by Priit Lätt and Rainer Eidemiller
* On 1 January 2009, the transition period granted to Estonia for harmonising the Income Tax Act with the EU Parent-Subsidiary Directive will come to an end. The Estonian Income Tax Act does not tax the income earned by companies upon its receipt, but rather upon distribution. Hence, it is disbursements, including dividends that are subject to taxation. However, the directive prohibits the subjecting to income tax of profit distributable by a subsidiary of one member state to a parent of another member state, if the parent’s holding in the subsidiary is greater than 10% as of 1 January 2009.
Automatic transposition of the tax exemption specified in the directive, to the current Estonian taxation system, would mean that the income of a company which is owned by a company of another member state would not be taxed in Estonia, neither upon its receipt nor upon its distribution as dividends to a parent undertaking of another member state. It is understandable that what is feared, upon the granting of such a tax exemption, is a negative impact on the Estonian state budget, as well as Estonia gaining the reputation of being a tax heaven, as well as the unequal treatment of companies with local and foreign holdings.
1. The reestablishment of the corporate income tax that was applicable in Estonia until 1999 ?
To harmonise the Estonian Income Tax Act with the directive, the Estonian Ministry of Finance has analysed six alternative .....
..... solutions, of which model B3 was selected as the most perspective one, which essentially means reestablishment of the corporate income tax that was applicable in Estonia until 1999, i.e. profit is also taxed upon its receipt, not only upon distribution (payment). Although a similar taxation procedure is used in many countries, Estonia’s major difference would lie in a low nominal tax rate, at a maximum of 10%. Currently, the tax rate of 10% is used in Cyprus, followed by Ireland (12.5%), and Latvia and Lithuania (both 15%). The nominal rate of corporate income tax (e.g. 10%) will, in essence, remain the effective tax rate of profit distributed to foreign parents. Dividends paid to natural persons are subjected to additional income tax at such a rate that the effective tax rate applicable to dividends distributed to natural persons would total precisely or approximately 20%.
The positive aspects of the favoured model provided by the Ministry of Finance are its transparency, low nominal tax rate which is attractive to investors, stability of the state income tax base and existence of experience in administration of a similar taxation system (system applicable until the end of 1999). The so-called profit locking effect, characteristic of the current income tax system, will also disappear — upon existence of better investment alternatives investors can in the future take profit out of a company either without additional tax expenses or with tax expenses lower than they are currently.
The negative aspect of the model is that the income tax system will undoubtedly become more complicated when compared to the current one. In addition, companies might be motivated to hide their profit, which means that accounting will reflect the actual financial condition of a company to a lesser extent than currently.
2. Minimal amendment to the applicable law ?
The model preferred by the Ministry of Finance is not, however, supported by the Estonian Employers’ Confederation, several large employers, the Reform Party who authored the income tax reform of 2000, and several others who support model A2, which has been analysed in the Ministry of Finance - i.e. a minimal amendment to the applicable law, which would fully exempt from income tax all dividends payable by a subsidiary that is an Estonian resident to a non-resident parent undertaking provided that the holding of the parent undertaking in the subsidiary is greater than 10% in 2009. Although the current income tax system would generally remain intact, it means that as of 2009 foreign parent undertakings could take out the earned profit from their Estonian subsidiaries (holding of at least 10%) without any income tax liability. Income tax exemption would apply in Estonia to the profit of Estonian subsidiaries as well as to the dividend paid to their parent undertakings. The Ministry of Finance considers a disadvantage of this option to be a decrease in budget revenues (a minimum of 800–900 million Estonian kroons per year, but it is possible that figure could be significantly higher).
A great danger exists for those Estonian companies who enjoy full tax exemption due to their ownership structure (all shareholders are legal persons with a holding of at least 10%), and also operate outside Estonia, as they may be deprived of the rights applicable to them under international tax agreements and income tax directives. The reason being, that other countries may refer to the fact that de facto such companies are not required to pay income tax on their profits and in essence they are no longer income tax payers in Estonia.
The above means that such companies may start paying substantially greater income tax in foreign countries on the income earned there. This is tax revenue that will be forfeited by Estonia and that will begin flowing into the budgets of other countries.
In foreign countries, Estonia may be subjected to the provisions of a low tax rate territory (e.g. Controlled Foreign Company Rules), according to which the resident country of a shareholder would tax a proportional part of the annual profit of an Estonian company as the income of the shareholder, even when the Estonian company does not actually distribute its profit as dividends. Thus, companies who operate across borders or whose ownership circle includes foreign investors may find themselves in a situation which is worse than the current one.
Supporters of model A2 have cited the fact that since model B3 would bring about a change in the income tax arrangement that has been successfully applicable and encouraged investments up until now — which would most likely not please investors who have come to Estonia — and the replacement of the current very simple taxation model with a significantly more complicated one, which is also more capital-consuming, the Ministry of Finance should in addition to a prepared analysis also conduct an in-depth survey that would cast more light on the advantages and consequences of the model to be selected.
