiving of communications, deeds and other underlying documents, on an ongoing basis. In hindsight, issues may no longer be so obvious and it is quite difficult to trace them back. Tax audits are usually started several years later, and interpretive practice may develop in a different direction. And the responsible staff may no longer be present in the company.
- It is likely that payments of dividends, interest and licence fees paid by Czech companies abroad will be subject to scrutiny by the tax administration (primarily Czech – but in some cases there may be an initiative from abroad). Especially in the case of large sums or beneficiaries from countries that have long been seen as jurisdictions with lower taxation or preferential tax regimes (e.g. Cyprus, Luxembourg, the Netherlands, etc.).
- This is far from being limited to multinational companies, it also concerns smaller or family-owned businesses that have foreign structures. We therefore recommend that you check the structure set-up and tax aspects of the income paid so that your company is not exposed to tax, financial or reputational risks.