Capital improvements to fixed tangible and intangible assets are not uncommon in practice but often raise questions as to their tax consequences. In the Czech Republic, they must be reviewed not only under income-tax aspects but also under the aspect of VAT.
First, let’s briefly recap what tax law has to say about capital improvements. Their central definition is found in the Income Tax Act: Capital improvements are expenses towards complete annexes, conversions, and other structural modifications, refurbishments and upgrades of assets which in the aggregate exceed an amount of CZK 40,000 per individual asset item in the given assessment period.
Having said that, tax subjects may categorize expenses whose nature matches this definition under capital improvements even if their total amount does not exceed the CZK 40,000 limit – these are so-called minor improvements.
Beware! Land plots are non-depreciable fixed assets; as such, no capital improvement can be performed on them or entered in the books. If land is being improved e.g. by recultivation or amelioration measures, then this improvement must be accounted for as separate assets.
Expenses towards capital improvements of fixed tangible assets cannot be deducted (as is the case for the acquisition value of these items itself). They become tax deductible only upon depreciation of the said assets. As a rule, capital improvements will raise the acquisition value (or book value) which forms the basis for the depreciation (i.e., they are not being written off separately). Only in certain cases specifically enumerated by the law do capital improvements qualify as separate assets (e.g. if they were created from the entrepreneur’s own labor).
In practice, one often encounters repeated improvements over the course of years. The first capital improvement raises the acquisition value, to which a special coefficient is then being applied for the purposes of tax depreciation. If a later capital improvement were to occur, the (previously raised) acquisition value is being increased again; the calculation of write-offs uses the same coefficient, newly applied to the re-upped acquisition value.
Finally, capital improvements have VAT consequences as well. If the tax subject claims input tax deductions for asset purchases or improvements and the scope to which these assets are used later changes, then the tax subject must perform a “time test” and, depending on the outcome, may have to adjust the previously claimed amounts. The statutory period within which the tax entity must adjust input tax deductions on these grounds is five years in the case of fixed tangible assets (or 10 years in the case of buildings). It is therefore important to keep detailed and consistent records of all business assets and their increase through capital improvement.
Capital improvements on fixed assets is a huge topic, and we shall return to it in a future article which will look into intangible assets and discuss how to handle capital improvements of leased assets.
VAT Act (Act No. 235/2004 Coll.) Income Tax Act (Act No. 586/1992 Coll.) Czech Accounting Standard No. 013 for businesses