Thus it has remained unclear to what extent the tax exemption of dividends would actually influence budget receipts (since it concerns only a certain group of non-resident parent undertakings) and to what extent it might be compensated by the investments added due to a taxation environment that has become even more attractive. The exemption of dividends from income tax may also have a positive impact on the reinvestment of profits already earned in Estonia, into new areas. The current position is that the tax revenue would flow to the countries where parent undertakings are located, instead of Estonia. It is also possible that Estonia, with its more favourable taxation environment, will have a completely different impact on such countries.
The question, to what extent would such an income tax exemption result in the actual unequal treatment of dividend recipients in economic terms, should also be analysed. The purpose of the Estonian Income Tax Act has been to encourage investments. Based on that, tax exemption for companies who reinvest received dividends cannot be considered as unequal treatment compared to dividends which are received by natural persons and are estimated to be put into personal consumption. And in the case of companies, only disbursements, such as salaries, gifts, etc would continue to be subjected to taxation, if income is not directly reinvested in the business.
At the same time it cannot be excluded that natural persons who have received dividends would like to reinvest the dividend income, which would imply a breach of the equality principle, but the equal treatment of investors could probably also be ensured by other means. Unequal treatment of parent undertakings whose holdings in subsidiaries is less than 10% would apparently not be very painful compared to those whose holdings are greater, because:
- such unequal treatment already arises from the parent undertaking-subsidiary directive,
- it is a principle based on a model which encourages investments.
Since, in the case of model A2, only those dividends payable to companies of another member state would be exempted from income tax in Estonia, and all other disbursements would continue to be subject to income tax, the selection of such a model would not necessarily endanger Estonia’s status as a low tax rate territory.
The principle of legitimate expectation would also require a more profound approach. What would be better for Estonia’s economy and reputation: adherence to the promise given by the Income Tax Act which entered into force on 1 January 2000, i.e. the exemption of invested profit from income tax, or the narrowing of the current investment-friendly business environment? Perhaps the threat of a violation of the legitimate expectation principle and the threat of unequal treatment lies in the fact that restoration of the corporate income tax would be a substantially greater burden on companies that have failed to run their business profitably before 2009, and only then start earning profit, compared to those companies that have been able, until now, to invest and expand on a tax-free basis?
It is certainly necessary to take into account the matter as to how one or another model would influence economic transparency. Thus, the taxation of dividends, including internal group taxation, has already led to the hiding of actual business transactions with fictitious ones (e.g. loans). This is also the source of companies fears that the restoration of the corporate income tax, i.e. model B3, would result in a taxation system that is significantly more complicated and capital consuming, for both tax payers and tax authorities, and whose impact on the state budget cannot be underestimated either.
The danger cannot be ignored that Estonia might not have enough time to prepare the taxation amendment desired by the Ministry of Finance. The 15 February 2005 IMF report "Estonia: A Program of Tax Reform" stresses the need to present the relevant amendments to the Income Tax Act to the Riigikogu for discussion at the latest by the autumn of 2005. Estonia already has experience in establishing the Excessive Stock Reserve Act on 1 May 2004, when the interval between the publication and entry into force of the Act was only four days, which was clearly insufficient for adjustment and therefore has brought about many legal disputes. As a result of conditions resulting from an unreasonably short adjustment period, it is inevitable that the uncertainty restraining the business activities of companies and the resulting potential legal disputes must be taken into account. To have a decision on a planned amendment to the taxation model made in a timely manner, it must be understandable to everyone, including in terms of its economic consequences, which is why it is necessary to continue public and substantive discussions before a final decision is made as to which tax model to select.
4. Alternatives to taxation of the income of companies as of 2009
Amendments indispensable for compliance with the directive (model A2)
Only such amendments are made which are indispensable for compliance with the directive. To ensure equal treatment, dividend payments between a parent and a subsidiary within Estonia should also be exempted from income tax. Dividends are taxable as the income of a natural person.
nature of tax exemption
Only dividends paid to a natural person, and to a legal person with a holding of less than 10%, are subjected to income tax. A foreign parent (with a holding of at least 10%) can take the profit of a subsidiary out of Estonia without paying income tax.
Dividends paid to a natural person, or to a legal person with a holding of less than 10%, are subjected to income tax at the level of a company or as a dividend income of a natural person (income tax at a rate of 20% is withheld). In other cases, the applicable tax rate is 0%.
Transition to traditional taxation system (model B3)
The entire profit of a legal person is subjected to income tax after the end of a financial year, but the tax rate is low.
nature of tax exemption
Both the nominal and effective tax rate is low.
The tax rate of a legal person is low; dividends are taxed as the income of a natural person. Combinations of the income tax of a legal person and dividends paid to a natural person, such as
6%+14%, 7%+13%, etc.
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