Czech Republic – 3 Afs 14/2024-62 – ELI LILLY ČR, s.r.o. vs Appellate Financial Directorate (Odvolací finanční ředitelství)
Case Reference
Court: Supreme Administrative Court of the Czech Republic Case Number: 3 Afs 14/2024-62 Date of Judgment: 12 September 2025 Parties:
- Claimant/Appellant: ELI LILLY ČR, s.r.o.
- Defendant/Respondent: Appellate Financial Directorate (Odvolací finanční ředitelství)
Executive Summary
This judgment concerns a cassation complaint filed by ELI LILLY ČR, s.r.o. against a decision of the Municipal Court in Prague dated 15 December 2023, which dismissed the company’s administrative action challenging additional tax assessments for corporate income tax for the tax periods 2013 and 2014. The Supreme Administrative Court dismissed the cassation complaint.
This case concerns transfer pricing matters and focuses on the interpretation and application of Section 24(2)(zc) of the Income Tax Act in the context of a cost-plus pricing arrangement between related parties.
Background and Facts
Business Structure
Since 1995, the claimant has operated as a distribution entity of the Eli Lilly group in the Czech Republic, where it ensures the import and distribution of pharmaceuticals and simultaneously performs marketing activities to support their sale. Within the supply chain, it purchases pharmaceuticals from Eli Lilly Export S.A. and supplies them to local distributors in the Czech Republic and Slovakia.
The Service Agreement
Marketing services are provided under a Service Agreement (the “Agreement”) concluded on 1 November 2010 with Eli Lilly Export S.A., which is the parent company of the claimant’s parent company. The Agreement defines the scope of services as advertising activities, market research, PR activities, informing the professional public, and patient education, with the aim of supporting the business of the client (Eli Lilly Export S.A.) in the Czech and Slovak markets.
Transfer Pricing Methodology
The remuneration for these services is set as the sum of direct and indirect operating costs of the claimant increased by a 5% margin. This represents a classic cost-plus transfer pricing methodology.
Tax Assessments
The Specialised Financial Office issued two additional tax assessments on 25 October 2018 for corporate income tax for the tax periods from 1 January 2013 to 31 December 2013 and from 1 January 2014 to 31 December 2014, assessing additional tax of CZK 2,661,710 and CZK 2,618,010 respectively, resulting in penalties of CZK 532,342 and CZK 523,602.
The reason for this procedure was that the tax authority rejected the tax deductibility of costs totaling CZK 4,038,373 (December 2012), CZK 9,969,897.08 (from 2013), CZK 5,258,590 (December 2013), and CZK 8,500,976.15 (from 2014), including expenses for employee catering above the limit, representation, promotional items above the limit, non-deductible gifts, non-tax fees and penalties, non-deductible shortages and damages, etc.
Legal Framework
Section 24(2)(zc) of the Income Tax Act
The subject of the proceedings was the assessment of whether the claimant proved a direct connection between the claimed non-tax costs and revenues flowing from the Service Agreement concluded with Eli Lilly Export S.A. within the meaning of Section 24(2)(zc) of Act No. 586/1992 Coll., on Income Taxes, as in force until 31 December 2014.
Section 24(2)(zc) of the Income Tax Act represents an exception to the general rule of tax deductibility of expenses (costs) as formulated in Section 24(1) of the same Act. While according to the general rule, only those expenses that were incurred to achieve, secure, and maintain taxable income are tax-deductible, this special provision allows the recognition of expenses that do not meet this condition but demonstrate a direct connection with such income.
Key Legal Issues
1.Interpretation of “Direct Connection”
The central issue was whether the cost-plus pricing mechanism itself establishes the required “direct connection” between non-deductible costs and revenues under Section 24(2)(zc).
The Claimant’s Position
The claimant argued that the direct connection is established by the very mechanism of price calculation – every CZK 1 of cost generates CZK 1.05 of revenue, and without incurring the cost, the revenue would not arise.
The claimant inferred the existence of a direct connection primarily from the Agreement and the financing model established therein, which was set in relation to its parent company. Specifically, it argued that the amount of remuneration it received from the parent company for providing marketing services was contractually set as the sum of direct and indirect operating costs, increased by a fixed mark-up of 5%.
The Tax Authorities’ and Courts’ Position
The Municipal Court stated that the mere establishment of transfer prices, even if linked to costs, does not prove that these costs actually relate to the services provided. The price-setting mechanism serves only to determine the price, not to prove the substantive connection of costs with the subject of the Agreement.
