The sudden change of Government in Estonia this autumn raised many questions about resulting changes to the Estonian tax system. After all, the Centre Party, which has now formed a government, has been critical of the existing tax system. It is a relief that the agreement between the new Estonian Governing Coalition foresees no major changes to the basic tax system. With minor modifications, the corporate income tax system, offering full deferral of taxes for reinvested profits, will remain. Likewise, the personal income tax system will see only minor modifications.
The unique corporate income tax system in Estonia has shown remarkable durability, having survived challenges both from the EU and from governments involving the full spectrum of the Estonian political landscape. To induce corporations to pay more tax, the government plans to offer a reduced 14% tax rate to those corporations that pay regular dividends. The details of this new arrangement remain to be seen.
As to the personal income tax system the government plans to retain the current single tax rate of 20% but replacing the current fixed general deduction (the so-called tax-free minimum income) with a new sliding general deduction, the amount of which will depend on income. The plan would result in income of EUR 500 or less each month being effectively tax free while the effective tax burden for persons earning more than EUR 1,700 each month would increase. In addition to changes to the general deduction, the government plans to reduce other permissible deductions from personal income tax.
The government does not plan to change the 20% VAT rate. The previous government planned to stop applying the reduced VAT rate for hotel services, but the new government intends to cancel this plan and instead raise the reduced VAT rate to 14%. The government also plans to raise excises, in particular for mild alcohol. The government has acknowledged that this will increase the cross-border alcohol trade with Latvia but reduce it with Finland.
Many of the changes planned by the government will not become effective until 2018. The results of municipal elections in Estonia in the autumn of 2017 could well also impact the composition of the government.
Minimum amount of payments exempted from income tax and workforce taxes
The central focus of the new coalition programme between the Estonian Centre Party, SDE and IRL is to increase minimum monthly payments exempted from income tax from EUR 170 to EUR 500. According to current talks the minimum amount exempted from income tax will be EUR 500 on a gross salary of under EUR 1200 a month by 2018. Starting from gross wages exceeding EUR 1200 a month, the minimum exempted from income tax starts to decrease and from EUR 2100 the gross wage minimum exempted from income tax will be 0. Changes to the taxation system should not be an independent goal but should support the long term development plan, which aims at certain economic effects. If the main purpose is to support people with low wages and a lower tax burden for enterprises hiring such people, then the proposed changes are positive. Increasing the minimum monthly amount of income exempted from income tax to EUR 500 corresponds to the understanding of contemporary minimum means of subsistence. The fact that minimum income exempted from income tax affects lower salaries and not higher salaries is not discriminatory in its essence but takes into consideration the ‘ability to pay’ principle.
However, we would welcome capping social tax contributions for high salary earners. This would notably lower the costs for companies in need of a highly qualified and highly paid workforce. In some European countries, salaries exceeding EUR 4,000-5,000 gross are exempted from social contributions. Highly paid specialists are relatively few, so that capping social contributions on higher gross income would not constitute a heavy burden for the state but would substantially encourage enterprises that require a highly paid workforce.
Decrease of income tax rate on dividends
According to the new coalition agreement, corporate income tax paid on regularly distributed dividends decreases from 20% to 14%. This amendment will not change the current income tax system, which was established in 2000 and which is special because income tax is imposed on distributed profit, not earned income. The purpose of this amendment is to make Estonia more inviting for foreign investors.
Decreasing the income tax paid on dividends is a welcome change and will surely help to create a more competitive business environment and motivate companies with stable profit margins to distribute profit. However, the tax rate is only decreased on dividends paid from company to company, so that dividends distributed to natural persons will be subject to additional income tax to keep the overall income tax liability at 20 percent. An obligation to pay an additional 6% income tax on dividends distributed to natural persons is imposed because otherwise paying dividends instead of salaries would become more frequent.
However, this planned amendment still requires further consideration because it will make the administration of income tax more difficult and after amendment the current system has to be changed. The change is required because non-residents and natural persons will have to fulfil the obligation to declare the additional 6% income tax. In addition, one question is still unresolved: what will happen in a situation where one company distributes dividends to another company (and 14% income tax is imposed) and the company receiving the dividends wishes to distribute dividends to a natural person?
