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This year seems to be again an interesting one for Estonia in terms of taxes. In April this year, the Ministry of Finance published its plans for changes to the Estonian Income Tax Act with the purpose of introducing measures against aggressive tax planning as proposed by EU Directive 2016/1164. This brings the following well-known concepts to Estonian tax laws – thin capitalisation, CFC and exit tax. Amendments are also being made to the general anti-avoidance regulation (GAAR), enabling the tax authorities to more easily set aside different legal structures (such as debt pushdown) and follow the principle of substance over form in a more resolute manner. As the exact wording of the new regulation is not yet agreed, we can only provide some insight into the current version of the draft bill. Nevertheless, changes will surely be implemented by 1 January 2019.
Taxation of excessive borrowing costs (thin cap) A well-known problem has been that profit generated by profit centres is shifted to some other entity through excessive interest costs. To give an example, an Estonian profit centre that receives a loan must pay loan interest. According to the planned changes, loan interest is deemed to be not economically justified (not related to the business of the borrower) when it exceeds certain thresholds. As a result, excessive interest payments will attract corporate income tax. This targets Estonian entities with a high ratio of interest costs and which are profitable. Real estate developers may be one focus group for this regulation. The following three criteria are taken into account in assessing whether loan interest is excessive or not:
A taxpayer that is a member of a consolidated group for financial accounting purposes can apply one of the following exceptions if it is more tax efficient compared to the above:
The planned thin cap regulation does not apply to some specific categories of entities, such as financial undertakings and independent units and entities which are not consolidated for financial accounting purposes and which do not have a related entity (to be determined under a shareholding or voting rights at a level of 25%) and no permanent establishment. Thin cap rules do not apply to loans aiming to fund long-term public infrastructure projects. Example 1: An Estonian OÜ and a Latvian SIA are in the same consolidated group. The OÜ pays loan interest of EUR 2,300,000 to the SIA. Interest payments will not be taxed as the EUR 3,000,000 threshold is not exceeded. Example 2: An Estonian OÜ and a Latvian SIA are in the same consolidated group. The OÜ pays interest of EUR 4,000,000 to the SIA. EBITDA of the Estonian OÜ are EUR 6,500,000, from which EUR 500,000 is received as dividend income falling under a participation exemption enabling tax-exempt payment of dividends. The OÜ is profitable. In this example, EBITDA taken into account are EUR 6,000,000 (6,500,000 – 500,000). The ratio of interest payments to EBITDA is 4,000,000 / 6,000,000, ie, exceeding 30%, which would be EUR 1,800,000. As this amount is less than EUR 3,000,000, the EUR 3,000,000 minimum threshold would apply. The OÜ must pay income tax on the amount of EUR 4,000,000 – EUR 3,000,000 = EUR 1,000,000. Income tax on that amount is 1,000,000 / 0.8 * 0.2 = EUR 250,000. Applying exception 1 or exception 2 may reduce taxes due. CALCULATOR Calculate possible income tax on excessive interest payments HERE → Exit tax Exit tax will burden Estonian entities that transfer assets to a permanent establishment abroad (such as a branch, office, production centre or agents). This also applies to situations where assets are transferred from an Estonian permanent establishment (such as a branch or representative office) to headquarters abroad. Exit tax is not levied on transactions between parent and subsidiary entities. Income tax falls due upon taking assets out of Estonia. Tax is calculated based on the market value of assets. Exit tax enables the state to tax capital before it is transformed into the form of business income. Exit tax is a specific type of corporate income tax. The current regime enables Estonian entities to send their assets abroad to carry out their business activities. This does not constitute a taxable event. Income tax liability may arise if assets sent abroad are not used for business purposes and the transfer should be treated as a gift or a non-business payment. Exit tax does not apply from the first euro of value of an asset – it does not apply to the extent the taxpayer can make tax-exempt payments from equity. It is possible to make tax-exempt payments from equity to the extent that payments have been made to equity. NB! Payments to the equity of an Estonian legal entity must be declared on the tax return “TSD” Annex 7. It is important to note that according to the Directive exit tax does not apply if assets are transferred abroad temporarily so that they are later transferred back to Estonia. Unfortunately the draft bill does not address how this tax exemption will be applied. We hope the draft bill will be supplemented and that temporary use of assets abroad will be regulated according to the purpose of the Directive. If exit tax applies, the taxpayer may apply to pay by instalments over a period of up to five years. Like any other tax payment by instalments, its negative aspect is delay interest at the rate of 21.9% per year applicable to the unpaid amount of tax. The tax authorities may require security (collateral) to enable payments by instalments. Example: An Estonian AS establishes a branch in Germany, qualifying as a permanent establishment from the tax point of view. An office will be opened there and some used computers with a market value of EUR 25,000 will be sent to the office. The AS plans to keep the computers in Germany as long as they are effectively usable. The AS must pay income tax, which will be calculated based on the market value of EUR 25,000. Income tax due is 25,000 / 0.8 * 0.2 = EUR 6,250. It is possible to apply for payment by instalments for up to five years. However, annual interest of EUR 1,368 (6,250*21.9%) applies in case of payment in one instalment after five years. It is reasonable to pay tax right away if the AS is able to get a loan with an interest rate of less than 21.9% p.a.
