Estimated items and provisions from the auditor’s point of view
In the following text, we present a summary of the basic rules for the creation and settlement of estimated items and provisions in accounts and draw attention to ills in practice with implications for tax proceedings.
One of the basic principles of Czech accounting is the accrual principle: accounting for expenses and revenues in the period to which they materially and temporally relate. An existing liability (or receivable) for which the purpose and period to which it relates are known, but the exact amount of which is not known, should be booked in the accounts as an estimated item. A typical example is the energy supply that the company consumed but for which it had not received the relevant invoices before the accounts were closed. However, this applies to all unbilled but yet received (or provided) performance.
Accounting for estimated items is regulated by Czech Accounting Standard No. 017 – Clearing Relations, and No. 019 – Expenses and Revenues. The creation of estimated items should be carried out in a targeted manner, for a specific performance, and as accurately as possible. At least as at the balance sheet date, the entity is required to assess the amount of created estimated items and their justification. The procedure for creating estimated items is determined by the entity itself in an internal regulation.
A prerequisite for the correct creation of estimated items is their subsequent evaluation. The evaluation should include (i) the comparison of the estimated item to the invoiced amount, and (ii) the justification of deviations. The method of accounting for subsequently received invoices should also correspond to this rule: the amounts invoiced should be booked against the estimated item (account 389) and only a difference, if any, should be booked to costs. Careful annual evaluation will significantly contribute to the elimination of errors due to omissions (non-charging) and/or insufficient creation (amount) of estimated items.
In practice, unfortunately, we still find that entities create an estimated item in a non-targeted manner, in one amount, without any link to a specific performance (they only make a “cushion” for invoices received later), and do not evaluate estimated items. The invoices are booked to costs of the following year, and the created estimated item is released to costs on a one-off basis. This approach results in the entity not having sufficient control over the completeness and adequacy of the creation of estimates.
Due to the fact that estimated items directly affect the economic result (profit/loss), non-transparency in the creation of estimated items may lead to the refusal of tax deductibility of the relevant costs by the Tax Authority.
Similar principles as described above for estimated items, i.e. targeted creation, the need for evaluation, also apply to provisions. We note that, in some countries, there is no distinction between an estimated item and a provision, and that everything actually has the nature of a provision. In the Czech Republic, there is one significant difference between an estimated item and a provision, namely that the creation of an estimated item is usually tax deductible, while the creation of a provision is usually non-deductible. The creation and release of accounting provisions is excluded from the tax base in the tax return. In practice, we often experience a situation where the Tax Authorities require proof that the release of the provision is related to its non-deductible creation in the past. If the (i) creation, (ii) utilisation or (iii) release due to the non-utilisation of provisions is not continuously monitored and evaluated, the subsequent demonstration of tax non-deductible creation in the past is often a problem. For this reason, the need for the careful annual inventory and evaluation of use applies to both provisions and estimated items.
Accounting provisions and transfer pricing
Lenka Pól Brožková
The role of accounting provisions is to reflect in the economic result (profit/loss) potential liabilities whose nature is known, whose occurrence is probable or certain, but whose amount or time of occurrence is not known. The provision for potential liabilities is booked by the company to which these liabilities will be charged.
From the point of view of transfer pricing, it is necessary to correctly understand the position of individual related entities in the group’s supply chain when creating provisions. Otherwise, provisions may be charged to an entity which, given its position, should not bear the costs associated with certain types of liabilities. An example is a contractual manufacturer which, according to the instructions of its parent company and on the basis of its parent company’s technological procedures, manufactures a certain product. This product is supplied by it to the parent company, which sells it to end customers. The parent company negotiates the terms of sale with customers, including e.g. (extended) warranty terms and conditions.
In accordance with the transfer pricing rules, the financial impacts of risks may be allocated to those group entities that have created, or decided on, the situations that give rise to such risks. These are risks that are associated with the functions/roles performed by these entities that have control over them. In our example, therefore, it should be the parent company that should book provisions for warranty claims resulting from technological procedures that it has created itself.
In practice, we often encounter a situation where these types of provisions are created by contractual manufacturers, even though these liabilities go beyond their responsibility for production. According to Czech law, the examples of accounting provisions discussed here represent the cost by which the company’s tax base cannot be reduced. Thus, it might seem that the discussion over the proper allocation of their creation among related entities is a purely academic discussion. However, assessing the profitability of entities or transactions in the context of transfer pricing rules primarily deals with accounting revenues and costs; their tax regime may not be decisive for the Tax Authority’s conclusion on the compliance or non-compliance of intragroup transactions with the arm’s length principle.
