The Supreme Administrative Court’s Current View on the Tax Deductibility of Interest in a Downstream Merger

Current practice regarding the tax deductibility of interest on acquisition financing is based primarily on Section 25(1)(zk) and Section 24(1) of the Income Tax Act. Under certain conditions, Section 25(1)(zk) excludes the tax deductibility of interest on loans and borrowings used to acquire a share in a subsidiary. In the case of an upstream merger, the prevailing practice is that interest becomes tax-deductible as of the effective date of the transformation, after which the loan is no longer used to acquire the interest in the subsidiary but, from an economic perspective, is used to acquire the assets of the dissolved subsidiary.

In the case of a downstream merger, the situation is different, as once the intended transformation is completed, this debt financing originally arranged for the purchase of a share in the subsidiary will effectively be assumed by the successor subsidiary. Unlike in an upstream merger, the assessment of the tax deductibility of interest after the corporate transformation has been completed is therefore not straightforward.

When assessing the tax deductibility of interest in connection with corporate transformation, the tax authority also evaluates the economic rationale for the transformation itself, specifically in relation to the doctrine of abuse of law. The Supreme Administrative Court recently decided in Case No. 8 Afs 246/2022-61 dated June 25, 2024, in which the dispute concerned the tax deductibility of interest on debt financing used to acquire an operating company; the tax authority argued that there was an abuse of rights, specifically a situation where the primary purpose of the taxpayer’s actions was to obtain a tax advantage in the form of tax deductibility of interest.

The core of the dispute was a situation in which an investment group establishes a completely new company to acquire a target operating company, and that new company subsequently obtains a loan from a bank to finance the acquisition of the target company. The target company is then merged into the newly formed company (through an upstream or downstream merger). From the tax authority’s perspective, the main issue is that, for example, a highly profitable target company is now burdened with interest on the acquisition loan, which may be tax-deductible, thereby reducing the company’s taxable profits or even causing it to report a tax loss. However, if the two companies had not merged, this interest would have been clearly non-deductible at the level of the newly formed company.

However, the Supreme Administrative Court rejected the tax authority’s argument regarding abuse of rights. A significant factor was that the financing bank had made the granting of the loan conditional upon the establishment of a new company and the subsequent transfer of part of the loan burden to the operating company. At the same time, the taxpayer credibly explained the economic rationale behind the bank’s requirement, particularly from the perspective of the bank’s position as a creditor. From the Supreme Administrative Court’s perspective, therefore, there was no abuse of rights in an effort to obtain a tax advantage; rather, the primary objective was to fulfill the financing bank’s conditions.

The Supreme Administrative Court addressed a similar situation in its judgment 5 Afs 164/2024-69 dated May 26, 2026. The subject of the dispute was also the tax deductibility of interest on financing for a downstream merger, where the the financing was not provided by an independent external party but was instead arranged entirely within the group of related parties. The taxpayer justified the method in which the merger was carried out and financed by obtaining a business plan, according to which it would manage its future business activities. However, this also resulted in high indebtedness of the successor company, which, in the Supreme Administrative Court’s view, could not be economically justified by the purported acquisition of the business plan. The Supreme Administrative Court did not find convincing the statement that the business plan represented adequate economic consideration for the debt incurred. The Supreme Administrative Court therefore confirmed the tax administrator’s conclusions, which deemed the interest non-deductible for tax purposes, as the general test for the deductibility of expenses under Section 24(1) of the Income Tax Act had not been met.

From the aforementioned Supreme Administrative Court judgments and the tax authority’s approach follows that the tax deductibility of interest in an upstream or downstream merger cannot be viewed solely through the conditions of Section 25(1)(zk) of the Income Tax Act, but must be viewed within the broader context of the general deductibility test under Section 24(1) of the Income Tax Act; it is also necessary to assess the entire process in light of the principle against the abuse of rights, which is laid down in Section 8(4) of the Tax Code. Recent case law of the Supreme Administrative Court indicates that, when assessing the tax deductibility of interest related to acquisition financing and subsequent transformation, one cannot rely solely on the formal fulfillment of the conditions set forth in Section 25(1)(zk) of the Income Tax Act. It is also necessary to assess the actual economic connection between interest expenses and taxable income pursuant to Section 24(1) of the Income Tax Act and, in relevant cases, the economic rationality of the entire transaction from the perspective of the doctrine of abuse of rights. Each case must therefore be assessed individually, taking into account its specific economic and legal circumstances.

Authors:

Filip Straka, Manager, Tax Department

Jan Čapek, Junior Consultant, Tax Department