Increased focus on transfer pricing is expected in Latvia due to fundamental tax reform that entered into force on 1 January 2018. Among other significant changes to the Latvian corporate income tax system, new requirements are introduced for controlling related party transactions. New transfer pricing documentation requirements related to preparing Master and Local files are planned to be introduced in the nearest future.
As of 2018, company profit is exempt from corporate income tax and 20% corporate income tax is payable only when a company pays dividends or other payments with the aim of actual profit distribution. Since the taxable base (dividends payable) should be divided by a coefficient of 0.8, the effective tax rate is 25% (ie, depending on the chosen calculation base: 20% on profits or 25% on dividends).
Thus, a company earns EUR 100 profit and wants to calculate tax and dividends payable. To do so, it multiplies EUR 100 by 20% tax = EUR 80 dividends. However, if a company distributes EUR 80 dividends and wants to calculate the tax payable in addition to dividends, it divides EUR 80 by 0.8 and multiplies the result (EUR 100) by 20%, or it can simply multiply EUR 80 by 25% (= tax of EUR 20). The tax is not a withholding tax, but merely conventional corporate tax postponed to the moment of dividend distribution.
The CIT base under the new Latvian corporate income tax law
In the new Latvian corporate income tax system, the following payments are considered to constitute the CIT base:
- non-business costs, eg costs of employees’ rest, cost of representatives’ cars, fines;
- interest payments to non-financial companies and individuals exceeding certain limits (ie thin capitalisation requirements; as of 2018 one existing restriction will remain – the debt ratio to equity is 4:1 and a new restriction will be introduced if interest paid exceeds EUR 3 million);
- on writing off a bad debt;
- transfer pricing adjustments;
- liquidation quota.
Note: loans to related companies are comparable to payment of dividends and are subject to CIT unless they qualify for a specific exemption. Exemption applies to the following:
- loans with a principal amount not exceeding retained profits as on 31.12.2017;
- loans provided by parent companies to direct subsidiaries;
- loans issued by a company to its foreign PE;
- agricultural or forestry cooperative society loans to members for business activities;
- issued loans with no profits retained as at the opening balance sheet of the current tax year;
- loan amounts not exceeding share capital as at the beginning of the tax year, minus loans mentioned in the following three sub-points:
- if loans issued do not exceed loans received from unrelated parties;
- short-term loans (12 months);
- social company loans.
During the tax period (monthly as of 2018) when the loan is repaid, the company can decrease the corporate income tax base by the amount of loan repaid. According to transitional provisions, the new rules apply to loans issued as of 1 January 2018 and to loans issued during 2017 if their aim is to artificially reduce the tax base.
Preparing proper transfer pricing analyses now more important
Due to the specific features of the new Latvian corporate income tax reform, the new CIT law aims at ensuring that taxpayers do not extract profits by means other than dividends, thus aiming to avoid CIT payment. A transfer pricing adjustment found to be necessary by the tax authorities will lead to CIT being payable. Therefore, preparing a proper transfer pricing analysis will become increasingly important as of 2018.
In this respect, note that there will be changes as regards transfer pricing documentation requirements. Latvia has already introduced country-by-country reporting regulations with the first reporting year being 2016. The plan (not yet adopted by the Parliament) is also to introduce Master and Local File requirements as to transfer pricing documentation as of 2018.