Czech Republic: What to watch out for when it comes to transfer prices

published on 1 March 2021 | reading time approx. 3 minutes

 

​Companies performing only routine functions should generally generate only a relatively low, but stable profit. Contrary thereto, companies of strategic importance should generate residual profit, and loss. This is unfortunately not always the case.

 

 

In your experience, how often do local tax authorities show an interest in transfer pricing?

Based on our immediate experience, the number of tax inspections directed at transfer pricing increases by the year. And it’s not just about the frequency of the inspections, but also the risk of a lot of additional tax. Statistics published by tax authorities show that tax officials are getting better at their job by the day. One of the reasons why this is the case is definitely the fact that tax inspectors are turning into professionals. But even so, I firmly believe that the main problem lies with the actual taxable persons, who quite gingerly underestimate the significant risks at hand and who fail to have at-the-ready documents supporting the transfer pricing methodology they have adopted.

 

When you look at the number of inspections carried out and aimed at transfer pricing, to what extent does the situation in the Czech Republic differ from that in other countries, like Germany, for example?

The situation is more or less the same in terms of the frequency and intensity of inspections. Tax authorities worldwide have been very active in the past decade in checking that pricing is right. But what is significantly different compared to Germany is how the tax authorities communicate with taxpayers. In Germany, tax authorities have been practicing open negotiations for a long time. When a tax inspection is opened, the tax authority clearly states its view on the various areas of inspection and the result is, to a certain extent, a compromise that both parties agree on. Here, in the Czech Republic, we are witness to a much more formalistic approach (submit → we assess → we don’t have an opinion right now). Inspections conducted in this way unfortunately tend to prolong the entire process and reduce the legal certainty of taxpayers to a pulp.

 

Where do you think companies in the Czech Republic make the most mistakes when it comes to transfer pricing? What should they be looking out for?

In my opinion, Czech companies underestimate two areas in particular. The first one is that they don’t reflect on ever-changing rules and new requirements ensuing from new recommendations issued by the OECD. To randomly name but a few its things like intra-group financing, intra-group services and the restructuring of relations within the group and the impact on the company’s business model. In general, it applies that transfer pricing methodology should be adapted according to where value is created. In practical terms this means that companies performing only routine functions should generate only a relatively low, but stable profit, whereas companies of strategic importance should generate residual profit, and loss. This is unfortunately not always the case.

 

The second underestimated area is that which follows after the determination of the transfer price, that being the obligation to demonstrate that the corporate tax base is determined in line with the arm’s-length principle. For this purpose, Czech companies should have at their disposal sufficiently conclusive means that they can submit in the event of a tax inspection and which they can use to demonstrate that their transfer pricing complies with the arm’s length principle. In reality, companies quite often only start collecting evidence when the tax authority has already launched a tax inspection, which makes the situation even the more complicated and somewhat compromises the company’s position.

 

What, according to you, most often draws the tax authority’s attention to the fact that the company made a mistake in its transfer pricing?

It’s usually information aimed at determining the functional profile of the company (emanating from the company’s website or annual report, for example), which does not correspond to the company’s profitability. Companies often provide information, in good faith, from which the tax authority then infers that the company under scrutiny is a so-called limited or routine company in terms of the scope of its functions, which is significantly controlled by the parent company. Based on transfer pricing theory, such companies should generally generate a relatively low, but stable profit. If, however, the company is loss making, it is just a matter of time before that tax authority will come knocking at its door. 

Another very sensitive area is when the data in documents already available to the tax authority prior to a tax inspection are inconsistent.

 

To what extent has the amendment to the Income Tax Act that transposes the ATAD affected transfer pricing?

The amendment to the Income Tax Act that transposes the ATAD has touched on transfer pricing primarily in limiting the applicability of interest costs in relation to the corporate tax base in that exceeding borrowing costs are deductible in terms of the tax base only up to 30 percent of the taxpayer’s earnings before interest, tax, depreciation and amortisation (EBITDA), i.e. CZK 80 million. In practice, this rule means tax entities must carefully monitor their financing structure and they must correctly choose between equity and debt. This is another rule that to a certain degree limits tax deductible expenses of financing economic activity and it applies together with already existing thin capitalisation rules. Due to the set limits, this new rule applies to a rather limited number of Czech tax entities.

 

Would you welcome any further changes to laws regulating transfer pricing that would aid companies in adhering to them and keeping everything straight? If so, what specifically are you looking for?

Companies would very much appreciate clear rules that would lay down how they should demonstrate correct transfer pricing. In other words, legislation governing the mandatory processing of transfer pricing documentation. In the absence of such legislation, companies are unsure how to do this and such lack of rules does nothing for standard document requirements during tax inspections. Updated methodological guidelines that would reflect the amended OECD guidelines would be enough to help companies keep their documentation accurate and up-to-date.

 

What impact will the new OECD guidelines have on transfer pricing (Taxing the Digital Economy Pillars 1 and 2)?

Only time will show what impact the new OECD guidelines will have on taxing the digital economy. The new guidelines as proposed by the OECD are currently in the public comment phase and their final version should be issued in mid-2021, as should the proposal for legislative amendments. So, we are now more or less at the start of the entire process of setting up an international taxation process, despite the fact that attempts to revive the fair taxation of digital economy activity have been one of the OECD’s priorities for several years now.

 

The proposed rules provide for a two-pillar principle. The first pillar gives states the right to tax income that has been generated in their territories, without the need for the tax entity that generated the income to be actually physically present. The second pillar sets the minimum level of total taxation to be achieved.

 

Generally I think that the impact of the new rules on transfer pricing will be significant because the new rules will have to be introduced into everyday life. Even though the OECD aims to instigate a system striving for administrative arrangements that are as simple as possible, we may expect increased administrative complexity that will go hand in hand with restructuring relations and the implementation of rules, and of course the necessary documentation.

 

Taking into consideration new strategy guidelines, it may be too early for specific recommendations to be given, because the second pillar may still undergo major changes. I would, however, recommend that all companies engaged in economic activity in any of the digital areas concerned closely monitor the situation and gradually prepare for certain changes to come about. In my opinion, we here in the Czech Republic are going to see cases when the Czech Tax Administration is going to want to tax the income of those foreign entities engaged in an economic activity falling within the definition of “digital” in the Czech Republic.