The Supreme Administrative Court (hereinafter SAC) dealt with this issue in its judgment file no. 2 Afs 100/2016, from 22 November 2016, examining, if a limited liability company was entitled to apply entitlement to tax deduction from the accepted performance (in the form of performance of an office) from its executive head, and has brought a significant conclusion, which most corporations as well as lawgivers should pay attention to. The point of departure for this conclusion is the interpretation of the term person liable to tax and the term economic activity, from the perspective of the Czech legal act and the respective EU legal act, which takes precedence over it.

VAT and economic activity

The first part of the judgment deals with an interpretation of the terms from the perspective of Council Directive 2006/112/EC on the common system of value added tax (hereinafter the Directive) and supports this view with the case-law of the Court of Justice of the European Union. In article 20, selected stipulations of the Directive are quoted:

„Council Directive 2006/112/EC defines persons liable to tax in its Title III. According to its Article 9 (1) “‘Taxable person’ shall mean any person who, independently, carries out in any place any economic activity, whatever the purpose or results of that activity”. According to the second paragraph of the same stipulation, “any activity of producers, traders or persons supplying services, including mining and agricultural activities and activities of the professions, shall be regarded as ‘economic activity’. The exploitation of tangible or intangible property for the purposes of obtaining income therefrom on a continuing basis shall in particular be regarded as an economic activity.” According to Article 10 of Directive 2006/112/EC “The condition in Article 9(1) that the economic activity be conducted ‘independently’ shall exclude employed and other persons from VAT in so far as they are bound to an employer by a contract of employment or by any other legal ties creating the relationship of employer and employee as regards working conditions, remuneration and the employer's liability.”

For the purposes of determining, if a person performs economic activity independently, it is necessary to determine, if it finds itself in a subordinate relation to another person. According to the case-law of the Court of Justice of the European Union, for the existence of this relation it is necessary to verify, if the respective person performs its activity in its own name, on its own behalf and under its own responsibility, as well as if it bears the economic risk related to the performance of such activity, freely determines the conditions of performing work and collects itself the remuneration, which represents its income.

The terms person liable to tax and independent economic activity represent autonomous terms, which are to be interpreted in a unified way in all member states. According to EU law, employees, who are bound to the employer by a contract of employment, and other persons, which are bound to a superordinate person by a commitment, which resembles an employment relationship by adjustment of work conditions, remuneration and responsibility of the employer, are excluded from the system of value added tax.

An important characteristic of independent economic activity is bearing one's own economic risk and one's own responsibility for potential damage.

The second part of the judgment discusses the nature of the executive head of a limited liability company according to Czech private law regulations. The activity of an executive head is governed especially by the Civil Code and the business corporations act, according to which if the executive acts on behalf of a company, his actions are attributable directly to the company, rights and obligations arise for the company following such action and the company is also responsible for the actions of its executive. This list should not suffice, though, for reaching the conclusion that the relation between an executive head and a company is a labour-law or similar relation and Article 10 of the Directive can thus be applied. It is necessary to examine other characteristics of the performance of activities of the executive head, such as the existence of subordinate relation and bearing independent economic risk.

While performing his office, the executive head of a company must act with due managerial care and diligence, and thus with the necessary loyalty, knowledge and thoroughness, and bears the burden of proof that he acts/ acted in this way. This duty may appear very harsh. As a minor moderation, the act introduces a so-called rule of entrepreneurial discretion, which lowers the risk of an executive head for his actions, which he performs as part of entrepreneurial decision-making. In case the executive head infringes on his duty and causes damage to a company, he is obliged to compensate such damage, and he also guarantees fulfilment of the liabilities of the company to creditors, up to the height of the unpaid sum, if this is the cause why the company itself cannot satisfy the claims of its creditors.

