SAC on how to interpret double taxation treaties

If a double taxation treaty can be applied, the tax administrator may not automatically use domestic legal regulations to interpret a treaty’s individual concepts but must apply international law principles and the commentaries to the OECD’s Model Convention.

In its recent decision (2 Afs 40/2018), the SAC dealt with credit transactions between a domestic and foreign company belonging to the same group of companies. The domestic company paid an appropriate amount of interest on loans and withheld a 15% tax in compliance with the Income Tax Act.  Subsequently, it claimed the withheld tax from the tax administrator, referring to the double taxation treaty between the Czech Republic and Great Britain allowing the taxation of interest only by the tax resident’s state. The tax administrator refused to refund the paid tax, claiming that they had applied an exemption from the general rule included in Article 11, according to which it is possible to tax interest exceeding the amount that would have been agreed by independent parties in the Czech Republic.

The tax administrator regarded the parties concerned as related parties in the meaning of the Income Tax Act, giving rise to a special relationship, and derived the interest exceeding the interest that would have been agreed by parties without a special relationship by applying the ITA’s thin capitalisation rules and applied a less advantageous article of the double taxation treaty relating to dividends to this part of paid interest.

The SAC did not agree with this procedure and stressed that the financial administration may not interpret the concepts of a double taxation treaty by applying local provisions of the ITA.  In the SAC’s opinion, even though a special relationship involving, inter alia, cash pooling did exist between the companies concerned, this relationship may not be automatically applied to all inter-company transactions. According to the SAC, the tax administrator also proceeded unlawfully when treating any interest that was non-deductible as a result of thin capitalisation rules as interest that would have never been agreed between the creditor and the debtor under ordinary circumstances (without a special relationship).  

The key message arising from the SAC’s decision is that concepts contained in a double taxation treaty must primarily be interpreted in accordance with the appropriate double taxation treaty and the relevant tools such as the interpretation principles of the Vienna Convention on the Law of Treaties or the OECD’s Model Convention. The concepts and definitions set forth in the national legislation are also relevant when interpreting uncertain concepts of a double taxation treaty, but they may not automatically replace the meaning of the concept being interpreted. The purpose of the treaty’s provisions at issue and any related context must always be taken into account.