Currently, the Czech Republic does not permit group taxation. Each company in a group is taxed individually. Consolidated tax base applies only for the general partners and their shares in profit of their general partnership.
For tax purposes, prices agreed between related parties have to meet the definition of the arm's-length principle, and these prices are often subject to tax audits by tax authorities. The consequences of incorrect transfer pricing and subsequent adjustments are tax exposure and penalties. In the case of companies receiving investment incentives, incorrect transfer pricing can result in additional penalties. Generally, pricing methods as described in OECD guidelines should be followed.
Although there is no legal requirement to keep transfer pricing documentation, in practice it is strongly recommended to keep it as the taxpayer bears the burden of proof upon challenge of prices by tax authorities.
Taxpayers may request the tax administrators to issue an advance pricing agreement (APA) regarding progressing or future transactions between related parties, as well as the determination of the tax base of PEs.
Country-by-country (CbC) reporting
The CbC report is an outcome of the Action Plan for Base Erosion and Profit Shifting (BEPS) by the OECD that was implemented to the Czech legislation based on the EU Directive DAC IV. The CbC report is a transparent report disclosing the income, earnings, taxes paid, and other information on the economic activity of multinational groups reporting consolidated revenues of over 750 million euros (EUR).
Czech entities that are part of a multinational group reporting annual consolidated revenues of over EUR 750 million were obligated to submit a one-off Notification. The Czech ultimate parents submitted the CbC report by 31 December 2017 for the first time. The report must be submitted every year within 12 months after the close of the relevant fiscal year.
Thin capitalisation rules apply in the Czech Republic and may limit the tax deductibility of interest payments on debt financing from related parties as well as in certain cases from third parties (e.g. back-to-back financing with a bank interposed between two related parties).
Below is a brief summary of the thin capitalisation rules:
- The tax-deductibility test applies not only to interest but also to all so-called ‘financial costs’ on loans (e.g. interest plus other related costs, such as bank fees).
- Thin capitalisation applies only to related-party loans.
- The debt-to-equity ratio for related-party loans is 4:1 (6:1 for financial services industry), i.e. interest on such part of the related-party loans by which the principal of these loans exceeds four times the accounting equity (based on Czech GAAP) of the borrower is tax non-deductible.
- Unrelated-party loans (e.g. bank loans) guaranteed by a related party are not considered related-party loans for thin capitalisation purposes. If, however, a bank provides a back-to-back loan to a Czech entity where the loan is provided to the bank by a related party, such a bank loan to the Czech entity is considered a related-party loan.
ATAD interest stripping rules
The EU ATAD rules limiting deductibility of interest and other borrowing related expenses have been implemented on top of the other rules (such as thin capitalisation). The ATAD interest deductibility rules apply to all interest expenses (i.e. on borrowing from related and unrelated parties). The ATAD test applies only to the interest expenses that successfully passed all other tax deductibility tests, which means that the ATAD rules can result in an additional amount of the interest expenses being disallowed.
Based on these rules, any 'net borrowing costs', defined as the excess of tax deductible borrowing costs over related taxable borrowing income, is only tax deductible up to:
- 30% of a taxpayer’s earnings before interest, taxes, depreciation, and amortisation (EBITDA) as defined for tax purposes, or
- CZK 80 million per year (the safe harbour),
whichever is higher.
The borrowing costs include various types of interest-like expenses, such as actual interest expenses, expenses that are similar to interest, deemed interest expenses included in hedging instruments, interest element included in the financial leasing costs, interest capitalised in the value of assets and subsequently included in tax depreciation, and foreign exchange costs related to interest.
Any interest costs treated as tax non-deductible due to these rules may be carried forward for an indefinite period of time and used as a deduction in the years where the threshold has not been reached (it does not pass to the legal successor).
Controlled foreign companies (CFCs)
The EU ATAD rules regarding a CFC have been implemented in Czech domestic tax legislation. A CFC is defined as a Czech non-resident company in which the Czech company participates (alone or together with its related parties) by more than 50% on voting rights or profits.
If such a CFC:
- does not carry out a 'genuine business activity', and the actual CIT that the CFC paid in the country of its residence is lower than one half of the CIT that the CFC would have paid if it had been a Czech tax resident company,
- is located in a country included on the EU black-list of non-cooperating jurisdictions as at the end of the tax period reviewed,
then the following types of income of the CFC must be included in the CIT base of the Czech controlling company in the proportion of the share of the Czech company in the capital of the CFC:
- Interest income.
- Royalty income.
- Capital gains from sale of shares.
- Financing lease income.
- Insurance, banking, or other financial services income.
- Income from sale of goods or provision of services between related parties with little value added.
This means that the above income must be taxed in the Czech Republic within the tax base of the Czech controlling company as if it the income was generated by this company.
The EU ATAD rules aimed at preventing the effects of hybrid mismatch arrangements in relations between associated companies have also been implemented. These arrangements occur in situations where, for example, expenses are deducted twice in different countries, gains are not taxed, or a combination of both.
The aim is to prevent these mismatches. 'Non-taxation' occurring as a result of hybrid mismatches is preferentially addressed by applying the primary defensive rule (e.g. by not allowing a tax deduction if the income is tax-exempt in the other country).
If the rule is not enforced, the other country should apply the secondary defensive rule (to tax the income the given case). The hybrid mismatch rules are effective from 1 January 2020.