Research and development tax credit

The tax deduction for research and development under Section 34c of the Income Tax Act is a key instrument of indirect support for the innovative activities of entrepreneurs. This statutory benefit allows entities to deduct research and development costs from the tax base in full. Costs incurred in carrying out research and development can even be claimed twice, first as tax deductible costs under Section 24(1) and secondly under Section 34(4), as confirmed by the established case law of the Supreme Administrative Court (SAC). At the same time, however, this mechanism attracts intense scrutiny from the tax authorities, which seek to prevent abuse of this tax advantage.

Author of the article: ARROWS (Mgr. Filip Ondřej, office@arws.cz, +420 245 007 740)

How does the SAC currently view this issue?

In its judgment of 22 November 2024, Case No. 5 Afs 56/2024, the SAC ruled on strict requirements for both formal and material aspects of research and development projects. The SAC confirmed that a research and development project must, inter alia, clearly define the element of novelty, the reason for the change, the procedure for the solution and the possibility of evaluating the results. This judgment is not only a precedent-setting decision in the field of tax law, but above all a key indicator of how the tax authorities may approach R&D deductions in this area in the years to come.

The legal framework for the R&D tax credit

The R&D tax credit was introduced to encourage private investment in innovative activities. However, as is clear from the legislation and case-law, the possibility of claiming it is subject to strict requirements designed to eliminate the unjustified use of this benefit.

Basic conditions for the tax credit

According to Section 34c(1), a research and development project must include:

• identification data of the taxpayer,
• the duration of the project,
• the objectives of the project,
• the estimated costs,
• a list of expert investigators,
• how the progress of the project will be monitored and evaluated,
• the date of approval of the project documentation,
• the name and signature of the person approving the project documentation.

The prospectivity of the project, i.e. its elaboration before the start of the solution, is also essential. If this condition is not met, the deduction is not available.

Contentious issues in the SAC judgment

The company claimed a tax deduction on the basis of two projects. However, on the basis of a tax audit, the tax administrator concluded that the projects did not meet key formal requirements and therefore additionally assessed corporate income tax in the total amount of over CZK 24 million.

In its judgment, the SAC identified four main areas of concern:

1. The non-viability of the projects,
2. unclear and insufficient specification of the projects' objectives,
3. an incomplete list of expert researchers,
4. the company did not prove that it had spent the research and development expenditure on the activities referred to in Article 34b(1).

Non-profitability of the projects

The key argument of the tax authority was that the projects were not developed and approved before the research activities started, which is a crucial condition for the tax deduction. The tax authorities substantiated this with the following findings:

• the annual report for the year in question did not contain any reference to research activities, even though the project should have been formally approved in the year in question,
• the project documentation used the template of a consultancy company which the company contracted only in the year following the year in which the project was supposedly formally approved,
• the company had already benefited from public support for similar projects in the past, which could indicate that activities had actually started before the formal approval of the project.

The company did not prove the prospectivity of the projects in the subsequent proceedings or dispel doubts about the prospectivity of the projects. The Supreme Administrative Court agreed with the tax authorities that the non-prospective project could not be retrospectively validated and that the taxpayer was obliged to actively refute the tax authorities' doubts, which it failed to do.

Insufficient definition of the objectives of the projects

The second problem was that one of the projects was defined very vaguely as 'the development of a new information system to support business activities in the field of public services'. The SAC found that the project:

• did not include a technical specification of the research uncertainty (i.e. what problems were to be overcome),
• there was no clear methodology for the project,
• no innovative added value over existing systems was demonstrated.

Similarly, the second project, which aimed to implement functionalities for a European electronic toll service, did not contain any technical information to justify that it was an R&D project and not a mere software development.

The SAC emphasised that a research project must contain clearly defined objectives, methods and innovative elements, otherwise it is not eligible for a tax deduction.

The objective of the research and development project must be clearly articulated to show the element of novelty and the removal of technical uncertainty. The project should make clear the current state of the art in the field, the reason for the need for change, the proposed approach to achieving the objective and the possibility of evaluating the results. It is also important to provide evidence and technical information to support the implementation of the project. The project should include a timetable and alternative solutions in case of failure.

Incomplete list of expert investigators

According to Section 34c(1)(e), the project must list all the experts involved in the solution. However, in the case of one of the projects, the company listed only about one-quarter of the personnel who were actually scheduled to work on the project during the course of the solution according to the statements.

The SAC confirmed that the project must contain a complete list of the professional staff at the time of approval, not retrospectively on the basis of the statements of work, and the failure to list all the professional staff is a serious formal defect which is sufficient in itself to disallow the deduction.

Implications of the SCA judgment

In its judgment, the SAC confirmed the application of the strict rules for the R&D deduction as applied by the tax authorities. Taxpayers wishing to take advantage of this tax benefit must comply with all the requirements set out in the Income Tax Act and, in light of the recent decision-making practice of the SAC, must not forget, in addition

• consistent documentation of projects before they start,
• clearly defined and quantifiable research and development objectives,
• complete and transparent registration of all project promoters.

To conclude

The current judgment of the Supreme Administrative Court is a fundamental decision in the field of R&D tax deductions. It shows that failure to meet even a single formal condition in the sense mentioned above leads to non-recognition of the deduction, which may result in a tax assessment (which may be high) and penalties for taxpayers.

If you plan to use the R&D deduction, do not underestimate the formal side of things!