Czech Republic: Economic substance of reorganization examined; related interest deductions

Czech Republic: Economic substance of reorganization

The Supreme Administrative Court in November 2015 issued a decision in a case concerning application of the “abuse of law” concept to intra-company reorganizations. In particular, the case concerned a claim for the deductibility of interest on a loan provided by a related party for financing the purchase of the ownership interest in companies acquired from the related party.

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The decision involved the merger of a creditor with acquired companies. The “Czech” part of the restructuring consisted of several phases, one of which was the establishment of a financing and holding arrangement in the Netherlands and Luxemburg. This plan involved “hybrid financing”—i.e., interest on a loan was treated as deductible in one country but as a tax-exempt dividend in the country in which the interest was received.

For Czech tax purposes, the taxpayer claimed that the taxable profit generated by the successor company from its business activities was reduced by the amount of interest expense associated with a loan related to the acquisition. 

Court’s decision

The Supreme Administrative Court agreed with the tax authority’s position concerning the “abuse of law” standard relating to interest on the loan. The court explained that it generally did not dispute the methods of financing, whether by debt or equity ownership interests, in completing a merger. However, the court stressed that such transactions must be made for clear economic and justifiable reasons—and not just for tax purposes. A substantial portion of the decision examined the economic grounds of the intra-company transaction, with the court finding that the reasons presented by the taxpayer were neither sufficient nor economically or rationally justifiable. 

According to the court, the restructuring at issue did not lead to a change in the overall ownership structure, a new acquisition, the integration of management, or the reduction of operating expenses. The court found that the merger resulted in the indebtedness of a thriving business without any economic grounds. Other facts, such as the conditions for the loan, only helped the court determine that there were not sufficient economic reasons—but that there were tax reasons—for the restructuring.

The court concluded that, in the context of the abuse of a right to deduct interest for tax purposes, compliance with the thin capitalization rules may only be relevant in the instances of economically justifiable intra-group financing.

KPMG observation

The decision may be viewed as underscoring the tax administration’s tendency to examine intra-company restructuring processes in more detail. Taxpayers involved in such transactions need to consider all associated risks and carefully document proper and economic reasons before undertaking any reorganization.


Read a November 2015 report [PDF 377 KB] prepared by the KPMG member firm in the Czech Republic: Tax and Legal Update 

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