Council Directive EU 2016/1164 of 12 July 2016 laying down rules against tax avoidance practices (ATAD) was implemented into Czech tax legislation in 2019. New provisions of the Income Taxes Act arising from the directive that impact payers of the corporate income tax and their permanent establishments are currently discussed in more detail in the issued information of the General Financial Directorate.
The European ATAD was created in 2017 with an objective to increase the level of protection of the tax system of individual member states and prevent aggressive tax planning. The implementation of these rules brought new provisions in the Income Taxes Act concerning the deductibility of excessive borrowing costs, exit tax, taxation of the controlled foreign company and dealing with the consequences of a different legal classification. The General Financial Directorate has currently issued the information in which it clarifies certain problematic issues of the application of these ATAD rules in the form of frequent questions and answers.
Limitation of the tax deductibility of excessive borrowing costs
The substance of this rule is to prevent taxpayers from an artificial decrease in the tax base in the form of excessive debt financing. Excessive borrowing costs (i.e. the difference between tax-deductible borrowing costs and taxable borrowing income) are consequently part of the tax base only up to the limit of CZK 80 million or 30% of the tax profit before interest, taxation, and depreciation. The act however makes it possible to deduct the amounts by which the tax base was increased in the current taxation period from the tax base in the following periods under specific conditions, without any limitation in time.
The published methodology clarified, among other things, the most frequently discussed question regarding the inclusion of foreign exchange differences in excessive borrowing costs. As stated by the General Financial Directorate, foreign exchange differences resulting from a payable arising from the selected borrowing costs listed in the Corporate Income Act, i.e. typically contractual interest, are included in borrowing costs. Foreign exchange rate differences that arise from the principal are not included in the borrowing costs. This interpretation has a significant impact on the calculation of excessive borrowing costs in numerous companies.
The Exit Tax measure aims to prevent taking out assets from the Czech Republic that would be subsequently sold abroad without the Czech Republic having the right to tax such income. The provision on the Exit Tax thus creates a fiction of the sale of assets to oneself for a market value. As a result, the taxpayer taxes the assets at the moment of the transfer under the same conditions as if it actually sold it to a third party by which the Czech state makes sure that the income from the sale of the transferred assets is taxed.
The benefit of the issued methodology in this aspect is that it confirms approach regarding Exit Tax in transformations and contributions that has been largely discussed since the start of the implementation. According to the General Financial Directorate, it is crucial for the application of the Exit Tax whether the transformation involved a change in the ownership or not. If the transformation does not involve a change in the ownership of the transferred assets, such transaction will be subject to Exit Tax provided that other conditions are met. If the transformation involves a change in the ownership, Exit Tax will not be applied to such transaction. A contribution to a business corporation is always treated as a change in the ownership, and therefore it is generally not subject to Exit Tax.
Taxation of controlled foreign entities (CFC rules)
This provision aims to prevent a purposeful taking out of assets, which generate passive income, into foreign entities based in states with low or zero taxation. These “empty shells” do not engage in any other economic activities and are used solely for the placement of this passive income in a specific jurisdiction with favourable tax treatment. If the statutory conditions of the relationship between the controlled and controlling company are met, the Czech Income Taxes Act thus treats the activities of the controlled foreign company and dealing with its assets as if they were the activities of the controlling company in the territory of the Czech Republic. This ensures that the selected income will continue to be taxed in the Czech Republic despite this special-purpose setting.
In this issue, the information of the General Financial Directorate describes a more detailed procedure of how to assess individual conditions to fit the definition of the controlled and controlling company, and provides further methodology in the determination of the included income in a controlling company.
A hybrid mismatch is generally a situation where an identical legal fact (of either an entity or a financial instrument) is assessed in different ways due to differences in the legal systems of two and more jurisdictions and that may result in the double deduction of costs or the deduction of costs in only one state without the taxation of the corresponding income in the other state. The methodology adds a more detailed description to fundamental concepts, such as “different legal classification”, and states basic examples of hybrid mismatches.
The issues brought by the ATAD is rather comprehensive and complex. In practical implementation, we encounter a very complicated compliance with the statutory requirements, so let us hope that the published information of the General Financial Directorate is only a start of the methodology that will gradually follow in this field.
The entire text of the information of the General Financial Directorate is available on the website of the Czech Financial Administration.