Loans between related parties from the perspective of interest.
Loans are a common financing tool. However, from a tax perspective, they bring a number of complications, especially when it comes to loans between related parties pursuant to Section 23(7) of Act No. 586/1992 Coll. on Income Taxes (the “Income Tax Act”).
When deciding whether or not to charge interest on a loan, it is necessary to take into account the tax consequences, which vary depending on who is the lender (creditor) and who is the borrower (debtor) and on the relationship between them. An interest-free loan may not always be beneficial from an income tax perspective.
Loans within a group of companies
When a loan is provided between related parties, typically between a parent company and a subsidiary or between sister companies, the main motivation for providing the money is often the unfavourable financial situation of the borrower. Where this is the case, it may appear an attractive option to provide an interest-free loan so as not to place any additional burden on the company.
If a shareholder provides an interest-free loan to a company, the borrower (subsidiary) does not receive any financial benefit in the form of savings on the usual interest that it would otherwise have to pay. This is because the shareholder will receive consideration in the form of a higher dividend. This approach is also confirmed by one of the conclusions of Coordination Committee 452/22.04.15 – Certain cases of tax implications of gratuitous income.
Of course, there is also the possibility of charging interest on the funds that pass hands between the parent company (creditor) and the subsidiary as the debtor. However, if the agreed interest rate is lower than the fair market rate (see below), then the exception under Section 23(7) of the Income Tax Act applies to this situation and the tax base will not be modified on either side.
If the opposite situation were to arise, i.e., the parent company is the borrower and the subsidiary is the lender, then the above-mentioned exception would not apply (unless the subsidiary were a non-tax resident). If the subsidiary is a tax resident of the Czech Republic and is not a member of a business corporation (nor is it a natural person), then, in accordance with Section 23(7) of the Income Tax Act, the arm’s-length principle must be observed for such a loan, i.e. the interest must be set in accordance with market conditions – the so-called customary interest (or fair market interest; see below).
In this case, the interest-free provision of money to the borrower represents a financial benefit in the amount of the savings on interest that would otherwise be customary on the market. This type of income is generally exempt from corporate income tax up to a limit of CZK 100,000 from the same person and in the same financial year (Section 19b(1)(d) of the Income Tax Act). If the borrower who has received this benefit uses the interest-free loan for tax-deductible purposes (e.g. to purchase supplies or pay wages), they may also reduce their tax base in accordance with Section 23(3)(c)(8) of the Income Tax Act.
A financial benefit therefore also arises in the case of loans between sister companies.
Fair market interest
The customary interest rate is considered to be the interest rate that would be agreed between unrelated parties in normal business relations (Section 23(7) of the Income Tax Act). GFŘ D-59 defines it as follows: “Customary interest means the interest rate that is usually applied by local financial institutions at the time at which the loan is agreed when providing similar products (loans) to the public and under similar terms of interest.”
Interest must therefore be set in line with the conditions customary between independent persons, although no “database of customary interest rates” exists.
The following can be used as a basis:
• bank rates published by the CNB in various interest rate statistics on its website,
• offers from commercial banks for comparable volumes and maturities.
Practical recommendations
• Record the interest calculation procedure, including the supporting documents used, in internal documentation (for tax inspection or auditing purposes).
• For longer loans, update the interest rate regularly (e.g. once a year).
• Formalise each loan in a contract – specifying the amount, maturity, interest rate and purpose.
• For related parties, prepare transfer pricing documentation, including a description of the method used to determine interest.
• Exercise due diligence – especially when approving loans to executives and partners.
• Record and regularly check maturities, including accounting for interest and any exchange rate differences.
• Create internal guidelines on the provision of loans – define the group of eligible persons, limits and interest rates.
Source:
Act No. 586/1992 Coll. on Income Taxes
Coordination Committee 452/22.04.15 – Certain cases of tax implications of gratuitous income
Instruction No. GFŘ – D–59 on the uniform procedure for applying certain provisions of Act No. 586/1992 Coll. on Income Taxes, as amended