The defence tax bill currently under discussion in the Estonian Parliament may impact Estonia’s approach to adopting Pillar Two rules, thus affecting all Estonian entities belonging to a Pillar Two group. Whether your group has reached the 750 million EUR revenue threshold already or will cross that bridge by FY 2030, this change is likely to impact how you decide to make future distributions.
Estonia is set to adopt legislation imposing a defence tax that includes a 2% CIT on accounting profits for Estonian resident companies, permanent establishments of non-resident companies and non-residents to the extent their income is taxable in Estonia. For more details, see HERE. Besides the obvious bump in overall tax burden and compliance obligations, the new tax may have far-reaching consequences once we fully implement the EU Council Directive 2022/2523 of 15 December 2022 on ensuring a global minimum level of taxation for multinational enterprise groups and large-scale domestic groups in the European Union (Pillar 2).
Challenges to Estonia’s eligible distribution tax system
Estonia, along with Latvia, has been one of the few countries in EU to have a long-standing system where income tax is paid only upon making distributions from the company. Due to this, Estonia has relied for Pillar Two purposes on the fact that its tax system qualifies as an eligible distribution tax system.
The EU Directive follows OECD rules, which have been supplemented by commentary and administrative guidelines following the publication of the Pillar Two Directive itself. Even though the OECD administrative guidelines and commentaries are not binding on the member states, practice shows they are normally relied on in courts and disputes with the tax authorities.
As Estonia has less than 12 ultimate parent entities (UPE) of multinational enterprises belonging to a Pillar Two Group, the implementation of the full scope of the Directive, especially charging tax under the Income Inclusion Rule (IIR) and Under-Taxed Profits Rule (UTPR) will be postponed for six consecutive fiscal years. This means that all Pillar Two rules will be applicable to fiscal years starting on or after 31 December 2029.
Potential impact on Estonia’s tax competitiveness
The OECD Commentary tells us that a country with an eligible distribution tax system can use some special rules. The most important advantage of maintaining Estonia’s status is qualifying under Article 7.3 of the OECD Guidelines, which allow Estonia to recognise deemed distribution tax in one fiscal year for the tax that will be paid during a later year (within the following four years). This means the tax is recognised within one fiscal year, but the income tax expense is expected to be reflected in a future fiscal year. Put more simply, a company paying dividends only in 2030 could adjust the tax paid (at the current CIT rate of 20%, and 22% starting from 2025) to count towards the required minimum tax of 15% to be effectively paid on qualifying income each year within the period FY 2030–2034.
Article 7.3 is an annual election that applies and affects the effective tax rate of all the entities within the scope of the rules (Constituent Entities) located in Estonia.
The definition of an eligible distribution tax system has three components:
- imposes an income tax on the corporation, with the tax generally payable only when the corporation distributes profits to shareholders, is deemed to distribute profits to shareholders, or incurs certain non-business expenses
- imposes tax at a rate equal to or in excess of the minimum rate of 15%
- was in force on or before 1 July 2021
A tax system meeting the criteria above can retain this definition when changing only as long as the change aligns with its existing design, as per the Commentary. The main issue with the new defence tax lies in the fact that it does not fit the current system, and it demands a new approach to tax calculation, filing returns and making payments, bringing about a significant change by creating a second layer of CIT in Estonia.
On the bright side, should the defence tax eliminate the possibility of treating the Estonian tax system as an eligible tax distribution system, entities located in Estonia could make use of transitional safe harbours, which are designed to ease the transformation and limit the calculation process for up to four years after the first application of the Pillar Two rules, so up to FY 2034. For now, Constituent Entities making the election under Article 7.3 cannot choose to apply transitional safe harbours once the full scope of Pillar Two rules is applicable.
One thing is certain—outside the Pillar Two eligibility question, this dual system is bound to lower Estonia’s position in the OECD International Tax Competitiveness Index, where it has ranked first for 10 consecutive years. We will update you on new developments in the defence tax discussions currently ongoing in the parliament.
