At the beginning of February, the Ministry of Finance published a draft which should lead to the implementation of the Anti Tax Avoidance Directive of the European Commission (further only ATAD) into the tax Czech legislation. The directive originates mainly from the BEPS project focused on Base Erosion and Profit Shifting. This is a joint project of the OECD and the G20 and includes 15 key steps which should lead to solutions for removal of gaps in international rules, which in their current form allow for profit shifting into countries with a lower tax burden. The ATAD is a case of evident effort to harmonize specific rules, especially in the area of direct taxation, which should assure that taxes are paid where profits and values are created. 

The drafts includes other tax changes as well which are not related to the ATAD. These will not be addressed in this article and instead we will focus solely on the five new elements which shall receive a place in the Act on Income Tax and the Tax Code. New tax laws will include the following regulation: (i) Regulation for the reduction of deductibility of borrowing expenses, (ii) Exit tax, (iii) Regulation for controlled foreign corporations, (iv) Hybrid mismatches and (v) General anti-abuse rule. 

These changes will come into force January 1st, 2019 except for the regulations regarding exit taxation and hybrid mismatches, which will come into force January 1st, 2020. 

i. Regulation for the reduction of deductibility of borrowing expenses 

The Act on Income Tax (further only AIT) already holds some regulations concerning the reduction of tax deductibility of interest. Specifically, these are the low capitalization regulation (Article 25 (1)(w) of AIT), regulation regarding interest tied on profits of the debtor (Article 25 (1)(zl) AIT), regulations concerning parent companies with shares in their subsidiaries (Article 25 (1)(zk) AIT), etc. 

The amendment introduces another regulation limiting the tax eligibility of borrowing expenses for legal persons. In the draft of Article 23e of AIT it stands that an amount of borrowing expenses (adjusted by borrowing profit) is not tax eligible if it exceeds the given limit. This limit was set as (i) the amount corresponding to 30% of tax earnings before interest, taxes, depreciation and amortisation (or EBITDA; the explanatory memorandum contains a commentary on the way how to calculate tax EBITDA - basically similar to line 200 of tax return of legal persons and further modified), or (ii) CZK 80.000.000, depending on whichever is higher. 

In the working version for implementation of the ATAD published February 27th last year, the Ministry of Finance speculated that with the coming of the new regulation, the low capitalization regulation will be abolished or preserved only for financial institutions. However, this has been omitted in the draft completely and both regulations limiting the tax eligibility of interest should work side by side. Taxpayers will first test for low capitalization and, if need be, exclude the appropriate portion of non-tax expenses from the tax base. Afterwards, the tax eligible borrowing expenses will be subjected to the new rule limiting the deductibility of borrowing expenses. 

“Borrowing expenses” are a harmonized term, thanks to the directive, which encompasses all interest costs on all forms of debt irrespective of who is the creditor (in this it differs from the rule of low capitalization, which aims only at financing from associated persons). In this context, the amendment contains an exhaustive list of what is understood under the term “borrowing expense”. It is a much broader term than the currently known financial expenses for the sake of calculation of non-tax interest for the low capitalization test. 

The rule limiting deductibility of borrowing expenses will be applied to all financial tools and all concluded contracts. According to the transitional provisions, the only exception will be made for interest which was included in valuation of depreciable assets, so called capitalised interest. In this case, only interest which was included in the valuation of depreciable assets launched into use from June 17th, 2016 on will be tested. Another exception is for interest included in payment on the basis of an agreement on cession of assets for pecuniary use and a subsequent pecuniary transfer to the user. In this case, interest arising from contracts concluded from June 17th, 2016 on will be tested. 

From the directive the amendment adopts the measure which allows a taxpayer, who was previously obliged by this provision to increase the tax base, to lower the tax base by this amount in the following tax periods. The taxpayer can proceed in this way without any time limitation. Certain restrictions will apply on conversions. 

The new rule limiting the deductibility of borrowing expenses will not apply to financial institutions such as: banks, insurance companies, savings banks, pension funds, etc. 

This regulation is the most important one in the whole package of new measures because one can expect it to affect the largest number of taxpayers, thanks also to the fact that in this case it does not matter whether we’re talking about a purely Czech company without subsidiaries abroad, or a multinational group.

ii. Exit taxation - taxation upon re-locating assets 

This regulation establishes the obligation to tax assets re-located abroad from the Czech Republic in cases where there is no change of the owner (re-location of assets of a single taxpayer). This regulation applies only to legal persons. To put it simply, it includes the following situations: (i) a Czech tax resident is re-locating their tax residence abroad and the income from such assets does not fall under the Czech tax liability anymore, or (ii) a Czech tax resident is re-locating their assets to their permanent establishment abroad and in relation to income of this establishment the exemption method is used in the Czech Republic (i.e. the income of the permanent establishment is no longer subject to taxation here), or (iii) a Czech tax non-resident is re-locating their assets abroad from a permanent establishment located in the Czech Republic and the income from the re-located assets no longer falls under Czech tax liability.  

