CZ GAAP

The implications of significant changes in Czech tax legislation on 2007 financial statements

A wide-ranging package of public finance reforms, which had been prepared by the government of the Czech Republic and approved by both chambers of the parliament, was finally signed-off by the president on 5 October 2007.   As a result, significant changes, mostly effective from January 2008, will be introduced to the Czech tax system.
You can see a summary of major changes to personal and corporate income tax in a special issue of Tax & Legal Alert prepared and released by the PwC Tax and Legal services department.
Not only will the tax position of the entities be affected by the proposed reforms, it will also have an impact on accounting. For example, deferred tax calculation will already be significantly affected for the financial statements for the period ending 31 December 2007 .
 

Examples of the changes, which will have an impact on the accounting practice, are as follows:

• Corporate income tax rate reduction
• Significantly tighter thin capitalisation rules
• The change in conditions for the tax deductibility of lease costs
• Proposed changes to the Act on Reserves

All significant changes will be applied prospectively.

Implications of the above-described amendments to the Income Tax Act to the calculation of deferred tax in accordance with CZ GAAP (2007 reporting periods):

The current 24% corporate income tax rate is proposed to be reduced by 5% in the period from 2008 to 2010 as follows:

• For tax periods starting in 2008 – 21%
• For tax periods starting in 2009 – 20%
• For tax periods starting in 2010 – 19%

The package of public finance reforms was already approved by Parliament (21 August 2007), by the Senate (19 September 2007) and also by the president (5 October 2007). This implies to the entities that they should be prepared to implement these rule changes to the process of deferred tax calculation. This approach should be applied in financial statements with a reporting date after the president`s sign-off (i.e. after 5 October 2007).
As regards to the financial statements and quarterly interim financial information with a reporting date as at 30 September 2007, the changed income tax rates should be treated as a non-adjusting post-balance sheet event with relevant disclosure in the notes to the financial statements. The effect of changed income tax rates should be calculated and also disclosed if material.

The entities should calculate their deferred tax using the income tax rate of the period in which reversals of temporary difference are expected. This for example raises the necessity of addressing the following issues during the process of deferred tax calculation: gradual reduction of the income tax rates will result in the necessity of more years projection of temporary differences reversal e.g.: differences between tax and accounting depreciation will need to be projected to periods of their expected reversal and reflected in deferred tax calculation using the appropriate income tax rate (i.e. 21%, 20%, 19%); the same analysis has to be prepared for other temporary differences such as valuation allowances for doubtful debts, inventories, etc.

Other proposed changes may have an impact on an assessment, whether a temporary difference will or will not arise at all. For example, one proposed change under the amendment of the Act on Reserves is the restriction of the possibility to create bad debt allowance to receivables of an amount exceeding CZK 200,000 for which court, administrative or arbitration proceedings have not been initiated. It will no longer be possible to create a tax deductible allowance for these receivables if court, administrative or arbitration proceedings have not commenced with respect to such receivables. This implies for example the following: Valuation allowance to receivables of an amount exceeding the limit provided above would never become tax deductible, if an entity does not have in place an effectively operating system of legal actions for collection of outstanding receivables. The tax value of this receivable would be zero in such a case.

The entities should also be prepared to present the profit/loss effect of the change in income tax rates on the closing balance of deferred tax and make relevant disclosures in the notes to financial statements.  

An income tax rate of 19% is considered to be appropriate for the calculation and disclosure of potential deferred tax asset, when the entity decides not to recognise it due to uncertain reversal of this asset, unless there are other specific reasons for applying of a different rate.

Other implications relevant to future reporting periods (2008 and after)

Not only will deferred tax calculation be affected by the proposed amendments, but tighter rules have been introduced in respect of the tax deductibility of certain expenses.

For example:

• Thin capitalisation rules will be significantly tightened
• Tax deductibility of financial lease expenses will also be restricted
• Minimum period of financial lease contract will be prolonged
• Depreciation period for passenger cars will also be extended 

The impact of all of these proposed changes should be carefully considered by the entities and properly reflected in their budgets and forecasts.