Estonian corporate income tax system from 2009

In March 2008 the Estonian Parliament passed amendments to the Estonian corporate income tax system (hereinafter CIT system) in order to highlight the compatibility of the system with the EU Parent-Subsidiary Directive1

(hereinafter PS Directive). At the same time, the basic principle of the current CIT system – the deferral of taxation of corporate profits until their distribution – will be retained. Hence, reinvested profits will benefit from tax exemption also under the amended CIT system. Additionally, amendments eliminate different treatment of resident companies and permanent establishments (hereinafter PE) of non-residents. Furthermore, the changes will reduce the administrative burden of taxpayers. The amendments will become effective on January 1, 2009.

 

Tax Period and Tax Base

Tax period of the companies will be extended from one month to one year. As the taxable period will be a calendar year or financial year, filing of the tax return will become more similar to a traditional system. Namely, the tax return and tax payment will be due within six months after the end of the tax year instead of monthly submission of tax returns and payments of CIT required under the current system. This amendment will significantly reduce administrative burden of taxpayers.

Additionally, the tax base will be altered. Whereas the Income Tax Act currently in force stipulates several separate taxable objects, since 2009 there will be a joint tax base which will consist of following components:

 

• corporate profits distributed in the tax period and

 

• adjusted by taxable gifts, donations, representation costs, expenses and payments unrelated to business and

 

• liquidation proceeds and payments made in case of reduction of the share capital of the company or redemption or return of shares in the amount in which they exceed monetary and non-monetary contributions to the equity of the company.

 

Taxation of liquidation proceeds and payments made in case of reduction of share capital or redemption or return of shares

One of the most noteworthy changes concerns taxation of liquidation proceeds and payments made in case of reduction of share capital or redemption or return of shares. If currently such payments are subject to tax as capital gains at the level of the recipient, as a result of the amendments, they will be taxable at the level of the company making such payments similarly to dividends and other profit distributions. Thus, company’s profits will be taxable at the corporate level despite the way they are taken out of the company. The tax will only be levied on the amount of these payments which exceeds monetary and non-monetary contributions to the equity of the company. Accordingly, these payments will be tax exempt at the level of the recipient so as to avoid double taxation.

¹ Council Directive 90/435/EEC of 23 July 1990 on the common system of taxation applicable in the case of parent companies and subsidiaries of different Member States (OJ, 1990, L 225, p. 6) with further amendments.

This amendment is necessary in order to eliminate different treatment of resident companies and PEs of non-residents. Regardless the type of the taxpayer, the CIT will be levied on profits taken out of the company or PE in the amount which exceeds contributions to the equity of the company or the cost of property brought to Estonia for the PE.

Taxation of permanent establishments

Currently, the taxable base of PEs slightly deviates from the one of resident companies. As a consequence of the amendments, the taxable base of PEs will be analogous to resident companies. Hence, the corporate income tax will be levied on

 

• the profits attributed to the PE which are taken out of the PE during the tax year and

 

• adjusted by taxable gifts, donations, representation costs, expenses and payments unrelated to business.

 

At present, the tax is levied on the amount of profits attributed to the PE (and taken out of it) to the extent that it exceeds the cost of property brought to Estonia for the PE. If the corporate profits of resident companies were taxed in the same way, the taxable amount would be equal to corporate profits after the deduction of share capital. Such a deduction is, of course, not available to the resident companies. Therefore, to ensure equal treatment of resident companies and PEs of non-residents, it will no longer be possible to reduce profits attributed to the PE by the cost of property brought to Estonia for the PE.

 

Avoidance of double taxation

In order to emphasize that the tax base consists of several components and not a dividend as such, the rules of avoidance of double taxation will also be changed.

Currently, the exemption method enables to reduce only taxable profit distributions if the company has derived dividends which meet certain conditions. As a result of the amendments, such dividends will be deductible from entire taxable base consisting of several complementary components in addition to distributed profits, as was explained before. Moreover, the 15% holding requirement for application of the exemption method will be abolished.

