Changes in the Slovak Income Tax Act valid from 1.1.2023 and 1.1.2024

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The amendment of the ITA (“amendment”) also implements the Article 4 of the Anti-Tax Avoidance Directive (ATAD) Council Directive (EU) 2016/1164 of 12 July 2016 laying down the limitation of interest rules aimed to fight against tax avoidance practices.

An overview of the most important regulatory changes in the area of transfer pricing from 2023, and the interest limitation rules effective from 2024 onwards, are summarized below:

• Changes in the transfer pricing area
  • Redefining the economic relation and clarifying the definition of a foreign related party
  • Dependent activity not considered a controlled transaction
  • Definition of a material controlled transaction
  • Benefit test
  • Determination of the tax base of a permanent establishment
  • The entitlement for a corresponding adjustment for permanent establishments
  • OECD Guidelines as “binding”
  • Use of the “median" in transfer pricing tax audits
  • Transfer pricing document in a foreign language
  • Changes to the bilateral and multilateral advance pricing arrangements (APA)
• New interest limitation rule (Thin Capitalization)
  • Principles of application of the new interest limitation rule

Changes in the transfer pricing area

The most significant changes in the ITA, related to transfer pricing, are summarised in the following paragraphs.

Redefining the economic relation and clarifying the definition of a foreign related party

The definition of close persons in determining their economic relation was amended in Article 2 point o) of the ITA. According to the new definition, if the sum of shares of close persons (e.g., two spouses) in a company exceeds 25%, and one of the spouses also owns another company with more than a 25% shareholding, the companies are considered economically related.

At the same time the original definition of a foreign related party was replaced by an extended definition of economic relation which will now include relations with permanent establishments.

Dependent activity not considered a controlled transaction

A dependent activity from which the income falls under Article 5 of the ITA will no longer be considered as a controlled transaction. This applies regardless of whether it is performed by an employee of a related party, shareholder, or a managing director.

Definition of a material controlled transaction

To reduce the administrative burden of taxpayers, a materiality threshold for controlled transactions is introduced. Only the taxable income or tax deductible expense that exceeds EUR 10,000 for any of the related parties involved in the transaction, or EUR 50,000 for loans (principal in the respective tax period), will be considered a material controlled transaction or group of material-controlled transactions which is/are subject to transfer pricing.   

If a transaction/group of transactions does not exceed these thresholds, it will not be subject to the arm's length principle (transfer pricing rules).

However, the evaluation of the materiality threshold will not be straightforward. It will be necessary to evaluate whether the transaction, or a group of transactions, exceeds the taxable income or tax deductible expense threshold not only from the perspective of the taxpayer, but also from the perspective of the related counterparty (e.g., in case of purchase of assets, it will be necessary to evaluate not only the materiality of the tax deductible expense from the buyer's perspective, but also the materiality of the seller's taxable income from the sale of the asset). If the materiality is exceeded for any of the party, the transaction will be significant for both parties. A one-sided assessment of the materiality threshold could thus lead to an incorrect assessment (e.g., sale of property).

At the same time, it is necessary to apply “grouping” of transactions of the same type. It means, transactions that would be considered immaterial in isolation could exceed the materiality threshold if they classify for grouping as closely related controlled transaction. This may lead to uncertainty in the assessment of materiality of the transactions.

Although the purpose of introducing the materiality threshold is to reduce the administrative burden related to small transactions, it could impose an excessive administrative burden on larger taxpayers when it comes to preparing transfer pricing documentation compared to the past.

Therefore, the Ministry of Finance of the Slovak Republic (“MF SR") promised to further align the obligatory scope of transfer pricing documentation with the new materiality threshold in the planned update of the Guidance related to content of the 2023-onwards transfer pricing documentations.

Benefit test

The amended ITA aligns the definition of the so-called benefit test with the OECD Guidelines. The benefit test is one of the conditions for tax deductibility of intra-group service costs).

Determination of the tax base of a permanent establishment

The amended version of the ITA seeks to ensure consistency between the Slovak legislation and the OECD Guidelines related to determination of the tax base of a permanent establishment. The aim is to avoid inconsistencies and differences which, according to the previous wording, could lead to double taxation.

As part of the amendment, the definition of the tax base was further clarified ensuring the use of uniform terms and aligning the determination of the tax base of the permanent establishment with the arm’s length principle. The view on attribution of expenses incurred by the head office for the purpose of the permanent establishments without applying ani profit mark-ups still remains.

It also explicitly mentions the obligation to document the method of determination of the tax base. The documentation obligation itself is not new, but it was specifically adjusted to the particularities of the attribution of profits to permanent establishments.

The entitlement for a corresponding adjustment for permanent establishments

The entitlement for a corresponding adjustment of the tax base of a Slovak permanent establishment was added into the ITA in cases when the Slovak permanent establishment entered into a mutual transaction with a Slovak tax resident which has undergone a primary transfer pricing adjustment. The Slovak permanent establishment could then perform a corresponding adjustment (decrease) of the tax base. 

OECD Guidelines as “binding”

The amended ITA makes direct reference to the OECD Transfer Pricing Guidelines, which are generally used as a guidance for interpreting transfer pricing issues and the preparation of transfer pricing documentation.

By adding a direct reference to the OECD Guidelines into the ITA, the MF SR has tried to increase the legal certainty in application of the OECD Guidelines in practice. However, we must point out, that neither the reference to the OECD Guidelines nor its translation (not planned at this moment) would make them part of the law in Slovakia nor a binding rule which has to be followed by the Slovak courts in tax disputes.

