New rules for tax deductibility of interest expense

6. November 2018 Czech Republic

The so-called Anti-Tax Avoidance Directive (ATAD) adopted at the EU level in June 2016 aims at the determination of measures preventing the avoidance of tax obligations. This directive is yet another output of the OECD and EU incentive for the prevention of erosion of the tax base and profit shifting (BEPS).

Like the other EU Member States, the Czech Republic is obliged to implement the ATAD directive. At the beginning of last February, the Ministry of Finance published a draft amendment to the Income Taxes Act, which should implement certain ATAD measures into Czech law as soon as from 1 January 2019. The Ministry planed originally
a much broader and much more ambitious amendment, which would have also included significant conceptual changes in the taxation of individuals; however, due to the political situation, all potentially controversial changes of the income tax have been postponed and the amendment only contains the adjustments required for the implementation of the ATAD measures and several less crucial amending rules.

The key novelty arising from the ATAD measures consists of the new rules limiting tax deductibility of interest expense. Unlike the current low capitalisation rules (Section 25(1)(w) of the Income Taxes Act), these rules will also cover loans from unrelated parties (such as bank loans). The new rules shall apply to all payers of corporate income tax, with the exception of financial undertakings and entities outside the group. The existing rules, which limit tax deductibility of interest expense (including the above-mentioned low capitalisation rule) will stay in force and will apply concurrently with the new rules.

The exceeding borrowing costs (i.e. the difference between the otherwise deductible borrowing costs and taxable loan income) will be deductible only to a specified limit, i.e. to the higher of the following amounts: 30 % of the taxable EBITDA (i.e. earnings before tax, interest, depreciation and amortisation) and CZK 80 million. In the end, the Ministry did not use in the draft amendment the formerly considered determination of stricter de minimis limits, which could be set by the Member States in accordance with the directive.

According to the proposed amendment, the term “borrowing costs” is defined relatively broadly and includes, for instance, interest capitalised in the input asset price, the interest components of leasing instalments or exchange rate differences related to financing.

The exceeding borrowing costs, i.e. the costs in excess of the above limit, will not be tax deductible for taxpayers; however, if their exceeding borrowing costs do not surpass the specified limit in the following taxation period, the taxpayers will be allowed to deduct them subsequently from the tax base. This possibility should not be limited as to time.

Although the ATAD permits the exemption costs of loans executed before 17 June 2016 from the effect of the new rules, this limitation was not reflected in the draft amendment. Hence, the calculation of non-deductible borrowing costs should include the costs of all lending instruments, notwithstanding their execution date. The sole exception is represented by the borrowing costs constituting a part of the valuation of assets put to use before 17 June 2016. Such costs will not be included in the calculation.

Given the high limits, it can be expected that only a small number of large companies with a high share of debt financing will be actually affected by the new rules. Such companies include, among others, namely real estate and developer companies. Moreover, the draft amendment to the Income Taxes Act does not allow transferring the possibility of reducing the tax base by the amount of non-deductible borrowing costs to the legal successor.
As frequent mergers and other transformation types are typical for real estate and developer companies, this measure may disallow them to claim non-deductible exceeding borrowing costs from previous years. In the event of implementation of stricter rules during the legislative process, or in case of a change of any external factors (such as an increase of the interest rate), the impact of the new rules on business companies may be broader.

Companies should keep in mind the new rules for tax deductibility of exceeding borrowing costs and should include them in their long-term investment and financial considerations. In connection with the introduction of the new rules, we recommend considering not only the overall amount and structure of loan resources, but also a prediction of the development of the interest rates. In addition to the pass-through interest expense, the exceeding borrowing costs also include, for instance, the interest capitalised in the acquisition cost of tangible assets in the form of the proportionate part of the tax depreciation in the relevant year. As the new rules will also affect the interest on loans executed before the effective date of the ATAD, it will be also necessary to include in the calculation of the borrowing costs the interest capitalised in the acquisition cost of assets that have already been put to use (with the above-mentioned exemption of assets which were put to use before 17 June 2016). Significant impacts in this respect may be expected particularly in case of sale of such assets due to the interest component of the tax residual price of the sold assets which will be included on a non-recurring basis in such calculation.

The draft amended has already passed the external comments round; therefore, the professional public has already had an opportunity to express their opinions on the draft. Some comments have been presented, for instance, by the Chamber of Tax Advisors of the Czech Republic. The draft amendment has been approved by the Government and presented for approval to the Chamber of Deputies; the first reading is scheduled for the second half of September. With regard to the length of the standard legislative procedure, it is not sure, however, whether the amendment will be approved in time to become effective on 1 January of the next year. It will still be interesting to follow any modifying proposals and it is a question whether the application of the new rules will not be ultimately postponed by several months or even by a whole year. We will keep you informed about all future developments.