Currently there are no rules for non-residents and natural persons to declare dividend income and it is unclear how this will be regulated in the light of tax treaties.
Taxation of cars to be linked to their power
Under the new government’s plans, a car tax will be imposed from the beginning of 2018. The rate of tax will depend on the power of the car (kW). The tax would have to be paid when the car is initially registered in Estonia and both new and used cars would be subject to tax.
According to preliminary plans, registering a car with power up to 130 kW would involve paying EUR 2.5 for each unit of kW. In the case of more powerful cars, the tax would be higher, so that when the power of the car exceeds 130 kW, then EUR 7.5 would be payable for each additional kW over 130 kW and when the power exceeds 200 kW, then EUR 17.5 would be payable for each additional kW over 200 kW.
The reason underlying this tax is the aim of imposing taxes on pollution and the understanding that more expensive and powerful cars are more harmful to the environment. However, no comprehensive reasoning has been presented as to why linking the rate of tax with the power of the car is more objective and reasonable than, for example, linking the rate of tax with a car’s CO2 emissions. Moreover, for sure it is not only the power of the car that indicates how harmful the car is for the environment. The government has promised that when establishing this regulation they will also consider granting some exceptions, for example for electric cars.
Raising excise duty on alcohol intensively and disproportionately breaches the legitimate expectation of market participants
According to the new coalition agreement, excise duty on beer, fermented beverages and wine go up.
According to current alcohol, tobacco, fuel and electricity excise duty legislation, adopted on 15.06.2015, excise duty rose by 15% in 2016 and in line with the explanatory report the plan is to raise the excise duty on alcohol by 10% every year from 2017-2020 (except for excise duty on certain wines, which rises by 20% in 2019 and 2020). Hence, adoption of the Alcohol, Tobacco, Fuel and Electricity Excise Duty Act means that market participants have been given a fixed-term promise that the excise duty on alcohol has been set for a fixed time and in a fixed amount, so that market participants have a legitimate expectation that these excise duties will remain in place.
Thus, raising the excise duty on alcohol before 2020 to fulfil the new coalition agreement breaches the legitimate expectations of market participants. Moreover, the fact that the parliament had already raised the excise duty set for 2015 and 2016 in 2014 and 2015 leverages the intensity of breach of legitimate expectations. As a result, the legitimate expectations of market participants would be breached for the third time in the past 3-4 years.
Taking into account that no dramatic changes have occurred regarding alcohol consumption or public health since the excise duty on alcohol for 2017-2020 was set, raising the excise duty on alcohol is not in accordance with the principle of legitimate expectations. Moreover, as Estonia, compared to other Member States of the European Union, stands out with its large consumption of spirits, raising the excise duty on beer, fermented beverages and wine is not justified.
Overall, these measures will reduce certainty for foreign investors in Estonia.
Transferring profit by granting loans
In relation to the new coalition discussions, the topic of granting loans to a parent undertaking has once again arisen. The general opinion is that granting loans to a non-resident parent undertaking enables covert transfer of profit out of Estonia, since the loan terms can essentially be indefinitely extended.
Current arguments opposing this view are mainly based on the fact that it is possible to make an investment by granting a loan, including by granting a loan to an entity connected with the lending company, for example to a parent undertaking. In order for a loan to be considered as transfer of profit, it has to be taken into account that it is already necessary to follow the market conditions of loan terms, interest, possible securities and other components. Otherwise, if a loan is granted to a parent undertaking under more favourable conditions compared to a similar loan between independent entities, income tax has to be paid according to the transfer price.
Despite the fact that loan transactions can be used improperly, granting loans to a parent undertaking cannot automatically be considered as transfer of profit. The argument that granting loans is used to defer income tax liability is not meaningless, since deferring income tax liability is a peculiarity of the Estonian tax system. Declaring loans and imposing a minimal interest rate are formal provisions and their effectiveness is currently unclear.