In these cases, re-location will be regarded as a transfer against payment, that is, for the price which was agreed on by independent entities - market price. For the purposes of establishing the tax base from this “sale”, the taxpayer has the right to deduct the net price of the re-located assets (or purchase or acquisition price, depending on the type of assets). In other words, the amount which will be taxed corresponds with the difference between the market price and the original tax value. This market value becomes the new tax value which can be applied upon the subsequent sale in the country where the assets are re-located. This new regulation is aimed at all assets which are used by the taxpayer in their economic activity either in the form of fixed assets or reserve. It does not necessarily need to be assets reported in the balance sheet as an internally developed software or intangible marketing assets, for example. 

Situations are not considered re-location of assets  if there is reasonable expectation that the assets will be returned to the Czech Republic within 12 months of the re-location and at the same time it is re-location of assets < -em data-mce-fragment="1">a)</ -em> connected to funding of securities; < -em data-mce-fragment="1">b)</ -em> provided as financial collateral; or < -em data-mce-fragment="1">c)</ -em> in order to meet capital adequacy requirements or for the purposes of liquidity risk management. 

In accordance with the directive, Czech taxpayers will be in many cases allowed to pay the tax in instalments, which may be spread over a five year period. Whether or not a taxpayer is eligible for this will depend on which country the assets are being re-located to.

iii. Regulation for controlled foreign companies (CFC) 

The draft of the amendment attempts to cover cases where Czech taxpayers have subsidiaries abroad or permanent establishments in locations with low tax burdens (with the use of the exemption method - i.e. income of the permanent establishments is not taxed in the Czech Republic), while these entities do not conduct any economic activity abroad. The Act on Income Tax should newly contain a provision for the taxation of income of foreign companies or permanent establishments in the Czech Republic. This will apply to controlled foreign companies only if the following three conditions are met: 

1. the foreign company does not conduct a substantial (real) economic activity; and 
2. the foreign company is a tax resident in a jurisdiction where tax on income of legal persons (or similar tax) is half as much as if the company was a Czech tax resident; and 
3. the Czech company alone or with associated companies directly or indirectly holds at least than 50% of a capital of a foreign company, or has a right to more than half of its profits; or if it is a permanent establishment in a country with which the Czech Republic has signed a convention for the avoidance of double taxation which allows the use of the exemption method. 

If the mentioned conditions are met, it is necessary to apply the rule for controlled companies and the Czech controlling company must include selected income of the controlled foreign company into its tax base. The draft contains an exhaustive list of types of which must be included in the tax base; for the most part they are passive types of income (e.g. income in the form of borrowing, royalties, profit from shares, etc.). Revenues are included in the tax base by a proportionate part calculated from the share of the controlling company in the capital of the controlled company. 

iv. Hybrid mismatches 

The amendment of AIT also contains provisions for the so called hybrid mismatches. Hybrid mismatches make use of the fact that direct taxes are not harmonised within the EU (except for a specific area in exemption from income tax of legal persons). Thus, the different rules and regulations in different member states make it possible for tax subjects to make us of hybrid mismatches such as double tax deductions or double non-taxation of income. There are many of these situations and a lot of the times the problems are quite complex. In addition, many of these are not feasible in the Czech legal environment.  

To illustrate, a hybrid mismatch can arise if the state of residence views activities of its tax resident in some other state as income realized by the permanent establishment located in the other state (source state) and because of that exempts this income from taxation. However, according to the rules of the source state, the permanent establishment did not originate there and that is why this state does not want to tax the income which was exempt from taxation in the first state. This creates a situation of double non-taxation. 

According to the amendment, the rule applies only to associated persons, which means subjects who hold at least 50% of the capital, voting rights, or revenues, or are associated in some other way, or are the permanent establishment of a domestic legal person. A combination of general and more specific protective provisions has been implemented, which should lead to limitation of these hybrid mismatches. In our opinion, it will be very difficult to meet all the demands of the new rules in practice. 

v. General anti-abuse rule 

Unlike the previously stated regulations, the general anti-abuse rule will not be implemented into the AIT but into the Tax Code. It aims to impact cases of aggressive tax planning which lead to fabrications of artificial transactions. The Ministry of Finance first stated that the implementation of the general anti-abuse rule directly into legislation is unnecessary since the principles against abuse are rooted in the Czech law through the case law of administrative courts and the Constitutional Court. However, the opinion of the Ministry has apparently changed.   

Unfortunately, the implementation of this rule is fraught with many questions. The most fundamental one is, whether it might broaden the current idea of what is and isn’t abuse. The draft brings support for this. Let us look at the definition: “Tax administration does not take into consideration actions and other facts the main aim or one of the main aims of which is obtaining a tax advantage or some other advantage contrary to the sense and purposes of the legislation”. However, previous rulings and readings used to accentuate the fact that obtaining tax advantage must be the main aim not just one of the main aims. We’ll see how this turns out in practice. After all, taxes are important for every single decision. No one wants to pay more than is necessary.  

We should conclude by saying that at the moment only the draft is available and has not even gone through the first reading in the Chamber of Deputies. Due to the fact that the amendment must follow the directive, it is highly unlikely that we will see any drastic changes to the amendment.   

Written by: Štěpán Hrubý 

Revision: Štěpán Osička