In recent months, we often encounter tax audits of foreign parent companies, which result in requests for (retroactive) adjustment of the tax base of their Czech subsidiary, claiming that the subsidiary’s profitability was too high and did not match its functional role. One can imagine a situation where an experienced foreign Tax Authority will focus not only on usual operating costs and revenues, but also on the creation of provisions by the subsidiary – contractual manufacturer that affected (reduced) its operating profit in the financial statements and will examine their validity. If the Tax Authority concludes that certain provisions should not have been created by the contractual manufacturer, it will increase the operating profit of such manufacturer. If the adjusted operating profit reaches a value exceeding the market range, the Tax Authority will require an additional transfer of the corresponding profit to the parent company. This can subsequently trigger an avalanche of additional tax returns and inspections on the part of the Czech contractual manufacturer, or even international arbitration proceedings.
When deciding on the creation of accounting provisions, it is recommended to consider them in a broader context and not to neglect the principles given by the transfer pricing rules.
War in Ukraine and tax measures
In connection with the outbreak of the war conflict in Ukraine, a huge wave of solidarity broke out in the Czech Republic, which the Government and the Ministry of Finance decided to support in the form of extraordinary tax reliefs. In the following text, we summarise the taxation rules applicable to the provision of donations to help the State of Ukraine or Ukrainian refugees, from the perspective of both the donor and the recipient of such aid. We also mention some other information from the tax area related to the war in Ukraine. The article is based on the current wording of the Income Taxes Act and also on the proposed law on tax measures in connection with the armed conflict in the territory of Ukraine caused by the invasion of Russian troops (hereinafter the “Measure”), which is currently being discussed by the Chamber of Deputies of the Czech Republic and is expected to be approved without major changes and complications. The new rules should apply to all donations made in 2022, even before the effective date of the Measure.
Taxation from the point of view of a donor
As concerns the year 2022, the Measure expands the possibilities for the use of donations as items deductible from the tax base:
- the possibility to use donations made to the State of Ukraine (e.g. through embassies), Ukrainian municipalities, companies or organisations as an item reducing the tax base;
- the possibility to use donations provided in support of the defence efforts of the State of Ukraine, i.e. for the purchase of ammunition, weapons, military equipment, etc., as an item reducing the tax base;
- the possibility for tax residents of Ukraine to deduct donations if they prove that their income from the Czech Republic accounts for at least 90% of their taxable income;
- the extension of the temporary increase in the limit for the maximum deduction of donations to 30% of the tax base by the period of one year (i.e., for natural persons for 2022, for legal entities for the tax period ended 28 February 2023);
- the possibility to claim the costs of non-monetary donations provided in 2022 to help Ukraine and its citizens in connection with the war as tax deductible expenses, if the donation is provided for specified purposes (humanitarian, charitable, medical, defence of Ukraine, etc.), whereas the recipient is not limited in any way (the recipient can also be a natural person). If the taxpayer decides to apply these non-monetary donations as tax deductible expenses, it is no longer possible to use them as an item reducing the tax base.
Taxation from the point of view of the recipient of a donation
Donations received for humanitarian or charitable purposes and/or from a public collection are exempt from tax on the part of the donation recipient who is a natural person (including donations given by an employer to an employee to help them in a difficult life situation related to the conflict in Ukraine).
As concerns recipients – legal entities, the tax exemption applies, inter alia, to a donation to a public collection or for humanitarian or charitable purposes. This provision may apply, for example, to collections within a company, which are not a public collection, whereas the funds or items collected within such a collection are further used to provide humanitarian or charitable assistance to Ukrainian refugees.
Donations that the recipient will receive in 2022 in support of the defence efforts of the State of Ukraine (e.g. weapons, ammunition, military equipment) will also be tax exempt, regardless of the recipient’s status (i.e. natural person or legal entity).
According to the draft Measure, an employee’s income from accommodation in 2022 provided by the employer to such employee and their family member will also be now exempt, provided that such family member resides in Ukraine but left Ukraine as a result of the war. According to this provision, it is not possible to exempt income from accommodation received before 24 February 2022, or more precisely before the arrival of the employee’s family member(s).
Tax on dependent activities of Ukrainian employees
When calculating income tax on dependent activity (employment), it is possible to apply tax credits and tax benefits for children even to the employment of citizens of Ukraine, provided the conditions stipulated by law are met:
- In order to apply the basic personal tax credit and the student tax credit within the calculation of monthly tax advances, the employee must sign the declaration by a taxpayer liable to personal income tax on dependent activity within 30 days of starting work.