Income tax from the profits of a foreign-controlled company (CFC) Under the CFC rules income received by a foreign-controlled company or a permanent establishment of an Estonian legal entity will be attributed to the Estonian entity and taxed accordingly. Income tax will be levied on income related to assets and risks linked to key employees of the controlling entity and received through transactions not corresponding to the actual economic content. The purpose of this should be to gain a tax advantage. It is worth noting that Estonia will not apply the tax rate applicable to the CFC but the tax rate applicable to the Estonian entity. So if the CFC receives business income from a transaction not corresponding to its actual economic content, the taxation rights transfer to Estonia. The main question with CFC tax will be whether a chain of transactions involving foreign entities is genuine or whether it does not correspond to its actual economic content. This will be assessed under division of risks and resources. A chain of transactions does not correspond to its actual economic content as long as the foreign entity or the permanent establishment under question does not have assets which generate profit, and it would not have taken the risks if the controlling entity with the assets and key employees had not been the controlling entity. Example: An Estonian entity establishes a Lithuanian UAB, which has a subsidiary GmbH in Germany. The UAB provides services to the GmbH and receives business income subject to Lithuanian reduced 5% corporate income tax. The services are actually provided by key employees working under the Estonian OÜ but the UAB does not provide any actual services. In that case the tax authority may argue that the business income received by the UAB is taxable as business income received by the Estonian OÜ as the UAB is not actually providing any services. Instead, the Estonian OÜ benefits from a tax advantage from that structure (Lithuanian 5% corporate income tax versus Estonian 20% deferred corporate income tax). The actual services are provided by key employees of the Estonian OÜ, so that the actual service provider is the Estonian entity.
General anti avoidance rule (GAAR) The fourth change will be a new rule with the purpose of providing a basis for setting aside artificial transactions so that such transactions would be taxable in terms of actual economic content. The prevailing principle of tax law is ‘substance over form’. According to this principle, the legal form of a transaction can be set aside for tax purposes and the economic substance of a specific economic transaction or chain of transactions is taken as a basis for taxation. An ‘economic transaction’ is economic performance or an economic act which constitutes a tax object liable to income tax (eg salary/income, interest, dividends, capital gains). Under the GAAR, the tax authority may set aside the legal form applied to a specific transaction if the two following conditions are cumulatively met:
It would indeed be interesting to see how this content-and-purpose test will be applied as its wording is really open for different interpretations. As for Estonia, section 84 of the Taxation Act has enabled requalification of transactions for many years already. The new GAAR will also apply in situations where participation exemption rules enabling tax-exempt payment of dividends are misused (section 50 subsection 14 of the Estonian Income Tax Act). So the new GAAR is not really a new topic for Estonia and most taxpayers are likely to be familiar with the concept already. Example: A typical situation for applying GAAR is so-called “OÜ-tamine” in which one company provides services to another company but from an economic point of view the service is provided by a natural person in the course of an employment relation which is disguised by a service agreement. In that case, salary is disguised as a service fee and dividend tax is paid instead of salary taxes. The second example is a debt pushdown scheme with the legal content of sale of shares and consecutive merger of legal entities, while the actual economic content of the restructuring activities may be to pay dividends without paying tax. As for sale of assets through a legal entity, it is surprising that this common technique for postponing tax liability (ie, a natural person makes a non-monetary contribution to the entity, which then sells the object of the payment and ‘transforms’ it into money, enabling postponement of income tax liability) which was accepted by the Supreme Court years ago has lately come under close scrutiny by the Estonian tax authorities with the purpose of requalifying it as a natural person’s income. |
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