The Supreme Administrative Court (the “SAC”) ruled in a case in which it assessed the tax deductibility of costs incurred for intra-group services set at a flat rate. The tax authorities challenged the claimed tax deductibility of the flat-rate overhead costs because the taxpayer did not provide a supporting calculation of the actual costs of the foreign service provider. What conclusion did the SAC reach and what are the legitimate requirements of the tax authorities for the purpose of proving the tax deductibility of intra-group services?
Taxpayers often find themselves in a situation where the tax authorities impose unrealistic requirements to prove the content (scope) of the intra-group services received. In many cases, the tax administrator infers a failure to prove the scope of the services received, leading to a failure to meet the general tax deductibility test, through insufficient evidence of the data entering into the calculation of the invoiced amount. A typical example is where a group company provides various support services to other companies, relating to which it incurs costs. In full compliance with the relevant Czech and international transfer pricing regulations, the company invoices its costs (plus a profit margin) to individual recipients using an appropriate allocation key.
In order to prove the extent of intra-group services received, the tax administrator often requires taxpayers to provide detailed information of how the invoiced amount was calculated, including, for example, a summary of the payroll costs of the service provider’s employees, evidence of which particular employee performed the specific invoiced activities, and a number of other supporting documents typically available from another (often foreign) taxpayer. If the required details of the calculation are not provided, the tax administrator often concludes that the taxpayer has not proved that it has actually received the service. Frequently, the tax administrator admits that a large part of the declared services was undisputedly provided, but since the taxpayer has not provided a detailed calculation of the amount invoiced, the total amount of the expense is assessed as tax non-deductible.
The tax administrator thus combines two concepts: proving the extent of the service received for the purposes of assessing general tax deductibility and proving the “correctness” of the amount of the cost charged between related parties. The tax administrator sees such a procedure as an assessment strictly under Section 24(1) of the Income Tax Act (the “ITA”) which aims to general tax deductibility. According to the administrator, until the general deductibility is assessed, assessment under the transfer pricing rules (Section 23(7) of the ITA) cannot be applied. One could certainly agree with such a view in general, but challenging general deductibility by disputing the calculation of the amount of the cost then becomes a kind of circular reasoning – the tax administrator challenges general deductibility because the taxpayer fails to prove the amount, but the tax administrator disregards the amount because the taxpayer has failed to prove general deductibility. The recent ruling of the SAC No. 2 Afs 27/2023-41 brings the explanation to such a circular assessments.
A foreign service company provided support services (accounting, administration and property management) to a Czech real estate company. The Czech company was required by the tax administrator to prove the legitimacy of claiming the tax deductibility of the overhead costs charged in connection with the support services received, calculated at a flat rate of 75% of the wage costs of the employees providing the support services. The receipt of the support services as such was not disputed by the tax administrator.
The tax administrator argued that the calculated flat rate did not correspond to the provider’s actual overhead costs and, since the taxpayer did not prove how it was calculated (and linked to the actual costs incurred by the service company), it did not assess the overhead costs set at a flat rate as a tax deductible expense in accordance with Section 24(1) of the ITA. Since the taxpayer, in the tax administrator’s opinion, did not prove general tax deductibility (because it did not prove the method of calculation), it was not relevant to consider the arm’s length principle and the rules for determining transfer prices under Section 23(7) of the ITA.
The Municipal Court upheld the tax administrator‘s conclusions, but the SAC overturned its decision.
According to the SAC, it is undisputed that the taxpayer actually incurred the declared costs and received the declared services from the service company. The SAC ruled that in fact the tax administrator did not question the extent of the services received, since it considered the part of the price attributable to the service company’s wage costs to be fully tax deductible, while it excluded the allocated overheads from tax-effective costs entirely on the ground that they had not been calculated in relation to the actual overhead costs incurred by the service company.
In the SAC’s view, it is essential for the assessment of the case that neither the tax administrator nor the defendant claimed that the service was not actually provided. However, by applying Section 24(1) of the ITA, the tax administrator in fact moderated the amount at which the charge paid by the taxpayer to the service company could be recognised as a tax-effective expense, for the reason that part of this charge was determined on a flat-rate (estimate) basis, and to that extent, according to the tax administrator, it is not an expense used to obtain taxable income, because the taxpayer did not provide evidence of the supporting calculation of the actual costs.
In this context, the SAC reminds that the parties to business transactions are free to agree on their prices. At the same time, the method of determining the allocated overheads does not in itself indicate whether the service provided could objectively (or at least according to the taxpayer’s reasonable expectations) have been used to obtain taxable income, unless the resulting charge for the service is “evidently disproportionate”.
According to the SAC, the tax administrator’s and the Municipal court’s opinion on the taxpayer’s obligation to prove the method of calculation of part of the service charge (allocated overheads) is not supported by Section 24(1) of the ITA. Therefore, even the tax administrator’s doubts related to this could not activate the burden of proof on the taxpayer’s side. However, this does not mean that the service charge should automatically be a tax deductible expense in full. Given the facts, it was necessary to apply the transfer pricing rules under section 23(7) of the ITA, which the tax administrator did not do. Since the case concerned the year 2012 and the 10-year general limitation period for the assessment of tax had expired in the meantime, there would be no further substantive assessment of the arm’s length amount from the transfer pricing perspective.
Although the Supreme Administrative Court in another recent case (9 Afs 42/2023-46, see paragraph [30]) stated that it is not for the courts to provide taxpayers with guidance on how to prove receipt of the invoiced services, the ruling discussed in this article quite clearly communicates that according to Section 24(1) of the ITA, the tax administrator can only test the (subjective) general reasonableness of the expense and that the amount of the expense itself is to be assessed (objectively) under Section 23(7) of the ITA (i.e. if it is a transaction between related parties).
In the SAC’s view, the method of determination (calculation) of the invoiced amount cannot in itself be relevant for the assessment of the general deductibility under Section 24(1). According to the SAC, the assessment under Section 24(1) and Section 23(7) cannot be combined or mixed. “These are two separate questions, and the parties are free to agree on the amount of the price. From the tax perspective, its amount is subject to assessment only in terms of the above-mentioned instruments (the arm’s length test under Section 23(7) of the ITA and the market reasonableness test under Section 24(1) of the ITA),” the court stated in another decision (No. 7 Afs 54/2022-36), to which it refers in the ruling.
Thus, if the tax administrator is not satisfied with the amount (and the method of calculation) of the price, it must assess it, in the case of related persons, in accordance with Section 23(7) of the ITA. Under Section 24(1) of the ITA, the tax administrator tests “only” its apparent (un)reasonableness in the context of assessing the amount. The fundamental difference may then be primarily in the burden of proof – while it is the taxpayer who proves compliance with the conditions of Section 24(1) from the outset, in the case of Section 23(7) it is the tax administrator who must prove the difference in the arm’s length price and the taxpayer only proves the difference, if any.
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