Serious evidentiary challenges in related party transactions
Intragroup transactions and transfer pricing are continuously on the radar of tax administrations around the world, including the Czech Financial Administration. Therefore, tax audits with focus on transactions between related parties are not a novelty in the Czech environment, and many companies already have experience with such audits, whether as part of broader income tax audit or specialised audit focused exclusively on transfer pricing. What makes the audit of transactions between related parties specific and how successful are Czech taxable entities in evidencing within said transactions?
The fact that the interest of the Czech Financial Administration in transactions with related parties has not decreased in recent years is confirmed by the statistics of tax audits in the area of transfer pricing. Between 2014 and 2021, the Czech Financial Administration conducted the total of 2,761 audits, and additional tax exceeding CZK 5.1 billion was assessed within these audits.
With the development of international trade and globalisation, the number, volume, and especially the complexity of transactions within multinational groups have increased, and although the Czech Financial Administration does not avoid any type of related party transactions, there are areas the Czech Financial Administration focuses on much more frequently. Such areas are mainly intragroup services, which include various types of management services or centrally provided services and fees for licences provided. The Czech Financial Administration does not forget to examine the functional and risk profile of the taxable entity, namely in a situation where a Czech company generates a loss, or its profitability drops year on year. Unsurprisingly, the listed areas of interest to tax administrators also represent areas where local taxable entities have the greatest difficulty with evidencing in tax audits. The most frequent evidentiary challenge in the above-stated areas is the absence of appropriate evidence with which the taxable entity is able to demonstrate its arguments in relation services or licences received or its functional profile.
Intragroup Services and Licences
Specifically, for intragroup services, it is usually not difficult to provide a tax administrator with the relevant agreements or invoices for performance received within an audit. It is also often not a problem to provide information on pricing; therefore, detailed information on how the price for the services or licences received was determined. However, the more difficult discipline is evidencing the substance of performance received (a substance test) and a benefit obtained by the taxable entity from performance received (a benefit test). In this situation, the taxable entities usually reach various limits that prevent them in successful demonstration of evidence both in the substance and the benefit test of services received. Issues we see the most often in tax audits are the following:
- According to an agreement, the extent of services received is defined rather broadly and generally; therefore, it may also be relatively variable in the individual periods. It is much more difficult for the taxable entity to evidence specific services provided in the relevant period. In a situation where the reality does not match the broad and general level of services, which are, moreover, relatively imprecisely and vaguely defined in agreements, the tax administrator, with a formalistic approach, does not understand a discrepancy between contractual provisions and reality, and considers such discrepancy suspicious.
- According to the individual invoices for the specific period (e.g. a month, quarter, etc.), the invoiced amount is the same or similar. The fact that the invoiced amount is repeated every month (i.e. the same number of hours, days, acts, etc. is invoiced), may rightly appear suspicious to the tax administrator, since it can be assumed that the extent of the services should replicate the needs of the recipient of services, and these needs are generally not constant over time.
- It is often the case that the taxable entity does not have written evidence to demonstrate the specific services that have been provided to this taxable entity or the specific person who has provided them, or the taxable entity provides the tax administrator only with the part of such evidence that does not demonstrate the whole volume of received services. Reasons for such lack of evidence may be entirely objective, e.g. the specific persons who accepted outputs of services no longer work with a company (the tax audit usually takes place after a longer period of time, even after several years) or a company, e.g. for capacity reasons or for reasons of personal data protection, has the automatic deletion of emails after a certain period set up, etc.
- Very often, the tax administrator anticipates that the relationship in the provision of intragroup services will take place under similar conditions as, for example, the provision of services by a third (unrelated) party. The tax administrator generally does not accept the fact that relations between companies with a group have certain specific aspects, and that communication between related parties is not conducted at the same level as between unrelated parties, e.g. that it is usually very informal, often only in verbal form or by telephone. After all, this is one of the benefits that members of a group enjoy. However, the tax administrator requires formal documents from members of groups as well, such as an order of works, and its approval, including the confirmation of the extent and specification of services before they are provided, as well as the approval of an output of works in the form of reports, summaries, statements, research statements, studies, tables, charts, etc.
