Tax credit for undistributed profits

Tax credit for undistributed profits

In order to enhance the capitalization of Spanish companies, a tax credit in Spain has been introduced as from January 2015. Undistributed profits will enjoy a more favorable tax treatment than those distributed as dividends. Therefore, the decision of the shareholders about the application of the previous year’s profits  will have relevant tax implications.  This new tax credit, together with the restrictions to deduct interest payments, will try to stop the tax bias which favors financing companies with debt, rather than with equity.

Article 25 of the new Corporation Tax Act has created a new tax incentive, called “reserva de capitalización” aimed at encouraging companies to increase their equity funds by retaining their profits within the company as reserves. Consequently, retained earnings will support a lower tax burden than earnings paid out as dividends, providing certain legal requirements are accomplished.

Namely, the law allows to reduce taxable base an amount equal to the  10% of the profits that are  allocated  to voluntary reserves.  As a consequence, the actual tax burden of the profits retained as reserves would be taxed at an  effective tax rate of  25,2% ( or 22,5% for small and medium size companies) instead of the standard 28% and 25% for 2015.

Although It could be confusing, the fiscal incentive will be implemented in the 2015 tax period, even though the shareholders meeting will decide about the distribution of the profits of the 2014 fiscal year; in other words, the decision made by the shareholders meeting about the application of the 2014 fiscal year result will have no effect whatsoever on the 2014  Corporation  Tax.

The amounts credited to legal reserves do not enjoy this allowance. The reason is that the law aims to enhance the capitalization of the companies by rewarding the constitution of voluntary reserves; on the contrary, since the creation of legal reserves is compulsory, it would make no sense to grant a fiscal incentive in this case.

Currently, the legal implications of the profits used to offset previous year’s losses are not clear and should be clarified in the future by the General Directorate of Taxation.  Anyway, companies with offsetable previous year’s losses would not normally be able to create a specific reserve, the “capitalization reserve”, which is s a legal  requirement that must be accomplished in order to enjoy this incentive.

The reduction has its limit in the 10% of the tax base. In case the reduction exceeds the 10 % of the taxable base, it can be carried forward and applied during the next two years.

The Law imposes two conditions for the tax payer to apply this allowance:

  • The funds must be kept within the company for a period of five years since the fiscal year when the tax allowance was applied. For instance, reserves constituted in 2015 must remain until 2020. However, if a company registers losses during that period it would be entitled to use the reserves to offset these losses, without hampering the tax allowance.
  • A indistributable capital reserve, equal to the amount of the reduction, must be created.

Failure to meet any of these conditions  (for example, using reserves to distribute dividends)would  imply that the tax incentive is lost and hence the tax payer would have to pay back the tax saved before, plus accrued interest, during the fiscal year when the rule was infringed. No sanctions or any other penalties would be applied.





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