CONTRACT SI2.ICNPROCE

Transcription

1 CONTRACT SI2.ICNPROCE IMPLEMENTED BY FOR DEMOLIN, BRULARD, BARTHELEMY COMMISSION EUROPEENNE - HOCHE - - DG ENTREPRISE AND INDUSTRY - Study on Effects of Tax Systems on the Retention of Earnings and the Increase of Own Equity Jean ALBERT Team Leader - ANNEX ESTONIA - - COUNTRY REPORT - Submitted by Jürgen VALTER Country Expert February 15,

2 ESTONIA Rimess MRI OÜ Jürgen Valter Ahtri 6a, Tallinn, Estonia Tel INTRODUCTION In the following pages we have answered the questions and given explanatory remarks when and where possible in order to give the reader as complete understanding of the Estonian tax system as possible. In our view it is extremely important for the reader of this report to understand the Estonian tax system (specially the income tax principles) from the start. It is important because our tax system is in many ways very simple, but at the same time its principles are different from all other EU countries tax systems) and therefore some of the questions (or even assumptions) are irrelevant to our tax system and therefore the answers are sometimes simple or YES. We have decided not to give long explanations to every answer because the explanations would in most cases be the same. We think that the most important and groundbreaking conclusion that we can draw from the results of this study keeping in mind the subject to identify the major tax obstacles for the retention of earnings in the different tax systems and collect possible solutions to promote retained earnings in order to strengthen the capital base of enterprises, especially small enterprises is that the Estonian tax system in 2

3 this respect is most probably one of the friendliest systems in Europe. Currently we do not have a corporate income tax as long as the income stays in the company and the income is in principle taxed only when it is distributed - therefore it is hard to imagine what would be a possible better way of favoring a retainment of earnings than this. The main difference of Estonian system 1 from corporate income tax systems in other countries is the timing of taxation. Estonian companies pay corporate income tax at the moment when the profit is distributed. This is usually done in the form of dividends. But in addition to distributed profits, all other elements of traditional corporate income tax still exist. For example, expenses that are not deductible in a traditional system are taxable in Estonia. Under the traditional system, the starting point (the basis) for taxing profits of a company is usually profit and loss account that is calculated according to the accounting rules and then it will be adjusted according to the tax rules. In Estonian system, dividends reflect the commercial profits and in addition to that, non-deductible expenses are taxed. Estonian simple system lies on cash-basis accounting and there is no need for amortization and depreciation rules or any special rules on tax-deductible. Estonian Commercial Code provides that dividends may be paid out from net profit of a company, but only after the deduction of losses from previous years 2. So there is no need for special tax provisions for loss carry forward. There is no liability to pay tax in the case of loss, since only the profit can be distributed. Estonian legislation provides that general and limited partnerships are treated taxwise similarly to corporations. They are considered non-transparent for tax purposes. Taking into account the aforementioned it can be said that SMEs in Estonia keep their income in their companies as long as possible and take dividends out only when 1 Income Tax Act (TMS RT I 1999, 101, 903; RT I 2006, 63, 468). TMS came into force on and is currently valid (with several amendments adopted after the initial versions). Consolidated versions with adopted amendments in the WEB valid until : valid until : valid until : valid from : 2 Articles 157 and 276, Commercial Code (ÄS RT I 1995, 26-28, 355; RT I 2006, 61, 456). 3

4 their owners really need it for personal purposes (thus taking into account other aspects than taxes). Another important element is the trend of lowering the income tax in general. This trend started 2005 and since that time the income tax in Estonia has been decreased every year (1-2%) from 26% , to 24% 4 in 2005, to 23% 5 in 2006, to 22% 6 in 2007, to 21% 7 in 2008 and 20% 8 in And this might not be all. This is currently of course merely a prediction but after the elections that took place March 2007 the party that overwhelmingly won the elections have taken as their target to keep reducing the income tax down to 18% by 2011 or The same party was the iniciator of the first mentioned reducing of the tax. Those trends have also played a significant part in the business owners decisionmaking since it is obviously more favourable to retain earnings in the undertaking and distribute dividends always in a next year because the tax rate itself goes down year by year. In case the politicians will to reduce the income tax rate finds ground then this will again favour the undertakings to retain earnings. Note! As part of its Accession Agreement to join the EU, Estonia agreed to modify its scheme of corporate taxation by December 31, 2008 to bring its income tax into compliance with the Parent-Subsidiary Directive 9. Which is also important is that some of the business owners (specially micro eterprises) have in the past years found a way to optimize the tax costs by not paying out salaries (or management fees) to themselves as natural persons but to wait until the end of the year and pay out more dividends. In principle this reduces the tax cost in the amount of 33% 10, which is a rate for social tax that has to be paid of the salary and similar and not on the dividend payouts. However this obviously 3 Article 4, Income Tax Act (TMS RT I 1999, 101, 903). Valid from through Article 4, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2003, 88, 591). Valid from through Article 4, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2005, 36, 277). Tax rate valid from through Ibid. Tax rate valid from through Ibid. Tax rate valid from through Ibid. Tax rate valid from through Council Directive 90/435/EEC (OJ, No. 225/1990, p. 6). 10 Article 7, Social Security Tax Act (SMS RT I 2000, 102, 675; RT I 2006, 61, 459). Valid from (partially from ). 4

