Abuse of law and tax assessment

In recent years, and unfortunately more and more often, the term abuse of law has been used in the public space and among the professional tax community. In this context, many of you will think of bonds denominated in crowns or the sale of companies to oneself. Often, among businesspeople, other considerations of abuse of the law are tossed aside with the words: "it does not concern us, we do everything honestly". The tax authority's appetite for assessing tax on the principle of abuse of law is growing and there is often a very extensive interpretation of this principle to obtain the maximum amount of funds for the today rather empty state treasury.

What can the tax authority consider to be an abuse of law? Although abuse of law has been taken into account in the case law of the Supreme Administrative Court many times, abuse of law was introduced into the Tax Code in 2019 in Section 8(4), which reads, "In the administration of taxes, legal actions and other facts relevant to the administration of taxes, the predominant purpose of which is to obtain a tax advantage contrary to the meaning and purpose of the tax legislation, shall not be taken into account." Other EU countries have implemented a similar rule in their national legislation. The provision can be paraphrased to mean that although all the steps were in accordance with the applicable law and formally in order (e.g. under the Civil Code, the Companies Act, etc.), they were deliberately carried out in such a way that the predominant purpose and consequence of the steps so chosen was the non-payment of tax or its minimisation.

An example that the tax authority clearly considers to be an abuse of law may be an attempt to sell land belonging to a limited liability company completely free of taxation. In case of a sale of land owned by a company, the entire (often not insignificant) proceeds of the sale will be subject to income tax at 19%. However, if the land is spun off into a separate LLC and subsequently sold (not the land, but the share in the LLC by the shareholder, an individual, after meeting the five-year time test), then the entire proceeds of the sale to the company (owning only the land) are exempt from income tax. If the whole demerger and share sale is done only to save tax and thus an artificial transaction of sale of share instead of land has been created, then it is an abuse of law.

As we all know, the practice is more colourful and myriad reasons may lead to the adoption of different legal procedures which may seem irrelevant to the tax authority. Unfortunately, the first impression, often without a thorough analysis, leads the tax authority to accuse the taxpayer of abuse of law and to try to claim the allegedly missing tax. In practice, we see that the tax authority will label a certain type of transaction as an abuse of law and then, without much effort to understand the meaning of the transaction or to properly prove and evaluate the evidence in all contexts, it attempts to obtain the tax. More recently, the tax authority has focused on holding arrangements with no change or apparent change in the ultimate owners, sales or contributions of shares within a group of companies or related parties, etc. Exempting income from the sale of a subsidiary of the holding company or the payment of equity components after the contribution of shares to the holding company is a current objective of the Financial Administration. According to the Financial Administration, the abuse of the right consists of several interrelated acts carried out within a short period of time, which in their totality led to the acquisition of a tax advantage.

Even though after receiving a letter from the tax authority the tax subject is at least a "dirty suspect" in the eyes of the authority (if not outright convicted), it is advisable to defend oneself adequately and explain everything to the tax authority. Unfortunately, as in many other tax proceedings, the taxpayer is at a disadvantage, defending itself against the tax authority's accusations and providing evidence of the facts it alleges, i.e. for example, the claim for exemption or the amount of taxation. In the case of abuse of rights, however, the burden of proof is on the tax authority and it is the tax authority that must prove that the predominant purpose was to obtain a tax advantage. According to the letter of the law, the tax authority must prove that the other factors for which the transaction was carried out were not predominant and the main reason was to obtain a tax advantage. In this spirit, the judgment of the Supreme Administrative Court No. 5 Afs 114/2019 reads as follows: "abuse of law cannot be applied as an interpretative principle if the activity carried out may have a purpose other than merely obtaining a tax advantage".

In reality, however, the tax authority's aim in conducting evidence is only to confirm its theory, so it is necessary to propose all evidence confirming the background, intentions and objectives of the transactions directly during the tax audit. Unfortunately, the tax authority usually only strives to challenge the explanations given for the transactions. It will always be the taxpayer who will have to refute the allegations of abuse of rights, fight for their innocence and prove that the overriding reasons for the transaction were not simply to obtain a tax advantage. It is always necessary to know, be able to describe and prove the economic substance of the transaction and the reasons for it. It is also relevant whether the intended economic objectives of the transaction have already been realistically reflected in the position of the companies in the group at the time of the tax audit.

Although the principle of abuse of rights only appeared in the Tax Code in 2019, the application and impact of the provisions also applies to transactions carried out before that year. Examples include income arising from a receivable on the sale of a business share, income from the return of a premium outside the share capital on a holding arrangement adjustment or seeking to withdraw the exemption on a share payment in profits between parent and subsidiary that are realised and paid today but originated in the past at the time of the sale or conversion in, for example, 2016, 2014 or even earlier.

We recommend paying attention to the principle of abuse of rights, as it is a frequently used method by the tax authority to collect tax. Review the corporate transaction targets achieved, both if the share sale or holding arrangement has occurred in the past and if you are implementing or planning one now. For existing holding arrangements, we recommend reviewing the economic substance and assessing whether you can demonstrate and defend it if challenged by the tax authority. If you are implementing or planning a new holding structure or transfer of shares within the family, pay attention to all economic reasons and their documentation. It is advisable to group information and reasons from the time of the transaction into one file for future proof and effective defence. At the time of the transaction, the reasons and the chosen procedures are clear to all involved; but in the event of an audit six or 10 years later, even key details will have faded from memory, proving them is complicated, and some of the participants may no longer be willing or able to explain everything and to make accurate statements to the tax authority.