Czech Republic: The Czech Supreme Administrative Court’s thoughts on related party definition

In the Czech Republic, transactions between related parties are regulated by the requirement to comply with the arm’s length principle. Related parties are understood, according to § 23 para. 7 of the Czech Income Tax Act, as follows:

• persons related through capital (25% threshold),
• persons otherwise related who are persons
   

1. where one person participates in the management or control of another person,
2. where identical persons or close persons participate in the management or control of other persons, then such other persons are persons otherwise mutually related. Persons otherwise related shall not be deemed to be persons where one person is a member of the supervisory boards of two persons,
3. controlling and controlled and also persons controlled by the same controlling person,
4. who are close,
5. who have created a legal relationship predominantly for the purpose of reducing a tax base or increasing a tax loss.
    

From the perspective of the precise definition of a related person, the last variant of “otherwise related persons” is the most problematic. For this reason, we consider it important to draw your attention to the judgements of the Czech Supreme Administrative Court, which are devoted to clarifying the definition.

The Czech Supreme Administrative Court is of the opinion that for the adjustment of the tax base according to § 23 para. 7 of the Czech Income Tax Act, it is essential to prove the fulfilment of the position of related persons, which is proved by the tax authority. It is true that proving a creation of a legal relationship predominantly for the purpose of reducing a tax base or increasing a tax loss is difficult, but it is not sufficient to find that the price is excessive. The only exception could be the case of a clear price overrun for goods or services whose normal price is generally known or available, in the absence of any reasonable explanation for the acquisition of those goods or services, that it was an artificial transaction (useless for the real economic functioning of the tax entity), the only explanation for which is the reduction of the tax base. In this case, the company would also not be able to explain the difference between the price paid and the arm’s length price.

Likewise, it would be sufficient evidence of creation of related persons as defined by that provision if the buyer accounts artificially increased tax costs, while the seller takes advantage of the tax loss they would already have available. It is essential, however, that the excessive price must be quite obvious, and the circumstances of the individual case must not offer any reasonable explanation other than the performed transaction being the result of agreement of two persons to obtain a tax advantage.

It follows from another judgment of the Czech Supreme Administrative Court (1 Afs 109/2021) that if the recipient of the service actually paid a certain price and at the same time it was not proved that the funds would be returned to them, paying for the overpriced service for the purpose of incurring higher expenses would lack any rationality as it would be financially disadvantageous.

Both court decisions therefore result in the tax administrator’s obligation to examine the possible existence of other circumstances which would indicate that such a relationship was established mainly to reduce the tax base or increase the tax loss, i.e. that the companies are otherwise related as defined by § 23 para. 7 b) of the Czech Income Tax Act.

Read the WTS Global Transfer Pricing Newsletter here.