Historically, foreign investors have often used intermediate holding companies in other countries when investing in the Czech Republic. Foreign holding companies have also been used by Czech resident investors. These holding structures used to be driven by Czech income tax applicable to dividends and capital gains on the sale of shares. However, this is no longer the case.
Holding Companies in the Czech Republic
Presently, the Czech Republic benefits from quite a broad participation exemption regime applicable to both dividends and capital gains. Specifically, the exemption applies with respect to participation in EU-based companies if at least 10 percent of shares are held for at least 12 months (subject to other conditions).
In the case of participation in companies residing outside the EU, exemptions can also be claimed under the same rules if (i) the Czech Republic has entered into a tax treaty with the country where the company is considered to be a tax resident, and (ii) the company is subject to a corporate income tax rate of at least 12 percent.
The above conditions also apply to nonresident company tax exmptions (including taxation by means of withholding) in the Czech Republic.
The Czech Republic has also implemented the EU Interest and Royalty Directive where interest and royalty payments from the Czech Republic abroad are exempt from Czech withholding taxes in the case of at least 25 percent direct ownership existing for at least 24 months (subject to other conditions).
The above shows that the Czech Republic is trying to stop the ongoing outflow of Czech-based investment abroad for the purposes of establishing a holding company. Although the traditional holding company locations (e.g., the Netherlands or Luxembourg), may be a better choice in certain cases (to a large extent in the non-tax area, as also highlighted below), the principal tax features of a holding company are competitive in the Czech Republic.
Why It Is Still Imporant to Consider Other Holding Company Jurisdictions
As mentioned above, the positive amendments to the Czech tax regime over the years increasingly lead to the question concerning why investors would continue to make use of holding companies in traditional holding regimes like the Netherlands, Luxembourg or Cyprus. Although differences are not substantial, other countries sometimes offer more beneficial regimes in terms of ownership thresholds (10 percent in the Czech system), minimum holding periods (12 months in the Czech system) or subject-to-tax tests (12 percent limit for non-EU participation in the Czech system).
Withholding Tax Planning
Another important point is the application of the EU Interest and Royalty Directive. As noted above, this Directive in the Czech Republic, like in many other countries, is implemented in such way that indirect ownership of an entity does not provide protection against source taxes on interest and royalties.
In such cases, application of double tax treaties continues to be an important tax planning tool. The table below provides for the withholding tax rates on interest and royalties in the various treaties the Czech Republic concluded with other traditionally used tax planning jurisdictions.
Click here to view the table.
An intermediate holding company may also play an important role if dividends need to be distributed outside the EU and do not qualify for exemption from the Czech dividend withholding tax.
Naturally, selection of a holding company jurisdiction may also be influenced by a variety of non-tax factors, including:
- Stability of political environment and legal system
- Quality of local service providers
- Access to bilateral investment treaties (BITs)
- Access to a reputable stock exchange (if listing is considered)
How to Invest in the Czech Republic
The most typical acquisition structure that has been used in the past is a legal merger of the acquisition company with the target, as follows:
- A Czech special-purpose acquisition vehicle (“HoldCo”) draws an acquisition loan from a bank and/or a group company
- HoldCo enters into a share-purchase agreement whereby it purchases the shares in the target (“target”)
- HoldCo and target merge together as a result of which (i) the acquisition loan and (ii) the income-generating business appear on a single balance sheet.
The merger can generally be done as up-stream (HoldCo being the surviving entity, most commonly used), down-stream (Target being the surviving entity) or a new entity can be created while both HoldCo and target cease to exist.
The interest accrued on the acquisition loan can generally be treated as tax deductible as of the decisive date of the merger (the date as of which the merger is deemed to be effective for accounting and income tax purposes). Although this conclusion is not directly derived from the law, it has been supported by the official Decree of the Czech Ministry of Finance and has also been successfully tested in disputes with tax authorities.
In general, it is critical that the Target’s book value of assets is increased to its fair market value (this is usually the case if upstream merger is selected) which increases the equity of the new company after the merger. The reason for this is that the merger accounting rules require that shares in the Target are excluded from the opening balance sheet against equity which may result in a significant decrease in equity.
Low (or even negative) equity after the merger may have an adverse impact on deductibility of interest arising from shareholder loans due to applicable thin-capitalization limitations (4:1 debt-to-equity ratio).
Another possible way to achieve deductibility of interest accruing on the acquisition loan against the Target’s is to change the Target’s legal form into a partnership (general or limited, HoldCo being the general partner). As a result, the share in the Target’s profit that is attributable to HoldCo (general partner) would not be subject to tax at the Target (partnership) level, but rather at the level of HoldCo. Consequently, HoldCo could deduct the acquisition loan interest against such profit. However, there are corporate limitations connected with this structure, which is why it is not widely used (unlimited liability for partnership debts, complicated corporate procedure upon exit from partnerships).
Czech Fund Regime
Foreign investors may also consider taking advantage of the current tax regime applicable to investment funds in the Czech Republic.
Czech investment funds are generally subject to corporate income tax at a special reduced rate of 5 percent.
The investment funds can either have a legal form of a joint stock company (a.s.) or can be established as mutual funds without legal personality. The first option involves applying benefits arising from the EU Parent-Subsidiary Directive, while the latter option does not (although benefits can be claimed at least from some double-taxation treaties on the basis that it is effectively subject to income tax).
Leaving aside investment funds established for retail investment (funds in line with the UCITS Directives, i.e., “standard funds, ” or other “special funds” collecting investments from public), the funds can also be established as funds for qualified investors only. Such option is subject to significantly lighter regulation by the Czech National Bank compared to retail funds, and this option enables the fund tax regime to be applied to investments of a preselected group of investors. A fund of qualified investors may be set up by at least two investors (maximum 100), theoretically also from the same group. In any case, the regulator (the Czech National Bank) must issue a license to any investment fund prior to its establishment andmay, as part of the licensing process, impose further conditions and restrictions.
The 5 percent tax rate is not applicable to any subsidiaries of the fund. As a result, the fund regime does not bring any tax advantage to holding structures whereby its investments (e.g., real estate) are shielded in special-purpose vehicles (except for tax rate arbitrage on any shareholder debt financing provided by the fund to the subsidiaries). In order for the reduced tax rate to result in any benefits, the profit-generating assets must be held by the fund directly.
The Czech government is currently proposing that investment funds are subject to 0 percent tax in the future (as opposed to the currently applicable 5 percent), while any distributions by the fund would be fully taxable by the investors. If such proposal is approved, it may increase the effective tax burden from the investors’ perspective in the case of certain qualified investor funds. Currently, the investors may (subject to conditions) benefit from the EU Parent-Subsidiary Directive exemptions, i.e., distribution of the fund’s profits (after paying the 5 percent tax at the fund level) may be fully exempt from taxation. If the amendment is approved, the 5 percent tax burden is abolished but investors would pay 15 percent to 19 percent tax from any distributions. The amendment, if approved at all, should be effective from 2013.
As a comparison to the above, establishing a branch of an EU-based fund in the Czech Republic may prove to be a better option from a tax perspective, rather than establishing a Czech fund after the amendment becomes effective: Czech branches (permanent establishments) of EU funds may be subject to 0 percent tax in the Czech Republic (if the amendment is approved, subject to conditions) and distributions by the Czech branch to the headquarters of the fund would not be subject to any Czech withholding tax (on the basis that it is a payment between two organizational units of the same legal entity).