Czech Republic: Binding opinions on the determination of the tax base of permanent establishments

Published on May 23, 2017

A new provision of § 38 of the Act on Income Tax addresses the taxation of permanent establishments founded by tax non-residents and the procedure for determining their tax base. The relevant amending bill to the Act on Income Tax (published in Parliamentary Material No. 873) is scheduled to enter into force on 1 April 2017.
  
The existing Czech legal regulation does not address this issue in detail and consequently there is some uncertainty among taxpayers as to what is the correct procedure for determining the tax base for their permanent establishments. The amending bill offers taxpayers the possibility of making a request to the tax authority for a binding opinion on the procedure used by a permanent establishment for determining its tax base.
 

Under Czech rules, a permanent establishment is not considered to be a legal entity. However, for tax purposes, it is treated as a separate taxable entity and is subject to the same legal rules in the area of taxes and transfer pricing as a corporate entity.
 
Under the provisions of the Czech Act on Income Tax, permanent establishments founded in the Czech Republic by tax non-residents are supposed to achieve a tax base that must not be lower, or tax losses that must not be higher, than those that would be achieved on the same activity or similar activity under similar conditions by a taxpayer having their registered office in the Czech Republic.
 

This means that a tax non-resident that has a permanent establishment in the Czech Republic is obliged to allocate to such permanent establishment a proportional amount of revenues and expenses that corresponds to the scope of activities of such permanent establishment.
 
This is also stated in Article 7 of double taxation treaties, which states that there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions, and there shall be allowed as deductions the expenses incurred for the purposes of the permanent establishment, whether incurred in the state in which the permanent establishment is situated or elsewhere.
 

Setting such a tax base, i.e. setting such an allocation of expenses and revenues, however, is in many respects a contentious issue, one frequently based on a subjective point of view. The existing legal regulation does not address this issue and consequently permanent establishments cannot be certain as to how the tax authority will view the procedure they use to allocate the revenues and expenses associated with the activities of their permanent establishment Up to now, it was only possible to request a non-binding opinion from the tax authority, one that was not legally binding. Although the aforementioned amending bill does not specify how to correctly determine the tax base for a permanent establishment, it does enable the relevant taxpayer to request a binding consent to the use of a particular method.
 
Such method must be based on rational, economic considerations and must reflect the functional risks associated with the permanent establishment and its founder, their roles in the value chain and their contribution within the framework of the relevant business model.
 

The request for the above-described consent from the tax authority must contain detailed information on the activities of the tax non-resident and the non-resident's Czech permanent establishment, as well as other descriptive data. The main part of the request, however, consists of a description of and documentation on the procedure used to allocate revenues and expenses to the permanent establishment. Such documentation should be based on a functional and risk analysis (see above) and should indicate how the results of such analysis relate to the procedure used for allocating revenues and expenses to the permanent establishment.
 
Properly prepared materials are an absolute necessity for an affirmative opinion from the tax authority.
 

Prospect on the profit allocation to Czech permanent establishments

This new instrument should mean greater legal certainty for permanent establishments. On the other hand, it should be kept in mind that the law does not impose any time limit within which the tax authority is required to decide on such request. This could pose a risk, especially with regard to an evaluation of the method used for determining the tax base for the activities planned by a permanent establishment. Another disadvantage could be the risk that a tax audit could be initiated by the tax authority if a negative decision is issued on the request for consent to a particular method. Moreover, when submitting the request, the taxpayer must submit very detailed information. Accordingly, before submitting the request, one would be well advised to first evaluate whether the present model for allocating revenues and expenses is set correctly and is in line with the activities and functional profile of the permanent establishment. If not, the model should be modified before the request is sent to the tax authority.
 

While the amending bill should enter into force on 1 April 2017, it will not be possible to file such requests for binding evaluations until 1 January 2018. However, in view of how time-consuming the preparation of all necessary materials is likely to be, foreign companies that have a permanent establishment in the Czech Republic would need to start on this process of preparation very soon.

And while we are on the subject of permanent establishments, soon we can expect changes in legislation as a result of the new treatment of permanent establishments pursuant to the BEPS action plan prepared by OECD. This will expand the circumstances under which permanent establishments are deemed to arise and will also mean changes to the rules for determining their tax base.
 

If you are considering the submission of a request for a binding evaluation of the method for determining the tax base for a tax non-resident's permanent establishment in the Czech Republic, or if you have any questions on this issue, we would be pleased to assist you.