1. IntroductionHidden profit distribution is a topic that regularly leads to long drawn-out and not always fruitful discussions between the tax authorities and taxpayers that often end with a compromise. In many cases, however, the taxpayer would be well advised to refuse such compromise and to insist on the correct application of the rules of evidence of tax law.
Small and medium-sized enterprises established as joint stock companies or limited liability companies often display contractual relationships between the company and the shareholder/partner. If the shareholder himself works for the company, such a relationship usually takes the form of an employment relationship. Often, however, the relationship is not limited to an employment relationship, and other transactions also take place between the shareholder and his company. For example, we often encounter a long-term debt relationship, where the shareholder grants a loan to the company or vice versa. Specific transactions where both parties are contracting parties also occur regularly, for example when the shareholder buys a product from his company.
These relationships bear opportunities for managing the company’s profit. If the company charges the shareholder less for a service it provides to the shareholder than it would charge an independent third party for the same service, the company’s profit is reduced. Such a transaction represents a hidden profit distribution. The company’s tax burden would be reduced commensurately unless tax law or the tax office applies a correction.
Tax law applies the “dealing-at-arm’s-length” rule, which means that transactions between a company and its shareholders must be structured in the same manner as transactions between unrelated parties. If this rule is not followed, the tax authorities are entitled (and obliged) to tax the transaction as if it were executed between independent third parties. This would then increase the company’s taxable profit by the amount of the so-called hidden profit distribution.
2. Area of discretion
It is not always a straightforward matter to judge whether a relationship between a company and its shareholder meets the conditions of the dealing-at-arm’s-length rule (e.g. if there is no market price). Unsurprisingly, the tax authorities often interpret this issue in a different manner from the taxpayer and discussions between the parties are inevitable. In practice, such discussions often end in a compromise under which the tax authorities only (but still) tax part of the amount it originally qualified as a hidden profit distribution. Taxpayers are prepared to accept such compromises because they worry that they will not be able to prove their compliance with the dealing-at-arm’s-length rule and will have to go through expensive legal proceedings. However, the tax effects of such a compromise are underestimated: quite often the taxpayer’s acceptance of a profit correction for the company also opens the door to additional tax consequences for the shareholder himself. If the income tax payable by the shareholder is increased as a result of the additional income tax due by the company, and if there is also a non-refundable withholding tax, as the case may be, the overall tax effect can easily equal the amount considered a hidden dividend distribution.
Our recent experiences in this field have shown that taxpayers often agree too quickly to such a solution. As per the following considerations, it is, however, not the taxpayer who is required to prove compliance with the dealing-at-arm’s-length rule, but rather the tax authorities who must prove non-compliance with this rule.
3. Hidden profit distribution in general
According to the standing practice of the Federal Tribunal, a hidden profit distribution requires the following conditions to be met cumulatively:
- A transaction is effected but no (equivalent) payment is made in return;
- A shareholder (or a party closely related to him) benefits from the service;
- The disparity between the value of the transaction and the payment received was clearly apparent to the parties.
4. General division of burden of proof under tax law
The general rule is that the tax authorities must prove any facts that would establish a tax obligation or lead to an increase in the tax payable, while the taxpayer bears the burden of proof for facts that would lead to a reduction in the tax payable. As a hidden profit distribution leads to a tax increase because it would increase the taxable income, the tax authorities bear the burden of proof in such cases. The tax authorities must prove that all three of the above conditions for a hidden profit distribution are met. The Federal Administrative Court confirmed this in a recently published decision: “Only if the tax administration can prove that all three conditions of a deemed dividend are fulfilled, the taxpayer needs to invalidate this proof by supplying proof to the contrary.”
5. Transaction without (equivalent) payment
As explained above, transactions between a company and its shareholders must comply with the dealing-at-arm’s-length rule to be accepted by the tax authorities. This means that transactions must be executed at fair market value.
In practice there can be various reasons why a deviation from terms considered appropriate by the tax authorities would be justified from a business point of view. An inept or even loss-making transaction with shareholders or parties related to them is generally not sufficient to qualify as a hidden profit distribution. Given the general rules on the burden of proof, the tax authorities have to prove that there was no (equivalent) payment for a transaction, i.e. that a service was provided solely on the basis of a shareholder relationship. This allocation of the burden of proof was confirmed by the Federal Tribunal in 2009.
6. Shareholders and their related parties
A shareholder by definition has a stake in the equity capital. Accordingly, someone who does not own any shares in the company in question cannot be a shareholder. In a formal sense, someone needs to own only one single share to qualify as a shareholder, but this does not necessarily mean that every transaction with such a minority shareholder will automatically qualify as a hidden distribution of profit. Legal practice usually agrees that a transaction with a minority shareholder may only be assumed to be a hidden distribution of profit if the minority shareholder controls the company in one way or another.
6.2 Related party
Related parties are primarily individuals with a family relationship to the shareholder or legal entities controlled by the same shareholder. However, according to judicial practice, persons with whom the shareholder has a business or personal relationship which, seen in the overall context, should be regarded as the reason for the inadequate transaction with the third party are also deemed to be related parties.
In some cases the tax authorities tend to use existing business relationships between the recipient of an (alleged) service and the company providing the service to confirm a qualification as related party. However, for a business relationship to lead to the assumption that the relationship is close enough to qualify someone as a related party, the business relationship must exceed the limits of a usual business relationship, and must include, for example, a significant influence on or even actual control over the service provider by the service recipient, or even economic dependence between the parties. In any case, not any business relationship can lead to the conclusion that the actual reason for the alleged service can be found exclusively in the relationship itself.
According to prevailing opinion, the reverse can also not be assumed, i.e. that the recipient of a service who does not make appropriate payment (from the point of view of the tax administration) must necessarily be a related party. Although an inappropriate transaction with a non-shareholder can strengthen the assumption that the reason for the service can be found in a family, friendship or business relationship, evidence must still be provided that there is no independent business reason for the transaction on the one hand, and that the transaction only took place as a result of the relationship to the shareholders without any business or other reasons for the transaction on the other hand. Here again, the tax administration bears the burden of proof.
7. Perceptibility of disparity between service and payment
The final criterion that must also be proved is that the disparity between the service and the payment must have been apparent to the parties. This concerns the motivation of the acting parties. The idea is to ensure that only a consideration made to a shareholder or a party related to him that was meant to benefit the latter is qualified as a hidden profit distribution. Vice versa, this also ensures that inept transactions are not qualified as hidden profit distributions. However, if the disparity is very clear, it is assumed that the parties must have recognized the disparity.
In practice the tax authorities often allege a hidden distribution of profit without having evidenced that all three conditions are met. However, as this comprehensive presentation of evidence is a mandatory prerequisite for a tax correction, in most cases taxpayers would be well advised not to simply accept a correction, but to insist that the tax authorities provide the required proof.