Tax Incentives Are an Increasingly Strong Asset in Investment Decisions

written by: Vlado Lalić, attorney, certified tax advisor Grubišić & Lović & Lalić Law Firm

In a time of prolonged structural inflation with no end in sight, companies and individuals are striving to preserve the value of money by buying and trading various types of assets. Alongside real estate and gold as classic forms of savings and investments, an increasing number of citizens have dared to invest in financial instruments and trade them (stocks, bonds, treasury bills, ETFs, etc.). This trend has also been supported by the state itself through the issuance of so-called people’s bonds and treasury bills offered to the general public, which have garnered significant interest from companies and citizens.

The comparative advantage of government bonds at the time of their issuance compared to traditional time deposits in banks was a significantly higher interest rate on invested funds (coupon), as well as a more favorable tax treatment of income earned from interest collection. While income from interest on bank time deposits is taxed at a rate of 12 percent, income from interest on bonds, regardless of the issuer, is exempt from taxation.

The broad interest of citizens in purchasing these financial instruments has also been aided by technological advancements such as e-wallet and m-wallet applications that have enabled simpler and cheaper purchases of the aforementioned financial instruments. In addition to bonds, there is a noted increase in citizen interest in trading stocks, cryptocurrencies, ETFs, and other financial instruments.

Investment Optimization

In the capital market, the issue of tax and its amount is an important variable, so market participants, especially citizens, tie their decisions to buy or sell financial instruments to the question of the taxability of such transactions. Tax is not just an expense that needs to be paid but also a force that shapes the capital market. So-called tax-aware funds and tax-efficient products are increasingly conquering global capital markets. JPMorgan Chase reported last year that its new line of tax strategy is the fastest-growing business, and large investment funds are now focusing on after-tax returns rather than pre-tax ones. It should be emphasized that this is a completely legal practice that utilizes tax incentives in accordance with legal purposes.

It is often highlighted in various brochures of financial companies, both domestic and foreign, that the income generated from holding or selling certain products is not taxable or is taxed at a lower rate than other forms of investment, etc.

For tax optimization of investments, special trading methods aimed at reducing tax liabilities have been developed, and technological advancements have facilitated and reduced the costs of implementing these sophisticated strategies such as heartbeat trades, box spreads, and long-short tax loss harvesting, which are now primarily executed using customized algorithms that would have been too complicated and expensive to implement in the pre-digital era.

So-called Tax Loss Harvesting

The mentioned strategies take into account the tax treatment of capital gains. Taxable capital gain is the difference between the selling price of, for example, a stock and its purchase price. Since the tax base is the annual net capital gains (capital gains reduced by capital losses and costs of alienation and acquisition of securities in the same year), brokerage firms see the possibility of reducing tax expenses if losses are realized alongside gains that will reduce the tax base.

Thus, the ‘tax loss harvesting’ strategy was created, which involves selling underperforming assets, often with the intention of repurchasing them. This strategy is effective in cases where the investor has control over their investments and can automate the process of selling and repurchasing, in which new digital technologies are key. The tax efficiency of some products is achieved by reinvesting the collected dividends; in this case, they are not taxable as is the case with accumulating ETFs. What was once reserved exclusively for ultra-wealthy individuals is now available to the general public without high entry fees, from individual portfolios, robo-advisors, and exchange-traded funds.

What is Taxed

Income from capital based on capital gains is the difference between the agreed selling price, or the receipt determined according to the market value of the financial asset being alienated, and its purchase value. The purchase value is taken as the value of the financial asset on the day of the first acquisition. Alienation is considered to be sale, exchange, donation, and other transfers.

Receipts from the alienation of financial instruments and structured products are taxed, i.e., receipts from transferable securities and structured products, including shares in the capital of companies and other types of associations whose method of disposing of shares is comparable to such companies; then money market instruments, units in investment funds, derivatives, and/or proportional part of the liquidation mass in the case of liquidation of an investment fund, as well as other receipts generated from ownership shares in the case of liquidation, cessation, or exit.

What is Exempt

Certain legally prescribed methods of transferring financial instruments are not considered alienation and are therefore not taxable, such as the transfer of shares from one to another voluntary pension fund, the division of shares of the same issuer, where the underlying capital and cash flow do not change, the alienation of debt securities and money market instruments issued by the Republic of Croatia and local and regional self-governments, the exchange of securities or shares in the capital of companies, or financial instruments for other or others’ securities, the acquisition of securities in cases of status changes, where in all cases there is no cash flow and provided that the sequence of acquisition of financial assets is ensured, etc.