The Municipal Court referred to the judgment of the Supreme Administrative Court dated 14 October 2021, case no. 1 Afs 190/2021-30 (the “Oriflame” case) and concluded that direct connection cannot be inferred merely from the claimant’s financing model, which ensures payment of all costs by the parent company increased by a fixed margin.
2.Burden of Proof
The Municipal Court addressed the question of the distribution of the burden of proof in tax proceedings and concluded that the claimant did not bear even the primary burden of proof, as it did not even assert how individual costs relate to revenues. It limited itself to a general reference to the Agreement and received payments, which is insufficient.
The case law of the Supreme Administrative Court repeatedly emphasises that the burden of proof regarding proving the direct connection between cost (expense) and revenue (income) rests with the tax subject.
Supreme Administrative Court’s Analysis
Relevant Precedents
The Supreme Administrative Court relied on several key precedents:
Raiffeisenbank Case
This interpretation was further developed in the judgment of the Supreme Administrative Court in the Raiffeisenbank case, in which the Supreme Administrative Court clarified that direct connection within the meaning of Section 24(2)(zc) of the Income Tax Act must be understood as a sufficiently intensive, unmediated, and logical link between a specific cost and a specific revenue.
Oriflame Case
In the Oriflame case, the Supreme Administrative Court assessed a model of price determination between related parties based on the so-called “Cost+” method, i.e., as a percentage mark-up on all costs incurred by the service provider. The Supreme Administrative Court stated that “direct connection cannot be understood merely as a proportion between costs and revenues […], i.e., that for the use of the mentioned provision it is sufficient that the increase in revenues is conditioned by a proportional increase in costs. Direct connection must be understood such that the given costs had the possibility to influence the amount of revenues, not only by being incurred and subsequently charged to other members of the group, but such that their incurrence contributed to achieving revenues otherwise than merely by their automatic increase.”
Sellier & Bellot Trade Case
The Municipal Court referred to judgments of the Supreme Administrative Court dated 30 November 2022, case no. 2 Afs 139/2021-51, and dated 20 December 2022, case no. 10 Afs 2021-55 (the “Sellier & Bellot Trade” case). The Supreme Administrative Court in both cases denied that merely documenting the amount of costs and their contractual anchoring is sufficient to prove direct connection with revenues.
Key Principles Established
The key concept of “direct connection” has been repeatedly interpreted in the decision-making activity of this court. In the judgment dated 28 March 2007, case no. 5 Afs 95/2006-80, published under no. 1225/2007 Coll. NSS, the Supreme Administrative Court emphasised that “[t]he purpose of this provision is […] to enable that in a situation where there is a mutual connection between specific income and expenses that would otherwise not be deductible, and they are part of costs and revenues in the same tax period, these otherwise non-deductible expenses (costs) can also be claimed.”
The expense must be specifically and substantively identifiable in relation to the specific income that was actually achieved by its incurrence or whose achievement was at least objectively intended. It is therefore not sufficient for the expense to be part of the taxpayer’s general business activity; it is necessary to prove a causal link between the expense and the specific income, not only at the formal level but also at the material level.
From the established case law of the Supreme Administrative Court, it therefore follows that direct connection within the meaning of Section 24(2)(zc) of the Income Tax Act must be based on a real, not merely accounting or contractual, link between a specific cost and a specific revenue.
Application to the Present Case
The claimant in the proceedings now under consideration did not bear the burden of proof regarding proving the direct connection between the costs it claimed as tax-deductible and the revenues it received from its parent company. The fact that these costs were included in the price calculation according to the Agreement concluded between related parties is not in itself sufficient to conclude their tax deductibility.
The claimant in this respect did not prove that the individual claimed costs (for employee catering above the limit, representation, promotional items above the limit, non-deductible gifts, non-tax fees and penalties, non-deductible shortages and damages, etc.) demonstrated a direct connection with specific revenues. It can be recalled again that the burden of proof regarding the tax deductibility of expenses rests with the tax subject, even if the expenses were formally accounted for and contractually regulated.
Transfer Pricing Implications
Cost-Plus Method Insufficient Alone
The fact that each cost is subsequently reflected in the price calculation does not automatically mean that it contributes to the creation of taxable income (revenue) within the meaning of tax law.
