Croatia, Professor Hrvoje Arbutina, Ph.D., Topic 1: Direct tax rules and the EU fundamental freedoms: origin and scope of the problem; national and Community responses and solutions

Explanation of the Croatian tax system

1.

Taxation of individuals

Taxpayer. Individuals are exclusive taxpayers of the personal income tax. They are divided in two categories – resident and non-resident taxpayers. Resident taxpayers are those that have residence or habitual abode in Croatia; individuals that do not have residence or habitual abode in Croatia but earn taxable income in the country are non-residents. Residents pay income tax on their worldwide income. Non-residents pay income tax only on their Croatian income.

Taxable income and tax base. There are five categories of taxable income: employment income, self-employment income, income from property and proprietary rights (e.g. income from renting and leasing movable and immovable property, capital gains), income from capital, income from insurance, and other income (e.g. income of members of supervisory and management boards, income of agents, journalists, artists and sportsmen). Tax base is generally the difference between receipts and expenses, except for the income from capital and insurance, where expenses are not allowed.

Withholding tax.Employers are obliged to withhold tax from salaries at progressive rates. If employee receives only employment income, the withholding tax is final. The value of shares received from the employer is subject to a final 15% withholding tax. Receipts from voluntary pension insurance and life insurance are subject to a final 15% withholding rax.Income of the category "other income" is subject to a final 25% withholding tax. Taxable types of interest (interest on loans and credits) and royalties are taxed by way of final withholding; the rate is 35% on taxable interest and 25% on royalties.

Allowances.A basic personal deduction of HRK 1.600 per month is granted for resident taxpayers. Retirees are entitled to personal allowance of HRK 3.000 per month. There are also monthly allowances for the dependent mebers of the taxpayer's family. Non-resident taxpayers may deduct only the basic personal allowance, and not the allowance for the dependent family members.

Tax rates.The rates of income tax are progressive:

Taxable income (HRK) / Rate (%)
Up to 38.400 / 15
38.401 – 96.000 / 25
96.001 – 268.800 / 35
over 268.000 / 45

Capital gains taxation.Capital gains from the sale of immovable property and proprietary rights are subject to 25% flat rate tax. Income from renting and leasing is subject to a 15% flat rate tax.

Losses.Losses can be carried forward for five years. They are set off against taxable income before deduction of personal allowance.

Investment income.As for the investment income, dividends are exempt from income tax. Interest on savings or current accounts in domestic or foreign currency and on securities is exempt. In general, no deductions are allowed for the calculation of the taxable base of investment income.

International aspects.Most types of income derived by non-residents are subject to withholding tax at the following rates: 25% on royalties, director's remuneration and on income of sportsmen, artistes and entertainers, and 35% on taxable interest.

In tax treaties that Croatia concluded as independent state, the method of the ordinary tax credit is applied; unilateral relief is also granted in the form of an ordinary tax credit for the taxes paid abroad.

Taxation of companies

Taxpayer.Taxpayers are legal entities engaged in business for the purpose of making profits. Permanent establishments of non-resident enterprises are also taxpayers. General and limited partnerships are legal persons, and taxable persons accordingly. Silent and civil partnerships are transparent for tax purposes, i.e. their partners are taxed individually on their share of the profits for the purposes of profits tax or income tax, as the case may be. Taxpayers are divided in two categories: residents, entities whose legal seat or place of effective management and control is located in Croatia, are subject to profits tax on their worldwide income. Non-resident taxpayers are permanent establishments of the foreign entrepreneuers (i.e. entrepreneuers whoselegal seat or place of effective management and control is not located in Croatia); they pay profits tax only on the profits from the Croatian sources.

An individual entrepreneur engaged in a business activity may opt to be subject to profits tax, instead of income tax. From 1 January 2006, an individual entrepreneur conducting a small business will be subject to profits tax if in the preceding year: his turnover was at least HRK 2 million, or his net income was at least HRK 400.000, or he employed on average more than 15 employees, or the value of his depreciable assets exceeded HRK 2 million.

Tax base.The taxable base is computed on accrual basis. The profits and loss account kept in accordance with the law on accountancy is adjusted for tax purposes. Dividends and other earnings from shares in legal entities are exempt. Losses can be carried forward for five years.

Tax rate.The rate of the profits tax is 20%.

Withholding tax.There are no withholding taxes on payments to resident companies.

Investment and employment incentives.A taxpayer may be taxable at a reduced profits tax rate or be exempt from profits tax altogether, depending on the level of investment and the number of employees, for a period of ten years commencing in the year in which the investment begins.

Transfer pricing.If prices or other conditions between related parties do not conform to the arm's length principle, the tax authorities may make an adjustment. In general, enterprises are deemed to be ralated if there are management, control or capital relations between them. The arm's length price is determined according to the following methods: the comparable uncontrolled price method, the cost-plus method, the resale price method, the profit-split method or the transactional net margin method.

