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In audits, how much proof is too much?Proving the actual rovision of services from foreign related parties
4 Mar 2013 František Cséfalvay Finances and Advisory
THE SLOVAK tax authorities have started to become more interested in taxpayers’ transactions with related parties. Practical experience from several tax audits shows that the tax authorities are focusing not only on the transfer pricing aspect of the transactions, but also on proving that intra-group services have in fact been provided by a foreign related party.
In the current globalised economy, groups of companies commonly centralise certain activities such as management, marketing, finance and accounting on a regional or a global level. As a result, intra-group service charges appear in the books of many companies.
The current trend from the side of the tax authorities is not to adjust the amount of the service fee on the basis of transfer pricing principles, but to reject the tax deductibility of the entire costs for the provided services. When doing so, the tax authorities are focusing on minor details in the supporting documentation and using any discrepancy as a reason to decline the tax deductibility of the costs.
Taxpayers often assume that contractual documentation covering the provision of services as well as invoices from their provider should be sufficient to satisfy the tax authorities that the services have been provided. However, as recent practice shows, the opposite is the case. The tax authorities go much further and, in addition to the contract with the related company and the invoices, also require the submission of “complete documentation” to prove that the respective services were actually provided.
However, the tax authorities have not presented any definition or indication of what constitutes “complete documentation”. Presentations from workshops, minutes from meetings, studies or analyses prepared by employees of the foreign service provider, management agreements or assignment letters are often not considered sufficient and the tax authorities still require more.
Are there any limitations on what the taxpayer is obliged to present to the tax authorities to fulfil the burden of proof?
In our opinion, there certainly should be. The tax authority should, in accordance with the basic principles of tax administration, uphold the rights and legal interests of taxpayers and use the most suitable means which allow for the correct levying and collection of tax. In our opinion, continual requests for additional documentation without explaining why the previously submitted documents are insufficient exceed the constitutional principle of proportionality required for the procedures of public bodies.
There are some practical implications resulting from these recent tax audits. Firstly, it is necessary to realise that while proving the provision of these types of services is not difficult at the time when they are received, it becomes more complicated – and perhaps impossible – after a few years.
When reviewing transactions between related parties, the tax authorities may open a tax audit for the past 10 years. Gathering the documents which would satisfy the tax authorities after such a long time is, in some cases, a tough challenge.
The parent company or the group structure may have changed, the responsible employees may not work for the company any more, employees may not have archived their mailboxes, new software databases may have been introduced, etc.
Reasons may abound. Collecting the documents after several years is a time-consuming and frustrating task – even if they are eventually found. A more practical approach seems to be to collect and archive supporting documentation continuously. Otherwise, the taxpayer should be prepared for a long and exhausting tax audit.
During recent tax audits, the tax authorities have used Article 17 (5) to challenge the tax deductibility of the costs of services purchased from foreign related parties. In the case of similar services provided by a Slovak entity to another Slovak entity, only the fulfilment of the general tax deductibility test according to Article 2 i) and Article 21 (1) of the Income Tax Act is required. For services purchased from foreign related parties, the last sentence of Article 17 (5) stipulates additional (stricter) conditions for tax deductibility.
The Slovak tax authorities do not seem to be concerned by the potential conflict of the Slovak Income Tax Act with the freedom to provide services within the EU. In 2012, the Court of Justice of the EU decided in the SIAT case (no. C-318/10) that Belgian tax rules which limited the deductibility of fees paid to certain non-residents had violated the EU freedom to provide services (old Article 49 of the European Community Treaty). Although the Belgian and Slovak rules are different, one of the key points in the SIAT case was the additional burden of proof for certain payments made to non-resident companies (compared to domestic transactions). Based on the arguments presented in the SIAT case, it could be argued that the Slovak legislation may also be restricting the freedom to provide services within the EU.
It should be noted that the EC Treaty allows restriction of the freedom to provide services if there is an overriding reason why this restriction is in the public interest, so long as it pursues a legitimate objective and is not disproportionate in relation to what is necessary to reach that objective. The question remains, therefore, whether the Slovak tax authorities are pursuing a legitimate objective in the public interest and whether the means are appropriate to that objective.
František Cséfalvay is a tax manager at Ernst & Young in Slovakia
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