Tax and Legal News – February 2024

Editorial – Ready for the New Year, or what tax administrators (also) like to do

The new year is upon us and there is so much new to write about – benefits, functional currency, new VAT rates, windfall profits tax, top-up tax and related tax (administrative and monetary) obligations…

However, I would like to stop at the imaginary pinnacle of tax practice, which is undoubtedly the tax audit activity of the tax administration and several topics that tax administrators deal with (and how they are subsequently successful in administrative courts).

I’ll leave out real and perceived VAT fraud, proving management, advertising and intermediary services, beneficial ownership and abuse of law, and I’d like to elaborate on one obvious evergreen, and one overlooked, topic.

The obvious one is, unsurprisingly, transfer prices. After awakening from their COVID hibernation, the tax authorities have embarked with their own zeal on a whole series of audits, examining the results of loss-making, under- (and in the case of investment incentive recipients, over-) profitable companies. We see a significant increase, especially in the automotive industry, which was significantly affected by COVID. In the recent past, the tax administration has succeeded in several cases before the courts to challenge the full functional and risk profile of manufacturing companies supplying independent customers, but with a significant share of decision-making centralized at the group level. Using the construction of the “hypothetical service of realizing a loss-making production for the benefit of the group”, the tax authorities more or less successfully impute what they consider to be missing routine profits resulting from market or capacity risk. As has been the recent custom, they have wormed their way through the courts with some not-so-happy stories and are now trying to apply this “settled case law” to other cases. Whether or not they succeed will depend on the particular circumstances (and, of course, the quality of the reasoning and documentation).

The second area where the administration is currently rather on the defensive is the magic of so-called benchmarks (studies of comparable companies), where, on the other hand, the courts have in several cases defied the established practice and require tax administrators to provide more detailed justification as to why the interquartile range was used instead of the full range, why loss-making companies were excluded, etc. It is obvious that the tax administration will not fold its hands in this area, because if both of these objections were applied at the same time, they would no longer assess anything – in every industry there is at least one loss-making independent company… .

The second, not so obvious topic that the authorities deal with is... work-in-progress (see also our judicial window)! More and more often, tax authorities are asking about this seemingly innocent accounting method, which is designed to ensure the temporal relationship between costs and income (specifically, to postpone an expense until the period in which the income is realized), and taxpayers are taken by surprise. “Failure to account for work-in-progress” has come up in several recent cases. An engineering firm failed to prove the cost of completing major foreign projects. A construction company was in trouble over the charging of an accrual for work it had invoiced its customers for but the contractors had not completed. A case dragged on for several years where the tax administrator refused to recognize overhead costs allocated proportionately to individual projects. Another engineering firm (in an audit initiated after eight years) failed to convince the tax authorities of the correctness of the valuation of work-in-progress as it “did not provide detailed breakdowns of the materials, wages and overheads used for individual orders”. Although the reasoning of the administration and the courts in many cases does not provide a clear answer as to whether these were accounting errors, a failure to carry an adequate burden of proof, or a lack of understanding by the authorities of the complexity of this complex subject, it can be concluded that accounting for work-in-progress may not be tax neutral, may lead to double taxation, and attention needs to be paid to both the maintenance and preservation of detailed records and to a factual and (to some extent to the non-specialized user) understandable explanation. Problems are also caused by the Czech specificity of looking at material and temporal continuity (with the period rather than each other) and the division of projects into sub-performances according to milestones, which may not be in line with the procedures applied in international accounting – this should improve with the upcoming amendment to the Accounting Act.

In conclusion, we can only wish all readers to avoid tax audits. And if their results have already got the interest of the analytical algorithm of the tax administration and triggered an inspection by the tax administrator, to meet with a tax administrator who will be sympathetic to the specifics of their business, so that the inspection goes smoothly and amicably, and most importantly, without any assessments!