The end of ‘step-up’?

On 1st January 2007 significant changes were made to Polish Corporate Income Tax Law, eliminating the possibility of a tax free step-up in the tax basis of fixed assets to their current market value. Nevertheless, some taxpayers still have an opportunity to benefit form the previous tax regime. Such a possibility is available under the transitional regulations

 A tax free step-up in the tax basis of fixed assets to their current market value, and, as a consequence, the possibility of increased depreciation write-offs was one of the tax optimization methods frequently used by the taxpayers active in the real estate market. Recent changes to the Polish Corporate Income Tax (CIT) Law, largely prevent the use of this method. However, the Polish legislator, while introducing the transitional regulations, has created a “loop hole”, which under certain conditions, enables taxpayers to take advantage of the step-up also in the year 2007.

The concept of ‘step-up’

 The step-up concept is based on adjusting the historical initial value of fixed assets to their current market value. Such adjustment, for tax purposes, may be effectively carried out by transfer of the ownership of the fixed assets. The associated tax burdens are minimized through an in-kind contribution of fixed assets classified as an enterprise to a subsidiary of the previous owner, in exchange for new shares issued by the subsidiary. Such a contribution is tax neutral from both CIT and VAT perspectives. The only tax burden to the parties of such transactions is the Civil Law Activities Tax (CLAT) at the rate of 0.5 pct, levied on the increase in capital of the company receiving the contribution in–kind.

As a consequence of such a transaction, the company receiving the in-kind contribution is entitled to recognize the same operational revenues of the acquired enterprise. However the tax deductible costs should include higher depreciation write-offs on the stepped-up (i.e. adjusted) basis. In many cases accelerated tax depreciation rates (so called “individual depreciation rates”) can be used.

Not all is yet lost

 Amendments to the Polish CIT Law, effective from 1st January 2007, have entirely changed the rules for setting the initial value and depreciation write-offs of fixed assets acquired through an in-kind contribution of an enterprise. Namely, pursuant to this amendment, the initial value of fixed assets contributed as an enterprise for tax purposes, is no longer based of their current market value. Now, the initial value of such assets is established in the same manner as in the case of conversion or merger of the companies, i.e. based on the carry-over method.

Therefore, it may seem that step-up, as a tax efficient form of restructuring, has been effectively eliminated by the Polish legislator. Nevertheless, not all is yet lost. As already mentioned above, the Polish legislator has left a “loop hole” in the form of transitional regulations included in the CIT Law amendments. These transitional regulations allow the taxpayers whose tax year commenced under the previous regulations and ends after 1st January 2007 to benefit from previous, more favourable provisions of the Polish CIT Law until the end of that year.

Consequently, the entities:

which tax year constitutes twelve consecutive months, but is not in line with the calendar year, or

which started activities and their tax year in the second half of the previous year and decided to prolong this until 31 December 2007,are able, until the end of the current tax year, to benefit from the privileges under the previous wording of the Polish CIT Law and receive an in

-kind contribution, valuing it under the old, not the current regulations.

In other words, step-up in the value of the real estate is still possible in the case of an in-kind contribution made to a company that meets one of the abovementioned conditions. This is very good news, considering the fact that the previous regulations were very popular among the taxpayers.

Benefits & costs

 Before we decide to undertake the transaction of an in-kind contribution aimed at step-up in the tax basis of possessed fixed assets, it is important to calculate the potential benefits and costs in order to avoid situations, where costs associated with the transaction exceed the expected benefits. Thus:

wthe expected decrease of the tax burden resulting from higher tax depreciation write-offs, being tax-deductible costs, constitutes a clear benefit of the transaction;

wbut, advisory and legal costs, Civil Law Activities Tax, costs of valuation of the fixed assets, as well as various costs connected with the registration requirements must be incurred.

For whom?

 Step-up should be considered by taxpayers when the current market value of the possessed fixed assets significantly exceeds their current tax basis recorded in the books (being the basis for tax depreciation write-offs) and the expected benefits outweigh the costs associated with the transaction. Additionally, it is essential that the tangible and intangible elements of the property, intended for the in-kind contribution, fulfil the definition of an enterprise. Otherwise, the tax neutrality of the transaction is not achieved.

To sum up, despite the recent changes to the Polish CIT Law regarding the tax treatment of in-kind contributions, it remains possible to achieve a tax free step-up in the tax basis of fixed assets and, as a consequence, optimize the tax result generated on the business activities. Such optimization is possible provided we are in possession of a company that has an appropriate tax year enabling the treatment of the transaction of an in-kind contribution, for tax purposes, in line with the previous CIT regulations. We are aware that there are some companies with the appropriate tax year still available on the market. Nonetheless, the acquisition of such a company and in-kind contribution should be preceded by a thorough analysis of the underlying risks, as well as of the feasibility and profitability of the transaction.

step-up is an attractive option in the real estate market for the likes of developers and investment funds mainly due to the significant increase of the market value of real estate in recent years. However, this opportunity should also attract the attention of taxpayers carrying out other businesses but having real estate portfolios, the current market value of which significantly differs from the tax value recorded in the books.   

Tomasz Ożdziński

leader

Grzegorz Ziółkowski

senior consultant

Real Estate Tax Team of PricewaterhouseCoopers