Furthermore, the exemption method will be extended to liquidation proceeds and payments received by the Estonian company in case of reduction of share capital or redemption or return of shares in the amount which exceeds monetary and non-monetary contributions made by the Estonian company to the equity of the paying company or the acquisition cost of the shares in the paying company. Such an amendment is necessary to avoid double taxation, as these payments will be taxable at the corporate level and, therefore, should be exempt at the level of the recipient.

Below are a couple of examples of application of the double taxation methods both under current Income Tax Act and after the amendments become in force in 2009:

Example 1 – Exemption method

Dividend received: 600

Exempt part of the liquidation proceeds received: 300

Profit distributed: 500

Donations: 200

Expenses unrelated to business: 300

Tax base: 1000

Current system: tax is levied on 200 (donations) + 300 (expenses unrelated to business) = 500

As of 2009: tax is levied on 1000 (tax base) – 600 (dividend received) – 300 (exempt part of the liquidation proceeds received) = 100

In addition, the rules of application of the credit method will be changed. Differently from the effective system, it will be applicable not only in respect of dividends, interests and royalties, but to any income which has been taxed in the source state. Moreover, the tax paid in the source state will be deductible from the final corporate income tax levied on the whole taxable amount, not only on distributed profits.

Example 2 – Credit method

Foreign income subject to foreign WHT 700

Foreign WHT (20%) 140

Distributed profits: 500

Donations: 200

Expenses unrelated to business: 300

Tax base: 1000

Current system (assume that tax rate is 20%): 500 (distributed profits) / 0,8 x 0,2 = 125 (CIT levied on distributed profits) – 140 (foreign WHT) > no CIT is payable on distributed profits; final CIT liability: (300 + 200) / 0,8 x 0,2 = 125

As of 2009 (assume that tax rate is 20%): 1000 (tax base) / 0,8 x 0,2 = 250 (CIT levied on the whole tax base) – 140 (foreign WHT) = 110 (final CIT liability)

 

Advance payments of CIT

As the taxable period will be a calendar year, an obligation to make advance payments of corporate income tax will be imposed on taxpayers. Pursuant to the amendments, advance payments will be due twice per taxable period. The amount of the installments will be computed on the basis of the average taxable amount for the last three tax years and the tax rate currently in effect. No obligation to make advance payments will arise if the installment amounts to less than 30 000 Estonian kroons (~ 2 000 EUR). When the tax return is filed and the corporate income tax due calculated, the advance payments will be credited against the

final tax liability. Due to the fact that the advance payments are determined according to the average taxable amount for the last three tax years, there is no link between the profits distributed during the taxable period and the advanced payments due.

In the years 2009–2012 the advance payments will be paid under the transitional provision. On January 1, 2009 the tax period of all resident legal persons and non-residents conducting activities through a PE in Estonia will begin. This tax period will last till the end of the financial year of a taxpayer. The tax period shall be at least 6 months and shall not exceed 18 months. The subsequent tax years will coincide with the financial year.

A legal person whose tax period coincides with the calendar year will have an obligation to file the first tax return and pay the CIT due by July 1, 2010. Meanwhile, such a taxpayer will have to make three advance payments in the year 2009 – by the 10^th of March, July and October. The amount of these payments as well as the amount of the advance payment due by the 10^th of March 2010 will be equal to ¼ of multiplication of the average taxable amount in the years 2006–2008 and the tax rate in effect in the tax period for which the advance payment is paid.

The transitional provisions also stipulate special rules as to how advance payments shall be paid in case tax year is different from calendar year (see § 60² section 2 subsections 2 and 3 of the Income Tax Act).

The following table illustrates how advance payments and final CIT shall be paid during the transitional period in case tax year coincides with the calendar year.

