Financing and related party services cost limitation, separation of sources of income and yet new transfer pricing (TP) reporting rules
This article is relevant for candidates sitting the Taxation – Poland (TX-POL) exam from the December 2020 session onwards. It is based on the tax legislation applicable to the tax years 2019 and 2020.
Scope of the rules
Historically Polish CIT rules allowed for largely unrestricted deductions of external (third party) financing costs (interest, commissions on loans granted and similar). At the same time costs of financing provided by related parties were restricted by both transfer pricing and specific, so called, 'thin capitalisation' rules, that set a given proportion of debt to equity as the limit for the amount of costs claimed as deductible in a taxpayer’s CIT settlement.
From 2018, this position has changed. While the TP regulations are still applicable in a similar format to related party transactions, the regime of restricting the tax deductibility of financing costs was overhauled.
Old 'thin capitalisation' rules were eliminated completely. Instead, a new global restriction on all financing costs was introduced. This means that both related party (eg shareholder) and third party (eg bank) financing costs are pooled together and tested for limitation on tax deductibility.
Calculation of the cost limitation
Tax EBITDA
The new rules (provided in article 15c of CIT Act) state that the financing costs of a taxpayer should be limited and the limitation cap should be calculated as 30% of the taxpayers EBITDA (adjusted by the safe haven rule discussed further below).
First, it should be noted that the Polish CIT Act does not rely directly on accounting rules and provides its own definitions of key concepts such as revenues, costs or income. Similarly, in this case its own 'tax' definition of EBITDA is provided.
Consequently, EBITDA for these purposes should be calculated as:
Taxable revenues (excluding taxable revenues from interest) less tax deductible costs (excluding financing costs) add tax depreciation.
Thus, for example, if Company A in 2018 reported:
| PLN | |
|---|---|
| Total taxable revenue | 300,000,000 |
| Total tax costs | 200,000,000 |
and we know that the above figures include:
| PLN | |
|---|---|
Interest income (on loans granted) | 20,000,000 |
Interest cost (on loans drawn) | 65,000,000 |
Tax depreciation | 45,000,000 |
Then the 'tax EBITDA', for the purposes of the deductibility limitation would amount to:
(300,000,000 – 20,000,000) – (200,000,000 – 65,000,000) + 45,000,000 = PLN 190,000,000
In this case, 30% of EBITDA would amount to PLN 57,000,000 (ie 190,000,000 x30%).
PLN 3,000,000 safe haven
The regulation also provides for a safe haven rule, allowing to claim as a tax deductible cost interest in the amount of up to PLN 3,000,000, irrespective of the value of the taxpayer’s EBITDA. In other words, even with a negative EBITDA the interest up to PLN 3,000,000 can be claimed as a tax deductible cost.
Safe haven vs 30% EBITDA controversy
Due to complex and ambiguous wording of the article 15c provision it is not entirely clear how the PLN 3,000,000 safe have rule interacts with 30% EBITDA cap. Hence there are conflicting tax interpretations, rulings and opinions issued.
One approach and way to read these provisions is to state that the allowed interest cap is the higher of the two figures. Thus, we compare PLN 3,000,000 and 30% of EBITDA and arrive at the cap for deductible interest costs. In the above example, it would be the amount of PLN 57,000,000 (higher of the two figures). Hence, out of the amount of interest cost of PLN 65,000,000 the part disallowed as a tax deductible cost would be PLN 8,000,000 (65,000,000 - 57,000,000).
However, an alternative interpretation of this law provision (shared in some rulings) is to state that the 30% EBITDA limit should be calculated on top of the PLN 3,000,000 safe haven amount. In this case, in our example the allowed interest cap would grow to PLN 60,000,000 (57,000,000 (30% EBITDA) + 3,000,000 (safe haven)) and thus the disallowed amount would be PLN 5,000,000 (65,000,000 – 60,000,000).
Exam approach to controversy
Such controversy in law and changing interpretation poses difficulty in examining this topic, however, the topic of financing costs is too important to be omitted from the exam. Hence, the approach taken in the TX-POL exam will be to use the approach resulting from the literary wording of law and predominant practice of tax authorities in the suggested solution – ie the limitation applied will be the higher figure of 30% EBITDA or the PLN 3,000,000 safe haven
However, considering the above-mentioned controversies and fluctuating tax practice and court jurisprudence, while marking, both methods of calculation will be granted equal marks. In other words, candidates calculating the interest deductibility cap as PLN 3,000,000 plus 30% EBITDA or taking the higher of the two figures as the cap would score equal marks. However, our recommendation to candidates would be to take the higher of the two figures in line with our approach.
Specific regulations
Last but not least, it should be noted that the above restriction applies to all costs of financing. While predominantly it would be the interest, also any commission, arrangement fees and similar costs imposed by creditors are treated as the equivalent of interest for the purposes of the cost limitation.
It should be also noted that in case the taxpayer incurs in a given year interest costs exceeding the limit, the interest in excess can be carried forward and off-set with income during the following five years (within the allowed limit).
