Deductibility for Hungarian corporate income tax
purposes of the provision release income in the case of business reorganisations
and business line transfers

Business reorganisations and business line transfers are often encountered in economic life. When compiling corporate income tax calculations following a business reorganisation or business line transfer, accounting and tax experts of the successor company may be perplexed whether the successor company is entitled to reduce its the corporate income tax base by the income accounted for a release of an accounting provision which was “taken over” from the predecessor company as a result of a reorganisation or business line transfer. The question appears legitimate, because the predecessor company should have increased its tax base with the relevant item in the year when the provision was created, therefore, an eligibility for deduction should stand. It seems obvious at first sight that it is the successor who is entitled to deduction, but on further consideration it may occur that it in fact it has been the predecessor company (and not the successor) who has accounted for the expense in its books and that it is also the predecessor company's corporate income tax return that shows the tax base increase, so is the predecessor company who is entitled to the reduction of the tax base? Because of this uncertainty, the successor company often forgoes this tax base reduction option. Likewise, in business reorganisations, parties do not tend to take this tax base reduction into account when evaluating the purchase price or measuring the effects of the business reorganisation, despite the fact that it is explicitly of a deferred tax asset nature.

In this article, we will explain in detail which party (the predecessor or the successor) is entitled to the tax base reduction, which documents support the tax base adjustments, and what specifics should be taken into account in this case.

The Hungarian Civil Code recognises the following forms of business reorganisation, which are relevant to the topic: business transformation in substance (change of legal form), merger (in the form of a merger or a takeover) and de-merger (in the form of a split-up or a spin-off). In each of these types of reorganisations, the successor may take over all or part of the accounting provisions created by the predecessor, therefore a question may arise whether or not the successor is eligible for the tax base reduction if it releases the accounting provision taken over, because it has not accounted for the expense when the provision was created and his own tax returns do not show the increase in the tax base.

In contrast to business reorganisations, the legal concept of business line is found in tax laws, which define it in a similar way. For the purposes of the Accounting Act, a business line is defined as an organisationally independent, autonomous unit of an enterprise (including a branch or network of branches), which is capable of carrying on an independent economic activity on a continuing basis with its associated assets (assets, liabilities, accounting provisions and accruals). The Corporate Income Tax Act refers to it as a separate organisational unit, which is defined as total assets and liabilities (including accruals) of a division of a company which constitutes an organisationally independent unit capable of operating with its own assets. For the purposes of the VAT Act, a division is a functional unit of an enterprise which is capable of carrying on an independent economic activity on a lasting basis, independently of the organisation, by virtue of the assets which it possesses.

Pursuant to Section 41 para (1)-(3) of Act C of 2000 on Accounting a provision shall be created, to the extent necessary, against the profit before tax for payment obligations to third parties arising from past and current transactions and contracts [including, in particular, statutory guarantee obligations, contingent liabilities, certain (future) liabilities, early retirement pensions, etc, or replacement early retirement benefits, termination benefits, environmental liabilities and expected losses under a contract or its unit of account] that are probable or certain to exist at the balance sheet date but of uncertain amount or timing and for which the enterprise has not otherwise provided the necessary funding.

In addition, accounting provisions may be recognised in profit before tax, to the extent necessary to determine the fair value of the result, for expected, significant and recurring future costs (in particular maintenance, restructuring and environmental costs) which are expected or certain to be incurred at the balance sheet date but whose amount or timing is uncertain and which do not qualify for recognition as accrued expenses. However, it is important to note that such provisions should not be made for costs that are regularly and continuously incurred in the ordinary course of business.

Furthermore, Section 77 para (3)(a) of the Accounting Act provides that the release (decrease, termination) of an accounting provision shall be accounted for as other income.

Under the International Accounting Standards (IFRSs), IAS37, which governs provisions, defines a provision as a liability of uncertain timing or amount. Accordingly, an entity which keeps its books under the IFRSs must recognise an accounting provision if, and only if, the following conditions are met: a present obligation (legal or constructive) has arisen as a result of a past event (the obligating event), it is probable ('more likely than not') that an outflow of economic resources will be required to settle the obligation, and the amount can be estimated reliably.

