The Estonian Government is planning to introduce a 2% annual income tax for natural persons and companies, payable in quarterly payments and all wrapped in a nice package as the “defence tax”. Besides the cost of the tax, it might cause cash flow and solvency issues for many people and companies. Therefore, as the first tax base year is 2025, it makes sense to keep a close eye on the progress of the bill and to make sure you are ready.

Current Estonian corporate income tax system – 0% tax until profit distribution

Currently, Estonian companies enjoy a deferred corporate income tax (CIT) rate of 20% (from 2025, 22%) that is due only upon distributing profits and making equivalent payments or arrangements. The same applies to permanent establishments (branches, construction sites, etc.) of non-resident companies that have business activities in Estonia, although there are fuzzy and complex profit allocation rules to follow. This system enables profits to be reinvested before tax, which is the main contributor to why the Estonian CIT system is seen as the most competitive one among OECD countries.

Defence tax – a new “brother” to CIT, a dry tax paid annually

The Estonian Parliament is currently discussing a bill introducing the defence tax. It will likely be adopted before the end of the year. The defence tax is not formally an income tax, but it works like an annual corporate and personal income tax. So we might as well call it an income tax. How will it work? All entities and persons liable for Estonian income tax (with some exceptions) will pay an additional 2% in defence tax. For legal entities, this would apply to accounting profits and would be payable on a quarterly basis, with the first year for tax base being 2025.

Why bother reading on, or getting ready for the defence tax?

As there are two months left to make sure you will be ready for the defence tax, and as it works as a dry tax, it makes sense to review your approach to accounting, recalculate your return on investment after taxes, design cash flows to ensure you are not stuck being unable to pay the tax, and, if some laws are unreasonable, maybe invest in letting the government know.

We have prepared a short summary on the defence tax as per the current status of the bill that is being discussed in the parliament. Just to be clear: things can still change and it may be that such a tax is not implemented. But if it is be implemented, it will happen at really short notice, when it might be too late to address the necessary matters.

1. What is the NATURE of the tax? The defence tax will be a temporary, specific type of income tax levied with the purpose of financing Estonian defence expenses. Although it will be regulated under the Defence Tax Law, it still functions as an additional income tax for natural and legal persons. In the context of cross-border taxation, it would be treated as income tax in the context of double tax treaties preventing double taxation in income and capital taxes.

2. WHO will have to pay the defence tax? Estonian tax-resident companies (not all corporate entities) and natural persons will have to pay the defence tax, as well as non-residents and the permanent establishments of non-residents to the extent that their income is taxable in Estonia.

3. What is the TAX BASE for the defence tax?  Rule of thumb states that the defence tax will be levied on the profits and income earned under the Income Tax Act, but with some important deviations. The defence tax will be levied on the accounting profits of Estonian tax-resident companies and the permanent establishments (PE) of non-residents entities, as well as on the income earned by Estonian tax-resident natural persons and Estonian non-residents.

4. Will it be a DRY TAX? Yes. The defence tax will be levied on the accounting profits of the previous financial year regardless of whether enough funds have been received to pay the tax or not. The biggest impact will be on entities that have assets whose accounting value increases significantly or continuously without generating any cash. This will mostly hit real estate companies, but also those working in forestry and investment. What does it really mean?

  • cash flow plans must be rewritten
  • accounting principles and valuation methods must be reviewed
  • intra-group positioning of services should be reviewed
  • profit margin on investments will change and need to be updated
  • financing might become a bit trickier
  • no losses carried forward
  • there may be lots of explaining to do if double taxation is to be eliminated in another country

5. When will the tax have to be PAID for the first time, and what is the FIRST TAX BASE YEAR for the Defence Tax? The first tax base year is 2025, so in two months your activities will already be determining how much tax you should be paying. The first defence tax quarterly payment would be due in the third quarter of 2026, the tax is calculated based on the profits from 2025. Certain special rules must be followed if the financial year does not match the calendar year.

6. What will the TAX RATE be? The tax rate will be 2% of the accounting profits of Estonian tax-resident companies and the permanent establishments (PE) of non-resident entities, as well as the income earned by Estonian tax-resident natural persons and Estonian non-residents. This will not be credited against the 22% corporate income tax that applies and will apply under existing rules.

7. Can I CREDIT the defence tax against corporate income tax once it is paid? No, defence tax is an additional independent tax applicable to your income, meaning it is additional tax cost on top of personal and corporate income tax.

8. Is the Defence Tax TEMPORARY in nature? Yes. The plan is to tax the profits from 2025 through to 2028. But only time will tell whether it will indeed be a temporary tax. Many say that the temporary taxes are here to stay and may be preparing us for an overall shift towards a traditional corporate income tax system.

9. How does it affect the CONTENT OF THE ANNUAL REPORTS that PEs of non-residents must present in Estonia? Be aware, all PEs and branches operating in Estonia: the content of the annual reports the PEs must present to the Tax and Customs Board once a year will change. This is to ensure the tax base for the defence tax is properly reflected.

10. Will it affect TRANSFER PRICING treatment in Estonia? As Estonia will become a more and more expensive jurisdiction in terms of tax costs, the diligent approach by business owners would be to review their transfer pricing models and service logistics to ensure their services are provided from the jurisdiction with the most optimal cost structure.

11. Could the defence tax cause STRUGGLES WITH PAYMENTS? Yes, as the defence tax must be paid on the accounting profits, regardless of whether the cash flow means cash is available for this. Indeed, the tax rate of 2% is not too high compared to the ordinary corporate income tax rate. But for companies making longer-term investments (forestry, winery, cattle farming, real estate, financing, etc.) that were relying on the deferral of tax under our existing system, payment of the defence tax could mean a real struggle liquidity-wise. The only way to be able to pay the tax might be to sell some forest or real estate.

12. How about an INVESTMENT ACCOUNT used by natural persons to (re)invest financial assets? The defence tax is levied only if there is profit distributed from the investment account to the account holder. Otherwise, if the cash is kept in the investment account or reinvested, it will not be taxable. So the system remains pretty much the same. It would be therefore possible to escape the defence tax if no profits are distributed from the investment account between 2025 and 2028. Should you be making some long-term investments now?

13. Is it true that FRINGE BENEFITS are not taxable under the defence tax? Yes, fringe benefits are exempt from the defence tax. Hence, purely from a tax perspective, it makes sense to pay compensation not in cash but in goods, services and other benefits. The latter are treated as fringe benefits, on which taxes are limited to our ordinary 22% CIT and 33% impersonalised social tax.

14. How should the defence tax be treated in an INTERNATIONAL context? Is it indeed an income tax? In the international context, and for the purpose of double tax treaties between parties, the defence tax will be seen as an income tax. This means that if the Estonian defence tax is levied on certain payments, a foreign country will see it as Estonian income tax paid on top of the soon-to-be 22% CIT, and consider that they both constitute income taxes.

15. Are PASS-THROUGH DIVIDENDS exempt from the defence tax? Yes, dividends an Estonian company has received from another Estonian company or from a foreign subsidiary (given that the minimum requirement of a 10% shareholding or votes is met) are not taxable under the defence tax in Estonia. Note that the annual reports must show that the pre-tax profit includes such dividends.