- The dependent spouse credit, disability tax credit or tax benefit for children may only be applied if the citizen of Ukraine is demonstrably a tax resident of the Czech Republic, or EU (if applicable). If he/she is a tax resident of the EU, the condition for the application of these credits is the fact that his/her taxable income from the Czech Republic accounted for at least 90% of all his/her worldwide income.
Road tax – cancellation of advances
As a result of the secondary effects caused by the emergency situation in Ukraine, the Government proceeded to a mass waiver of road tax advances. Advances payable on 19 April 2022, 15 July 2022, 17 October 2022 and 15 December 2022 are waived for taxpayers.
The waiver of advances does not abolish the road tax for 2022. However, an amendment to the Road Tax Act is currently under preparation, which should lead to a significant reduction of the group of persons who will be obliged to pay the road tax. The amendment should also be effective retroactively for the 2022 tax period, and the abolition of the road tax should apply to passenger cars and vans with the gross weight of up to 12 tonnes.
Waiver of default interest and interest on a deferred amount
Value added taxpayers and persons identified for value added tax that generate majority of income from the transport business have been granted a waiver of default interest and interest on a deferred amount. The condition for such waiver is the payment of the relevant value added tax on or before 31 October 2022. The waiver concerns default interest and interest on a deferred amount for the tax period February to August 2022, or the 1st and 2nd quarters of the year 2022. A payer who wants to use the waiver shall notify his/her tax administrator, when filing an ordinary or additional VAT return, that he/she operates in the field of transport.
Reverse financial lease from the VAT point of view
The interpretative change takes place in connection with the decision-making practice of the Court of Justice of the European Union on so-called reverse financial leasing. The application of the conclusions in case C-201/18 Mydibel was confirmed by the Coordinating Committee of the Chamber of Tax Advisers of the Czech Republic held in March and the General Financial Directorate, stating that the existing administrative practice, according to which reverse lease from the point of view of VAT has been considered as two separate transactions, i.e. delivery of the item by the future lessee to the leasing company and its subsequent delivery in the form of a financial lease to the lessee, on condition of a consistent approach by both the leasing company and the lessee. However, as concerns contracts concluded after the beginning of April 2022, such a procedure will no longer be tolerated by the financial administration, and the reverse financial lease will be deemed to be only the provision of a financial activity by the leasing company to the lessee.
New obligation of employers
Starting from 1 April 2022, the scope of data that the employer is obliged to notify to the relevant district social security administration upon termination of the employee ’s employment is changing as a result of the amendment to the Employment Act. As a rule, the employer informs of the termination of the employee’s employment within 8 calendar days. As part of this notification, the employer is now obliged to provide the following information:
- type of employment;
- duration of employment;
- pension insurance period;
- the amount of the employee’s average or probable monthly net earnings determined in accordance with the relevant legislation;
- the amount of the employee’s entitlement to a redundancy pay, lump-sum compensation, severance package (“golden handshake”), including the information whether it has been paid;
- the manner and reason of the termination of employment.
The notification is to be made using the pertinent form. Please note that if the notification is not made in time, the employer will commit an offense for which a fine of up to CZK 20,000 can be imposed. If the notification lacks the above information, although the notification would otherwise be made timely, there is a risk of a fine of up to CZK 100,000. For the purposes of the timely fulfilment of this new obligation, we recommend keeping the above data in the available records.
The ultimate beneficial owner registration is still relevant
We would like to remind the legal entities’ ongoing obligation to register their ultimate beneficial owners (“UBO”) and to continuously update the information entered in the UBO register.
The ultimate beneficial owner is a person with ultimate influence, i.e. any natural person who can exercise a decisive influence in a legal entity without being instructed by any other person (especially if such person holds a direct or indirect share of voting rights higher than 25%), or the ultimate beneficiary, i.e. any person that may ultimately receive more than 25% of the company’s total property benefit (e.g. profit or liquidation balance) and does not pass on that benefit. If such UBO cannot be identified, then the so-called substitute beneficial owner can be registered.
Even though your UBO has already been registered, we encourage you to check on a continuous basis that the information you have entered, including the amount of your registered UBO’s share, is still current. If any data changes, it is necessary to update the entry immediately. At the same time, it is not possible to rely on the automatic transcription of data from the Commercial Register. Such transcription occurs only for legal entities whose beneficial owners were automatically transcribed after 1 June 2021, without the given legal entity having previously registered its UBO. As concerns other legal entities, there is no automatic transcription of changes, but it is possible to request it from the competent court. Even in this case, it is advisable to check the automatic transcription.