5 does not make the tax authorities too happy and therefore it is currently well known that the tax authorities are seeking ways to tax such dividend payouts as salary payments (using the content over form principle 11 ). There is no case law in our knowledge but it is possible in the future. Citation Citation rules of University of Tartu have been used when citing Estonian legal acts. In the brackets the abbreviation of the legal act in Estonian, the date of acceptance of the legal act and the number of the Estonian official journal where the legal act is published is set. When citing EC legal acts the rules of Official Journal of the European Union have been used. 11 Article 84, Taxaction Act (MKS RT I 2002, 26, 150; RT I 2007, 23, 121). 5

6 PART 1 GENERAL QUESTIONS 1. What are the main characteristics of the tax systems applicable on enterprises and business owners in your Country (corporate income tax, income tax, capital gains tax, other profit based taxes, capital based taxes, other taxes)? Introduction of the Estonian tax system Estonian tax system consists of state taxes provided and imposed by tax Acts and local taxes imposed by a rural municipality or city council in its administrative territory pursuant to law. State taxes are: income tax, social tax, land tax, gambling tax, value added tax, customs duty, excise duties, heavy goods vehicle tax. Taxation Act 12 is the basic act to all other tax acts. It specifies the Estonian tax system, the requirements for tax Acts, the rights, duties and liability of taxpayers, withholding agents, guarantors and tax authorities, and the procedure for resolution of tax disputes and main definitions used in all tax acts Corporate Income What are the general principles for the computation of taxable profits? Resident companies and permanent establishments of the foreign entities (including branches) are subject to income tax only in respect of all distributed profits (both actual and deemed), including dividends and other profit distributions, fringe benefits, gifts, donations and representation expenses and payments not related to business Taxaction Act (MKS RT I 2002, 26, 150; RT I 2007, 23, 121). 13 Article 48-53, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2006, 63, 468). 6

7 All distributions are subject to income tax at the grossed-up rate of 22/78 of the net amount of taxable payment (therefore the rate of income tax on the gross amount of income is 22% 14 ). The transfer of assets of the permanent establishment to its head office or to other non-residents is also treated like a distribution. 15 Dividends paid to nonresidents are additionally liable to withholding tax at the general rate of 22%, unless the non-resident legal entity holds at least 15% of the share capital of the distributing Estonian company What are the main differences between the tax balance sheet and commercial balance sheet? In Estonia, the corporate income taxation is cost-based. The period of taxation is regulary one calendar month; despite of the fact whether company has a profit or loss. 17 Annual profit is not taxed in Estonia and due to this, there are no differences between tax and commercial balance sheet What are the most important adjustments for the computation of taxable profits/taxable gains on the base of accounting profits? In Estonia, the profit is not taxed before it is taken out from the company. The actual amount of dividend paid is subject to tax, therefore no adjustments to accounting profits are made since they are irrelevant Income What are the general principles of income taxation of business owners on business income, wages, distributed earnings, interest on loans and capital gain (sale of shares)? If business owner is legal entity then please see differences from the table in answer 23. Personal income is taxed on the moment of earning. 14 Article 4, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2005, 36, 277). Tax rate valid from through Article 53, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2006, 63, 468). 16 Article 50, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2006, 63, 468). 17 Article 54, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2006, 63, 468). 7

8 18 In case of income from indivual business (enterpreneurship) the taxpayer may deduct also related expenses from taxable profit. 19 There is difference between capital gain and other types of income. Generally the income is taxed through the withholding method (that is final tax). 20 In case of capital gain individual taxpayer himself shall declare the profit. 21 The income tax rate is the same for all types of income Is there a different tax treatment for income from different income sources? On the level of companies there is no difference about income source when income is earned (all types of income are exempted from corporate income tax). On the level of natural person, the income is taxed at the moment when the income is earned. The income is divided into 2 basic groups active income and passive income. Active income is income from employment, also income from entrepreneurship. Active income is taxed with income tax and also with social security contribution. Passive income (for example interest, capital gains and etc) is only subject to income tax. Relying to the Estonian Income Tax Act article 12, the income tax is charged on income derived by a resident natural person during a period of taxation from all sources of income in Estonia and outside Estonia, including income from employment, business income, gains from transfer of property, rent and royalties, interest, dividends, maintenance support, pensions, scholarships, grants, benefits, awards, lottery prizes, insurance indemnities and payments from pension funds, income of a legal person located in a low tax rate territory. The taxable income of a natural person does not include fringe benefits, gifts and donations, dividends 18 Article 36, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2006, 63, 468). 19 Article 32, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2006, 63, 468). 20 Article 41, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2006, 63, 468). 21 Article 15 and 44, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2006, 63, 468). 22 Article 4, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2006, 63, 468). 8