The Supreme Administrative Court simultaneously stated in the mentioned judgment that in the method of determining the transfer price by the cost-plus method, one cannot without further ado see a direct connection between costs in the form of refreshments, catering, or fines and penalties with revenues for provided software services.
Economic Substance Required
If the tax administrator expresses specific and justified doubts about the existence of this direct connection during a tax audit, the burden of proof passes to the tax subject, who must refute these doubts with specific evidence. Mere assertion of the formal existence of a contract or accounting document is not sufficient, but it is necessary to assert and document the economic reality of the transaction and its direct impact on the creation of taxable income.
This interpretation serves not only to protect public budgets from unjustified claiming of costs (expenses) that may be accounted for as costs but from the perspective of tax law do not demonstrate sufficient material connection to income, but at the same time ensures equal treatment of tax subjects that properly document their costs and prove their direct relationship to achieved income.
Formal vs Material Connection
Given that this is an exception to the general rule, it is necessary to approach its interpretation restrictively and consistently materially. Direct connection between cost and income therefore cannot be assessed only formally (for example, based on the existence of a contract or accounting entry), but it is necessary to examine whether the given cost actually substantively relates to the income, from the perspective of the economic reality of the given case.
Procedural Issues
Concentration Principle
The claimant newly argues in the cassation complaint that it was not sufficiently informed by the tax administrator about the insufficiency of its assertions regarding the direct connection of costs with revenues, respectively that a dialogue was not conducted with it that would enable it to respond to the tax administrator’s doubts. These objections, however, have no prototype in the complaint assertions that the claimant raised in proceedings before the Municipal Court. These objections are therefore inadmissible.
Retrospective Application of Case Law
The Supreme Administrative Court concludes that although the judgments of the Supreme Administrative Court concerning specifically the “Cost+” method in relation to Section 24(2)(zc) of the Income Tax Act (Oriflame, Sellier & Bellot Trade) were issued only after the issuance of the respondent’s decision, they represent a clarification of the interpretation of a legal norm that was effective already in the relevant period. The case law of the Supreme Administrative Court has an interpretative nature and its conclusions also apply to factual and legal situations that occurred before its issuance, if there was no change in the legal regulation.
Outcome
The cassation complaint was dismissed. No party was awarded costs of the cassation proceedings.
The Supreme Administrative Court, in view of the above, concluded that the cassation objections raised by the claimant are not well-founded. The cassation complaint was therefore dismissed pursuant to Section 110(1) in fine of the Code of Administrative Justice.
Key Takeaways for Transfer Pricing
- Cost-Plus Pricing Alone is Insufficient: The mere fact that costs are included in a cost-plus transfer pricing calculation does not automatically establish “direct connection” for tax deductibility purposes under Czech law. The economic substance and actual contribution to revenue generation must be demonstrated.
- Material vs Formal Connection: Tax authorities and courts will look beyond formal contractual arrangements and accounting entries to examine the economic reality and material connection between specific costs and specific revenues.
- Burden of Proof: Taxpayers bear the burden of proving that costs have a direct connection to revenues. When tax authorities raise specific doubts, taxpayers must provide concrete evidence beyond mere contractual documentation or accounting records.
- Types of Costs Scrutinised: Certain costs are particularly vulnerable to challenge, including employee catering above statutory limits, representation expenses, promotional items, gifts, penalties, and other costs that may not have a clear and direct link to revenue-generating activities.
- Related Party Transactions: Transactions between related parties receive heightened scrutiny, particularly where contractual structures allow automatic cost pass-through regardless of actual economic contribution.
- Documentation Requirements: Taxpayers must maintain robust documentation demonstrating not just that costs were incurred and contractually agreed, but that they actually contributed to revenue generation through economic analysis, business rationale, and objective evidence.
- Retrospective Application: Clarifications in case law apply retrospectively to pending cases, even if the judgments were issued after the tax periods in question, provided the underlying legislation has not changed.
Conclusion
This judgment represents a significant development in Czech transfer pricing jurisprudence, establishing that cost-plus transfer pricing methodologies do not automatically confer tax deductibility on all costs included in the pricing calculation. The Supreme Administrative Court has firmly rejected a purely mechanical or formulaic approach, requiring instead that taxpayers demonstrate the economic substance and material connection between specific costs and specific revenues. This places a substantial evidential burden on taxpayers operating under cost-plus arrangements with related parties, particularly in respect of costs that do not have an obvious and direct connection to revenue-generating activities.