Amendment to Income Tax Act introduces huge changes in personal income tax

We discussed the impact of the amendment on corporate income tax in our June Tax and Legal Update. However, the amendment also has a very significant impact on personal income tax, as many provisions of the Income Tax Act apply to both legal entities and individuals. Moreover, the overall concept of the Income Tax Act is to change. Below, we discuss selected changes that will significantly affect individuals (natural persons).

Tax asset

For individuals, the definition of ‘business property’ will be abolished following the newly introduced accounting concept of ‘asset’.

Currently, for tax purposes, the business property of a taxpayer who is an individual is considered to be the portion of the taxpayer's property that has been or is being accounted for or included in their tax records. The taxpayer does not have any business property if they claim expenses as a percentage of income or if the property is leased. Whether the taxpayer has or does not have business property then has implications on the taxation and tax exemption of income from the sale of such property. The tax exemption is subject to a time test (10 years; 5 years for real property acquired before the end of 2020) from the moment of the acquisition of the real property and not from the moment of the disposal of the real property from the business property. And this is just one of the most common examples where this approach is applied.

The amendment completely changes the basic principles described above. For tax purposes, a new concept of ‘registered asset’ is introduced. This is to be an asset which the taxpayer has entered in their tax records or which is crucial for generating the taxpayer’s taxable income (i.e., rental income or income from self-employment where the taxpayer claims expenses as a fixed percentage, but also income by taxpayers under the lump-sum tax regime). The decisive factor is the factual state and purpose of the asset, i.e., whether the use of the asset is crucial for generating the taxpayer’s taxable income and not whether the asset is registered in their tax records. Its disposal should be the point at which the registered asset ceases to be an asset of the taxpayer. For a better understanding of the provision in question, it is necessary to look at the explanatory report, which states that this point in time will be considered to be, e.g., the sale of the asset in question. In other words, even if the real property has not been leased by the taxpayer for several years, it will still be considered a registered asset until sold.

The taxpayer who claims (deducts) actual expenses (instead of a fixed percentage) may choose not to register an asset in their tax records even if the asset is used for their business purposes. In this case, it will be treated as private asset. However, this option will not be available to individuals who have opted for the lump-sum tax regime or who claim expenses as a percentage of income. The term ‘registered asset’ will therefore have a much broader content and will affect a very wide range of taxpayers. For example, in the case of the lease of real property and its subsequent sale, the relevant income from the sale of the registered asset will be taxed as the individual’s income from self-employment.

The Ministry of Finance has already declared that such a radical change was not the aim of the amendment. Let us therefore wait to see what the amendment will look like after comments are settled.

Prohibition on depreciation of foreign real property generating income exempt from taxation in the Czech Republic

A Czech tax resident will not be considered to have a registered asset if income flowing from this asset is only income from foreign sources for which the exclusion method is applied to avoid double taxation. If the taxpayer, a Czech tax resident, owns real property in the UK and rents it out (lease income is taxed in the UK and exempted from taxation in the Czech Republic under the Czech-British double taxation treaty), it will not be possible to depreciate the real property in the Czech Republic. By not being able to claim depreciation expenses, the effective tax rate at which post-exclusion income will be taxed will increase significantly. The tax position of these taxpayers will thus effectively worsen compared to others (e.g., those who apply the foreign tax credit method under the relevant double taxation treaty).

Bookkeeping

The current Accounting Act prescribes the obligation to keep accounting records for a selected group of individuals (e.g., an individual who is an entrepreneur registered in the Commercial Register or whose turnover exceeds CZK 25 million).  The new draft Accounting Act establishes bookkeeping for individuals on a voluntary basis. However, the amendment to the Income Tax Act does not follow this approach and treats individuals keeping accounts as if they were not accounting entities. Such persons will not be able to derive their tax base from the results of their operations as has been the case so far, but their tax base will be determined in a similar way to other individuals (natural persons), i.e., on a cash basis.

However, the paradox is that many provisions of the amendment directly refer to the Accounting Act and introduce the valuation of things, services and debt according to the Accounting Act into the cash basis for determining the tax base. Although individuals will determine the tax base on a cash basis, a detailed knowledge of accounting will still be necessary to determine it correctly, which will undoubtedly be administratively demanding for them and cause disproportionate additional costs.

Transitional provisions

The transition to the cash basis for determining the tax base on the proposed effective date of the amendment, i.e., 1 January 2025, will be regulated for all individuals who keep accounts by applying the provisions governing the transition from keeping accounts to keeping tax records as applicable on 31 December 2024. Taxpayers with rental income or income from self-employment switching from keeping accounts to keeping tax records will follow a similar procedure. Another option will be to use the transition from keeping accounts to claiming expenses as a percentage of income or using the lump-sum tax regime.

Cancellation of the period for which the tax return is filed

Since the taxable period for corporate income tax will be newly linked to the accounting (reporting) period, the Ministry of Finance proposes to delete the term ‘period for which the tax return is filed’ throughout the amendment. However, the submitter of the amendment has obviously forgotten that occasionally, individuals also file tax returns for a period shorter than the taxable period (i.e., the calendar year), e.g., in the case of death of a taxpayer.

Conclusion

Perhaps now is the time for the Ministry of Finance to consider setting aside personal income tax into a separate law. This amendment shows that the principles of corporate taxation (accrual principle) and the direct link to the Accounting Act cannot be applied across the board to individuals where the cornerstones of taxation are based on the cash principle.