9 or other profit distributions, which are subjects to corporate taxation at company level Capital Estonia RELEVANT TAX PROVISIONS AND SUBSEQUENT CHANGES FOR CORPORATIONS (distinguish specific tax rates for SMEs) Corporat e tax 1. Tax rate Standard % 24 from gross base (26/74 from net base) 26% 25 from gross base (26/74 from net base) 26% 26 from gross base (26/74 from net base) 24% 27 from gross base (24/76 from net base) Reduced Minimum Tax Special Rates Non profit tax (local tax on corporati ons, energy tax ) 2. Tax accountin g rules Local governments have a right to impose sales tax, advertisement tax, boat tax, motorvehicle tax, and amusement tax. Has no significant effect for SMEs or others. Tax accounting rules do not exist, therefore Local governments have a right to impose sales tax, advertisemen t tax, boat tax, motorvehicle tax, and amusement tax. Has no significant effect for SME-s or others. Tax accounting rules do not exist, Local governments have a right to impose sales tax, advertisement tax, boat tax, motorvehicle tax, and amusement tax. Has no significant effect for SME-s or others. Tax accounting rules do not exist, therefore no differences Local governments have a right to impose sales tax, advertisemen t tax, boat tax, motorvehicle tax, and amusement tax. Has no significant effect for SME-s or others. Tax accounting rules do not exist, 23% 28 from gross base (23/77 from net base) Local governments have a right to impose sales tax, advertisement tax, boat tax, motorvehicle tax, and amusement tax. Has no significant effect for SMEs or others. Tax accounting rules do not exist, therefore 23 Article 12, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2006, 63, 468). 24 Article 4, Income Tax Act (TMS RT I 1999, 101, 903). Valid from through Ibid. 26 Ibid. 27 Article 4, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2003, 88, 591). Valid from through Article 4, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2005, 36, 277). Tax rate valid from through

10 Estonia 3. Depreciat ion no differences from accounting rules. RELEVANT TAX PROVISIONS AND SUBSEQUENT CHANGES FOR CORPORATIONS (distinguish specific tax rates for SMEs) therefore from accounting therefore no rules. no differences differences from from accounting accounting rules. rules. As Estonian system lies on cash-basis accounting there is no need for depreciation rules for tax purposes. As Estonian system lies on cash-basis accounting there is no need for depreciation rules for tax purposes. As Estonian system lies on cash-basis accounting there is no need for depreciation rules for tax purposes. As Estonian system lies on cash-basis accounting there is no need for depreciation rules for tax purposes. no differences from accounting rules. As Estonian system lies on cash-basis accounting there is no need for depreciation rules for tax purposes. Basis Methods Rates Accountin g Intangible s Non depreciab le assets Provisions Risks and futures expenses Bad debts Pensions Repairs Losses Does not affect corporate income taxation. Not applicable for corporations, only for sole Does not affect corporate income taxation. Not applicable for Does not affect corporate income taxation. Not applicable for corporations, only for sole Does not affect corporate income taxation. Not applicable for Does not affect corporate income taxation. Not applicable for corporations, only for sole 29 NB! The sole proprietorship (mentioned upwards) is an undertaking of a natural person who offers goods or services for charge in his or her own name where the sale of goods or provision of services is his or her permanent activity and who has registered (or obliged to register) him/herself by the tax authorities and commercial register; sole proprietorship is not the same as Sole Trader in the meaning of this reports s glossary because sole proprietorship is not a legal person (where the Sole Tarder is). 10

11 Estonia Carry forward 30 Carry back Transfer of losses 6. Inventorie s Valuation rules Allocation methods Personal Income tax Interest Income Dividends RELEVANT TAX PROVISIONS AND SUBSEQUENT CHANGES FOR CORPORATIONS (distinguish specific tax rates for SMEs) proprietorship. corporations, only for sole proprietorshi p proprietorship corporations, only for sole proprietorshi p proprietorship Sole proprietorship, which can carry forward losses for 7 years to reduce the taxable income. Not applicable. Not applicable. Has no effect for taxation. Sole proprietorshi p, which can carry forward losses for 7 years to reduce the taxable income. Not applicable. Not applicable. Has no effect for taxation. Sole proprietorship, which can carry forward losses for 7 years to reduce the taxable income. Not applicable. Not applicable. Has no effect for taxation. Sole proprietorshi p, which can carry forward losses for 7 years to reduce the taxable income. Not applicable. Not applicable. Has no effect for taxation % 31 26% 32 26% 33 24% 34 23% 35 Not taxed if reicived from credit institution of Estonian resident. Otherwise 26% income tax. Dividend income received from the resident companies is excluded from Not taxed if reicived from credit institution of Estonian resident. Otherwise 26% income tax. Dividend income received from the resident companies is Not taxed if reicived from credit institution of Estonian resident. Otherwise 26% income tax. Dividend income received from the resident companies is excluded from Not taxed if reicived from credit institution of EU resident. Otherwise 24% income tax. Dividend income received from the resident companies is Sole proprietorship, which can carry forward losses for 7 years to reduce the taxable income. Not applicable. Not applicable. Has no effect for taxation. Not taxed if reicived from credit institution of EU resident. Otherwise 23% income tax. Dividend income received from the resident companies is excluded from 30 Article 35, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2006, 63, 468). 31 Article 4, Income Tax Act (TMS RT I 1999, 101, 903). Valid from through Ibid. 33 Ibid. 34 Article 4, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2003, 88, 591). Valid from through Article 4, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2005, 36, 277). Tax rate valid from through

