Czech Supreme Administrative Court rules on landmark case on debt pushdown and tax deductibility of acquisition debt costs

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1 2 November 2015 EY Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Services/Tax/International- Tax/Tax-alert-library#date Czech Supreme Administrative Court rules on landmark case on debt pushdown and tax deductibility of acquisition debt costs Executive summary On 15 October, the Czech Supreme Administrative Court (SAC) issued a landmark judgment 1 that may have significant impact on tax deductibility of acquisition debt costs in the Czech Republic. Detailed discussion Facts The main facts are as follows: a foreign (i.e., non-czech) group sold its Czech active company to another Czech company it had newly established (the SPV) and financed this intra-group acquisition with intra-group debt. In 2007, the group established a new sub-holding structure through a second-tier Dutch holding. A Dutch corporation N.V. (the NV) held a Luxembourg corporation S.a.r.l. (the Sarl), which held the SPV. The SPV purchased shares in the Czech active company and thus owed the purchase price. The group assigned the receivable from the sale to the NV, which in turn assigned it to the Sarl. The receivable from the assignment between the NV and the Sarl was converted into a hybrid loan and the receivable from the sale, now between the SPV and the Sarl, was converted into a loan receivable. A portion of the loan receivable was immediately converted into basic capital of the SPV. The Czech active company was then merged into the SPV effective 1 January 2007.

2 Deductibility of acquisition loan interest rejected by tax administrator and courts In 2009, the Dutch Tax Administration delivered a request to the Czech Ministry of Finance for simultaneous performance of a tax audit. After a series of steps, the Humpolec Tax Office started the tax audit. In 2011, the audit concluded with the Tax Office s issuance of a payment assessment. The decision takes the view that the interest on the loan between the Sarl and the SPV is not a tax deductible expense. The Financial Directorate in Brno rejected the appeal of the SPV the taxpayer then filed a suit, which the Regional Court in České Budějovice (the court) rejected. The main reason for excluding the loan interest from tax deductible expenses was that the taxpayer s conduct had appeared to be an abuse of a right. The transactions in question were not performed for economic reasons, but in order to obtain a tax advantage. The SAC rejected the taxpayer s cassation complaint for the same reasons the court rejected the suit, in principle repeating the same argument. Detail on the positions of the tax administration and courts It is the view of the tax administration and the court that the conduct of the SPV was antieconomic. If all the parties had acted in accordance with standard business terms and with due care, the loan could not have arisen in the form in which it did. No funds were ever provided; the sale of the shares took place between related entities, merely creating the illusion of financing. The taxpayer countered that the entire restructuring was designed to create a structure that separated assets generating stable income from other group activities, to harmonize corporate structures with Dutch (and European) law, to create a clear management structure, to enable employees and key advisors to acquire a stake in the group s results, to obtain funding at the group level so that banks would disregard other activities of the group and to facilitate an initial public offering (IPO). The IPO did not take place due solely to the financial crisis. The court and the tax administrator did not challenge the taxpayer s stated restructuring objectives, and in particular did not question the taxpayer s sincerity in wishing to take the NV public; they only stated that all these motives were irrelevant. It is not enough that the restructuring arrangements made commercial sense for the group as a whole. It is necessary to review whether the conduct of each participant was economically justified on an individual basis, which was not the case in the tax administrator s opinion. In the court s opinion, the tax administrator had correctly deemed the loan to be part of an artificially constructed situation designed to gain a tax advantage for the group s Czech companies, where the other participating companies were not taxed on any transaction in relation to the purchase and sale of the shares. While the entire group reported profit in the Czech Republic before the restructuring, afterwards it reported huge losses, which were associated with the debt load. The terms of the provided loan were unusual. The tax administrator contacted banks and learned that they would never have provided a loan in such an amount and with such (non-existent) collateral. Moreover, the loan was repaid solely in the form of set-offs, never by a transfer of funds. The taxpayer faced no penalties for default. When asked, the taxpayer also stated that in the event of the need to discharge the payables arising from the loan, there would be little likelihood of the loan being repaid to the parent. The restructuring could have been performed in a more economical manner, i.e., without incurring huge loan repayment and interest costs, by directly merging the given companies. In other words, the SPV need not have purchased shares in the Czech active company in order to merge with it and obtain taxable income from its business dealings. The two companies were under joint control. The court and tax administrator thus deemed the condition for the tax deductibility of interest not to have been met according to the basic test of Section 24(1) of the Income Taxes Act. 2 This reference to non-fulfillment of the conditions of Section 24(1) is repeated several times in the judgment, though not in a 2

3 consistent manner. In another place, the court says though the statutory conditions for claiming loan interest in costs incurred to generate, assure and maintain taxable income were formally met, the actual substance and meaning of the respective steps indicate that their primary (and clearly their sole) purpose was to obtain a tax advantage. The tax administrator had access to correspondence between both of the group s owners based on which the court believes it incontestable that the structure was proposed in order to ensure no income tax would be paid in the Netherlands, Luxembourg and the Czech Republic, and that the Sarl was primarily founded to optimize tax structures. It is interesting to note that the concerned entities were not Czech residents, and the s were clearly obtained, and subsequently shared, by the Dutch Tax Administration. The taxpayer argued that a merger following a company acquisition is standard practice, and suggested that supporting evidence be sought in Commercial Register extracts and documents from the Collection of Documents concerning other business companies. The court did not seek out such evidence, arguing it had no bearing on the taxpayer s case and would not help in any way to clarify why and under what conditions such business companies would have acted in this manner and how this would have impacted their tax liabilities. The SAC rejected the taxpayer s cassation complaint for the same reasons the court rejected the suit, in principle repeating the same argument in its earlier decision. The entire rationale is underpinned by the reasoning that the economic reasons given by the taxpayer were entirely secondary in comparison to the many millions in expenses and the indebtedness of a prospering company. Implications Based on this case, it seems intragroup restructuring of a similar nature, i.e. the combination of a sale under joint control and the financing of this transaction by an intra-group loan, could be highly problematic. However, it appears the more interesting question is the impact on a situation with just one of these elements sale under joint control financed by a bank or purchase from a third party financed by intra-group debt. A number of options present themselves in practice and the quality of their implementation differs from case to case. For balance, it should be added that the SAC has indicated its findings might have been otherwise, if, for example, there had been an actual change in ownership structure, a new acquisition, a standardization of management or operating cost savings. The SAC did not elaborate on this idea, though, as the case under review had no such elements and, accordingly, it must be seen in the context of the full rationale. Endnotes 1. Decision 9 Afs 57/ of 15 October Simply put, the test says that the taxpayer may deduct from the tax base costs incurred under reasonable expectation of generating taxable income. 3

4 For additional information with respect to this Alert, please contact the following: Ernst & Young, s.r.o., Prague René Kulínský Ernst & Young LLP, Eastern European Business Group, New York, NY Miklos Santa Ernst & Young LLP, Eastern European Business Group, San Jose, CA Gabor Toth

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