Date	Type of Payment	Calculation of the Average Taxable Amount	tax
10.03.2009	2009 – I advance payment	1/4 of the average taxable amount in the years 2006, 2007, 2008	20%
10.07.2009	2009 – II advance payment	1/4 of the average taxable amount in the years 2006, 2007, 2008	20%
10.10.2009	2009 – III advance payment	1/4 of the average taxable amount in the years 2006, 2007, 2008	20%
10.03.2010	2010 – I advance payment	1/4 of the average taxable amount in the years 2006, 2007, 2008	19%
1.07.2010	2009 – final CIT	CIT due on the basis of the tax return filed for the year 2009 and reduced by the advance payments made in the year 2009	20%
10.10.2010	2010 – II advance payment	1/3 of the average taxable amount in the years 2007, 2008, 2009	19%
10.03.2011	2011 – I advance payment	1/3 of the average taxable amount in the years 2007, 2008, 2009	18%
1.07.2011	2010 – final CIT	CIT due on the basis of the tax return filed for the year 2010 and reduced by the advance payments made in the year 2010	19%
10.10.2011	2011 – II advance payment	1/3 of the average taxable amount in the years 2008, 2009, 2010	18%
10.03.2012	2012 – I advance payment	1/3 of the average taxable amount in the years 2008, 2009, 2010	18%

Source: Estonian Ministry of Finance
www.fin.ee

Estonian tax policy

Links to the tax legislation and powerpoints about the income tax on the website of the Ministry of Finance see HERE

Recovery of economic growth depends on improvement in export capacity

Initial figures released by the Statistical Office indicate that gross domestic product (GDP) grew in Estonia in the second quarter by -1.4% compared to the same quarter last year. The negative real growth of GDP is largely explained by the drop in domestic demand, the decrease in exports and the accelerated rise in prices. 

The negative economic growth in the second quarter was expected and we are forecasting improvement in the general economic situation at the start of next year. Recovery of economic growth depends on improvements in export capacity and more active real estate sector. Estonia is not yet facing recession, a term which can only be applied according to its broadly accepted definition when economic growth has been negative for at least two successive quarters.

Positive aspects of the slowdown in economic growth are the slower growth of external debt and the lowering of the current account deficit brought about by the reduction in domestic demand. Better availability of unoccupied labour is allowing companies to select their employees and is reducing the rise in salaries, which to date has been much more rapid than the rise in productivity. The development of the Estonian economy has become more balanced and is gradually adapting to the changed conditions.
 
Private consumption made a significant contribution to the negative economic growth, that was influenced by the considerable decrease in the growth of the amount of money at people’s disposal. Growth in salaries is gradually levelling out and the number of workers has clearly fallen. Moreover, people’s expectations of the future are growing ever more pessimistic, which is having a negative impact on their willingness to borrow, consume and invest. The rise in pensions in April will not be able to compensate for decreasing volumes of debt and the 11 percent rate of inflation will significantly reduce the real growth of income. As such, the negative growth of GDP in the second quarter has also partly been caused by the rise in prices.
 
Apart from domestic demand, another reason for the negative economic growth is the reduction in exports. The rapid rise in the cost of production input and a low level of productivity have harmed sectors offering limited added value, such as the timber and textiles industries. The restructuring of companies to offer new and more complex products and services will take time.

The level of company and household investment probably also fell in the second quarter. A weak economic conjuncture, the reduction in companies’ profitability and the lethargic real estate sector have not favoured capital investment. The key terms in the turn of the economic cycle are the contribution of investments to raise efficiency and offer greater added value, which in turn will enable export potential to increase. However, these changes will take time, as so far capital investments serving domestic demand have been dominant.

Negative economic growth is expected to continue in the coming quarters. The pessimism of people,, reflected in the sentiment indexes that continued to fall in July, is retarding consumption and investment.
 
In calculating economic growth the Statistical Office has adopted a new chaining method, as a result of which the figures for the second quarter are not directly comparable to those of previous periods. The new method enables what is happening in the economy to be more accurately measured and ensures better international comparability of data. The Statistical Office had been planning the implementation of the new method for several years, since it is used in the calculation of GDP by the majority of European Union countries and Estonia was obliged to adopt it in accordance with the EU legislation.

Corrected economic growth indicators based on the new method from 2000 onwards will be published by the Statistical Office on September, 8th.

Source: Estonian Ministry of Finance