12 Estonia RELEVANT TAX PROVISIONS AND SUBSEQUENT CHANGES FOR CORPORATIONS (distinguish specific tax rates for SMEs) excluded taxable income excluded from taxable of the natural from taxable income of person (taxation income of the natural takes place at the natural person the company person (taxation level where the (taxation takes place rate is 26/74). takes place at the If dividends are at the company received from company level where abroad and level where the rate is income tax has the rate is 26/74). If been paid on 24/76). If dividends are the share of dividends are received profit on the received from abroad basis of which from abroad then they are the dividends and income subject for are paid or if tax has been individual income tax on paid on the taxation. In the dividends share of case dividens has been profit on the are received withheld in a basis of from foreign foreign state which the tax treaty then the dividends are country then exemption paid or if the credit method is income tax method is applicable on the applicable - (from Estonian dividends has the Estonian income tax) been income tax withheld in a shall be foreign state reduced by then the paid tax in exemption abroad). method is applicable (from Estonian income tax) taxable income of the natural person (taxation takes place at the company level where the rate is 26/74). If dividends are received from abroad then they are subject for individual taxation. In case dividens are received from foreign tax treaty country then the credit method is applicable - the Estonian income tax shall be reduced by paid tax in abroad). taxable income of the natural person (taxation takes place at the company level where the rate is 23/77). If dividends are received from abroad and income tax has been paid on the share of profit on the basis of which the dividends are paid or if income tax on the dividends has been withheld in a foreign state then the exemption method is applicable (from Estonian income tax) Employm ent income Capital gains tax Flat 26% Flat 26% Flat 26% Flat 24% Flat 23% There is no capital gains tax. In case of natural persons the capital gain transactions are taxed by income tax (26%). In case of companies capital gain is There is no capital gains tax. In case of natural persons the capital gain transactions are taxed by income tax (26%). In case of companies capital gain There is no capital gains tax. In case of natural persons the capital gain transactions are taxed by income tax (26%). In case of companies capital gain is tax-free. There is no capital gains tax. In case of natural persons the capital gain transactions are taxed by income tax (24%). In case of companies capital gain There is no capital gains tax. In case of natural persons the capital gain transactions are taxed by income tax (23%). In case of companies capital gain is 12

13 Estonia RELEVANT TAX PROVISIONS AND SUBSEQUENT CHANGES FOR CORPORATIONS (distinguish specific tax rates for SMEs) tax-free. is tax-free. is tax-free. tax-free. Sale of fixed assets Timing rules Accountin g rules Inflation Rates Exemptio ns Sale of shares Capital loss Not applicable for companies. Natural persons may deduct from capital gains or carry forward Not applicable for companies. Natural persons may deduct from capital gains or carry forward Not applicable for companies. Natural persons may deduct from capital gains or carry forward Not applicable for companies. Natural persons may deduct from capital gains or carry forward Fixed assets Shares Wages Average Wage+33,5% 36 Wage+33,5% Wage+33,5% 38 Wage+33,3% cost to the Undertaki ng Average cost to the employee 41 ~39,9% (non taxable income 1000 kroons) ~39,3% (non taxable income 1000 kroons) ~39,3% (non taxable income 1400 kroons) ~35,1% (non taxable income 1700 koons) Not applicable for companies. Natural persons may deduct from capital gains or carry forward Wage+33,3% 40 ~33,3% (non taxable income 2000 kroons) Overall Distributed Distributed Distributed Distributed Distributed 36 Article 7, Social Security Tax Act (SMS RT I 2000, 102, 675; RT I 2006, 61, 459). Valid from (partially from ). Article 41, Unemployment Insurance Act (TKS RT I 2001, 59, 359; RT I 2006, 31, 236). Valid from The cost is calculated upon social security tax and undertaking s part of unemployment insurance premium. The rate of unemployment insurance premium is set separately for each year. 37 Ibid. 38 Ibid. 39 Ibid. 40 Ibid. 41 The calculation for average costs does not include non-taxable base. 13

