We informed you in the March issue of our newsletter that at the beginning of February, the finance ministry published a draft bill, which implement the EU Anti-Tax Avoidance directive (ATAD). Since then, this governmental draft bill has only reached the Chamber of Deputies, where after more than three months it has only been discussed in the first reading (out of three in total). It is thus very likely already that the government draft bill will not be approved within such a time frame that the amendment would take effect as of 1 January 2019, as required by the EU directive. Probably the only advantage of such a long process of approval is that the taxpayers have more time to familiarise themselves in greater detail with the intended novelties. This is of course on the presumption that the draft bill is not changed meanwhile.

Let us use this time to focus on the intended novelties in detail. In this article, we will focus specifically on the new rule limiting tax deductibility of interests, or borrowing expenses. According to the current version of the amendment, which currently finds itself in the Chamber of Deputies, it will be the new articles 23e and 23f in the income tax act.

There are many rules, which test tax deductibility of interests, in the current income tax act already. By way of reminder - these are for example the thin capitalisation test (article 25 paragraph 1 letter w) of the income tax act) or tests according to article 25 paragraph 1 letter zl), zk), i) or also according to article 24 paragraph 2 letter zi) of the income tax act. According to the current draft bill, these rules will remain in effect even after it has been passed. Basically, in terms of procedure, the taxpayer will first apply these existing rules, and he will then apply the new rule to the interests, which pass these tests.

The previously mentioned rule of thin capitalisation is the closest to the new rule. It has the reason of its origin in common with it, which basically consists in restricting the option of using debt financing within a supranational company as a tool for preventing erosion of the tax base. Compared to this thin capitalisation rule, when tax deductibility of interest is only assessed in relation to loans received from related parties, the so-called thin capitalisation test, the new rule considerably widens the range of borrowing expenses, which the taxpayer needs to assess. Interests paid to unrelated parties (for example a bank), exchange-rate differences from revaluation of borrowings, “implicit interest” paid as part of financial lease, etc. will enter into the new rule, too, among others.

The new rule also adjusts the list of taxpayers, to whom the rule will or will not apply. The lawgiver has chosen a negative list. This means that it will apply to all corporate income tax payers, with the exception of specifically listed taxpayers (new stipulation of article 23f of the income tax act). Most taxpayers will certainly mainly be interested in the last letter l), where it is stated that the new rule will not affect taxpayers, who do not control foreign companies, have no permanent business premises abroad and are not obliged to undergo compilation of a consolidated financial statement or are not a consolidating accounting entity. In order to be able to assess, if the new rule applies to us or not, it is necessary to find out, what the term “controlling a foreign company” means. It is a newly defined term, which includes cases, when a Czech taxpayer alone or with his affiliated companies participates with more than 50 % in the registered capital or voting rights of a foreign company or is entitled to a share in profit in the company reaching more than one half. Permanent business premises of the taxpayer located abroad will also be considered a controlled foreign company. It is thus clear that the rule will not apply to strictly Czech companies. The new rule also will not apply to financial institutions, pension and investment funds etc.

The fact that the taxpayer falls into the circle of subjects, to whom the new rule reducing deducibility of interests will apply, does not in itself mean that the new rule will influence him directly. In order for the new rule to influence the taxpayer, his excessive borrowing costs must be higher than the sum of CZK 80m. If it happens, only then the real ‘survival game’ begins for the taxpayer, because in such a case he needs to compare the sum of CZK 80m to the sum corresponding to 30 % of tax earnings before interest, taxes, depreciation and amortization charges. The higher of the sums assessed in this way will serve as a limit for determining deducibility of excessive borrowing expenses and logically, the sum, which will exceed the specified limit, will be non-deductible expense for the taxpayer.

In the previous paragraph we used the term “Excessive borrowing expenses”. What does that mean? Let us imagine all possible expenses (in certain cases even notional ones), which need to be spent in order to obtain some form of debt financing and which can with the exception of this rule be considered a tax deductible expense and which at the same time are lowered by the value of all taxable income obtained from various forms of provided financing. At the same time it is not decisive for the individual entries, whether the counterparty is or is not a related party, and borrowing expenses as well as borrowing income from related as well as unrelated parties is included. Capitalised interests, that is interests, which the accounting entity has decided to include in the acquisition cost of an asset, represent a special chapter. Capitalised interests are not subject to the thin capitalisation test and according to the current rules they become a tax expense in the form of tax depreciation of by application in residual value. This will not be the case for the new rule, though, where it will be necessary for the purposes of the deductibility test to calculate the part corresponding to capitalised interest from the tax depreciations or residual values in every period. From the practical perspective, the taxpayer will thus need to keep very careful records after filing assets, as to what percentage of the acquisition price is represented by borrowing expenses, and adequately adjust this percentage after every technical improvement performed. This will be necessary both in the case of depreciated assets and in the case of non-depreciated assets, where capitalised interests only get into costs at the time of sale, which may even be dozens of years later.

The greatest complications can be expected in the case of calculation of the limit corresponding to 30 % of the tax earnings before interest, taxes, depreciation and amortization charges. According to the amendment, tax earnings before interest, taxes, depreciation and amortization charges will be calculated as a sum of the profit and loss after adjustments performed according to the income tax act, which from the practical perspective will correspond to line 200 of the tax declaration, but without reflecting the new rule relating to regulation of deduction of interests. All tax bases, where the tax was collected by means of withholding, will be added to this. If the taxpayer enters such income into revenues in net sum already, it is necessary to reflect the entire tax base for the purposes of the calculation, that is income after tax captured in revenues and the tax paid by the payer – gross sum. Further, all depreciations, by which the taxpayer has lowered the tax base, the positive valuation difference when buying a commercial establishment and positive goodwill and at the end the excessive borrowing expenses will be added. On the other hand, income, which is exempted from the income tax, is not reflected in the calculation.

In case the taxpayer is obliged in one taxable period to increase the tax base by the value of excessive borrowing expenses, but in the following taxable periods he will no longer be subject to this obligation, he is entitled to lower the tax base in these following taxable periods by the value of unrecognized excessive borrowing expenses from previous year, up to the height of unused limit for deductibility of excessive borrowing expenses calculated in the given period. The taxpayer can use this option without a time limit.

For example if the taxpayer was obliged to raise the tax base in the first year by a sum of CZK 10m, but in the following year excessive borrowing costs only reached a sum of CZK 75m, with the limit of deductibility of excessive borrowing expenses being CZK 80m in the given year (because it is higher than 30 % of tax earnings before interest, taxes, depreciation and amortization charges). The taxpayer can then lower the tax base by CZK 5m in the second year. He will be able to use the remaining CZK 5m in any subsequent taxable period, in which excessive borrowing costs will be lower than the calculated limit.

The new rule limiting tax deductibility of excessive borrowing expenses will apply to all excessive borrowing costs resulting from contracts made after but also before the amendment has taken effect. An exception will be the capitalised borrowing expenses, when only interest contained in depreciation or residual or acquisition values of assets filed from 17 June 2016 will be included among borrowing expenses. 

To what extent the new rule will become administratively burdensome for the taxpayers will only be shown by practice, but it clear now already that it will be one of the most demanding rules for evaluation of tax deductible costs, which we have in the tax laws. 

The article, which you have just read, was not intended to provide complex explanation of all eventualities and options for interpretation or effects of the new rule. We must point out that the rule has many unclear places, which will probably be subject to professional debates. Moreover, the financial administration is currently preparing methodological information for this rule. Hopefully, this methodological information will help the practice and ensure the necessary legal certainty.

In case this topic has caught your interest, we are at your service and will be happy to provide more detailed information for you.