The highest body of the Supreme Court will rule on the constitutionality of advertising tax
The first disputes regarding the constitutionality of advertising tax have reached the Supreme Court. The Administrative Law Chamber of the Supreme Court referred the case to the highest body of the court – the Supreme Court en banc, which consists of all 19 judges of the Supreme Court
The Administrative Law Chamber raised doubts whether the Local Taxes Act is in accordance with the Constitution since it allows local municipalities to impose the rate of advertising tax but does not specify an upper or lower limit of the tax rate or other criteria for imposing the tax rate. Previous practice of the Supreme Court demands that all substantive elements of all public law monetary duties must be determined at the level of the law.
A decision in this landmark case will presumably be made at the beginning of 2017.
Changes in Income Tax Law that came into force in November
In November, amendments to the Income Tax Law came into force that could affect entrepreneurs working cross-border. The amendments can in some circumstances limit the use of tax exemption applicable to further payment of dividends received from a foreign subsidiary. Additionally, the amendments do not grant tax exemption to payments related to hybrid loans which a foreign payer could deduct from its taxable profit.
The first amendment limits the use of the exemption method to further payments of dividends received from a foreign subsidiary in cases where the exemption method was deemed to be abused. The explanatory material to the amendments gives an example of abuse – a situation where the subsidiary that is paying the dividends is established or acquired without any business reason other than to distribute the profit of the subsidiary in the form of dividends or payments from equity without paying taxes.
The other amendment concerns hybrid loans which are considered to be loans in one country but capital contributions in another country. Previously the possibility was that certain payments related to hybrid loans enjoyed exemption in the country of the payer (where payment was deductible from taxable profit) and also in Estonia (where use of the exemption method was allowed). Since November this kind of double non-taxation is excluded.
Contractual investment fund can be granted treaty benefits of avoidance of double taxation on income and capital
The OECD Model Tax Convention on Income and on Capital (the “Model Convention”), which is the basis of tax treaties worldwide, contains general provisions addressing each Contracting State’s taxing rights over income derived by a person resident in another Contracting State, but it does not have any specific provisions relating to collective investment vehicles (CIV). In the absence of specific rules applicable to CIVs, a CIV will be entitled to the benefits of a convention in its own right only if it is a person that is a resident of a Contracting State. It may also have to be the beneficial owner of the relevant income. The OECD Fiscal Committee adopted a report on “The Granting of Treaty Benefits with Respect to the Income of Collective Investment Vehicles” in 2010. On this basis OECD recent commentaries on the Model Convention consider CIV to be covered by treaty benefits. Specifically, commentaries on the Model Convention (2014 edition) state about CIVs:
The primary question that arises in the cross-border context is whether a CIV should qualify for the benefits of the Convention in its own right. In order to do so under treaties that, like the Convention, do not include a specific provision dealing with CIVs, a CIV would have to qualify as a "person" that is a “resident” of a Contracting State. In most cases, the CIV would be treated as a "person" since commentaries on the Model Convention enable wide interpretation also covering bodies of persons. Most importantly, the decision whether a CIV is a "resident” of a Contracting State depends not on its legal form (as long as it qualifies as a person) but on its tax treatment in the State in which it is established.
In 2014, the provisions regulating taxation of real estate funds were adopted in the Estonian Income Tax Act. Based on these provisions real estate funds are taxable in Estonia and although investment funds have no legal entity in Estonia it enables the conclusion that contractual real estate funds are persons resident in Estonia under tax treaties.
Although Estonia has exempted interest and dividend payments to non-residents from withholding tax in Estonia, the fact that contractual investment funds can be considered residents under a tax treaty may be relevant to foreign investors, since it can eliminate possible double taxation of income from Estonian contractual funds in their home countries.
Estonia moves to implement BEPS Action 13 Country by Country Reporting
The Estonian government has introduced a bill that would, once adopted, implement country-by-country reporting in Estonia. The new requirement would apply to companies with worldwide consolidated turnover exceeding EUR 750 million and the first report would have to be submitted at the end of 2017 covering the year 2016.
The new act would also implement the amendments to the Mutual Assistance Directive and elements of BEPS action 5 which will increase automatic information exchange with the tax authorities of other EU member states. In addition to information regarding income from employment, director's fees, pensions, ownership of and income from immovable property, the automatic information exchange will expand to more general financial income and account balance information.