Current reports

On 16 February 2010 the proxy of Netia S.A. (the “Company” or “Netia”) was informed of the issuing of a decision (“Decision”) of the Director of the Tax Chamber in Warsaw (“Tax Chamber Director”) according to which Netia’s corporate income tax (“CIT”) due for the year 2003 was set at PLN 34.2m plus penalty interest of approximately PLN 25.3m. The decision closes proceedings related to Netia’s appeal of a decision of the Director of the Tax Control Office in Warsaw (“UKS Director”) according to which Netia’s corporate income tax (“CIT”) due for the year 2003 was set at PLN 58.7m (see current report 42/ 2009 dated 17.08.2009) plus penalty interest amounting to PLN 41.3m.

The decision of the Tax Chamber Director was issued despite legal arguments presented by the Company, which claimed that the conclusions delivered by the Tax Control Office were incorrect and groundless. According to the Tax Chamber Director and the UKS Director, Netia understated its taxable income by PLN 247.5m by excluding from its revenues the accrued and not received interest from loans granted by Netia in earlier years to subsidiaries which subsequently merged with Netia on 31 December 2003. The Director of UKS, as the first instance tax authority, claimed in its earlier decision that Netia understated its taxable income by PLN 303m.

In the opinion of the UKS Director and subsequently the Tax Chamber Director, the fact that the Company did not claim the repayment of the loans and accrued interest from its subsidiaries justifies the adjustment of Netia’s revenues pursuant to Article 11 of the CIT Act. According to this regulation, the tax authorities are entitled to make adjustments to taxable revenues if, as a consequence of a capital relationship or a personal relationship, a taxpayer provides services to related parties on terms more favourable than those generally accepted at the time and place where such service is provided, and as a result of these transactions the entity does not report taxable income or reports lower income than expected had such relationships not existed.

According to Netia, the decisions of the UKS Director and the Tax Chamber Director are in conflict with the relevant tax regulations. In addition to major procedural faults, Netia believes that the tax authorities’ decisions incorrectly interpret and apply a number of material regulations. According to the Company the following are the most important deficiencies:

1. Incorrect interpretation of art. 11 of the CIT Act (which deals with transfer pricing), especially the notion of “services” and “more favorable conditions” and assumption that the non-commencement of the execution procedure constitutes such a service of the lender towards the debtor on non-market conditions. Such interpretation of this provision and its application towards the Company is not justified in the light of the fact that in the decision issued by the tax authorities it was confirmed that loans were granted on market terms; (interest, payment terms, etc.).

2. Failure to consider the absolutely mandatory prohibition on broadening the interpretation of art. 11 of the CIT Act, which covers exceptions from the principle of taxing actual revenue, without special care and consideration of all business, legal and economic circumstances. In the case of Netia the tax authorities did not take into account issues such as:

- Netia was not able to report interest income in 2003 because even if Netia had received interest from its subsidiaries the amount received would have been spent on the repayment of Netia’s interest liabilities (and the repayment of the interest would have been a tax deductible cost);

- the execution of interest by court enforcement proceedings, which according to the Tax Chamber Director and the UKS Director is the only proper way to proceed when debts remain unpaid, would be inefficient from a business and economic point of view and would have led to the bankruptcy of the subsidiaries. The Company chose the less expensive way, by settling its receivables through merger with its subsidiaries and thereby taking over their operating assets. In parallel to this restructuring, Netia restructured its own liabilities with the external lenders to the group;

- to assess Netia’s conduct of non-commencement of a formal execution procedure (comparable market transaction) in the case of loans granted to its subsidiaries the tax authorities considered exclusively the loan granted by Netia to Millennium Communications; in fact, Netia was involved in numerous litigations with Millennium Communications due to the unsuccessful acquisition of that company by Netia.

3. Ignoring the norms of art. 12 of the CIT act by rejecting in the decision the rule that exclusively interest received constitutes taxable revenue (on the cash basis) and leading to the situation where the tax payer’s revenue is assessed in violation of general principles relating to the mode of revenue generation.

4. Netia’s taxable losses were settled incorrectly, resulting in a significant overstatement of tax being claimed. Whilst the Tax Chamber Director has recognized some of the Company’s corrections to the CIT calculation in respect to 2003, reducing the claimed amount by PLN 15.0m, the Company continues to claim other increases in taxable expenses that the Tax Chamber Director has not accepted.

Due to the reasons indicated above, the Company intends to appeal to the Voivodship Administrative Court against the decision issued by the Tax Chamber Director. The Tax Chamber Director’s decision is enforceable as a decision of the second instance tax authority. As a result, the Company must immediately pay the liabilities resulting from the decision plus statutory penalty interest to an account of the II Mazovian Tax Control Office (II Mazowiecki Urząd Skarbowy). Netia has received opinions from several independent tax and legal advisors, as well as tax law experts, which conclude that the claims of the Directors of the Tax Control Office and the Tax Chamber have no legal grounds. Due to the above, the Company does not intend to treat tax arrears and interest reported in the tax decision as an expense. The said amounts will instead be treated by Netia as receivables from the tax authorities. Should the decision of the Voivodship Administrative Court be positive for the Company, the amount of unduly paid tax plus interest will be treated as an overpayment and must be returned by the tax authorities together with interest (currently the interest rate on tax liabilities amounts to 10%).

Netia will undertake all possible legal steps to prove that the decision of the Tax Chamber Director was groundless.

Netia will execute the decision of the Tax Chamber Director in the coming days using some of the Company’s cash deposits and government bonds that together total in excess of PLN 200.0m. Even after setting the decision of the tax authorities, Netia will remain debt free and continue to generate positive free cash flow.