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Estonian CIT – problematic issues
The Polish Deal has led more and more CIT taxpayers to consider adopting the lump-sum tax on company income (so-called Estonian CIT). Some taxpayers already use the lump sum and, in practice, must deal with provisions that are not entirely precise.
Hidden profits – what are they?
Under Estonian CIT, CIT generally arises only when the company pays profits to its shareholders as dividends or uses those profits to cover a loss incurred before the lump-sum taxation period.
Nevertheless, in addition to profit paid out, other items are subject to Estonian CIT, including income from hidden profits (Article 28m(1)(2) of the CIT Act).
Taxpayers have difficulty determining what hidden profits are. The definition in the CIT Act does not make the task any easier.
Hidden profits mean any monetary, non-monetary, paid, unpaid or partly paid benefits provided in connection with the right to participate in profit, other than distributed profit (a dividend), whose direct or indirect beneficiary is a shareholder or an entity directly or indirectly related to the taxpayer or that shareholder (Article 28m(3) of the CIT Act).
In other words, hidden profits are benefits provided by a company using Estonian CIT to a shareholder or an entity related to that shareholder.
The definition of hidden profits is vague and makes it difficult to determine what constitutes hidden profits in practice. For example, it is not fully resolved whether, when a shareholder invoices the company for particular services, the remuneration received constitutes hidden profits. The Ministry of Finance's Guide to the Lump Sum suggests that in certain circumstances such remuneration may be a hidden profit, for example when paid for advisory services.
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Estonian CIT on expenses unrelated to business activity
Another problematic provision of the CIT Act is the taxation under Estonian CIT of expenses unrelated to business activity; income from expenses unrelated to business activity then arises (Article 28m(1)(3) of the CIT Act).
Unlike with hidden profits, the Act provides no additional guidance about what falls into the category of expenses unrelated to business activity.
In the Guide to the Lump Sum, the Minister of Finance indicates that these include public-law expenses of a punitive nature, such as penalties, fines or interest on late payment of a tax liability.
Expenses on company cars as unrelated to business activity
An interesting issue in this context is expenditure on company cars used for mixed purposes, that is, both for business activity and other purposes (for example, employees' private use). In such a case, the taxpayer must exclude 25% of expenses for using the car, such as fuel or operating costs, from tax-deductible costs (Article 16(1)(51) of the CIT Act).
The answer to whether the above 25% of expenses constitute expenses unrelated to business activity, subject to Estonian CIT, is no.
Above all, it should be stressed that “expenses unrelated to business activity” is not the same as “expenses that are not tax-deductible costs”. The Minister of Finance also points this out in the Guide to the Lump Sum. The distinction is that expenses that are not tax-deductible costs are not incurred to earn revenue from a source, or to maintain or secure a source of revenue. Representation expenses, such as buying gifts for contractors, are a good example: they are not tax-deductible costs, yet they are connected with the business conducted.
Expenses unrelated to business activity, on the other hand, have no connection at all with the business and fall outside its scope.
Returning to car expenses, 25% of the expenses of using cars are not tax-deductible costs. In my opinion, however, one cannot say that they fall outside the scope of the business (the car belongs to the company; even if the employee uses it privately, their employment is still connected with the business). Therefore, these expenses cannot be regarded as unrelated to business activity, so Estonian CIT does not arise.
Moreover, under Estonian CIT, revenue and costs for calculating the tax are determined under accounting law, not tax law. Taxpayers using lump-sum taxation therefore do not have, among other things, tax-deductible costs for tax purposes. This means that, while using Estonian CIT, provisions excluding or limiting the amount of tax-deductible costs, including for company cars, do not apply to them.
Or perhaps hidden profits?
As Article 28m(4)(2) of the CIT Act indicates, hidden profits do not include expenses and depreciation or impairment charges related to the use of passenger cars, aircraft, watercraft and other assets:
● in full – where the assets are used solely for business purposes;● at 50% – where the assets are not used solely for business purposes.
The above means that, if a company car is used for mixed purposes, half of the expenses incurred by a company under Estonian CIT to use that vehicle constitute income from hidden profits.
The income determined for a given month on this account forms the tax base for the lump sum on company income (Article 28n(1)(2) of the CIT Act). The applicable tax rate is:
● 10% for small-taxpayer companies and companies starting business activity;● 20% for other companies (taxpayers).
If you found this article interesting, explore our tax advisory services and read how we can help you:
Summary
In summary, Estonian CIT is an attractive form of taxation for CIT taxpayers. Effective taxation is lower here than under the general rules. However, a number of provisions on the company lump sum are unclear. Moreover, as the provisions have been in force for only a short time, there are still few individual rulings to help taxpayers apply them.
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