Interest in tax optimization rises as companies expand abroad

The Czech Republic is turning from an inbound investment location into a source of outbound investment with companies expanding to Europe and Asia. But the expansion can pose some tricky tax issues.

Czech tax law can be often interpreted in multiple meanings, according to Zenon Folwarczny, seniormanager in the tax office of PwC (PwC) in Ostrava, North Moravia. On top of that, the behavior of Czech tax authorities can be unpredictable. With companies expanding internationally, many are now showing increased interest in tax optimization. Setup costs and other factors need to be looked at before trying to shift the tax burden to another country with more lenient regulations. Tax-shelter countries such as the Cayman Islandsmay not always be the best alternative to paying taxes where the company actually does business. From a double taxation perspective, the Czech Republic has treaties with 70 countries, but the situation in other countries may be difficult, he says.

* Q: Howmature is the tax optimization market here compared with Central and Eastern Europe (CEE) andWestern Europe?

A: European companies try to implement the same tax optimization structures on the whole region, so there are usually no specific structures for Eastern or Western Europe. The difference is therefore not in the tax optimization schemes that are implemented, because they are implemented equally in the region, but in the responses on the same structure that the client gets fromdifferent countries fromthe advisers based on their experience with local tax authorities and courts.

* Q: In which sector are tax optimizing structures themost seen?

A: Production groups that have usually manufacturing and purchase/sales companies in the structure are usually those that are in a constant move—merging, restructuring, changing the group’s risk and function profile. A change of the risk and function profile is themethod that is often used in tax planning. …When the group of companies changes the allocation of risks and functions in the group, the profits of the individual companies may change even though the profit of the group is staying the same. This can then affect the tax burden of the group given different tax rates in countries involved. However, if the tax liabilities are shifted among countries, the tax authorities usually scrutinize such changes.

* Q: Do Czech or foreign companies use tax optimization servicesmore?

A: In the past, it wasmostly used by foreign companies (multinational groups owning Czech companies). Usually the company headquarters develop a tax plan for the whole group in cooperation with their advisers, and this scheme is then verified in each of the countries involved. Recently, however, Czech companies are having significant growth and are expanding internationally. Thanks to these companies the Czech market is turning from being solely an inbound investment location into a base of companies investing outbound toward Europe, the Commonwealth of Independent States (CIS), or even to the Far East. In connection with this expansion, these Czech companies are looking at tax optimization more often.

* Q:What ismissing in optimization structure, and what can be improved?

A: Based on my experience, the optimization structures implemented in the Czech Republic are very similar to these inWestern Countries. What might be different is the approach of tax offices. The country has tax anti-abuse rules briefly described in the law that can be often interpreted in multiplemeanings, whichmakes themunclear. Some guidance can also be found in Organization for Economic Cooperation and Development (OECD) documents including comments on anti-abuse rules, application of double tax treaties ormethods of setting prices between related parties. However, these documents are not legally binding, and tax offices are often not so experienced in working with them. The approach of tax authorities to tax optimization structures is therefore always difficult to predict.

* Q:What are themain challenges of doing tax optimization for Czech-based firms?

A:The company’s first step is to discuss with the adviser whether it makes sense for the company to think about implementing a complex tax planning structure. Tax optimization schemes are usually connected with shifting functions or risks to foreign jurisdictions. This can easily work on paper, but it can have many limitations in practice. It can be rather difficult for a Czech company to shift functions or risks to a foreign jurisdiction in which it did not have any presence before. Another limiting factor is the structure’s costs. Tax optimization structures are connected with setup costs that then pay back via tax savings. The size of the transactions therefore has to be large enough to justify the setup costs.

* Q: Are there some other legal changes concerning tax optimization?

A: Czech tax law has some provisions aimed at preventing tax optimization. Besides general anti-avoidance rules, there are also some specific provisions, such as transfer pricing—stipulating rules for determination of prices in intragroup transactions— or thin capitalization, which can limit the tax deductibility of interest paid on the loans froma related party. The thin capitalization rules weremade stricter in 2008. On the other hand, some rules on the exemption of capital gains from sale of subsidiaries weremademore favorable, so now capital gains from the sale of a limited-liability company or a joint-stock company could be free of tax by the corporate shareholders in Czech Republic or in the EU. Furthermore, the Czech government has realized that the thin capitalization rules are presumably too harsh and proposed softening these rules … from the beginning of 2009.

* Q: Is the Czech Republic still attractive for foreign investors?

A: Some companies still enter the Czech market despite knowing that the tax system is not the most favorable and simple in the region. For them, the top priority is the business result, where the effective high tax burden is overridden by the effect of growing business.

* Q:What is the situation on double taxation?

A:The Czech Republic is in a very good position because we have more than 70 agreements on avoidance of double taxations…in countries around the world. Double taxation treaties between countries allow the headquarter country to credit the tax paid abroad (or in some cases not to tax again income already taxed abroad). Allowance for a credit of foreign tax is, however,missing in Czech local law, which creates a certain obstacle in trade with nontreaty countries.

* Q:What are the benefits for large multinational companies?

A: The major benefit of shifting profits to low-tax jurisdiction is, of course, tax saving. However, the shift of the profits is connected setup costs and implementation difficulties. The tax law risks of a dispute with tax authorities also needs to be well-considered. Using tax havens such as Bermuda or the Cayman Islands may not always be the optimal solution because everything that is paid to those countries may be either in numerous jurisdicitons taxed by a higher withholding tax rate and/or should be very well-documented because there is constant suspicion that it is only a transfer of profit to those countries, for example, without the real delivery of services. Companies thereforemay rather choose to stay in the location of their business, pay a bit more tax and not risk a dispute with the tax office.

* Q:What trends do you foresee for tax optimization in the region?

A: In general, the interest of Czech companies in tax optimization is increasing. … An EU directive enabling cross-border mergers by using a legal company form called Societas Europaea (SE) has been implemented in Czech law. Cross-border mergers were not possible in the past in the Czech Republic, and the Societas Europaea structure and cross-border mergers would presumably be another trend in tax planning trend (see “Czechs lead Europe in establishing new type of firm,” CBW, Feb. 4, 2008).

* Q:What country targeted by Czech investors has themost complicated taxation system?

A: In general, those countries with developed tax law and sophisticated tax authorities, such as Germany or the UK, have relatively complicated tax systems. Countries outside Europemay also have a tax systemthat is complicated fromthe Czech perspective, not because it is developed but rather because it is very different fromwhat we are used to in Europe. This can be, for instance, (the case in) India and China.