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Limitation of depreciation costs in real estate companies

Amendments to the Corporate Income Tax Act proposed by the Polish Deal introduce an unfavourable regulation regarding the possibility to treat as tax deductible costs depreciation write-offs on real estate in real estate companies.
Rafał Zuchowicz
Senior TAX Specialist

Below we summarize the most relevant issues in the area of corporate income tax deductible costs on account of depreciation in real estate companies. It should be emphasized that on 8 September 2021 the whole draft of changes resulting from the Polish Deal was submitted to the Parliment and was referred for the first reading. This means that a stage of parliamentary work on the draft has begun. Therefore, it is difficult to predict what the final shape of the changes will be. The new regulations are to take effect as of January 1, 2022.

Proposed amendment to the provisions

According to the new Article 15 section 6, deductible costs are to be write-offs on account of wear and tear of fixed and intangible assets (depreciation write-offs), but in the case of real estate companies, write-offs connected with fixed assets classified under group 1 of the Classification of Fixed Assets (covering buildings and premises located therein, co-operative ownership right to residential premises, co-operative right to commercial premises) cannot be higher in a fiscal year than depreciation or amortization write-offs on account of wear and tear of fixed assets made according to the accounting regulations, charged in that fiscal year to the financial result of the entity.

Reason for amending the provisions

In the explanatory memorandum to the proposed amendments, the Ministry of Finance indicates two main reasons for introducing the above change.

First of all, the change is dictated by the need to reduce the differences between the value of taxable income reported by real estate companies in a tax year and the value of gross profit reported for the same period. The Ministry emphasises that the rules for determining the depreciation period and the annual depreciation rate specified in the Accounting Act are of a more individualised nature, based on the economic useful life of a given fixed asset. When determining them, one should consider, among others, the number of shifts during  which the fixed asset works, the pace of technical and economic progress, the efficiency of the fixed asset measured by the number of working hours or the number of manufactured products or another appropriate measure, as well as legal or other limitations on the time of using the fixed asset. Therefore, if a taxpayer, as a result of considering the aforementioned premises, deems it appropriate to apply a certain depreciation rate for accounting purposes, in the Ministry's opinion, there is no justification for applying a different rate for tax purposes. Of course, this is based on a belief that the rates used for accounting purposes will be lower than those currently in force for tax purposes.

At this point one might wonder why the Ministry did not decide to change the determination of depreciation write-offs according to the accounting regulations for all entities and all types of fixed assets? This question is answered by an additional argument in favour of the introduction of the said change, which, according to the Ministry, is the fact that in many cases real estate companies are entities whose revenues are derived from real estate they own, situated in attractive locations (e.g., in the centres of large cities). As time goes by the market value of such real properties increases rather than decreases, and the current rules of recognising depreciation write-offs on their value as deductible costs indicated its systematic decrease, which was contrary to the economic reality of the operation of such entities. The fact that depreciation write-offs constitute a significant cost item in real estate companies is probably also significant.

In our opinion, the Ministry of Finance completely ignored the fact that while the value of land as such increases systematically (which is reflected in the principle that land is not subject to depreciation), the value of buildings or structures decreases over time due to their physical wear and tear, i.e., it is a natural process of ageing.

Consequences of the amendment

Real estate companies that currently apply depreciation rates on Group 1 property for accounting purposes lower than those used for tax purposes must expect a reduction in deductible costs in this respect from 1 January 2022, which will increase the tax base.

In this situation, it seems that taxpayers who are real estate companies should immediately commence analyses aimed at reliable verification of the depreciation rates used for accounting purposes.  It must be remembered that, according to the Accounting Act, the correctness of the applied depreciation periods and rates should be periodically verified by each entity (in principle at least once a year), and the effect of such verification should be an appropriate (downward or upward) adjustment of the write-downs made in subsequent financial years. For this purpose, the aforementioned premises concerning the remaining period for which the fixed asset will be used should be analysed each time, i.e., whether the output of the fixed asset has changed, the number of shifts during which the fixed asset works, etc.

As a result of such periodic verification, depreciation periods and rates can be changed from the beginning of the next financial year - such a change cannot be made during the financial year. In addition, it should be remembered that accounting regulations permit a change in the period and rate of depreciation, but it is not possible to change the depreciation method adopted at the date of putting a fixed asset into use (for example, a change from the straight-line method to the declining balance method).

Another interesting issue is the impact of the amendment on real estate companies which recognise property held for accounting purposes as investment assets, i.e., assets held by the entity for the purpose of generating economic benefits from them. This type of real estate can be valued either according to the rules envisaged for fixed assets (and thus depreciated) or valued to market price or otherwise stated fair value (in this case depreciation write-offs are not made, but only changes in the market/general value are reflected in the books).

Unfortunately, the proposed amendment to the provisions of the Corporate Income Tax Act does not in any way refer to entities recognising real property as investments at the market/fair value, which leads us to assume that such entities will lose the right to depreciate their real property for tax purposes as of 1 January 2022.

