The Croatian Investment Account (Croatian: Hrvatski investicijski račun – HIR) is presented as a tax-efficient way of investing. But what if, due to failure to meet the prescribed conditions, the HIR itself results in something that would never be taxable outside the HIR – becoming taxable? Situations of this kind may arise under the tax treatment of the Croatian Investment Account currently proposed. Namely, in certain circumstances, where withdrawals from the HIR become subject to personal income tax, the proposed method of determining the taxable base upon withdrawal from the HIR may result in the taxation of income that, had the assets not been held within the HIR, would be tax-exempt under the currently applicable rules. Therefore, we believe that, when considering whether to open a HIR, it is important to carefully assess not only its tax benefits, but also the details of the conditions, the failure to meet which may result in unexpected tax consequences.
To ensure that the tax benefits are used to their fullest potential and do not result in unpleasant tax surprises, please feel free to contact us with any questions or for assistance and advice regarding the tax treatment of investments and other tax matters. Below, we provide a more detailed overview of the several tax issues arising from the model currently proposed.
At the end of August, two public consultations were closed on the e-Savjetovanje platform that may be of interest to individuals investing in financial instruments: the consultation on the Draft Proposal of the Croatian Investment Account Act and the consultation on the Draft Proposal of the Act on Amendments to the Personal Income Tax Act.
The Croatian Investment Account (HIR) has been presented as a special individual account intended to encourage individuals to invest their savings in financial instruments that meet the conditions prescribed by law. Under the draft legislation, the assets of the HIR would consist of cash and eligible financial instruments, while one of the key benefits of the HIR is its preferential tax treatment of investments, whereby, provided that the conditions prescribed by law are met, income derived from the investment of assets held within the HIR would not be subject to personal income tax.
This commentary does not address the provisions governing, among other things, the maximum amount that may be deposited into a HIR, the financial instruments in which investments may be made, or the minimum percentage of the financial instrument portfolio that must be linked to issuers with a registered office or permanent establishment in Croatia. The focus of this commentary is exclusively on the tax aspects of the HIR.
One of the key tax benefits provided for in the draft HIR Act arises from Article 8 paragraph 5, pursuant to which the acquisition, disposal, exchange, transfer and other dealings in financial instruments within the HIR, as well as the accrual of dividends, interest and other returns, would not constitute a tax-relevant event at the time they occur.
In other words, transactions carried out within the HIR, as well as the accrual of dividends, interest and other returns, would not constitute a tax-relevant event at the time they arise. This represents a significant difference compared to investments held outside a HIR, particularly where an investor repeatedly buys and sells financial instruments, realizes capital gains or receives various types of returns within the account, while the funds remain within the HIR. At the same time, Article 13(1)(k) of the draft HIR Act provides that the mandatory contents of a HIR include information on the taxation of personal income generated through the investment of assets held in the HIR.
In parallel with the draft HIR Act, amendments to the Personal Income Tax Act were also subject to public consultation, proposing the introduction of a new type of income from capital – “income from capital based on assets held within a HIR”. Under the proposed amendments, income generated from the investment of assets within a HIR would not be subject to personal income tax, provided that the conditions and requirements prescribed by the HIR Act are met.
However, if these conditions are not met, the proposal provides for taxation at a rate of 12% as withholding tax, to be calculated and withheld by authorized intermediaries upon, and simultaneously with, the payment from the HIR, in accordance with the legislation governing HIR.
Particularly important in this regard is how the taxable base would be determined under the proposal – personal income tax would be payable on the portion of the amount paid out from the HIR that exceeds the cumulative amount of all deposits made by the account holder into the HIR.
This approach raises a number of questions, some of which are outlined below.
- New type of income from capital – no offsetting against other capital gains and losses
Under the proposed model, this new and separate type of income from capital would not interact with other, existing types of income from capital. For example, let us consider an individual who simultaneously has:
- a capital gain realized within the HIR, which, due to non-compliance with the provisions of the HIR Act, becomes taxable as income from capital based on assets held within a HIR, and
- a capital loss realized from the disposal of financial instruments held outside the HIR,
where both the gain and the loss arose in the same year from financial instruments held by the individual for less than two years.
Under the proposed concept, such a capital loss incurred outside the HIR could not be offset against the amount taxable as income from capital based on assets held within the HIR, solely because the relevant assets were held within the HIR. This is an important distinction from the treatment of capital gains and losses arising from investments held outside the HIR.
- The holding period of the financial instrument is not taken into account
Another issue arises from the fact that, under the proposed model, the taxation of amounts withdrawn from the HIR would not take into account the holding period of the particular financial instrument, nor the tax treatment that would have applied to that instrument had it not been held within the HIR.
