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New case law on proving direct link between expense and income

Recent case law has again confirmed how difficult it can be to apply a special provision of the Income Tax Act allowing non-deductible expenses to be considered deductible up to the amount of the related income or income to be considered non-taxable if it is related to non-deductible expenses. At the same time, the court decisions below also show that an economic link between income and expense is not sufficient, as there must be a direct link, i.e., a sufficiently intense and unmediated logical link between income and expense.

The Municipal Court in Prague ruled on a case (3 Af 4/2020 48) where a company operating in pharmaceutical distribution treated expenses typically considered as non-deductible (such as entertainment costs, non-deductible gifts) as deductible for income tax purposes on the grounds that these expenses were directly included in the calculation of its income. The company's pricing model consisted of the sum of its direct and indirect operating expenses plus a margin of 5%. The company therefore assumed that the conditions for the application of Section 24(2)(zc) of the Income Tax Act had undoubtedly been met, including the direct link between expense and income.

However, the court argued that the direct link between expense and income could not be inferred merely from its direct inclusion in the price calculation. The key is to show that had it not been for the expenses in question, the customer would not have purchased the goods or would not have done so on the given terms. The fact that the price was determined using the "Cost+" method based on non-deductible expenses does not make these expenses directly related to the generated income. According to the court, the direct link between expense and income must be understood to mean that the expenses in question could have influenced the amount of income, not only by being incurred and subsequently charged to other entities, but also in such a way that their incurring contributed to the generation of income in a way other than by automatically increasing it. It is thus necessary to prove a direct link to the services provided to customers and to distinguish whether the expenses actually benefit the customer or instead only the company itself. The Municipal Court’s conclusions are yet to be examined by the Supreme Administrative Court.

Another judgment (10 Afs 221/2022 - 70), this time of the Supreme Administrative Court, involves the opposite point of view and concerns the question whether under a special provision of the Income Tax Act it is possible not to tax income up to the amount of directly related non-deductible expenses. A company recorded non-deductible interest expense relating to issued bonds (non-deductible due to not meeting the thin capitalisation test) and, at the same time, interest income from a loan agreement. According to the company, there was an immediate link between the bonds and the loan agreement and therefore also between the related interest; it argued that the receivable arising from the subscribed bonds and the payable from the loan agreement were offset, leading the company to believe that the relevant interest was also linked.

However, the Supreme Administrative Court disagreed with this approach. In its view, although interest is an accessory to a receivable and, in principle, follows its fate, that does not necessarily mean that a direct link between receivables will always lead to a direct link between their interest. That relationship must always be examined individually. It is not appropriate to assess the direct link solely based on whether the income and expense arise from the same legal title without considering the other circumstances of the case. The court also pointed out that in assessing the direct link, it is always relevant to consider whether the taxpayer would have received the income without incurring the non-deductible expense. In doing so, the purpose of the income and expense, the motives behind their creation, and their interdependence or interrelatedness may be taken into account.

Czech case law has been quite consistent in this area for a long time. If you decide to apply these special provisions of the Income Tax Act when preparing your income tax calculation, we recommend always analysing the situation thoroughly. In particular, consider whether you are able to prove a direct link between expenses and income in the light of the above case law and make sure to support your conclusions with appropriate reasoning, as it will come handy in a possible inspection by the tax authorities.