Thin capitalization.Under the thin capitalization rules, interest paid or accrued on a loan is not deductible if 1. the loan is granted by a shareholder owning more than 25% of the share capital or voting power of the company and 2. the loan exceeds the amount of four times the shareholder's interest in the company's capital.

International aspects.As in the case of individuals, in tax treaties that Croatia concluded as independent state, the method of the ordinary tax credit is applied; unilateral relief is also granted in the form of an ordinary tax credit for the taxes paid abroad.

National courts

2. The court authorized to deal with direct tax matters is the Administrative Court of Republic of Croatia. This authorization follows from the Constitutional warranty of the court's control of administrative rulings. Materializing that warranty,the Administrative Court decides on the legality of administrative acts on rights and obligations in administrative matters; this includes tax matters too.

The Constitutional Court may, also, decide direct tax cases as the court of last instance if some administrative ruling violates Constitutional rights of individual taxpayers.

3. There is a number of cases, concerning direct taxes, decided by the Administrative Court, especially if it comes to the individual income tax. However, since Croatia is not (yet) the Member State of the EU, the issue of EU's fundamental freedoms and their violation has not yet been decided by the Administrative Court. TheCourt deals mostly with questions concerning tax base determination, personal allowances and the status of taxpayers (resident/non-resident). As for the profits tax, the number of cases reported is significantly lower than that of the individual income tax, and they all refer to tax base determination.

To sum up, at the moment there is no litigation of a particular significance, i.e. of significance as a milestone for the future practice, andcertainly not one interesting from the "European" aspect.

4. One could hardly conclude on the issue of increase of decrease in the volume of litigation, since the Administrative Court does not report the number of cases separated according to administrative field particular case belongs to. However, the Administrative Court displays, on its web page, an overall statistics; it shows a significant number of cases being decided since 2001. Namely, the key problem of the Croatian court system generally was, and still is, a large number of unsolved cases, that drags on through years, becoming even bigger. Statistics of the Administrative Court show a decrease of unsolved cases in last years, thanks, according to the Court itself, mostly to the computerisation of the Court. Consequently, one could conclude, with certain caution, that the number of unsolved direct tax cases has droped accordingly.

The Administrative Court is not only willing, but obliged to decide direct tax cases itself. This kind of cases is, by all means, within its authority and capacity, so the Court has to decide them. TheCourt has not so far shown the intention to decline its jurisdiction in direct tax matters.

The body authorised to decide in second instance in tax matters is the Independent Second Instance Service for Tax Procedure. Although established within the Ministry of Finance, this Service is (or should be), independent while deciding cases; hence the word "Independent" in its name. After a case is, by reason of appeal, decided by the Service, taxpayer can begin legal action at the Administrative Court. That is why this Service is perhaps the instance most qualified for critical judgement of the Court's decisions.

In a lengthy conversation, the Director of that Service did not point at any case of particular disagreement with the Court's decisions, although there were some remarks on the lack of the Court's expertise in tax matters. These remarks, however, might originate from the (perhaps natural and understandable) rivalry between tax specialists on one side and general judiciary personnel of Administrative Court on the other, authorised to decide, inter alia, the tax matters. In the literature, too,rulings of the Court have not been chalenged by, for example, tax administration.

Areas of potential conflict

  • In the context of the systems of taxation of corporate profits and dividends, there is no ground for conflict, since Croatia, in this moment, does not tax dividends, neither outbound nor inbound.
  • In the Croatian profits tax system, losses (and profits) of branches, including foreign branches, are reported in consolidated report of the parent company; therefore, losses can be offset against the profits of the parent. Subsequently, the foreign branch's profits tax can be credited against the home tax that would burden that profits. However, Croatia does not stipulate any particular system of the group taxation; therefore, losses incurred by subsidiaries cannot be taken into account. As it follows from the cases important for the group taxation, the key problem is the privileged tax treatment of domestic subsidiaries, compared with foreign ones. Inexistence of such, partially privileging, system of group taxation makes, in this part, Croatian tax system simple, eliminating thus the possibility of discrimination, since all branches and subsidiaries (domestic and foreign) enjoy the same tax treatment.
  • Resident taxpayers pay income tax on their worldwide income; consequently, worldwide loss may be taken into account when it comes to calculating their income tax. Croatian rules stipulating losses are scarce. Namely, if in the process of determining the tax base a negative base is determined, the taxpayer shall have a tax loss.Losses can be carried forward for five years, equally for companies and individual taxpayers. Earlier tax losses are set off before later losses. Since there are no other limitations for companies, it could be concluded that there is no ground for a potential conflict. Individuals can offset the loss against the sort of income of the same kind; in the case of the capital gains tax, if theloss is incurred, it can be offset only against the income from alienation of real estate and intelectual property, which is realised during the same calender year.There is no, however, territorial limitation to carry-over of losses, so it can be assumed that there is no ground for the discriminatory treatment in the present Croatian tax system.
  • Taxation of gains on transfers of assets is stipulated in Croatian Income Tax Act, as well as in Profist Tax Act. However, it should be stressed that those Acts nowhere refer to transfers abroad. When concerns individuals, taxation of (realised) gains arises if the business is alienated or liquidated and if there is no the so-called "tax continuity", meaning that there is no change in the value estimation of the transferor's assets. If the "tax continuity" exists (if the vendor of the business continues the business activity), transferor's gains will not be taxed if the later taxation of hidden reserves is secured.Transfers of shares are also not subject to tax, if those transactions do not constitute transferor's business. As for the legal persons, profits stemming from liquidation, selling, change of legal form are forming the part of tax base, based on the market value of assets.