Based on the above definitions, it can be seen that the provision is essentially based on probable factors (the amount of expected liabilities, future costs or the time when they will be incurred being still uncertain), and therefore may involve a degree of subjectivity. In order to prevent such items from affecting the corporate income tax base, which would result in fluctuations in the state budgetary revenues, the Corporate Income Tax Act requires that any income and expenses accounted for releasing or creating of accounting provisions for expected liabilities and future costs should be adjusted for the corporate income tax calculation purposes. The income recognised on the release may reduce the corporate income tax base, whereas the expense recognised on creating an accounting provision should increase it.

It is also not explicitly stated in the legislation, but it follows from the above logic that a taxpayer can only reduce the tax base by the income on the provision release if the corporate tax base has been increased when the provision has been created, as the amount of the tax base increase and reduction must exactly match each other in order to have a neutral effect on the aggregate corporate income tax base over several years.

However, before turning to the legitimacy of the tax base reduction and its supporting documentation, it is important to note that in the course of a reorganisation it should be considered whether retaining the accounting provision shown in the successor's books is justified. The provision should only be transferred to the successor if the third-party payment obligations for which the provision was created should be borne by the successor, too. Thus, for example, a provision for restructuring costs recognised by predecessor may not be transferred to successor. A further example is when the contract or asset in respect of which the provision has been created remains with predecessor and is not transferred to successor. In such a case, the provision cannot be allocated to the future successor and cannot be included in the closing statement of assets and liabilities. If successor is supposed to re-negotiate certain contracts with third parties after the reorganisation, it may be prudent to release the provision before the reorganisation; after the reorganisation the successor creates a provision in its own books if it considers that the renegotiated contract should result in a new obligation to third parties that is due to be settled after the balance sheet date and its nature requires the provision to be recognised.

Another important point to note is that large companies, due to the interim reporting requirements of the competent supervisory authority or the parent company's internal regulations, often create or release provisions during the year in order to ensure that their quarterly or monthly reports (not otherwise required by any accounting standards) reliably reflect their current financial position. In such cases, it needs to be further examined whether these liabilities would still exist at the balance sheet date for the successor entity, i.e. whether they are not just “interim” provisions, which typically have no impact on the annual financial statements because they are predominantly released at the balance sheet date (for example, due to a bonus paid in December or annual holidays taken out before the year-end). Note that such a “provision” does not actually meet the definition under the Accounting Act because the underlying payment obligations are unlikely to exist at the balance sheet date. In the case of such “interim” provisions, it is also justified to eliminate the provision before the restructuring.

To summarise the above, the successor is entitled to reduce its corporate income tax base up to the amount of the income recognised on the release of the accounting provision transferred to him, provided that the predecessor has created the provision in accordance with the Accounting Act and increased the corporate income tax base by the expense of the creation. In such a case, the legislator's intention that the accounting provision should not affect the corporate income tax base is fully respected, in particular, since there is a legal continuity between the taxpayer who creates the provision and the taxpayer who releases the provision. The same is the case if the provision is transferred to another company (the purchaser) among the assets of a business line in the course of a business line transfer. In this case, there is also a legal continuity between the taxpayer making the provision and the taxpayer releasing the provision in respect of the transferred business line, the legal basis for which is the sale and purchase agreement

The taxpayer can support its entitlement to a tax base reduction, as well as the amount of the reduction with the documents reasonably available to it, which are:

1. in the case of reorganisation:

1. the corporate income tax return of the predecessor for the tax year of the provisioning;
2. the analytical records of the creating and releasing the provision;
3. the closing statement of assets and liabilities (which includes the provision transferred from the predecessor).    

2. in the case of a business line transfer:   

1. the seller company's corporate income tax return for the tax year when the accounting provision was created;
2. the analytical records of the creating and releasing the provision;
3. the business line transfer agreement, including the assets of the transferred business line (including the provision transferred).

The author of this article is Marina Lisznyanszkaja, senior tax advisor of VGD Hungary.