To begin this article, let us ask a question: is an auditor responsible for the correctness of a tax assessment of a company he or she conducts an audit in? The first reaction to this question would probably be: not really, that should the work of a tax advisor. But let me ask in a different way: should the auditor feel responsible if following his or her audit the Financial Administration assesses significant additional tax to the audited entity? By significant I mean such an amount which surpasses a limit of significance (materiality) set by the entity. Almost everyone would probably reply saying yes, of course. Definitely the entrepreneurs who pay for auditor’s stamp feel this way, because they pay the money to make sure that everything is being carried out right, taxes included.

The question of tax risks within an audit gains special importance in the case of bigger firms, groups, and primarily international groups. The reason isn’t only the fact that bigger groups are normally subject to a bigger total tax burden in comparison to smaller firms, but mainly the fact that the structures of groups (and international groups especially) allow for more possibilities to legally lower the tax burden. And international groups do try to do that. One could hardly say that lowering the tax burden is the main criterion for building company or entrepreneurial structures, but it is true that although it’s not the main criterion it’s definitely an important one. As a proof we have the stories of big multinational firms from recent years which have led G20, OECD, the European union and its member states to initiatives that should prevent companies from trying to avoid paying their taxes. The first step was the OECD Transfer Pricing Guidelines. Thanks to globalization the activity of multinational groups is rising in the area of relocating of assets to states with a lower tax burden, and with that the activity of multinational organizations and primarily the activity of individual developed states to prevent such activities is rising, too. The biggest action currently must be the already approved document by OECD known as BEPS (Base Erosion and Profit Shifting) which is supposed to prevent activities called aggressive tax planning. BEPS should serve as a sort of manual for individual states in order for them to follow unified guidelines to prevent relocation of assets to states with a lower tax burden, besides other things. Also the European Commission (EC) considers a fairer and more effective system of income taxation of corporate bodies fundamental for better and fairer internal market which is necessary for the economy to strive, which is subsequently profitable to everyone. In order to reach these goals, the EC thinks that companies should pay taxes in those states in which they make their earnings. Aggressive tax planning undermines this by allowing to lower capital costs and thereby disturb the conditions of a single market. According to the EC this is most detrimental to small and medium firms mainly. Besides that, aggressive tax planning has negative effects on individual member states because companies, and especially bigger ones, endeavor to relocate their assets to lower tax burden countries. To counteract aggressive tax planning the EC suggests the following measures:

• Limiting deductibility of interests which is one of the main tools of assets relocation
• Limiting the negative effects of hybrid structures, which use inconsistencies in tax systems to their advantage, and thereby preventing double non-deduction
• Strengthening rules relating to controlled foreign companies that will ensure effective income taxation of income transferred to countries with low or no tax burden
• Strengthening rules relating to the taxation of assets when relocated to a different state (exit taxation)
• Refusing tax exemption for some corporate body income with a body in a foreign country if the income is not effectively taxed in the other country (rules for relocation)
• Introducing a rule for the whole of the EU against abuse and
• Adjusting the rules so that it is more difficult for companies to artificially avoid taxable presence in member states or to abuse taxation conventions

There is no doubt about the fact that fight against tax evasion in the Czech Republic is getting rougher. As a proof we have some, whether already approved or currently in the state of preparation, new legal provisions such as the electronic record of sales, VAT control statement, stricter supervision of transfer pricing by Czech tax administration, the introduction of automatic data exchange etc.

When we sum up what is currently happening in the department of changes relating to taxation it becomes clear that when auditing groups, an auditor must concern himself or herself with taxes and the potential risks. So what are those risks exactly?

Firstly, it is necessary to realize that taxes are cost items and that every manager endeavors to lower costs. When an audit is carried out in a company that belongs to a group whose members are located in several states with different tax burdens, a question rises automatically about relocation of assets to a country with a lower tax burden. The risk mentioned could be called a risk of correct or incorrect assessment of transfer prices within a group of companies in an international group.

Transfer pricing

The issue of transfer pricing is very complex and impossible to describe in one article. I will, therefore, aim to bring attention only to some areas where there is the highest possibility of transfer prices not being assessed correctly. To begin with it is useful to find out what state is the documentation of transfer prices of said concern in, how is it being processed and if at all, and what principles are used to assess the prices. The sole existence of this documentation usually minimizes the risks, however, in my practice I have seen a lot of documentation, namely such as is used in other states and not the Czech Republic and is not sufficient for the type of documentation one needs to provide in the Czech Republic, in other words documentation that is prescribed by the OECD Transfer Pricing Guidelines. But even if the needed documentation is available the battle is not won yet.

