Do you finance your company using debt capital and deduct the financial costs from the corporate income tax base?

If so, we recommend acquainting yourself with the proposed amendment to the Income Taxes Act in sufficient time in advance. The amendment is currently before its second reading in the Czech Parliament’s Chamber of Deputies as the implementation of the European Anti-Tax-Avoidance Directive (as we informed you in our August newsletter) will bring a significant tightening (extension) of thin capitalisation rules.

The rules are to be extended to also apply to financial costs from unrelated parties. Besides currently applicable rules, the test will be carried out by first excluding borrowing costs that are not deductible under current thin capitalisation rules, then outstanding interest paid to individuals, interest related to the holding of an ownership interest in a company, etc., and only currently tax-deductible interest will be subject to the procedure for exceeding borrowing costs as stipulated in the Directive.

Under this procedure, a company will first determine exceeding borrowing costs and compare them with the limitation on the deductibility of exceeding borrowing costs, which is (a) 30 percent of the taxpayer’s earnings before interest, tax, depreciation and amortisation (“30% of EBITDA”), or (b) CZK 80 million, whichever is higher. If a company has exceeding borrowing costs below CZK 80 million or the limit calculated as 30% of EBITDA is higher than the exceeding borrowing costs, there will be no change in the tax base compared to the current rules. However, the problem is that EBITDA can only be determined after a rough tax return is prepared, i.e. when the taxpayer knows the value in line 200 of the tax return that will be further adjusted by the tax base, withholding tax bases, tax depreciation, exceeding borrowing costs, etc. Another pitfall is the definition of exceeding borrowing costs itself. In our opinion, it will be impossible to clearly detect the costs from, for example, a trial balance.

Exceeding borrowing costs will be deemed to include borrowing costs less non-tax-deductible financial costs under other provisions of the Act and less taxable borrowing income. However, the stumbling block will be the definition of the borrowing costs itself, as it will not only include financial costs (standard interest on credits and loans) from related parties but also all financial costs including bank financing, costs of other debt financing instruments, such as bonds, and the notional interest associated with derivatives and expenses relating to derivatives, interest on financial lease and expenses similar to such costs. In addition, the calculation will also include costs in the form of exchange differences related to the liability arising from the financing and the interest that is part of asset valuation under accounting regulations. However, to make things even more complicated, in the case of the last-mentioned interest, only such interest will be calculated that is part of the valuation of assets put into use after 17 June 2016.

In the end, the debt costs as set out in the Directive will either be deducted in full or the tax base will be increased in the current tax period by the difference exceeding the above limit. The good thing is that if, in the next tax period, the exceeding borrowing costs fall below the limitation of deductibility in a given year (i.e. below CZK 80 million or 30% EBITDA, whichever is higher), the tax base can be decreased again by the amount by which the tax based was increased earlier. However, in the given year, the tax base may be reduced by no more than the positive difference between the limitation of the deductibility of such costs and the costs incurred in the given period. At the same time, the Act does not define any deadline by which this compensation may be made. It only proposes that the possibility to reduce the tax base will not pass to the company’s legal successor.

Exemptions from the above rules will only apply to entities included in an exhaustive list of taxpayers whose activities consist in a specific form of dealing with debt financing (such as banks, securities traders, insurers, and pension funds). In addition, the above limitation will not apply to companies with a limited risk of tax avoidance, which means companies that are not members of any groups, have no permanent establishment and are not subject to the consolidation obligation.

If you need any help with tax optimisation or want to discuss anything, please contact us. We will be happy to help.