In 2019, Council Directive (EU) 2016/1164 of 12 July 2016 laying down rules against tax avoidance practices (ATAD) was transposed into Czech tax legislation. Therefore, new rules concerning the limitation of the deductibility of borrowing expenses, taxation of asset transfers with no change of ownership, taxation of a controlled foreign company and hybrid mismatches (the consequences of a different legal qualification) were implemented into the Czech tax system. 

These new rules, which have an impact on corporate income taxpayers and their permanent establishments, are now also discussed in detail in the information issued by the General Financial Directorate (hereinafter as the GFD), which clarifies - in the form of frequent questions and answers - some problematic issues concerning the application of these rules.

This article focuses only on limitations of the deductibility of borrowing expenses pursuant to Sections 23e and 23f of the Income Tax Act (hereinafter as the ITA). These sections came into effect on 1 April 2019 and will apply to the majority of taxpayers who use a calendar year for the first time in 2020.

Before tackling the issues discussed in the aforesaid information of the GFD, let’s recapitulate the basic information.

The reason for limiting the deductibility of borrowing expenses is the different taxation of equity and debt financing in individual EU Member States, which could be abused by an excessive reduction of the tax base through debt financing and interest payments.

The essence of this rule is to prevent taxpayers from artificially reducing the tax base through excessive debt financing. Pursuant to Section 23e of the ITA, excessive borrowing expenses (i.e. the difference between tax-deductible borrowing expenses and taxable borrowing revenues) can be included in the tax base only in the amount of up to 80 million CZK or 30% of the tax profit before interest, tax, depreciation and amortization. Excluded excessive borrowing expenses can be carried over to the following years (and claimed, provided that the limit allows so); however, this option does not pass onto the legal successor.

Furthermore, it is necessary to point out that only a tax-deductible expense can be a borrowing expense. It must be an expense or cost that is included in the tax base of the given time period as a tax-deductible expense, i.e. based on the accrual principle and the rules of the ITA. However, it is necessary to continue to apply other provisions of the ITA as well, such as the low capitalization test (Section 25 (1) (w) of the ITA) or the tests specified in Section 25 (1) (zl), (zk) and (i) and Section 24 (2) (zi) of the ITA. It is first necessary to apply these rules to evaluate tax-deductibility before applying the new rule based on Section 23e of the ITA.

Regarding the classification of above-limit excessive borrowing expenses for determining the tax base, the GFD’s information specifies that excessive borrowing expenses exceeding the limit specified in Section 23e of the ITA represent an item that increases the profit or loss or the difference between revenues and expenses. They are not considered tax-non-deductible expenses for the purposes of determining the tax base and adjusting the profit or loss or the difference between revenues and expenses.

The definition of borrowing expenses and borrowing revenues, based on which excessive borrowing expenses are then determined, is the key part of entire Section 23e of the ITA.

The law provides a broad definition of a borrowing expense. Based on Section 23e of the ITA, a borrowing expense is understood to mean:

1. A financial expense;
2. An expense that, by its nature, represents consideration for a provided credit financial instrument, regardless of the obligation arising from such consideration;
3. Notional interest as part of a derivate;
4. An expense associated with a derivative that is to hedge the risk of the obligation under (a) to (c);
5. An expense in the form of a foreign exchange difference associated with the obligation under (a) to (d);
6. Interest included in consideration for the obligation to relinquish an asset for use for consideration with the right to repurchase the asset by the party to this obligation; 
7. Interest that is part of asset valuation based on accounting laws;
8. An expense similar to that under (a) to (g).

The GFD’s information explained, among other things, the frequently discussed question of the inclusion of foreign exchange differences in borrowing expenses. According to the GFD, borrowing expenses include foreign exchange differences incurred in connection with the obligation concerning select borrowing expenses specified in the law, i.e. interest. Foreign exchange differences incurred from a principal are not included in borrowing expenses. This interpretation has a major impact on the calculation of excessive borrowing expenses in many companies.

The definition of notional interest as part of a derivative is another discussed issue. According to the GFD, it mainly concerns derivatives that are to hedge the risk of debt financing (acquiring of funds), i.e. mainly derivatives that are to hedge the currency risk (to hedge the exchange rate of the given currency) or the interest rate risk (to hedge the interest rate).  Borrowing expenses associated with derivatives that are to hedge the risk of the obligation pursuant to Section 23e (3) 9a) to (c) of the ITA include the part of expenses associated with the aforesaid derivatives, which relates to the obligation concerning financial expenses or similar expenses but not the obligations concerning the “principal,” based on which the expense incurred.

There is also a very broad definition of interest included in consideration for the obligation to relinquish an asset for use for consideration with the right to subsequently acquire the asset by the party to this obligation. This in fact means interest included in payments made based on all contracts, based on which the asset is used and which stipulate the obligation or option to repurchase the asset. In the context of the ITA, it mainly concerns leases and finance leases. According to the GFD’s information, interest included in consideration made based on the contract, based on which the asset is used for consideration, is a borrowing expense. The contract must include the option or obligation to repurchase the used asset so that interest could be considered a borrowing expense. This applies regardless of whether or not the asset is actually repurchased upon the termination of the contract. If the contract does not include any provision regulating the transfer of the ownership right to the used asset, the interest included in the payment made based on such a contract will generally not be considered a borrowing expense.

The information also specified the procedures for evaluating interest that is part of asset valuation based on accounting laws. Interest that – according to accounting laws – is part of asset valuation (so-called capitalized interest), is considered a borrowing expense in the time period in which it was included in the tax base and claimed as an expense in the form of tax-deductible depreciation, tax-deductible residual price of the asset or a tax-deductible book value in other cases (e.g. the sale of inventory of own production). Based on the information, it is necessary to determine what part of such depreciation represents capitalized interest, i.e. a borrowing expense, in the given time period. Such a part will be determined as a percentage of the capitalized interest on the asset valuation. If the taxpayer does not claim the asset deprecation in the given time period (e.g. the taxpayer suspends asset depreciation), the capitalized interest will not be included in borrowing expenses because it was not reflected in tax expenses in the form of depreciation. The same rule for determining the amount of borrowing expenses in the form of capitalized interest applies to a claimed tax-deductible residual price. The information does not discuss how difficult it is to determine and keep records of such cases.

The fact is that the taxpayer must very carefully keep records of what percentage of the acquisition cost of a recognized asset represents borrowing expenses and to adequately adjust this percentage after every technical improvement. This is necessary to do both for depreciated assets and non-depreciated assets where capitalized interest does not become an expense until such assets are sold, which may take decades.

In the end, the information answers the question of how the adjustment of the profit or loss due to excessive borrowing expenses will be handled on the corporate income tax return form. Such adjustments will be made on line 63 and 163 and in Annex no. 3.

The goal of this article was not to provide you with complete information published by the financial administration. However, we hope that this article helped you to sum up some basic issues. It is obvious that the implementation of excessive borrowing expenses still has many problematic areas that will be the subject of professional discussions, and we will certainly come across some cases to which the answer will not be inambiguous and easy – both in calculating excessive borrowing expenses to evaluate the limit of 80 million CZK and in calculating the tax profit before interest, tax, depreciation and amortization.

If you are interested in this topic or are currently dealing with this issue, we will be happy to help you and to provide you with more detailed information.