- In the case of evidence provided, the tax administrator proceeds very formally in their assessment and identifies by whom and when the relevant documents were prepared and for what purpose. In this context, it is necessary to state that, for example, when providing electronic outputs, the tax administrator uses a number of standard functions to verify when and by whom the file was created and who resaved or saved it last. It is important to understand in this regard that electronic files generally do not allow tracking of the specific changes made by the relevant user, only when a change was made. In practice, we often see the absurd formal assessment of such evidence by the tax administrator or subsequent rejection of evidence purely for formal reasons, e.g. that it is not clear in content or form what it is supposed to demonstrate, that it is not clear for whom the relevant documents were prepared, whether they were confirmed by a recipient, or that a document does not have a logo.
- In some cases, we see the misinterpretation of evidence by the tax administrator, namely in the event of documents written in foreign languages or in events of less formal internal communication, which is simpler and more abbreviated than more formal communication between unrelated business partners. In such cases, the evidence presented is rejected again, as the link to the services provided is not clear to the tax administrator. Also, documents prepared for more than one company in a group are often rejected as evidence.
- Evidence that is dated in period other than the audited period, quite often despite its apparent link to the audited period, is also formally rejected by the tax administrator for the reason that it does not relate to the audited period.
This formalistic approach of the Czech Financial Administration in the assessment of evidence within the production of evidence is quite often confirmed by case law. Among older rulings concerning the evidencing of intragroup services, we refer to, e.g. ruling of the Supreme Administrative Court 8 Afs 216/2017-75 of 7 June 2018 or among more recent rulings to, e.g. ruling of the Regional Court in Brno 30 Af 57/2021-76 of 28 November 2022.
It should be mentioned that although this is an audit of transactions between related parties, the tax administrator proceeds to the additional tax assessment not for the reason of non-compliance with Section 23 (7) of the Income Tax Act (the “ITA”), which concerns transfer pricing and conditions under which intragroup transactions are carried out, but pursuant to Section 24 (1) of the ITA; therefore, in connection with general tax deductibility of the relevant expense spent on intragroup services received. Quite often, transfer pricing is not assessed pursuant to Section 23 (7) of the ITA. However, such steps of the tax administrator prevent the taxable entity, inter alia, from defending and accessing procedures to eliminate double taxation through a dispute resolution on the basis of an agreement or tax arbitration, as these concepts may only be used in the case of additional tax in the area of transfer pricing.
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Functional and Risk Profile
Similar to intragroup services or licences received, evidencing the functional and risk profile of the taxable entity presents a number of difficulties. Despite the fact that the preparation of transfer pricing documentation is not a statutory obligation in the Czech Republic, the fact that the taxable entity, which is part of a multinational group of companies, does not have any (not even a simplified version of) transfer pricing documentation to present to the tax administrator in the case of the tax audit, usually creates a suspicion for the tax administrator that such a taxable entity did not pay sufficient attention to the setting of transfer pricing. Even if the taxable entity has such documentation, the taxable entity has to be prepared to evidence information and claims stated in documentation through credible evidence. In other words, not only are agreements and invoices insufficient in tax audits focused on transfer pricing but transfer pricing documentation prepared in accordance with the recommendations of the Czech Financial Administration is no longer sufficient either. In evidencing the individual claims included in documentation, the taxable entities experience practical difficulties again. The reason for such difficulties may be the above-stated less formal communication within the group or the insufficient formalisation of certain decision-making processes within the company, e.g. the decision in a certain area, the management of certain risks, etc.
Within the presentation of certain evidence, similar to evidencing intragroup services, the tax administrator assesses evidence presented in an absurd manner, and quite often rejects the evidence based on very formal reasons (see above). The result of the failure to evidence the declared functional and risk profile, which is examined in particular in the case of loss-generating companies or companies whose profitability has decreased, is much more significant additional tax, including related sanctions, not only from the perspective of the Czech taxable entity, but often also with impact on the whole group.
In this regard, we refer to ruling NSS 7 Afs 398/2019-49, of which we informed you in our article SAC: The parent company must compensate the contract manufacturer for losses. Currently, we see quite often similar cases where the taxable entity has insufficient evidence on its functional and risk profile. Despite the fact that, for some reasons, not all cases end up in court, there is a high number of such additional tax assessments, as evidenced by the statistics of additional tax assessments in the area of transfer pricing.
In conclusion, it has to be stated that the timely and thorough preparation of the defence file (the collection of evidence), whether it concerns intragroup services or licences received, the functional and risk profile declared, or other complex transactions (e.g. the restructuring of activities, a change to the functional profile, or the termination of activities, etc.), is currently a necessary requirement for success in a potential tax audit.