Finally, it is worth noting that there is considerable disagreement between tax practitioners when it comes to the question whether exit tax on unrealised capital gains exists in Croatian tax system or not. Be that as it may, neither of the aforementioned Acts explicitly stipulates tax consequences of assets transfers abroad, so it could be concluded that thepresent situation does not give rise to any discriminatory treatment based on cross-border transactions.

  • Croatia applies thin capitalisation rules non-discriminatory: the interest on a loan between related parties has to correspond to an interest on a loan between unrelated parties. As for the head office's charges related to the Croatian permanent establishment, Croatian Profits Tax Act stipulates the deduction of those charges, domestic or foreign, from the branch's profits.
  • There is no CFC legislation in Croatia, or other rules designed to combat use of tax havens.
  • According to Croatian tax rules, premiums for life insurance, additional health insurance and voluntary retirement insurance, paid to domestic insurers, are deemed expenses and can be deducted from taxable income, up to a certain amount. Deduction of these premiums is linked to taxation of the later benefits, and non-deductibility results in tax exemption. These rules are in force since January 1, 2005. Especially domestic insurere were not mentioned in the Income Tax Act in force until December 31, 2004. In this way, Croatian rules are in accordance with the Court ruling in Bachmann case, based on fiscal coherence argument.
  • The Croatian Income Tax Act stipulates the right for non-residents to deduct the so-called basic personal allowance, i.e. the personal allowance granted to the non-resident taxpayer because of his existence as the taypayer, from the taxable income. However, non-residents cannot deduct the rest of the personal allowance (the part based on the existence of his dependent family members); this deduction is explicitly limited to resident taxpayers. To described extent, Croatian income tax system currently violates some Court rulings that have concerned this matter, for example Asscher and Gerritse cases, if not Schumacker, more permissive to the source states.
  • There were not, so far, problems concerning the treatment of permanent establishments of foreign entrepreneuers in Croatia. Croatia has already developed considerable tax treaty network; it includes the most EU Member States, as well as some other countries. The OECD Model Convention concept of the permanent establishment prevails in these treaties; basically the same concept has been adopted in internal Croatian tax legislation currently in force. According to both concepts, that in treaty network, as well as one in Croatia's internal statutes, permanent establishment has got the status of non-resident taxpayer and is in no way treated discriminatory, compared with resident companies.

6. It is easy to see that, generally and so far, there are no particular grounds for the conflict between Croatian and Community rules in direct tax area. Explanations for such a situation are, I believe, simple. On the one hand, during the building of the new Croatian tax system, that started in 1994, highly respected principles were simplicity, i.e. transparency, and neutrality of the tax system – they were achieved, to some extent, at the expense of, for example, principle of equity. Since 1994, the Croatian tax system had been changed, but aforementioned principles were never completely erased, so that intentional simplicity and neutrality are still present. The consequence of their presence is, inter alia, minimal impact of cross-border activities of individuals and legal persons on their tax position – and that is, as it can be seen from the analysis of the cases decided by the ECJ, the main cause of conflicts between national and Community law.

On the other hand, however, inexistence of the areas of potential conflict is unintentional, stemming from the simplicity of the Croatian tax system. Namely, the lack of experience of the tax administration causes that elaborate cross-border transactions, based on international tax planning, pass unnoticed, and, therefore, untaxed. That is because those situations are not statutory regulated – since tax administration is not aware of their relevance, there is no initiative to enforcerules that would result in taxing those situations. So, for example, the problem of transfer pricing only now iscoming to the fore; before 2001, rules regulating transfer prices did not exist in Croatian tax system, and only since January 1, 2005, rather elaborate transfer pricing rules became the part of the Croatian legislation, meaning that taxpayers had to apply them filling tax return in 2006, for2005. Very similar situation exists when thin capitalisation is concerned.