Please keep in mind that there is a risk of a fine of up to CZK 500,000 for a breach of obligations concerning the UBO registration, which may be imposed on both for the registering entity, if it fails to register, and the UBO, if he/she fails to provide the registering entity with the cooperation required for registration. If the data on the UBO is missing, a ban on the payment of a share of profit or other own resources or a ban on the exercise of voting rights at a general meeting may be imposed on business corporations. As a result of these restrictions, the general meeting of a legal entity, which does not have its UBO registered, cannot be held at all. In practice, we also face negative reactions from banking institutions to inconsistencies in the registration or the absence of registration of the UBO. As part of the fulfilment of their obligations, banks may suspend the provision of services to their clients in whole or in part.
Advance on profit sharing – decision of the Supreme Court
We would like to introduce a new decision of the Supreme Court, which brought very important information regarding the payment of advances on profit sharing. The said judgment of the Supreme Court of 9 March 2022, issued under File No. 27 Cdo 3330/2020 (hereinafter referred to as the “Decision”), has key practical implications for the operation of business corporations that are considering the payment of advances on shares of profit.
Summary of the facts
The plaintiff (a joint-stock company) demanded payment of an amount exceeding CZK 40 million from the defendant (the plaintiff’s then current sole shareholder) due to the alleged unpaid consideration for the assignment of a receivable. The plaintiff entered into an agreement with the defendant, on the assignment of the plaintiff’s receivable from a specific entity. The defendant undertook to pay approximately CZK 40 million for this receivable. However, the defendant adopted a decision when exercising the powers of the general meeting of the plaintiff, and approved the plaintiff ’s interim financial statements and, based on the proposal by the plaintiff’s board of directors, decided on the payment of an advance on profit sharing for that period in the amount of approximately CZK 40 million, and further decided to set off the advance on profit sharing against the payment due for the assignment of the receivable. It is important to note that the payment of the advance on profit sharing did not cause the plaintiff to become insolvent or over-indebted.
Legal questions arising from and practical impacts of the Decision
Does the decision of the competent body of a joint-stock company on the payment of an advance on a share of profit give rise to a shareholder’s monetary receivable from the company for its payment?
The Supreme Court answered the question in the affirmative. Once the provision of the advance has been agreed upon, the obligated party has the duty to provide the advance and the entitled party has a corresponding receivable.
Does the phrase “sufficient funds” used in § 40 Section 2 of the Business Corporations Act, in the wording effective until 31 December 2020, mean only own resources, or also assets, i.e. cash?
The Supreme Court stated that sufficient resources mean own resources. “Although the Czech language version of the marked articles uses the term “resources”, it is obvious, given the context of the rule in question (which falls within the regulation of the distribution of profits as one of the own resources) that this term must be understood as “resources.” The purpose is to ensure that advances paid do not exceed the amount that could be distributed from these resources at the time the competent body decides on granting the advance. The amount of these resources (shown in the current interim financial statements) thus represents the limit for any advances.
Is it possible for the company sole shareholder to decide on the payment of the profit share instead of the board of directors? Does such sole shareholder’s decision give rise to the shareholder’s receivable from the company for the payment of an advance on the share of profits vis-à-vis the company?
The law does not explicitly entrust the decision on the provision (payment) of an advance on a share of profit to any of the company’s bodies; it thus belongs to the company’s board of directors (the administrative board in the case of a monistic system). The decisions that the company will provide (pay) advances on a share of profit (as well as the decision on profit distribution) do not fall within the company’s business management. Accordingly, they are not subject to a ban on issuing instructions concerning business management.
The articles of association (statutes) may entrust these powers to the general meeting. However, even if the statutes entrust these powers to the supreme body of the company, the board of directors (the administrative board) still has the duty to assess whether the decision to provide (pay) the advance is in accordance with the law and whether it can be implemented.
If the general meeting of the company decides to provide (pay) an advance on the share of profit, even though the company’s statutes do not entrust it with these powers, it is necessary to assess in each case whether the decision is not only the general meeting’s instruction requesting the board of directors (administrative board) to decide on the provision (payment) of the advance, or whether it is a decision on a matter falling outside the scope of the powers of the general meeting, or whether such decision represents a so-called one-off breakthrough into the statutes.