Move your firm … and management, too?

Czech firms have frequently been setting up parent companies in recent years, mostly in the Netherlands, Luxembourg and Cyprus. The most often noted reasons include an option to resort to investment protection treaties in the case of disputes with the Czech authorities, and there are also tax considerations.

But there are traps that Czech businesses should be aware of when transferring their business activities into a foreign holding.

A holding company being domiciled abroad will not prevent the Czech tax authorities from „reaching out” for a holding’s profits and taxing them under the Czech laws. The point is that, according to Czech tax laws and double taxation treaties, the worldwide income of such a company may be taxed in the country of its place of effective management, instead of the country of its formally registered office.

In the country of the registered office, the company will then tax only the profits generated by its activities in that territory. In practice, “the place of effective management” will mean the place where key management and business decisions are actually made that are required for carrying out company’s business activities, i.e., the place where de facto the firm’s business strategy is developed and approved.

What would this mean in practice for, say, a Cyprus-based holding company CypCo, established by Czech owners?

The Czech managers of CypCo will manage the company from the Czech Republic. This is because the holding also owns the Czech company CzechCo and other firms across Central and Eastern Europe. Managers travel the region as part of business but always return to the Czech Republic from their trips. Managers come together in Cyprus approximately four or six times a year for two or three days to discuss the working papers required for the board of directors’ meetings. When CypCo generates a profit it will be—perhaps surprisingly—taxed under the Czech tax laws.

From what place is the firm managed? The key to identify from which country the company is managed will, as a rule, be the place and “method of performance” of the board of directors’ meetings. The tax authority, however, may consider the above insufficiently demonstrable if the directors travel to the respective country in the morning to return again in the evening, as such a procedure may give grounds for the assumption that the directors already made their decisions in their home country prior to leaving, and that the decisions were then only formally approved in another country.

Day-to-day presence of managers in the Czech Republic or their return to the country as part of the firm’s business within Europe may naturally suggest that both day-to-day management and strategic management of the company take place in the Czech Republic.

Such speculations could possibly be avoided only by moving abroad on a temporary basis (i.e., during workdays). If the managers claim their stays in Czech territory are not that frequent, the tax authority may infer from a series of other facts whether that is true, whether they intend to stay permanently in the Czech Republic (for business reasons), what type of decisions they make in the country, etc. Facts, such as costs of office leases recognized by either the Czech or foreign company, costs of cars operated in the Czech Republic or witness depositions made by collaborators from a local subsidiary, may be indicators of the above.

Distribution and taxation of profit given that the tax authority would challenge the effective place of company’s management, based on information on the place of execution of strategic decisions made by the managers, it is in the first place the holding company that is exposed to the taxation risk. The Czech tax authority would claim taxation, in whole or in part, of the profits generated by the foreign company, despite the company not having a legally registered branch in the Czech Republic.

If the legal viewpoint also concludes that the company carries out a de facto business operation in Czech territory, the statutory requirement of legal registration of such business by entering a branch in the Czech Commercial Register will arise, in addition to the statutory tax registration.

As the company is required to subject to an unlimited tax liability in a single country only, the question to answer remains what portion of the profit (and according to what method) should be apportioned to the country of effective management, and what portion should then be taxed in the company’s country of legal registration. If management makes its decisions in one country only, the procedure to allocate costs between two countries may be comparatively simple as the foreign company would hardly be able to document that it will not tax its entire profit in the Czech Republic. If management strategically manages the company from multiple countries, Organization for Economic Co-operation and Development (OECD) documents have suggested various options as to how a single country of effective management should be determined, while such documents have never prioritized any decision over others. These solutions have included determination of the effective place of management in the country with which the company has established the closest economic relations, where the business activity is the highest, where management meets, where most of the company managers are tax residents, etc.

The OECD has recently published a report confirming that no universal rule may be set down for determining the place of effective management if management strategically manages a company from multiple countries, and that the best way to address the issue consists in negotiations by separate countries in each individual case. Such negotiations, however, are time-consuming and the existent international documents usually enable only bilateral negotiations between states, rather than multilateral discussions.