Dear Readers,
This article is to inform you about Czech Supreme Administrative Court’s (the “SAC”) Judgment Ref. No. 5 Afs 236/2022 - 36 dated 29 November 2023. In this judgment, the SAC dealt with a question of tax deductibility of costs pursuant to Section 24 (1) of Act No. 586/1992 Coll., on Income Taxes (the “ITA”) from a settlement agreement.
Background Information
Where disputes with regard to mutual rights arise between entities, such situation can be resolved for example with the use of a settlement agreement (see Section 1903 of the Civil Code). In such case, the original obligation (or a receivable, as the case may be) is replaced with a new obligation, i.e. the original one ceases to exist.
Tax implications of entering into the agreement are not explicitly addressed by the Income Tax Act. Instruction No. D-59 only specifies that the costs should be recognised in the period, in which the settlement agreement comes into effect. This issue was previously dealt with by the Coordination Board (see below).
What Was the Above-mentioned Judgment About?
A taxpayer entered into a settlement agreement in order to eliminate future costs related to conducting potential suits rather than to change the original disputable obligations. The taxpayer applied the amount under the agreement, which was identified as a financial compensation entitlement, as a tax deductible cots pursuant to Section 24 (1) of the ITA. It supported the tax deductibility by claiming that the agreement would result in future cuts of costs related to litigations, i.e. it will have an impact on future higher taxable income.
The tax administrator found the taxpayer’s reasons insufficient and did not recognise the compensation entitlement as a tax deductible cost. The taxpayer disagreed with the payment assessment and filed an appeal with the Appellate Financial Directorate that agreed with the tax administrator.
The dispute was therefore referred to the Regional Court, the subject matter being a consideration of the question and conditions, under which the settlement agreement could be a tax deductible expense pursuant to Section 24 (1) of the ITA, and a question whether tax deductibility can result from cuts of future costs.
Decision of the Regional Court (the “RC”)
In the RC’s opinion, the ITA does not regulate the settlement agreement and, as a result, it is always necessary to consider tax deductibility on a case-by-case basis in compliance with Section 24 (1) of the ITA.
The RC refers to the existing decision-making practice. For example the SAC states in Judgment No. 1 Afs 58/2011‑94 that there is a causal relationship between the new obligation’s origination due to the settlement agreement’s establishment and cessation of the original obligation. The settlement agreement changes the legal reason for the obligation’s existence, but the economic reason remains unchanged. Analogically, it is important to consider an income’s economic reason (cause) for tax purposes pursuant to SAC’s Judgment No. 1 Afs 74/2009‑62.
The RC states in connection with the above-mentioned judgments that an identical procedure should be applied to both expenses and income in the concerned context.
The above information indicates that the original obligation, in which a change occurs, cannot be separated from the settlement agreement. This means that tax deductibility of costs from a settlement agreement is conditioned upon the original obligation’s tax effectiveness.
This was also confirmed by conclusions of the Coordination Board dated 26 January 2005 that arrived at a conclusion in relation to conditions for tax deductibility of costs – a settlement agreement:
(a) The agreement was entered into between independent legal entities as part of their business activities;
(b) The agreement’s formation precedes future litigations and eliminates future costs of conducting those litigations;
(c) The cost related to the disputable obligation, which ceases to exist upon settlement, would be considered tax deductible; and
(d) Costs of the payment under the settlement agreement are not enumerated in Section 25 (1) of the ITA.
As the taxpayer’s only reasoning in considering tax effectiveness of costs was the fact that the agreement was to prevent additional costs from growing (pursuant to section (b) above), the RC fully agreed with the financial authorities’ conclusion and considers the action groundless. In the particular case, the condition that the obligation (provided in the settlement agreement) that ceases to exist would be considered tax deductible, was not met.
The SAC’s Statement
The Supreme Administrative Court took a stand for the RC. The SAC highlighted in relation to a definition in Section 24 (1) of the ITA that a cost’s tax deductibility is derived from the existence of an immediate relationship between income and expenses. Hence, a relation to past costs, based on which anticipated taxable income originates, is critical.
As a consequence, the SAC did not accept the taxpayer’s reasoning involving irrelevance of the future costs’ nature. In the SAC’s opinion, the connection with Section 24 (1) of the ITA cannot be supported only by the effort to provide for cutting of additional litigation costs that will result in an increase in future income. As a result, the fundamental condition of spending costs in order to generate, secure and maintain taxable income (i.e. those costs would only result in additional costs rather than income in the future) would not be met. The SAC considers such procedure circumvention of the law where the taxpayer is able to make a tax non-deductible obligation tax deductible based on a settlement agreement.
The SAC (agreeing with the RC) arrived at a conclusion that costs cannot be considered tax deductible in the case of compensation payments related to a settlement agreement pursuant to Section 24 (1) of the ITA. In the SAC’s view, relevant grounds in dealing with the taxpayer’s assets are missing and, as a result, those costs’ spending has no influence on results of operations (no real profit will be generated in the future). Hence, tax deductibility depends on tax effectiveness of the cost related to the disputable obligation.
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Stela Bartošová
bartosova@clarksonhyde.cz