14 Estonia RELEVANT TAX PROVISIONS AND SUBSEQUENT CHANGES FOR CORPORATIONS (distinguish specific tax rates for SMEs) tax on distribute d earnings or Dividends Timing Tax credit structure Excluding non profit tax Including non profit tax Deductio n of expenses General rule dividends are taxed with corporate income rtax at 26/74 (calculated from a net payment) Tax is levied at the moment of distribution dividends are dividends are dividends are taxed with taxed with taxed with corporate corporate corporate income rtax income rtax at income rtax at 26/74 26/74 at 24/76 (calculated (calculated (calculated from a net from a net from a net payment) payment) payment) payment) If corporate income tax has been paid on share of profit on the basis, which the dividends are paid, or if income tax on the dividends has been withheld in a foreign state, income tax on re-distributed dividends shall be reduced by the paid amount (credit method) Tax is levied at the moment of distribution. If corporate income tax has been paid on share of profit on the basis, which the dividends are paid, or if income tax on the dividends has been withheld in a foreign state, income tax on redistributed dividends shall be reduced by the paid amount (credit method) Tax is levied at the moment of distribution. If corporate income tax has been paid on share of profit on the basis, which the dividends are paid, or if income tax on the dividends has been withheld in a foreign state, income tax on re-distributed dividends shall not be charged (exemption method) Tax is levied at the moment of distribution. If corporate income tax has been paid on share of profit on the basis, which the dividends are paid, or if income tax on the dividends has been withheld in a foreign state, income tax on redistributed dividends shall not be charged (exemption method) Expenses that are not deductible in a traditional system are taxable with corporate income tax in Expenses that are not deductible in a traditional system are taxable with corporate income tax in Expenses that are not deductible in a traditional system are taxable with corporate income tax in Expenses that are not deductible in a traditional system are taxable with corporate income tax in dividends are taxed with corporate income rtax at 23/77 (calculated from a net Tax is levied at the moment of distribution. If corporate income tax has been paid on share of profit on the basis, which the dividends are paid, or if income tax on the dividends has been withheld in a foreign state, income tax on re-distributed dividends shall not be charged (exemption method) Expenses that are not deductible in a traditional system are taxable with corporate income tax in 14

15 Estonia Nondeductibil ity of expenses Thin capitaliza tion Overall corporate tax on retained earnings Excluding non profit tax Including non profit tax Debt financing Interest deductibil ity Limits on interest deductibil ity Interest deductibil ity on business owner loan to Undertaki ng Estonia (see the overview). RELEVANT TAX PROVISIONS AND SUBSEQUENT CHANGES FOR CORPORATIONS (distinguish specific tax rates for SMEs) Estonia (see Estonia (see the Estonia (see the overview). the overview). overview). Fringe benefits, gifts, reception costs, hidden profit distribution, non-enterprise expenses Fringe benefits, gifts, reception costs, hidden profit distribution, nonenterprise expenses Fringe benefits, gifts, reception costs, hidden profit distribution, non-enterprise expenses Fringe benefits, gifts, reception costs, hidden profit distribution, nonenterprise expenses Estonia (see the overview). Fringe benefits, gifts, reception costs, hidden profit distribution, non-enterprise expenses No rules No rules No rules No rules No rules Not taxed before profit distribution. Not taxed before profit distribution. Not taxed before profit distribution. Not taxed before profit distribution Not applicable no impact on taxation of dividends. Not applicable. Not applicable. Not applicable Not taxed before profit distribution. Not applicable Is there a different tax treatment between distributions of earnings and capital gains realised by the sale of the business or the shares in the undertaking? 15

16 Yes, there is in case of companies selling the business. When earnings are distributed, its object for corporate income tax (see answer ). Capital gains realised on a sale of a business by a company are not taxed on the company level. The taxation takes place at the moment of profit distribution by the selling company. But if the business is sold by a natural person then the capital gain is subject to tax and the tax rate is the same as on distribution of earnings from the business to the owner Are there different tax treatments for long-term capital gains and short-term capital gains? Are there different tax treatments for capital gain from SME business stock and capital gain from larger companies business stock? Whatever types of capital gains are not taxed at company level (when earned). All the gapital gains received by individuals are taxed with income tax. The gain or loss derived from the sale of business (shares) is the difference between the acquisition cost and the selling price of the business (shares). 42 Natural person can deduct the loss from sale of securities only from capital gain derived from securities and not other types of assets. 43 Estonia RELEVANT TAX PROVISIONS AND SUBSEQUENT CHANGES FOR PARTNERSHIPS (distinguish specific rates for SME-s) Note! Estonian legislation provides that general and limited partnerships are treated tax-wise similarly to corporations. They are considered non-transparent for tax 42 Article 37, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2006, 63, 468). 43 Article 39, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2006, 63, 468). 16

17 purposes and therefore the table upwards 1.3. RELEVANT TAX PROVISIONS AND SUBSEQUENT CHANGES FOR CORPORATIONS applies also to partnerships. 2. What are the main types of business entities and the main differences in (corporate) income taxation for sole traders, general partnerships, limited partnerships and corporation and other business entities if relevant? The Estonian legislation (mainly the Commercial Code 44 ) prescribes the main business entities as follows: sole proprietorship (natural person) and legal persons such as general partnership, limited partnership, private limited company, public limited company or commercial association. Legal business entities are all taxed alike Are partnerships treated transparent for tax purposes? 2.2. Can partnerships opt for corporate income tax? Partneship is treated in the same way as corporation for corporate income tax purposeses Once they have opted for a regime is it easy to switch back? Not applicable 2.4. Is there a difference in this respect between general and limited partnerships? 2.5. Can corporations opt to be treated tax transparent? 44 Article 2, Commercial Code (ÄS RT I 1995, 26-28, 355; RT I 2006, 61, 456). 45 Article 6, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2006, 63, 468). 17

