The pitfalls of parent company costs in relation to holding a subsidiary, plus a little bit of case law
Any parent company that has established, purchased or otherwise acquired a subsidiary must look very carefully at whether the costs it incurs on an ongoing basis in holding the subsidiary can be claimed as tax-deductible expenses.
The Income Tax Act is relatively strict on this issue and, unfortunately, in many respects quite ambiguous. First, it should be remembered that when talking about the relationship between the parent company and the subsidiary in the context of the Income Tax Act, we must rely on the definition of that relationship in the Income Tax Act. Among other conditions, these are mainly the length of time the share is held, the legal form of the companies and the size of the share. If these characteristics are not fulfilled, the relationship between parent and subsidiary will not be a relationship at all in the spirit of the Income Tax Act, which is often forgotten and has other important implications.
The law basically defines two categories of such costs: direct and indirect (overheads). In addition to the interest on credit financial instruments clearly mentioned in the law, these are other direct, clearly attributable costs related to the acquisition of the financial investment. These will include, for example, the costs of subsidiary general meetings, i.e. travel expenses, and the remuneration of the person authorised to exercise shareholder rights. Examples include administrative fees for maintaining property accounts, archive services, etc.
Far more complicated, however, are the indirect (overhead) costs associated with owning a subsidiary. These will be a proportion of the parent company's costs associated with the exercise of shareholders' or members' rights, which relate both to the holding of the shareholding and to the company's other activities, in particular the remuneration of the directors, the travel expenses of those directors, but also a whole range of other overheads, such as telephone calls, rent, etc. It will be up to the taxpayer to prove the actual amount of overheads (indirect costs) by a suitable economically justifiable criterion. The legislator is aware of the difficulty of establishing such calculations and therefore allows taxpayers to choose the alternative of excluding from tax deductible expenses the 5% amount of profit shares paid out by the subsidiary in a given year. The chosen method of applying overheads can be changed from year to year, as the tax administration has previously confirmed, among other things, in one of the Coordination Committees dealing with this issue.
In the course of time, given the complexity and breadth of the subject, the courts have also begun to comment on the related issue. There are many matters to address in this area. For example, in a recent judgment, the Supreme Administrative Court also commented on the exclusion of indirect costs. There, the taxpayer initially sought to argue that it had not incurred any overheads in connection with the holding. It modified this following the call of the tax authorities and claimed indirect expenses to the tune of hundreds of crowns. The tax authorities did not believe this and questioned the economic substance of the calculation submitted. The tax authorities then proceeded to assess tax at the rate of 5% of the profit shares paid, which was subsequently confirmed by the courts. This judgment is not only a warning to those who claim that they do not incur any costs in connection with the holding of a subsidiary or that they incur an absolute minimum of such costs. Some of the older judgments also go into more detail on specific costing items that should not be missing from overheads.
In the past, the courts have also dealt with interest costs related to the acquisition of a subsidiary. In particular, there was a well-known judgment of the Supreme Administrative Court in 2013, which dealt with interest costs related to the acquisition of a financial investment when the companies subsequently merged. Here, the deductibility of the costs of this financing was defended, although it should be noted that the specifics of this case were not fully determined on the merits by the court, which remanded the case for further completion, which ultimately did not take place.
Among recent judgments, I would point out one that primarily dealt with so-called crown bonds. The Supreme Administrative Court uncompromisingly rejected a specific case from the point of view of proving the interest costs of these bonds in terms of the costs of achieving, securing and maintaining income. The taxpayer did not help himself by arguing that the effectiveness of interest costs was explained by financing the purchase of shares in subsidiaries. As can be seen from the above, this defence was in vain.
Finally, I would draw your attention to a new judgment that is already pending before the Supreme Administrative Court and whose final resolution we are waiting for. This case involves a very high-value financial investment for the purchase of a business stake in a subsidiary, where the financing was secured within the group. The essence of the transaction was the establishment of a new holding company in the Czech Republic, which subsequently purchased from the group shares in two manufacturing companies in the Czech Republic, again belonging to the group. The purchase of these shares was financed from abroad also under intra-group financing. The purchased subsidiaries subsequently merged with each other and changed their legal form to a limited partnership, whereupon the parent company became the general partner. This was apparently done, among other things, to avoid the tax consequences of the interest expense on the financing of the parent company's purchases of shares in the subsidiary. In principle, all profits from the hitherto normally operating and profitable companies were passed on to the general partner, which in turn claimed the interest expense on the intra-group financing against those profits. Thus, no tax was levied in the Czech Republic on the previously taxed profits, which went abroad in the form of interest income. The taxpayer was not helped by arguments along the lines of taxation of interest income abroad, where the taxpayer repeatedly referred to earlier court judgments in which there was no such taxation abroad. The Regional Court found no economic and rational sense in the whole transaction and, in the spirit of the now very modern view of so-called abuse of rights, upheld the tax assessment requested by the tax administrator. We will certainly continue to follow the case here and await the final decision of the Supreme Administrative Court.
The issue of links and connections between parent and subsidiary companies in the Income Tax Act has been comprehensively addressed in this norm since the Czech Republic joined the European Union in 2004. Nevertheless, in my opinion, taxpayers often neglect and underestimate it. Even the case law is not as rich in this respect, unlike other issues. However, as is clear from the case law cited above, it is not only in larger interconnected groups of companies that there can be complex relationships of considerable value where one must be extremely attentive. Please do not hesitate to contact my colleagues with questions on an ongoing basis to help you untangle these complex issues.