The following article is written by Peep Kalamäe, tax manager of PricewaterhouseCoopers AS, at BBN.ee.
The Government of Estonia has submitted a new draft Act (352 SE I) to the Riigikogu (Parliament of Estonia) which among other matters plans to once again change the taxation of dividends payable to non-resident minority shareholders in a manner which would prolong the incompatibility of the Estonian Income Tax Act with European law.
In addition to the corporate income tax payable upon distribution of dividends, the Income Tax Act stipulates additional withholding tax on dividends payable to minority shareholders who are non-resident legal persons. Withholding applies when a non-resident owns less than 15% of the share capital or votes of an Estonian distributing company. 21% withholding tax applies when the person receiving the dividends is located in a low-tax territory, irrespective of such person’s participation in the Estonian company. According to the amendments to the Income Tax Act adopted by the Riigikogu this spring, withholding of income tax on dividends payable to non-residents should be abolished from 1 January 2009.
According to the new draft (352 SE I) amending the Act passed in spring, 21% withholding tax (or mostly 15% in case of a tax treaty) should remain in force for the dividends payable to such non-resident legal persons who do not own at least 10% of the share capital or votes of the Estonian resident company at the time of announcement or payment of dividends. The adoption of the amendment proposal as an Act would primarily preserve the current discriminatory investment environment for foreign pension and investment funds because dividends from portfolio investments of similar Estonian resident funds are not subject to withholding tax. The European Commission that drew the attention of several EU Member States to a potential inconsistency with the provisions of the EC Treaty regarding the free movement of capital, terminated the infringement procedure against Estonia for the reason that on 26 March 2008 the Riigikogu ruled to terminate withholding of income tax on all dividends payable to non-residents,
Non-resident service providers are in an unfavourable position
Pursuant to the Income Tax Act, the service fees payable to non-residents for services rendered in Estonia are subject to 15% withholding tax. However, if the recipient of the fee is a resident of a country that has an effective tax treaty with Estonia, the respective withholding tax is not applied in Estonia. The withholding tax is also not applied to such service fees when the recipient of the fee is an Estonia registered branch office or a permanent establishment of the non-resident.
Similarly to Estonia, service fees payable to non-residents are subject to a 15% withholding tax also in Portugal, whereas service fees payable to residents are not subject to any withholding tax. On 18 September 2008, the European Commission announced that it has decided to refer Portugal to the European Court of Justice for its discriminatory tax rules in respect of the service fees and to demand that Portugal would harmonise its tax rules with the principles of the free movement of services as laid down in the EC Treaty (IP/08/1353).
In the view of the European Commission, the referred rules are incompatible due to the fact that in case of fees payable to non-resident service providers the tax is levied from the gross amount whereas for service fees payable to residents the tax is levied from the net amount (which enables to take into account also costs incurred with the provision of services). However, the 15% rate on the gross amount may often lead to a higher tax liability than the 25% tax rate on the net amount. In the opinion of the Commission, such different taxation may dissuade foreign service providers from providing services in Portugal and may indirectly favour the purchasing of services from local service providers. Portugal has attempted to justify the different taxation of service fees with different tax rates (i.e. a lower tax rate is applied to foreign service fees upon withholding) and with the fact that the withholding tax is not applicable in case of an effective tax treaty. Of the EU Member States, Portugal does not have an effective tax treaty with Cyprus. Therefore, the European Commission is of the view that Portugal applies discriminatory taxation against Cyprian service providers. In the opinion of the Commission, discriminatory taxation exists when it cannot be ensured that differences in the level of taxation due to the differences in the tax bases are always offset by the differences in the tax rates. The Commission regards such different taxation disproportionate even when a Member State justifies it as an administrative method for preventing tax fraud.
Estonia that likewise applies different taxation of service fees payable to non-residents and residents also faces the potential issue described above. In Estonia, different tax treatment of service fees payable to resident and non-resident companies is even more striking than in Portugal, as resident companies are essentially subject to 21% corporate income tax only upon distribution of profits.
Of the EU Member States, in addition to Cyprus (with whom negotiations are under way) Estonia does not have an effective tax treaty with Bulgaria (signed on 13 October 2008 and is subject to ratification in both states) and Greece (will be effective from 1 January 2009). Therefore, Estonia should carefully take into account the decision of the European Court of Justice with regard to Portugal’s case described above and if necessary, amend the current taxation of service fees. As a solution to above issue, Estonia might consider to exempt from withholding tax all service fees payable to residents of the member states of the European Economic Area or Switzerland.
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