Regulars
REAL ESTATE
Real estate investments and recent changes in the Fiscal Code

by Richard Grotendorst
March 2005

Real estate investors throughout Europe are optimistic about the industry’s potential to generate healthy returns over the coming year, according to the highly regarded real estate investment report, Emerging Trends in Real Estate® Europe 2005, published in January by the Urban Land Institute and PricewaterhouseCoopers LLP. “The intense competition for prime assets has forced almost everyone to search for overlooked corners of markets,” the report says.

This sense of buoyancy has been felt in Romania as well in the past year, as the real estate market has witnessed rapid development. This has been underscored by the heightened interest shown by real estate developers who have constructed a host of class A offices, shopping centres, industrial facilities and residential buildings.

In the meantime, Romania’s new government has been quick off the mark in modifying the country’s tax system and a raft of changes have either already been enacted or are in the pipeline, which will influence real estate investments.

But first a few legal aspects need to be addressed to better understand the impact that these tax changes will have on real estate investment structures.

Legal framework
Romanian individuals and companies (regardless of the citizenship of the shareholders) are free to acquire land. Although foreign individuals and companies can not own land in Romania, they may own buildings (excluding the land under the building) and/or acquire the right to use the land (based on lease agreements, concession agreements, and so on). In practice, foreign real estate investors acquire land through Romanian companies.

Reduction in both income tax and profit tax
Individuals investing in real estate are subject to individual income tax on the net rental income - the rent less a deemed expenses deduction. Since 1st January 2005 the individual income tax rate was reduced to 16 per cent and the deemed expenses percentage has been reduced to 25 per cent. Thus the effective tax rate on the rental fees has been reduced from 20 per cent to 12 per cent, increasing the return for investors.

If the property is owned by a real estate investment company, the rental income and expenses incurred are part of the total profit of the company. Since 1 January 2005 the profit tax rate was reduced from 25 per cent to 16 per cent, which has a positive impact on the effective return on real estate investments. Dividends increased from 5 per cent to 10 per cent for natural individuals, however for residents of a country with which Romania has signed a Double Tax Agreement (DTA), the domestic withholding taxes can be overridden by the DTA.

Capital gains on property sales
At the sale of real estate by a local company 16 per cent profit tax is due on the difference between the sale price and the fiscal book value. The capital gain from the sale of shares in a Romanian company is also subject to 16 per cent profit tax. Please note that DTAs do not always allocate the right to tax the capital gain derived from the sale of shares in a Romanian company to the country of residence of the shareholder if the assets of the company principally consist of real estate.

Any profit, including capital gains, obtained by non-resident companies directly from Romanian real estate is subject to 16 per cent profit tax. Under the majority of applicable DTAs, the right to tax this income is allocated to Romania.

A 10 per cent profit tax rate may apply to capital gains from the sale of Romanian real estate as well as from the sale of shares held in Romanian companies, provided the transaction does not involve related parties and the property or shares were held for more than two years.

Until now, capital gains on the sale of real estate by individuals were tax exempt in Romania (provided that such transactions were not frequent). Capital gains on the sale of the shares in companies owning real estate by individuals were taxed at 1 per cent.

But in mid-February the Ministry of Finance issued a release on the taxation of capital gains, announcing that individual income tax due on capital gains on shares will be increased from 1 per cent to 10 per cent as of 1 April 2005. The ministry announced that the 1 per cent individual income tax would still be applicable for shares that were held for a period of at least one year prior to 1 April 2005. The individual income tax on capital gains from shares acquired less than one year prior to 1 April 2005 should be calculated as the sum of (a) 1 per cent of the difference between the value of shares on 31 March 2005 and the acquisition price and (b) 10 per cent on the difference between the sale price of the shares and their value on 31 March 2005.

The reduced 10 per cent rate for capital gains of companies is expected to be abolished in the future, implying that these capital gains will be taxed at the standard profit tax rate of 16 per cent.

The statement also indicated that a tax may be introduced for capital gains from the sale of real estate by individuals if made for speculative purposes. It is expected that there will either be a 10 per cent tax on capital gains for sale of real estate held for less than a certain period (probably two to four years), or a 2 per cent tax on the transaction value if the real estate is held for less than two years.

Thin capitalisation
The tax-deductibility of interest on debt used to finance real estate projects and foreign exchange losses related to long-term loans are limited by the thin capitalisation rule incorporated in the Romanian Fiscal Code. This rule stipulates that the interest expenses and net foreign exchange losses related to loans (other than those expressly mentioned by law) are not recognised as deductible in the year when they are booked if the debt-to-equity ratio of the company exceeds a certain limit. This rule obviously influences the ratio in which real estate investment companies finance their investments with equity capital and / or debt. However the non-deductible expenses can be carried forward and will become deductible when the debt-to-equity ratio is achieved.

Since 1 January 2005 this thin capitalisation rule has been brought more in line with similar rules applicable in other EU countries, with the limit for the debt-to-equity ratio being increased from 1:1 to 3:1. This increase will allow real estate investors greater flexibility in deciding on their financing strategy and more possibilities of attracting external financing.
Loans from financial institutions as well as short-term loans (duration period below 12 months) are not subject to the thin capitalisation rules.

VAT
The purchase of Romanian real estate is subject to 19 per cent VAT. Provided the real estate investors were registered as VAT payers, this VAT charged by the seller could be recovered from the state through a VAT return. In practice, VAT refunds can take a considerable amount of time, as, among other things, the refund could be subject to an audit by the tax authorities. Although interest compensation can be paid by the tax authorities, this leads to a cashflow disadvantage. Since 1 January 2005 this disadvantage can be solved if both parties in the sale-purchase transactions are registered as VAT payers. If so, both parties can record the VAT both as output and input tax in the VAT return, without effectively paying the VAT.

Advance tax rulings
In November 2004 a Government Decision was published regarding the approval of the criteria and required documents for issuance of advance tax rulings by the tax authorities. Until 2007 this is only available for large companies. The advance tax ruling is defined as being the individual administrative act, issued by the Central Tax Board at the request of the taxpayer, which establishes the legal framework for a transaction or an action, which will be performed in the future by the taxpayer. In our view this is a positive development within Romanian taxation, which could lead to more certainty for real estate investors about tax implications on their transactions.

Envisaged changes upon EU accession
Romania’s target date to join the European Union has been set at 2007. The Romanian Fiscal Code provides that the so-called EU Parent / Subsidiary Directive would be applicable for dividends distribution starting EU accession date. The EU Directive basically stipulates that dividends distributed by a company resident in one EU member state to a company tax resident in another EU member state should generally not be taxed with dividend withholding tax at the level of the subsidiary. Furthermore, it implies that the EU member state of the parent company receiving the dividend should provide for a method to eliminate double (corporate income) taxation of the dividend received. These regulations will be subject to certain minimum holding provisions, so that a certain minimum percentage of shares in the subsidiary are owned for a certain period of time. Implementation of this EU Directive would generally lead to a reduction of Romanian and other EU member state taxes to be imposed on investments in Romanian real estate, consequently increasing returns for investors.

Richard Grotendorst is a senior manager at PricewaterhouseCoopers.