Use of the “median" in transfer pricing tax audits

We consider the most significant change in the amendment to be the use of the middle value (median) in tax audits where inconsistency of the prices applied by the taxpayer and the arm's length principle is identified by the tax authorities.

In practice, the above would result in adjusting the transfer prices which are identified in a tax audit as not compliant with the arm's length principle (i.e., prices are outside of the arm’s length range of a comparability study) to a median value of the arm’s length range of a comparability study. In such a case, the tax authority will assess additional tax on the difference between the actual transfer price of the taxpayer and the median value of the comparability study.

After numerous objections from the expert community the ITA allows that the taxpayer demonstrates and proves that a more appropriate value than the median exists. However, in practice is it rather difficult to objectively justify and prove a different point in the arm’s length range so it may be expected that the above disputes would result in the use of a median anyway.

It should be noted that this rule is not applied consistently in all countries and differs in practice. Some countries apply a less strict approach by adjusting the prices to the closest value from the inter-quartile range of the comparability analysis.

The different international approaches to the same transaction ultimately can and will result in the emergence of international disputes in situations where the tax authorities of the states involved in the transaction will not agree to adjust the prices to the median, but to a different value. Double taxation will thus have to be solved through a lengthy Mutual Agreement Procedures (MAP).

Transfer pricing document in a foreign language

The amendment eliminates the obligation to ask for a permission to file the transfer pricing documentation in a foreign language. From now on it will be possible to submit the documentation in a foreign language and the translation into the official language will have to be prepared only in case of a request from the tax authority. After the receipt of such request, the taxpayer will have 15 days to translate the documentation into the official language. This change reduces the administrative burden of having to ask for filing in different language and provides additional time for a potential translation.

Changes to the bilateral and multilateral advance pricing arrangements (APA)

The amendment introduces the possibility of issuing a bilateral and multilateral advance pricing arrangement (APA) for more than five tax periods.

At the same time, it will be possible to apply the   bilateral and multilateral APAs to a tax period that preceded the submission of the application, if the competent tax authorities agreed so (i.e., so-called "rollback").

New interest limitation rule (Thin Capitalization)

Another important change is the mandatory transposition of the Anti-Tax Avoidance Directive (ATAD) into the ITA. It aims to limit the use of excessive debt financing that artificially reduces the income tax base.

The thin capitalization rules are already applied in the Slovak legislation under the Article 21a of the ITA, but these were applied exclusively to interest paid on loans between related parties.

The new (additional) rules will apply to legal entities – Slovak tax residents as well as tax non-residents with a permanent establishment in the Slovak Republic - that fulfil the criteria outlined below. There are exceptions for financial institutions and debtors (legal entities) who only have related parties which are natural persons.

These new interest limitation rules under Article 17k of the ITA supersede the current rules under Article 21a of the ITA which remain in force. As a result, if the taxpayer does not fall under the new rules (due to not meeting the conditions) it will be still obliged to apply the thin capitalization rule under Article 21a of the ITA.

Principles of application of the new interest limitation rule

The limitation applies to taxpayers for whom the amount of net borrowing costs, i.e., the difference between interest expense and income in the relevant tax period, exceeds EUR 3,000,000 (the so-called 'de minimis' rule).

For the purposes of this amendment, the interest expenses and/or income are considered to be the costs and/or income related to all forms of debt financing (e.g., including interest from loans, bonds, financial lease, derivatives, exchange rate differences, other fees in connection with loans, etc.) and in relation to all creditors, not only to the related parties of the taxpayer.

In contrast to Article 21a of the ITA, under the new rules the net borrowing costs also include interest expenses which are part of the acquisition price of the asset (so-called capitalised interest) included in the tax base in the respective tax period.

Considering the nature and complexity of the individual items of the net borrowing costs the new rules will require a rather complicated calculation in comparison to the already existing thin capitalisation rule under Article 21a of the ITA.

If the amount of net borrowing costs exceeds EUR 3,000,000, the tax base will be increased by the amount by which the net borrowing costs exceed 30% of the so-called tax EBITDA.

For the purposes of the new interest limitation rule, the tax EBITDA indicator (i.e., earnings before, interest, tax, depreciation, and amortisation) for the relevant tax period is calculated as a sum of:

• individual types of tax bases (before the adjustment according to the interest limitation rule),
• net interest expenses, and,
• tax depreciation of assets.

On the positive side, the amendment allows carrying forward the unused interest deduction capacity to future tax periods. The taxpayer will be able to deduct the unused net borrowing costs in up to five consecutive tax periods after the tax period in which he could have not utilized the costs. Nevertheless, even when applying carried forward net borrowing costs in the future tax periods, the total net borrowing costs (including the costs carried forward) cannot exceed the limit of 30% of the tax EBITDA of the given year.

The new rule will apply only to the net borrowing costs related to financing agreements concluded after 31 December 2023, including amendments to pre 2024 agreements concluded after 31 December 2023. The new interest limitation rule shall thus not apply to financing agreements and their amendments concluded up to and including 31 December 2023.

If you will be affected by any of the changes presented above or if you are not sure what impact the changes will have on your company, do not hesitate to contact us.

If you need a more comprehensive advice on your transfer pricing obligations, risks or opportunities, please contact us directly via this link and we will get back to you with a tailor made proposal.

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