18 2.6. Once they have opted for a regime is it easy to switch back? Not applicable 2.7. Are their differences in this respect between the different types of corporations? Estonia General Partnership Corporate tax 46 Tax rate decreases from 2004 to From 26% to 20%. See also first comparable RELEVANT TAX PROVISIONS IN 2002 AND SUBSEQUENT CHANGES UP TO 2007 Limited Corporation Partnership Tax rate Tax rate decreases decreases from 2004 to from 2004 to From From 26% to 20%. 26% to 20%. See also first See also first comparable comparable table. table. table. Tax rate Tax rate decreases decreases from 2004 to from 2004 to From From 26% to 20%. 26% to 20%. See also first See also first comparable comparable table. table. table Income tax 47 Tax rate decreases from 2004 to From 26% to 20%. See also first comparable Capital gains tax Option for Transparent treatment No No No No Sole Trader Tax rate decreases from 2004 to From 26% to 20%. See also first comparable table. Tax rate decreases from 2004 to From 26% to 20%. See also first comparable table. 46 Article 4, Income Tax Act (TMS RT I 1999, 101, 903). Valid from through Article 4, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2003, 88, 591). Valid from through Article 4, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2005, 36, 277). Tax rate valid from through Ibid. Tax rate valid from through Ibid. Tax rate valid from through Ibid. Tax rate valid from through Ibid. 18

19 3. Are there any special tax regimes for SME-s for (corporate) income tax purposes? There are no special tax regimes for SME-s for corporate income tax purposes What are the conditions to be fulfilled in order to benefit from these special tax regimes? Not applicable 3.2. Are there limits on the length of time during which these special tax regimes are available, or other limits? Not applicable 4. Are there any special tax incentives, such as (re-)investment reserves or provisions, special depreciations/capital allowances deductible for (corporate) income tax purposes? There are no special incentives as such but the tax system in principal favours retaining of profit, as it is not subject for corporate income tax Do these elements of internal financing represent an important alternative to the financing by retained earnings? 4.2. Are there any compulsory measures in relation to the retention of earnings (e.g. legal constraints for the distribution of profits and dividend policy)? 19

20 5. Are there any differences in the tax treatment of stock and cash dividends? 48 YES Corporate income tax is not charged on profit distributed by way of a bonus (stock dividends) issue. 49 Generally a resident company (including a general or limited partnership) shall pay income tax on profit distributed as dividends or other profit distributions upon payment thereof in monetary or non-monetary form. 6. Have there been any changes in the tax regulation in recent years - since 2002 that have had an important effect on the retention of earnings, the distribution earnings or the reinvestment of profits for a particular purpose? changes in tax regulation but the corporate income tax rates on profit distributions have been decreased yearly and this has had effect on the retention of earnings since it has been more beneficial for the shareholders to postpone the profit distribution and therefore to pay less tax when distributing the profits. Naturally this trend should not be overvalued but it has had some affect on the decisionmaking of the shareholders. In principle the reduction of the corporate income tax rates can be considered as having an effect in favour of retention of earnings (or at least postponing payment until the tax rate is lower). Explanation and comment of table under Question 1 48 For the Undertaking stock dividend means increased own equity. For the shareholder it means additional shares in the Undertaking, which may be untaxed until sold, unlike a cash dividend. 49 Article 50, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2006, 63, 468). 20

21 7. Are there any current plans for tax reforms that have as their object to have an impact on the retention of earnings? Some political forces are eager to continue to reduce the income tax rate and this might have further effect on the retention of earnings but currently it is not yet a legally clear and binding plan. 21

22 PART 2 TAX ASPECTS OF RETAINED EARNINGS VERSUS DISTRIBUTED PROFITS AND WAGES 8. What is the tax treatment of retained earnings compared to distribution of earnings on the level of the Undertaking and at a combined level of Undertaking (corporate) and business owner (individual)? In general it can be said that the tax treatment of retained earnings is friendly meaning that the income earned and retained earnings are tax-free. At the level of the undertaking the earnings are not taxed as long as they are not distributed to the shareholders. When dividends are distributed then corporate income tax applies. Taxation surely plays a part when deciding whether to pay out dividends or to retain earnings Is there an economic double taxation of distribution of earnings (taxation of Undertaking income and then taxation on the distribution of earnings at the Undertaking level or at the business owner level)? Case study Undertaking level Financial income (annual): Distribution of dividends: corporate income tax free taxed with corporate income tax Business owner level (individual) Income from received dividends: individual income tax free 22