Also, income from capital based on capital gains is not taxed if the alienation was carried out between spouses and relatives in the first line and other members of the immediate family, between divorced spouses if the alienation is directly related to the divorce, inheritance of financial assets, and if the financial assets were alienated after two years from the date of acquisition or acquisition of that asset.

It is important to note that tax regulations encourage long-term investment in financial instruments and that capital gains realized from the sale of financial assets two years after their acquisition will not be taxable.

What Comprises the Tax Base

The tax base consists of capital gains realized from the alienation of financial assets, if the transaction is not exempt under any of the aforementioned legal reasons, reduced by the amounts of capital losses. Capital losses can only be deducted from income from capital gains realized in the same calendar year. Capital losses also include all related costs that have been charged to the taxpayer (brokerage fees, etc.). The capital loss is reported up to the amount of the tax base.

If the income from capital based on capital gains has not been determined or reported at market prices, the income will be determined by the Tax Administration at market prices. The application of this rule will come into consideration when the transfer transaction has not been executed within an organized market, exchange, or when the taxpayer has not fulfilled the obligation to report the tax.

Determination and Payment of Tax

The taxpayer who is the holder of financial assets is obliged to calculate, withhold, and pay the income tax from capital based on capital gains, except for capital gains based on the alienation of shares in a company that are not transferable on the capital market in accordance with a special regulation, by the last day of February of the current year for all capital gains realized in the previous year, reduced by realized capital losses at a rate of 12 percent.

For the purpose of proving the realized capital gain and/or capital loss, the taxpayer is obliged to keep records of similar financial assets according to the method of successive prices (FIFO). Records for financial assets realized in the foreign market can be kept in the currency of acquisition of the financial assets. The maintenance of the aforementioned records, determination of income from capital, and calculation of income tax from capital and reporting on it can be taken over on behalf of and for the account of the taxpayer by a financial intermediary (investment company and credit institution that provides investment services, management company, etc.). The taxpayer is obliged to pay the income tax from capital based on capital gains according to the calculation by the last day of February of the current year.

The income tax from capital based on capital gains from the alienation of shares in a company that are not transferable on the capital market is paid by the taxpayer according to the decision of the Tax Administration within 15 days from the date of delivery of the decision, at a rate of 12 percent. The alienation of financial assets based on shares in capital must be reported by the taxpayer to the relevant office of the Tax Administration no later than eight days from the date of alienation.

Income from Interest

Interest is considered to be receipts from receivables of any kind, especially those from interest on savings in euros and foreign currency savings (on demand, time deposits, or annuity savings, including yield, reward, premium, and any other compensation earned above the amount of invested funds), receipts from interest on securities, receipts from interest based on loans granted, and receipts generated based on the distribution of income from an investment fund in the form of interest, if they are not taxed as shares in profit based on the distribution of profit or income from the investment fund.

In the context of investing in financial assets, it should be noted that taxable interest does not include receipts from interest earned from investing in bonds, regardless of the issuer and type of bonds, as well as in debt securities and money market instruments issued by the Republic of Croatia and local and regional self-governments, as well as receipts based on returns on life insurance with a savings feature (paid compensation above the paid insurance premiums) and returns based on voluntary pension insurance. The income tax from capital based on interest is paid by withholding, meaning that it is calculated, withheld, and paid by the payers simultaneously with the payment or crediting of the receipt, at a rate of 12 percent.

Income from Dividends

Income from capital also includes receipts from dividends and shares in profit based on shares in capital, as well as other equivalent receipts that are considered profit distribution. Income from capital is not determined based on dividends and shares in profit if the dividends and those shares are used to increase the company’s capital or if they are realized by investing the Fund of Croatian Veterans from the Homeland War and their family members and are intended for and distributed to members of that fund. The income tax from dividends is calculated, withheld, and paid by the payers simultaneously with the payment as withholding tax, at a rate of 12 percent.

Income from Abroad

Croatian tax residents pay income tax in the Republic of Croatia concerning their worldwide income. Consequently, capital income earned abroad is also taxable in Croatia. However, the obligation to pay tax in Croatia and its amount will primarily depend on the existence or non-existence of a double taxation avoidance agreement between the Republic of Croatia and the country where such income was earned.

These agreements prescribe various methods of avoiding double taxation, whether the income is taxed only in one state or whether both states offer the possibility of taxation according to the agreed key, and the tax paid abroad is credited against the tax paid in the Republic of Croatia. In the event that such an agreement has not been concluded, the income may be subject to double taxation, which is important to keep in mind.