For example, if a financial instrument held within the HIR is disposed of after having been held for more than two years and a capital gain is realized, that capital gain would not, in the event that the conditions for the HIR tax exemption are not met, be excluded from taxation solely because the financial instrument itself had been held for more than two years. By contrast, for investments held outside a HIR, the expiry of the two-year holding period is one of the key elements determining the tax treatment of certain capital gains.
Likewise, under the proposed concept, the holding period of a financial instrument prior to its transfer into the HIR would not be taken into account. This raises questions regarding the tax treatment of, for example, a financial instrument that an investor had held for more than two years before subsequently transferring it into a HIR.
- The taxable base may include income that would not otherwise be taxable
Another important issue arises from the manner in which the taxable base would be determined. Under the proposed model, the taxable amount is linked to the difference between the amounts paid out from the HIR and the cumulative deposits made by the account holder into the account. It appears that no distinction is made as to the source of that difference, i.e. whether it results from capital gains on the disposal of financial instruments within the HIR, dividends received, interest, other returns, or a combination of different types of income.
This may lead to interesting, and potentially tax-disadvantageous, situations.
For example, the amount subject to personal income tax upon withdrawal from the HIR could potentially include interest earned on bonds held as assets of the HIR, even though interest on bonds, in itself, may not be subject to personal income tax.
A similar question arises in relation to capital gains realized on debt securities and money market instruments issued by the Republic of Croatia and by units of local and regional self-government, for which specific personal income tax treatment also applies.
This raises the question of whether, under a model in which the taxable base is primarily linked to the relationship between total deposits and total withdrawals from the HIR, income that would, if considered separately, be exempt from taxation could effectively become subject to taxation.
An additional open question concerns the crediting of any foreign tax paid, for example in relation to dividends received from foreign issuers, particularly given that the proposal provides for authorized intermediaries to calculate, withhold and remit the tax simultaneously with the payment from the HIR. The tax would be levied on the portion of the amount withdrawn from the HIR that exceeds the cumulative amount of all contributions made by the account holder to the HIR, which means that any tax paid abroad would not be taken into account.
The HIR provides tax benefits, but may also give rise to potentially disadvantageous situations
There is no doubt that the HIR concept offers certain significant tax benefits. In particular, the fact that the acquisition, disposal, exchange and other dealings in financial instruments within the HIR, as well as the accrual of dividends, interest and other returns, would not constitute tax-relevant events at the time they occur may be particularly significant. Such a model also enables the reinvestment of returns without the need to calculate personal income tax on each individual transaction within the account which, had the assets not been held within the HIR, could constitute a taxable event under the applicable rules.
However, the tax benefits of a HIR do not necessarily mean that every withdrawal or individual situation will result in more favorable tax treatment than if the investment were held outside the HIR.
On the contrary, in the event that the conditions prescribed by the HIR Act are not met, the proposed taxation mechanism may result in situations where, upon withdrawal from the HIR, the taxable base includes a return that, had the investment not been held within the HIR, would have received more favorable tax treatment or, under the applicable rules, could have been entirely exempt from taxation.
At this stage, it should of course be emphasized that these are draft legislative proposals that have been subject to public consultation, and it remains to be seen what will ultimately be provided for in the final versions of the two acts once they are officially published in the Official Gazette of the Republic of Croatia (Narodne novine).
For this very reason, we believe it is important that individuals considering opening a HIR, which is presented as a model offering tax benefits, are fully informed not only about the tax benefits available when the conditions prescribed by the HIR Act are met, but also about situations in which, where those conditions are not met, the proposed model may result in less favorable tax treatment compared to investments held outside the HIR.
Under the currently proposed model, certain amounts may, in specific circumstances, become taxable even though, had the assets not been held within a HIR, such amounts would not be taxable under the currently applicable provisions of the Personal Income Tax Act. We consider this to be an important aspect that prospective HIR users should take into account before deciding to open such an account.
Therefore, before deciding to open a HIR, it is important to consider the overall tax implications, rather than focusing solely on the tax benefits available while the assets are held in the account and the conditions prescribed by the HIR Act are met.
It should also be emphasized that tax treatment is only one of the factors to be considered when making an investment decision. As certified tax advisers, our focus in this commentary is specifically on the tax aspects of the HIR – both its tax benefits and the potentially less favorable tax consequences that may arise under the proposed model. Other aspects of investing, as well as the investment decision itself, are left to investors and their investment advisers.
To ensure that the tax benefits are used to their fullest potential and do not result in any unpleasant tax surprises, please feel free to contact us with any questions or for assistance and advice regarding the tax treatment of investments and other tax matters.