23 RELEVANT TAX PROVISIONS IN 2002 AND SUBSEQUENT CHANGES UP TO 2007 Estonia Undertaking Individual Business owner Corporate All corporate income is tax-exempted Not applicable tax when earned. This includes both passive and active type of income. Income tax Not applicable See tax rates in the table of part Dividend tax The Act imposes corporate income tax on all distributions (actual and deemed) dividends, fringe benefits, gifts, donations, reception costs, hidden profit distribution, nonenterprise expenses. 1 Payments subject to the distribution of corporate (profit) tax (such as dividends, fringe benefits and etc) are not considered to be shareholders income. Dividend credit Capital gains tax If option for Transparent treatment chosen See tax rates in the table of part 1 The credit method was applicable in Estonia * Currently an exemption method** applies if dividends are paid by an Estonian companies out of dividends received from qualifying participations, provided that tax has been paid on the underlying profits. * was valid ** at least 15% holding , 20% Not applicable Not applicable Instead of credit method* now exemption method applies if dividends received from foreign qualifying participations, provided that tax has been paid on the underlying profits. * was valid ** at least 15% holding , 20% Only individual income tax will apply - see tax rates in the table of part 1 q 1.3. Not applicable 9. Please describe the differences in the tax treatment of distribution of earnings realised as a capital gain in the context of a sale of the shares or of the business compared to that (i) of retained earnings, (ii) of wages salaries paid to the business owner and (iii) of a loan granted by the Undertaking to the business owner? 50 Article 50, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2006, 28, 208). 51 Article 50, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2005, 57, 451). 52 Article 50, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2006, 28, 208). 53 Article 50, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2005, 57, 451). 23

24 As already mentioned in several occasions in Estonia income earned by the undertaking is tax free therefore it makes no difference whether the income comes from the sale of business or the sale of shares (an undertaking sells shares of another company owned by that undertaking). The earnings earned can indeed be paid out by way of dividends, wages or retained but the source of the income (sale of business or shares) does not make any difference. Therefore the columns downward are identical. Comparison of tax rates (2007): Capital gain from sale of company vs. retained earnings 22% vs. 0% Capital gain from sale of company vs. salary to owner 22% vs. 22% + 33% Capital gain from sale of company vs. loan to owner 22% vs. not allowed Estonia Sale of shares RELEVANT TAX PROVISIONS IN 2002 AND SUBSEQUENT CHANGES UP TO 2007 Distributed Retained Wages/Salaries to Loan to profits Profit business owner business Corporate income tax See tax rates in the table of part 1 All corporate income is taxexempted when earned. Subject to: Income tax (withholding) Unemployment insurance payment (partly withholding) Social tax (100% employers costs) owner If company has, as of the end of month, granted to related natural persons (inc. individual business owner) loans or advances in the amount exceeding 50% of salary funds that month, corporate income tax shall apply on that part exceeding the limit. 54 NB! According to the law it is generally forbidden to 54 Article 51, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2006, 63, 468). 24

25 Estonia Sale of business RELEVANT TAX PROVISIONS IN 2002 AND SUBSEQUENT CHANGES UP TO 2007 Distributed Retained Wages/Salaries to Loan to profits Profit business owner business owner lend to the shareholders and it is allowed only in a limited occasions. In case the loan has been granted in violation of the law the contract is null and void meaning that the loan has to Corporate income tax See tax rates in the table of part 1 All corporate income is taxexempted when earned. Subject to: Income tax (withholding) Unemployment insurance payment (partly withholding) Social tax (100% employers costs) be returned. If company has, as of the end of month, granted to related natural persons (inc. individual business owner) loans or advances in the amount exceeding 50% of salary funds that month, corporate income tax shall apply on that part exceeding the limit. 55 NB! According to the law it is generally forbidden to lend to the shareholders and it is allowed only in a limited occasions. In case the loan has been granted in violation of the 55 Ibid. 25

26 Estonia RELEVANT TAX PROVISIONS IN 2002 AND SUBSEQUENT CHANGES UP TO 2007 Distributed Retained Wages/Salaries to Loan to profits Profit business owner business owner law the contract is null and void meaning that the loan has to be returned. 10. Is the combination of wages (paid to the business owner by the Undertaking), profit distributions and retained earnings a tax planning issue that is anticipated and addressed by business owners in view of minimising the overall tax burden of the business owner and the Undertaking? YES It could be issue both for individual business owner and Undertaking. Salaries are subject to both income tax and social tax, whereas dividends are only subject to income tax, therefore business owners prefer to be remunerated in the form of dividends and pay themselves only minimal salaries In respect to the previous question, is the business owner more interested in minimising his/her tax burden and then the Undertaking s or both equally? Both equally. The smaller the company s total tax expenses the higher the earnings that can be distributed to the owner. It is usually more related with individual owner interests in case of SME it is typical that instead of salary income individual business owner rather pays out the profit distributions as 56 The smaller the company s total tax expenses the higher the earnings that can be distributed to the owner. It is usually more related with individual owner interests in case of SME it is typical that instead of salary income individual business owner rather pays out the profit distributions as dividends in order to reduce tax burden (avoiding undertaking`s costs from social tax that is in Estonia 100% payable by the employer). 26

