SAC: tax treatment of non-deductible expenses does not change by including them in transfer price calculation
The Supreme Administrative Court (SAC) has recently addressed again the tax deductibility of expenses, in particular dealing with a section of the Income Tax Act allowing non-deductible expenses (e.g. entertainment expenses) to be treated as deductible for income tax purposes if they are directly linked to the related income. In case 3 Afs 14/2024, the court assessed whether non-deductible expenses being included in the calculation of the price between related parties could justify the application of this ITA provision.
At issue was whether expenses typically treated as non-deductible (e.g., entertainment, gifts, penalties, or promotional items exceeding the statutory limit) could be claimed as deductible for income tax purposes when these were included in the price of services charged to the parent company using the cost+ model.
The taxpayer argued that this gave rise to a direct link between expenses and revenues (income): if the expenses had not been incurred, they could not have been included in the price of the service and hence no reinvoicing plus a profit margin (in this case, five percent) would have been done.
However, the court emphasised that the mere inclusion of expenses in the calculation of the price between related parties cannot automatically be regarded as a demonstrable link to a specific income and that the tax deductibility of expenses cannot be based on an accounting construct alone. Instead, the key is that the expense has a genuine economic purpose and actually contributes to the generation of income. The court questioned, in this particular case, e.g., how expenses incurred on donations or penalties contributed to the provision of marketing services.
In the case under consideration, the taxpayer did not prove that the expenses in question were directly related to the generation of taxable income. Both the Municipal Court in Prague and the Supreme Administrative Court (SAC) stated that the contractual setting of prices between related parties, e.g., a situation where each CZK 1 of the expense is supposed to generate CZK 1.05 of the income, does not in itself demonstrate a link between the expenses and the provided services. The pricing mechanism serves only to determine the price, not to prove the actual impact of the expenses on taxable income.
With this judgment, the SAC effectively confirmed its earlier approach to the interpretation of the relevant provision of the Income Tax Act, as expressed, e.g., in its judgments 1 Afs 190/2021-30 and 10 Afs 20/2021-55. In both cases, the court held that tax deductibility cannot be inferred solely from the internal pricing setup between related parties when there is no demonstrable and concrete link between the expenses and the taxable income.