Capitalization of interest within acquisition cost of fixed assets

Matěj Merxbauer

During our audit practise, we encounter cases where companies address the potential negative tax implications of financing their investment and operating needs. There is, therefore, an increasing effort to optimize the tax base. This idea led us to summarize the possible procedures and pitfalls of this issue.

A relatively significant milestone regarding tax legislation is the date of April 1, 2019, when Act No. 80/2019 Coll., Amending certain tax laws and some other laws, comes into effect.

The identification of the lender or loan provider is crucial. In practice, we divide providers into natural and legal persons. The most frequent creditor from the group of natural persons is a partner. From the group of legal persons, we will only deal with creditors from the group of related parties for this article.

Creditor natural person - partner

In a situation where a creditor is a natural person of a partner who provided the company with an interest-bearing loan for operating or investment needs, the situation is much more complicated. According to § 24 par. (zi) Income tax law, Interest from such a loan is tax-deductible only if it has been paid during the period in question. Frequent cases occur where the deferred maturity of principal and related cumulative interest is determined. In such cases, interest is not tax-deductible in the period and will not be deductible in any subsequent periods. Thus, the pressure of the company for another form of tax base optimization is increasing, so that it does not deprive itself of the interest tax shield.

Creditor a legal person - a related entity

The situation of creditors by legal persons is different. A debtor entity performs a low-capitalization test where non-tax-deductible finance costs are the costs of the amount by which the aggregate amount of the related credit instruments exceeds the amount of four times the equity. From 1 April 2019, however, it is necessary to pay attention to the test for excessive borrowing expenses even after passing the low capitalization test. It sets tax-deductible costs up to 30% of tax profit before taxes, interest, depreciation, max. CZK 80 million. If an entity has incurred interest costs higher than a given level, the excess can be claimed within the tax base of subsequent periods. In this situation it is necessary to evaluate the impact of the temporary difference on the deferred tax, the drawdown is not time-limited. If the low capitalization test fails, as mentioned in the previous paragraph, the pressure of the company for another form of tax base optimization is increasing, so that it does not deprive itself of the interest tax shield.

As a result of both of the above, we have encountered cases in which our clients have capitalized interest expense in an attempt to draw an interest tax shield, as allowed by paragraph 5 a) Section 25 of Act No. 563/1991 Coll., on Accounting and in accordance with other legislation. Capitalized interest enters the cost of assets and is reflected in the tax base through tax depreciation. The entity thus avoids losing the tax shield and draws it gradually.


Historically, an entity drew an operating loan from its parent at an interest rate of 5% p.a. with deferred maturity of principal and accumulated interest until the period of 2023. Accumulated interest as of January 1, 2019, was CZK 900 thousand. Interest expense for 2019 was CZK 1,200 thousand. Taking into account the previous experience with the preparation of CIT tax return for 2018, the entity decided to carry out a technical improvement on its assets in the amount of CZK 500 thousand. As of 30 November 2019, the Company has put the technical improvement into use at cost of CZK 2,600 thousand. CZK, which will be depreciated under valid tax legislation for 5 years. Therefore the total amount of capitalized interest was CZK 2,100 thousand.

Following the representative example above, if an entity decides to capitalize interest, it is important to first examine several factors. These are the following:

  • Purpose and volume of funds drawn
  •  Amount of interest rate

If the entity decides to capitalize the interest, The original purpose of the funds received should be linked to the acquisition of the property in question. It is clear from the Accounting Act that only related interest to the acquisition cost of the asset can be capitalized. There may be situations in which an entity decides to use the tax capitalization instrument to optimize its tax base. The entity will therefore develop efforts to capitalize as much of its interest costs as it is unable to classify as tax-deductible. Unfortunately, the Czech legislation does not provide us with a precise definition of exactly what part of the interest can be capitalized and what is over. The term RELEVANT is decisive. It can be considered as an abuse of the Tax Code, in the cases when the interest is capitalized on loans that were not and should not be used for acquisition purposes of the relevant asset.

In some cases of less developed recordings of loans in entities when identifying the relevant portion of interest versus the irrelevant portion is uneconomically demanding. In this respect, the Czech legislation is inadequate and allows considerable free use. For these cases, we are looking for a helpful opinion with International Accounting Standards. In particular, IAS 23 deals with the issue of borrowing costs. Among other things, this Standard speaks of determining capitalizable interest. It divides situations into two possible cases:

  1. Situation in which the entity is able to identify a particular loan and related interest that relates to the acquisition of the property in question
  2. In situations when the entity is unable to identify a particular loan and related interest, the average interest rate of all loans drawn ought to be used, the so-called capitalization rate.

In situation A, capitalization is appropriately simpler, component of the acquisition cost will be relevant amount of the capitalized interest. In situation B it is necessary to calculate the weighted average interest rate of all drawn loans and multiply it with the actual acquisition cost of the asset in question. This gives us the total amount of interest related to the acquisition of the property, that can be capitalized if necessary.

Given the fact that the company from the example mentioned above had only drawn only one loan, the total amount of capitalizable interest would be calculated as follows. Interest rate 5% of CZK 500 thousand, which represents the purchase price of technical improvement, which was under construction for 21 months. The total value of capitalizable interest in this case would therefore be approximately CZK 44 thousand. In this example, it is apparent how much the specimen entity has erroneously increased the value of its assets and modified its tax base.

Although the provisions of IFRS may be taken for the statutory financial statements purposes, prepared under Czech accounting legislation rather as helpful, given the gradual harmonization of Czech accounting legislation with IFRS, it is certainly a suitable tool to proceed in case of absence of clearly defined local accounting procedures in compliance with the tax law and accounting standards to actively prevent a possible dispute with the tax authority.

In case of any further questions regarding this topic, do not hesitate to contact me.


Matěj Merxbauer
Junior Audit Manager