27 dividends in order to reduce tax burden (avoiding undertaking`s costs from social tax that is in Estonia 100% payable by the employer). 12. Are there instances in which minimising the tax burden of the business owner would mean dramatically increasing the tax burden of the Undertaking? Different fringe benefit cases if individual business owner is also employee or member of management/supervisory board. Undertaking shall pay corporate income tax on all monetary appraisable gifts, favours and other benefits granted to mentioned persons. 57 Including payoff of a loan or purchase of property at price which is higher than market value are considered fringe benefits for example. In such cases the individual business owner can shift his/her personal expenses to Undertaking`s costs and therefore avoid tax costs on salary income or corporate income tax costs on profit distribution. In the other hand, Undertaking must report fringe benefits as salary income and that means additionally social security tax payment (related taxation rates are equal effective rate today is ~ 70% calculated from net benefit). Fringe benefit taxes are fully payable by Undertaking 13. For corporate income tax or capital gains tax purposes, are there any incentives/disincentives to retain earnings rather than distribute them or pay wages? YES but In the course of the corporate income tax reform, all classical tax incentives were abolished. Since 2000, there are no special rules in favor of different economic sectors, investments to certain regions or special tax incentives for foreign investors. However, there is important incentive to retain earnings, because all corporate income is tax-exempted when earned (e.g. trading, earned 57 Article 48, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2006, 63, 468). 27

28 dividends, royalties, interest, capital gains from transfer ot what ever type of assets, including securities and immovable property) Are there any limitations or ceilings for these incentives? There are no limitations for theses incentives Is there a risk that these incentives can be used more than one time by the business owners by splitting up the business activities into different legal entities? Not Applicable Reorganisation process of companies (e.g. division, merger and etc) doesn t have influence for tax-exemption of retained earnings. In the course of reorganisation the divided or merged retained earning will remain tax-free also in the new company. 14. What is the tax treatment of declared loans granted by the Undertaking to the business owner? Tax treatment of loans granted to business owner as legal entity: Loan interest rate must correspond with market conditions (arms length) otherwise transfer pricing regulations shall apply. 58 If loan interest rate is lower than market price the Undertaking must pay corporate income tax on that amount decreasing the market rate. If loan interest rate is higher than market price the business owner (borrower) must pay corporate income tax on that amount exceeding the market rate. The interest income/cost doesn t have influence both for lender or borrower because of lack of corporate income when income earned. 58 Article 50, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2006, 63, 468). 28

29 Tax treatment of loans granted to individual business owner: Loans granted to individual business owner who is also member of management or supervisory board must carry at least fixed minimum interest rate (today 3% per year). Lower amount shall be subject of fringe benefit taxes corporate income tax and social tax. All other cases the interest rate must correspond with market conditions (arms length) otherwise transfer regulation shall apply for Undertaking. If loan interest rate is lower than market price the Undertaking must pay corporate income tax on that amount decreasing the market rate. In order to avoid fictitious loans to individuals then if company has, as of the end of month, granted to related natural persons (inc. individual business owner) loans or advances in the amount exceeding 50% of salary funds that month, corporate income tax shall apply on that part exceeding the limit. 59 NB the paid tax shall be returned to the company when the borrower has returned the loan. The interest income doesn t have influence both for lender or borrower, because interest income is not taxable when earned and individual business owner can t deduct the interest costs from its taxable income. NB! According to the law it is generally forbidden to lend to the shareholders and it is allowed only in a limited occasions. In case the loan has been granted in violation of the law the contract is null and void meaning that the loan has to be returned Is there a minimum interest rate to be charged for tax purposes? According to the law it is generally forbidden to lend to the shareholders and it is allowed only in a limited occasions. In case the 59 Article 51, Income Tax Act (TMS RT I 1999, 101, 903; RT I 2006, 63, 468). 29

30 loan has been granted in violation of the law the contract is null and void meaning that the loan has to be returned. If loan interest rate is lower than market price the Undertaking must pay corporate income tax on that amount decreasing the market rate. Loans granted to individual business owner who is also member of management or supervisory board must carry at least fixed minimum interest rate (today 3% per year) How is the interest rate treated for tax purposes for the Undertaking? If loan interest rate is lower than market price the Undertaking must pay corporate income tax on that amount decreasing the market rate How is the interest rate treated for tax purposes for the business owner? If loan interest rate is higher than market price the business owner (borrower) must pay corporate income tax on that amount exceeding the market rate What are the combined tax effects of such a loan compared to a distribution of earnings equivalent in amount? The interest income/cost doesn t have influence both for lender or borrower because of lack of corporate income when income earned. 15. Are there any other taxes (e.g. net worth tax), which are imposed or based on the net equity of the Undertaking? 30