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New tax exemption for reinvested profit – a doubtful tax incentive for Romanian operations
In 2009, Romania was granted credit facilities by the International Monetary Fund which imposed, together with the European Community, certain economical conditions to be met at country level. Under these circumstances, Romanian authorities enforced measures meant to sustain the business environment in its efforts of overcoming financial difficulties and cash flow shortages. The so-called "tax exemption for reinvested profit" was one such measure, being retro-actively enforced since October 2009 and intended to be preserved until 31 December 2010. Currently, there is a public debate in the business environment on the benefits of such a measure, given the burdensome application methodology and the potential adverse impact in the future. Taxand Romania analyses the impacts of the tax exemption, its constraints and obligations and whether businesses will actually benefit from the cash-flow advantage it seems to provide.
Under this measure, the profit reinvested in the acquisition / production of equipment and machinery may be exempted from corporate income tax. By "reinvested profit", the law refers to the accounting profit of the period (cumulated from the beginning of the year up) when a new investment is undertaken. In other words, the exemption does not apply to retained earnings, but only to current profits. This approach is somewhat contrary to basic investment principles, where investments are made from funds earned in the past.
The benefits of the exemption are countered by an adverse requirement: the fiscal value of the assets purchased / manufactured has to be decreased with the value of the accounting profit considered to have been invested in those assets. In practice, this means that the tax deductible depreciation charges allowed over the useful lives of the assets will be lower or even nil (if the full value of the investment is covered by current profits), thus increasing the taxable profits of future periods. Overall, this tax incentive will therefore result merely in a cash-flow benefit, as the so-called exemption granted at the time of the investment is netted off by the increase in tax liabilities over the useful life of the assets acquired.
Another constraint in applying this tax incentive is an obligation to keep the assets acquired for at least half of their useful life. Otherwise, if the fixed assets are sold before this term, the taxpayer would owe the corporate income tax previously exempted (at 16%), plus late payment interest (at 0.1% per day of delay, counted from the date when the exemption was applied).
Another obligation imposed if applying this incentive is to allocate the exempted profit to a reserve, thus diminishing correspondingly the amount of profits available for dividend distributions. In other words, profit is exempted from tax but at the same time access to it is restricted. Moreover, the law does not mention any time limit for maintaining this reserve, which could be interpreted as a requirement to keep the reserve indefinitely.
Although no specific provisions are given as to the treatment of the above mentioned reserve if used anytime before or after completion of the minimum holding period of the assets, there is a general provision under the Romanian law dealing with reserves from tax incentives, which requires retroactive calculation of corporate income tax liabilities if reserves are used to cover losses or increase share capital. This means that late payment interest also accrues since the date of applying the incentive. Should this general treatment apply to the reserve in question as well, irrespective whether used up before or after the minimum investment holding period lapses, this would make the application of the incentive much more expensive than paying the tax in the first place.
The corporate income tax exemption for reinvested profit provides merely a cash-flow advantage by granting a tax relief at present while concomitantly increasing the tax base over the useful life of the assets acquired. The tax treatment of the reserve that needs to be created if using this tax incentive is not fully clear at this stage, thus leading to a potential risk of overall higher taxation if this reserve is eventually used up.
Under these circumstances, companies should analyse, in the context of their own business needs, whether the cash-flow advantage provided under this incentive is valuable enough to be worth running the risk of higher taxation at a later point. A prudent approach may be to wait until further clarification (if any) on the treatment of the incentive reserve issued by the tax authorities and apply the incentive only afterwards, if it proves to be favourable to the company. Of course, such a prudent approach may not be an option for companies undergoing cash flow difficulties, as this would mean tax is paid in full at the beginning and reduced with the amount of the incentive only at a later stage.
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