Inflation adjustment

1.    Introduction

Numerous changes have occurred in the Argentine economy during year 2002. Law Nno. 25,561, “The Emergency and Amendment to the Exchange Regulations Law” repealed the currency board after a decade of monetary stability. As a logical consequence, two phenomena already familiar to the Argentine population came back on stage: devaluation and inflation. From the beginning of 2002, the value of the dollar increased 270% vis-à-vis that of the peso. There was a 115% variation in wholesale prices (for 8 months) and a variation in retail prices (for 8 months) of 38%. This situation required the Federal Government to adopt regulations and procedures to allow economic transactions and accounting information to adjust to the new reality.

New accounting rules in Argentina allow companies to allocate, in certain circumstances, negative exchange differences to the cost of assets and re-establish techniques of restatement of financial statements in constant currency.

In tax matters, the government is studying the possibility of re-establishing inflation adjustment procedures in the Income Tax Law. In addition, there are also some bills providing for inflation adjustment with different variations under analysis.

Nevertheless, since non-application of the inflation adjustment method may have relevant effects on their tax results, some companies are analysing the possibility of applying it even if the authorities do not re-establish it. The rationale behind applying inflation adjustment techniques would be that not applying them may violate the hability to pay, since fictitious profits would be subject to tax.

Foreign currency credits generate taxable income caused by differences on exchange rate differences and losses caused by inflation. On the contrary, debts devalued by the inflationary effect generate taxable income and losses caused by exchange rate differences.

If a company has credits denominated in dollars, it would have to allocate all its income caused by the increased value of the currency in the present fiscal year, and would not be entitled to allocate any losses caused by the inflation consequences in those assets. Therefore, it would be paying income generated by re-valuing the credit denominated in dollars. The reestablishment of the inflation adjustment method would allow the company to pay taxes for the income effectively obtained on the credit in question.

The opposite situation may occur in companies significantly indebted in foreign currency. If the company had a foreign currency negative net balance (foreign currency assets less foreign currency liabilities) as of January 6, 2002 it can allocate only 20% of the losses caused by exchange rates differences in this fiscal year.

The relationship between inflation and devaluation require companies to analyse:

a)    The currency in which debt restructuring will take place and the different mechanisms to apply to          reduce the exposure to the variations in the foreign currency quotes.

b)    The relationship between its assets and liabilities in local currency and in foreign currency.

c)    The relationship between the monetary net worth and the non-monetary net worth.

Disregarding consideration of the above in price fluctuation periods and the quotes of foreign currency may considerably increase the tax burden.

2.    Restatement of financial statements in constant currency

Inflation is defined as the constant and generalised increase in the price of goods and services. This variation in prices generates distortions in the valuation of the patrimony and results of the corporations.

Although Argentine Companies Law and professional accounting accepted principles state that financial states should be made in constant currency to account for the effect of variations in the purchasing power of currency, several rules issued during the Convertibility Regime established that financial statements containing inflation adjustment methods would no longer be accepted.

The change in economic circumstances requires that financial statements be unavoidably restated and expressed in constant currency again. The procedure to perform this task basically consists in restating non-monetary items and estimating the result of the exposure to the inflation countereffect of the correction of the non-monetary items. To perform the restatement, the wholesale price index (“Indice de Precios Internos al por Mayor”) is applied, which is prepared and published by the Statistics Governmental Authority (“Instituto Nacional de Estadísticas y Censos”).

The restatement of financial statements in constant currency is relevant for corporate decisions such as distribution of dividends, directors´ fees, mergers, splits and setting of reserves.

3.    Income Tax adjustment for inflation rules

The distortions generated by inflation in the patrimony and results of the corporations is transferred to income and patrimonial taxes.

Title VI of the Income tax law provides inflation accounting rules. To date the coefficient applicable to the restatement for inflation is one; thus, no adjustment is made.

In income tax, adjustment methods for inflation may be categorised as (a) static adjustment and (b) dynamic adjustment. The static adjustment reflects the components of the patrimony at the beginning of the fiscal year; in turn, the dynamic adjustment method is applied to reflect transactions that occurred during the current fiscal year that modify the company’s assets and liabilities with their value affected by inflation (please see attached Annex I with diagram of this procedure).

Static adjustment on account of inflation is calculated by multiplying the excess of the company’s assets exposed to inflation at the beginning of the fiscal year over the liabilities exposed to inflation by the general wholesale price index (“GWSPI”) during the year.

The assets exposed to inflation (“Computable Assets”) are calculated by excluding items not exposed to inflation such as fixed assets, intangible assets or stock from the total assets of the company.

Liabilities exposed to inflation are then deducted from the amount of the “Computable Assets”. For this purpose, liabilities include bank and financial debts without limitation, accounts payable and reserves and accruals allowed by the Income Tax Law (“Computable Liabilities”).

If the difference between the “Computable Assets” and the “Computable Liabilities” is positive, the adjustment will be a loss. If, however, the resulting amount is negative, then the adjustment will be a profit.

On the other hand, a dynamic adjustment is used to reflect transactions occurred during the fiscal year that modify the company’s assets and liabilities exposed to inflation. The aforementioned index should be applied from the month the variation takes place until the end of the fiscal year.

The following transactions generate positive adjustments (inflation gains) from the month of payment, acquisition or withdrawal to the end of the fiscal year:

· Withdrawal of funds or disposition of assets, except for accrued interests and actualisation
· Dividend distributions (except issued shares).
· Capital reductions.
· Acquisitions of assets not protected against inflation.

The following transactions generate negative adjustments (inflation losses) from the month of sale, contribution or transfer, to the end of the fiscal year:

· Contributions, including particular accounts and capital increases during the year.
· Investments abroad when they are devoted to activities that generate incomes of Argentine source.
· The tax costs in the case of the sale of moveable assets subject to depreciation (with certain    exceptions).

Since the static adjustment is determined according to the difference between computable assets and liabilities, an inadequate analysis of the rights and obligations evidenced by the assets and liabilities of the tax payer might generate recognisable taxable income or losses to the corporation for exposure to inflation. Also, the tax consequences of carrying out certain transactions during the fiscal year should be reviewed, since they could result in taxable income or losses for exposure to inflation as per the dynamic adjustment.

E X H I B I T I

INCOME TAX ADJUSTMENT FOR INFLATION PROCEEDURE