The executive head is also responsible for financial health of the company. In case a decision is made about bankruptcy of the company upon a motion from a person other than the debtor and it is proven that this bankruptcy is the result of unprofessional performance of the office of an executive head, who should or could have known about this impending bankruptcy but took no counter-measures, the insolvency administrator may call on the executive head to give up the benefits received according to the contract on performing the office, as well as any other benefit he has received from the company, for up to 2 years retrospectively, before the decision on bankruptcy becomes final.

The business corporations act forbids anyone's intervention in the business management of a company. With this ban, it ensures a high rate of independence or autonomy of decisions for executives when performing an office.

Based on the above-mentioned cases of responsibility of an executive head when performing his office, it is clear that he bears economic risk of his own, which is not a negligible one. At the same time, the law lays down that the performance of the office of an executive head of a limited liability company is independent, not bound to instructions, and thus the relation of subordination of the executive head to the company does not exist here, as would have been the case with an employment relationship.

The activities of an executive head taxed as employment according to the income tax act are an economic activity according to the VAT act

The third part of the judgment deals with compliance of the Czech VAT act with the Directive, more specifically article 5 paragraph 2, which defines the term economic activity for the purposes of the Czech VAT act, and Article 10 of the Directive. According to the Czech VAT act, an independent economic activity is not: “the activity of employees or other persons, which have a contract with the employer, based on which an employment relation is formed between the employer and the employee, or the activities of persons, which are taxed as income from employment according to a special legislative act.”

This special legislative act is act no. 586/1992 Sb., on income taxes, which governs taxation of income from employment in article 6 and which for its purposes introduces a legal fiction, when income defined in article 6 is viewed as income from employment, even if it were income from an activity, which is not employment in the sense of article 2 of the Labour Code. And this is the case of remuneration to an executive head, too, for the performance of his office. The case-law of the SAC stipulated for this case that not all income of the executive head received from the company will be taxed according to article 6 of the income tax act. The income paid to him for something else that the performance of his office and not ensuing from a corporate-law relation but a supplier-customer relation is not taxed according to article 6 of the income tax act.

Disagreement between the VAT act and EU law

For the purposes of VAT, the SAC adjudged as follows: The legal construction for remuneration for an executive head, which may be legitimate for the purposes of the income tax act, cannot, however, be expended also: “into the system of value added tax, which does not reckon with any legal fiction on the level of EU law, understands the term of a person liable to tax in a broad way and interprets an exception set for persons in employment or similar relation with regard to the factuality of their relation. While Directive 2006/112/EC sees it, for the purposes of an exception according to Article 10, as decisive if an relation between an employee and an employer actually exists, or a similar legal relationship, by referring to article 6 of the income tax act in the final sentence of article 5 paragraph 2 of the value added tax act the Czech lawgiver also adds the criterion of taxation by the income tax. This is while Directive 2006/112/EC does not give the member states the option of deflecting when implementing Article 9 or Article 10 from their formulation and filling the defined term of a person liable (or not liable) to tax with different content, as the Czech lawgiver has done. Due to the fact that the value added tax act does not consider a person, whose income is taxed as income from employment, a person liable for tax, it thus occurs in some cases that the system of the value added tax excludes persons, which do not perform their activity in an employment (or similar) relation and which fully bear the risks ensuing from such activity, which is in disagreement with the EU law.”

Conclusion

The judgment concluded the case saying that the subjective rights, which ensue from the Directive, of the limited liability company, whose entitlement to tax deduction was not granted, were reduced, and that the duty to apply EU law with primacy over Czech law, if Czech law is in disagreement with the EU law, does not apply to courts alone, but to all public authorities (see decision of the Constitutional Court from 1 April 2004 file no. PL. ÚS 19/04).

In the conclusion, the SAC noted: “that the directive only binds the member state, for which it was intended, and thus cannot on its own establish obligations but only rights for an individual. As a result of this, an individual can claim rights from the state, which pertain to him based on a directive that the stated did not implement sufficiently or implemented erroneously. The state, on the other hand, cannot use a failure to fulfil its own obligations against an individual, invoke directives as such with regard to an individual an impose obligations on him, which he does not have according to the national law.”

Ivan Fučík