These are the most common areas in which I have found incorrectly assessed transfer prices in my practice:

• Remuneration or no remuneration of long-term claims and liabilities past due
• Remuneration and interest assessment of credits and loans
• No evidence for real assets and no evidence for usual invoiced price of the so-called management fees
• No evidence for usual invoiced prices of group services
• Different selling prices of goods for group customers and third party customers without sufficient reasoning
• Insufficient or incorrect assessment of reward for using intangible assets including license, patent, know-how or other intangible assets,
• Providing insurances from the side of parent companies without requests for payment for given insurance
• Omitting or incorrectly carrying out the comparative analysis whilst comparing independently established prices with prices invoiced in a group between connected persons (or bodies/firms within the group, if you will)

When conducting the comparative analysis one must compare at least the following five factors:

• Character of goods or services
• Marketing strategy
• Economic situation, economic conditions
• Trade and contractual arrangements
• Comparing of risks, property, and functions in relation to a comparable transaction (correct execution of functional analysis of risks, used property, and functions)

Other common mistakes include:

• Wrong or insufficient selection of comparable transactions and comparable samples
• Wrongly assessed profit margin with regard to performed functions and accepted risks
• Wrongly assessed distribution and sales margins

Last but not least, an inappropriate choice of method for assessing a comparable usual price can also be a problem.

With production co-operation a problem can arise from wrong assessment of price with respect to the type of production, depending on whether it is a toll manufacture, contract manufacture, licensed manufacture or fully fledged manufacture.

(relation of function – risk – profits)

Wrongly assigned functions to individual companies in a group may be a problem also. The functions in question may be: design, research and development, acquisition, production, distribution, financing, management, transport, marketing, sales support etc.

I cannot fail to mention that even if the documentation for usual prices does not exist it doesn’t have to be a cause for additional tax assessment. It is up to every auditor to consider all ascertained facts and risks in the audit report statement.

Even though incorrectly assessed transfer pricing is the most common tax risk during an audit of a group, it is not the only risk.

Thin capitalisation

I consider thin capitalisation to be another risk. Act on income tax has a test of thin capitalisation for interest provided by an associated company. To evaluate thin capitalisation we need to have a list of associated persons first, and in case a loan has been given from such a person we need to compare the equity with the average stock of loans and credits from associated persons and to evaluate the taxability of interests.

Decrease of core capital and dividend payments

Operations which require auditor’s attention when it comes to tax problems include operations with the core capital or equity, mainly operations that decrease the core capital. In the moment of decrease it is necessary to assess whether this decrease is neutral in relation to taxes or whether it is subject to taxation and whether it is necessary to deduce withholding tax.

Dividend payments to associates also have tax consequences. Dividend payments within a parent and a daughter company are usually exempt from taxation. However, if the exemption cannot be applied, the company must as according to Act on income tax additionally pay 15 % or 35 % of withholding tax. The amount of withholding tax can be reduced with a contract for prevention of double taxation. If one fails to pay the withholding tax or wrongly evaluates the exemption from this tax, the financial consequences will usually be very significant.

License fees

Attention should be paid also to payments for license fees and the obligation of withholding tax of these fees. In the case of license fees the withholding tax is limited either directly by exemption as according to Act on income tax, or by a rate stated in contracts for prevention of double taxation. Various fees for software licenses can pose problems because these fees can include license fees which are not made subject to withholding tax taxation or the tax is deduced from either a wrong or incomplete amount.

Costs of parent company connected to shares held by daughter company

Audit of groups undeniably raises the issue of other costs of a parent company connected to shares held by a daughter company as according to Act on income tax. Such costs include for example interests on loans and credits accepted for the acquisition of shares. Non-taxable are also indirect administrative costs connected to shares held by a daughter company of 5 % of profit from income shares unless the taxpayer proves, that the real amount of the administrative costs is smaller.

Transformations and business transactions

Operations connected to transformation of a company may have negative effects in the tax department. The general rule is that transformation of companies (fusion, consolidation, division) are tax neutral but only if the prerequisites in Act on income tax are fulfilled. Here the auditor is recommended to ask for a statement from a tax advisor who was present during the fusion from the perspective of the tax neutrality of the fusion.

VAT

Last but not least, during a group audit it is necessary to concern oneself with the issue of choosing the right regime for value added tax payment. From what I’ve seen in my practice I can say that most transactions between groups are from the point of view of VAT made correctly and there are rarely any mistakes made. However, it is necessary to point out that should a mistake occur it will most of the times be quite significant, sometimes even so fatal that its consequences could be liquidation of all profits of a company or a group. This is the reason why I would strongly recommend auditors to pay attention to this and make sure there are no mistakes as concerns transactions between companies in a group from the point of view of VAT.

Additionally assessed tax to a company within an international group

The risk of incorrectly assessed transfer price between two group companies must be considered not only from the point of view of a Czech subject but also from a point of view of a foreign subject. In case that there is no or only a minimal risk of additional tax in the Czech Republic because the transfer price is set advantageously and the company presents sufficient or bigger gains there is a risk of the other state assessing additional tax which may give rise to a request for the return of already payed tax. Most of the times this situation is more complicated because the tax control in the other state is happening after the prescribed period has ended in the Czech Republic. This is the case of Germany for example. The request for additional tax return is then usually under close supervision of the financial administration and requires documentational evidence of the pricing. If such evidence does not exist and was not provided in the other state either, there is a possibility that the Czech financial authorities won’t recognize the request for tax return and because of that the tax will be payed twice from the same income.