Therefore, also in this case, taxpayers should consider both the correctness of the classification of real estate held as investment property (the provisions of the Accounting Act provide for the possibility of reclassification of real estate from investment property to property used for own purposes and vice versa) as well as the valuation model adopted for investment properties (the provisions of the Accounting Act provide for the possibility of changing the applied accounting policy concerning the valuation model for investment properties).

When it comes to the reclassification of properties from investment to own properties, this may happen, in principle, only if there is a change in the manner of using the property. As mentioned above, investment properties include real properties constructed and held for the purpose of deriving economic benefits from them, other than using them in operating activities (production, supply of goods, rendering of services, administrative activities). Thus, in fact, only the commencement of the use of a real property for the purposes of one's own business operations justifies its reclassification.

When an entity has designated a property as investment property and has decided to measure the property at the market value or at some other fair value, the entity may change its measurement model. However, it should be remembered that the change involves a change in the accounting policy and cannot be made entirely arbitrarily. Pursuant to the information contained in National Accounting Standard No. 7 "Changes in accounting principles (policy), estimated values, correction of errors, events after the balance sheet date - recognition and presentation", an entity may, in justified cases, depart from the continuous application of the adopted accounting principles (policy) and change them by making a retrospective restatement of comparative data if it considers that this is necessary for a clearer presentation of its property and financial situation and financial result. The new policy is always applied from the first day of the financial year (depending on the decision made by the entity's manager, it is the first day of the current or the next financial year). Such a change may be caused, among others, by an individual decision of the entity dictated by a change of the subject of its activity, an increase or decrease in its scope, the need to adjust to the solutions in force in the capital group which the entity entered or in the industry in which the entity started operating, the use of simplifications possibilities, the implementation of audit or financial review recommendations. A change in the adopted principles of measurement results in a need to change the presentation of such assets in the financial statements, also retrospectively (i.e., comparative data should also be restated).

The internal inconsistency of the proposed changes and the grounds for them is also worth noting, as the grounds for the bill indicates that the change will not apply to:

- the right to accelerated tax depreciation of brand-new fixed assets purchased by the taxpayer (Article 16k section 14 of the CIT Act), and

- one-off depreciation of fixed assets, addressed to small taxpayers and taxpayers commencing their business operations (Article 16k section 8 of the CIT Act).

However, these exceptions refer to other groups of fixed assets (groups 3-6 and 8 of the FAC), whereas the proposed changes are to concern group 1 of FAC. In addition, these exceptions described in the grounds for the bill have not been included in the bill itself.

Protection of pending interests

It seems that without introducing any transitional provisions the above-described change of regulations under the Polish Deal may violate the principle of protection of pending interests. A similar issue was resolved by the Constitutional Tribunal, which in its judgment of 10.02.2015 (Case No. P 10/11) referred to the possibility of depreciation of intangible assets, such as the right to use a share in a real property, in the light of changes in corporate income tax depriving taxpayers of the possibility to depreciate this right, entered into the register of fixed assets and intangible assets before 1 January 1999.

The Tribunal pointed out that the principle of protection of pending interests is an element of the broader principle of citizen's trust in the state, imposing an obligation on the legislator to formulate new regulations governing economic activity, while at the same time ensuring stability of its rules. According to this principle, if a provision of law ensures that certain rules will be in force for a certain period of time, and a citizen, guided by this assurance, commences certain activities, then such rules cannot be changed later to the disadvantage of the citizen. In practice this means, according to the Tribunal, that the legislator is obliged to take account, in appropriate transitional provisions, of the situation of taxpayers who, while conducting business, used the right granted to them to make depreciation deductions on account of ownership of the right to use a share in a real property and other intangible and legal assets.

The change in corporate income tax regulations resulting from the Polish Deal described here will have a significant impact on the amount of tax liabilities of real estate companies and, consequently, on the effectiveness of their business. It must not be forgotten that this business is often connected with high investment outlays (frequently financed with loans), the profitability of which will suddenly and significantly deteriorate in this situation. Therefore, as indicated by the Constitutional Tribunal, it seems appropriate that the proposed regulation should not only enter into force on 1 January 2022 but should also apply to properties placed in service after that date.

The regulations have not entered into force yet and parliamentary work on the project is currently underway, so it is impossible to say what the final shape of the proposed changes in this respect will be. Perhaps the Members of Parliament will also eliminate internal inconsistencies in the proposed amendments to the CIT Act. Nevertheless, it is already worth considering whether there are possibilities of avoiding the negative tax consequences of the planned changes. The KR Group offers full support in the analysis of both the depreciation rates adopted by taxpayers and the classification of properties as investment or own property, as well as the principles of their valuation, in view of the changes to be introduced.   

In the event that there are positions and further proposals we will keep an eye on the situation and inform you of the developments. 

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