Scope of the rules
Similarly to limitation of financing costs, 2018 CIT law changes introduced art. 15e of the CIT Act with a specific limitation of cost deductibility of expenses related to:
if such services are purchased from related parties or entities from tax havens.
It should be underlined that while the financing cost limitation applies to all financing costs, the above limitation of deductibility of service costs applies only to the above two cases of related party services and services rendered by tax haven based entities. In other words, a consulting service provided by a third party provider either Polish or resident in another country which is not listed as a tax haven should be fully deductible in the tax return.
Furthermore, the limitation does not apply (even if the parties are related), in the case of:
Calculation of the cost limitation
However, if the above exclusions from limitations do not apply, costs incurred directly or indirectly for related parties or entities from the so-called tax havens are excluded from tax deductible costs, where these costs in total exceed 5% of the amount corresponding to tax EBITDA in the tax year.
Tax EBITDA is calculated in the same manner as in the case of financing costs limitation. Thus in our example it would amount to PLN 190,000,000 and 5% of this amount would be PLN 9,500,000.
Safe haven and controversy
Similar to the financing costs limitation, the regulations also provide a PLN 3,000,000 tax deductibility safe haven, so the taxpayer can claim limited costs up to this amount regardless of the EBITDA level.
Also, similar to the financing costs limitation, the complicated wording of the provision caused disputes as to whether the total limitation cap should be calculated as the higher of PLN 3,000,000 or 5% of EBITDA, or rather as PLN 3,000,000 plus 5% of EBITDA.
In our example it would mean allowing as deductible costs either PLN 9,500,000 (higher of the two figures) or PLN 12,500,000 (3,000,000 + 5% EBITDA).
It should be noted that due to slightly different wording of the provision dealing with the intangible services as compared to the one dealing with financing costs, the controversies in this case are lower and the latter approach allowing the higher amount (3,000,000 + 5% EBITDA) is rather widely prevailing.
Exam approach to controversy
While in the case of intangible services cost limitation, the prevailing approach may be identified, due to limited contrary opinions still arising and possible changes in the interpretations, the examining approach is similar as in the case of financing costs. Although in the suggested solutions, the PLN 3,000,000 + 5% EBITDA approach will be adopted, both ways of calculation of the limit (ie higher of two figures and 3,000,000 + 5% EBITDA) will score equal marks.
Carry forward rules
It should be also noted that in case the taxpayer incurs in a given year restricted services costs exceeding the limit, the costs in excess can be carried forward and off-set with income during the following five years (within the allowed limit).
Another important change introduced by 2018 changes to CIT law, which requires clarification, is the clear separation of sources of income in CIT into capital gains source and operating income source.
Broadly, the capital gains income includes income (revenues) from:
Operating income comprises all other, 'standard', business activity income (manufacturing, trading, services etc). It is important to note that financial income from interest on loans (other than profit participating loans), bonds or bank deposits is treated also as operating income.
Both types of income are subject to the same 19% tax rate. However, the tax is calculated on each source of income separately and costs and losses from one source of income cannot be compensated with another source of income.
Thus, from a practical perspective the key implication of the above described income source separation is the necessity for the taxpayers (and candidates in the exam) to separate the costs (and tax losses carried forward if applicable) which are connected with the revenues from the two separate sources.
While in a situation of companies recording income on both capital and operating sources the eventual amount of tax will be the same as the one which would be calculated without the separation of sources, in a situation of one source producing income and the other a loss, a difference would occur. In this case the taxpayer would be obliged to pay tax on income derived from one source (eg capital gains) while the loss incurred on the other source (operating) would only be carried forward to be offset against potential income from the same source in future years.
The loss carry forward rules have not been changed (ie it is still five years with a maximum of 50% of the loss from a given year utilised in any following year), save for the necessity to calculate potential losses carried forward separately for each source of income and the ability to offset the losses only against the income from the same source (broadly in this respect the CIT rules are now similar to personal income tax rules).
In principle, the TP rules require related parties to enter into transactions which are based on market conditions. Under the amended definition of related parties, the TP provisions apply to direct or indirect relationships of at least a 25% shareholding (or other ownership participation if shares would not be issued by the given entity). Similarly to previous years (albeit with amended wording) where the same persons manage or have effective decisive influence over different entities then such entities shall be considered as related parties.
Amended provisions also clarify the possibility of TP adjustments to the reported taxable revenues or costs (which is in line with the exam approach taken in past years when such direct provisions were not present).
There was also an important change related to TP thresholds. Previously taxpayers had to prepare a specific documentation if their revenues or expenses in the previous tax year equalled at least the given amount of revenues.
The amended regulations impose a documentation obligation exclusively depending on the value of a transaction with the related party, and introduce documentation thresholds of:
The change of limits on one hand may limit the number of taxpayers needing to prepare TP documentation, on the other hand some taxpayers with small turnover who were in the past exempt from TP documentation obligations will still need to prepare the documentation for more material transactions.
It should be also noted that there is a formal obligation put on the management of the companies to certify that the transactions executed are of an arm’s length character and the management may be held responsible (under the Fiscal Criminal Code) if such statements are proven false.
Written by a member of the TX-POL examining team