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On 1 January 2021, provisions on the lump-sum taxation of company income, commonly called Estonian CIT, entered into force. The lump sum is an alternative taxation system for CIT taxpayers. Its attractiveness and availability to taxpayers increased with the entry into force of the Polish Deal provisions.
Estonian CIT – why is it not very popular?
The lump sum on company income is regulated in chapter 6b, Articles 28c et seq. of the Corporate Income Tax Act (CIT). The Polish Deal simplified the above conditions, and Estonian CIT is now available to more CIT taxpayers.
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How does taxation under Estonian CIT work?
The idea of the lump-sum taxation of company income is that there is no obligation to pay CIT until the company's profit earned during the period of Estonian CIT taxation is distributed – by paying that profit to shareholders (dividends or advance dividends) or by using the profit to cover a loss incurred before the lump-sum taxation period.
The absence of CIT is of course a tax saving for taxpayers, which they can, for example, invest in growth.
It should also be remembered that if a company decides to distribute profit as described above, CIT rates under Estonian CIT differ from those under the general taxation rules.
According to Article 28o of the CIT Act, the lump sum amounts to:
● 10% – for a small taxpayer and a taxpayer starting business activity;● 20% of the tax base – for a taxpayer other than one indicated in point 1.
Tax credit for shareholders
Unlike a company taxed under the general CIT rules, shareholders of a company under Estonian CIT may benefit from an additional relief. It allows them to deduct the CIT paid by the company from the tax due on distributed profit (a dividend).
Article 30a(19) of the PIT Act states that the flat-rate tax on income received by a shareholder from payments of the company's distributed profits earned while it was taxed under the lump sum on company income, if they come from the distribution of profits from that period separated in the company's equity, is reduced by an amount equal to:
● 90% of the amount corresponding to the product of the shareholder's percentage share in company profit on the date they acquire the right to payment of the distributed profit and the lump sum due on company income from that company's distributed profit from which that income was obtained – for income from distributed profits paid out of the profits of a company that is a small taxpayer or is starting business activity; or● 70% of the amount corresponding to the product of the shareholder's percentage share in company profit on the date they acquire the right to payment of the distributed profit and the lump sum due on company income from that company's distributed profit from which that income was obtained – for income from distributed profits paid out of the profits of a company other than the one indicated above.
In summary, Estonian CIT rates and the above deduction for shareholders mean that the effective taxation is 20% for a small taxpayer and 25% for other companies. In contrast, effective CIT taxation under the general rules is 26% for a small taxpayer and 34% for other taxpayers.
The conclusion is that Estonian CIT is a much more advantageous form of taxation than taxation under the general rules.
Conditions for using Estonian CIT
A taxpayer wishing to switch to lump-sum taxation must meet the conditions of Article 28j of the CIT Act. These are:
● Earning less than half of revenue from sources other than revenue from receivables, interest, sureties and guarantees, copyrights, disposal/exercise of financial instruments, and transactions with related entities where the transaction does not create added value in economic terms or that value is negligible;● The taxpayer employs at least three full-time equivalent employees, who are not its shareholders or partners, under employment contracts for at least 300 days in the tax year or, if the tax year is not twelve consecutive calendar months, for at least 82% of the days in the tax year; or
● The taxpayer incurs monthly expenditure of at least three times the average monthly wage in the enterprise sector on remuneration paid to at least three individuals engaged under contracts other than employment contracts, who are not its shareholders or partners, if the taxpayer must withhold PIT advances and ZUS contributions in connection with that remuneration;● the company's shareholders are exclusively natural persons;● the taxpayer conducts business as a limited liability company, joint-stock company, simple joint-stock company, limited partnership or limited joint-stock partnership;● the taxpayer does not hold, among other things, shares in the capital of another company;● the taxpayer does not prepare financial statements in accordance with IFRS for the lump-sum taxation period;● the taxpayer does not earn income from business conducted in a special economic zone or specified in a decision supporting new investments.
Doubts concerning Estonian CIT
Finally, it is worth noting that Estonian CIT has not only advantages but also disadvantages. These arise from unclear and imprecise provisions. Above all, Estonian CIT applies not only to profit distribution in the strict sense – payment of a dividend or covering a loss.
Tax must also be paid on so-called hidden profits. Article 28m(3) of the CIT Act states that hidden profits referred to in paragraph 1 point 2 mean monetary, non-monetary, paid, unpaid or partly paid benefits provided in connection with the right to participate in profit, other than distributed profit, where the direct or indirect beneficiary is a shareholder or partner, or an entity directly or indirectly related to the taxpayer or that shareholder or partner, in particular:
1. the amount of a loan (credit) granted by the taxpayer to a shareholder or partner, including through funds created from profit, or to an entity related to a shareholder or partner, and interest, commissions, remuneration and fees on a loan (credit) granted to the taxpayer by those entities;
2. benefits provided to:
a) a private or family foundation, an entity equivalent to such a foundation or an enterprise run by such a foundation or entity, or the beneficiaries of such a foundation or entity,
b) a trust or another entity or legal relationship of a fiduciary nature;
3. the excess of the market value of a transaction determined under Article 11c over the agreed price of that transaction;
4. the excess of the refunded amount of an additional contribution made to the company under separate provisions over the amount contributed; if the contribution was made in a foreign currency, the conversion into zlotys is made at the average exchange rate published by the National Bank of Poland for the respective dates of the refund and actual contribution;
5. remuneration paid from profit for the redemption of shares, reduction of share value, a partner's withdrawal from the company or reduction of a partner's capital interest in the company;
6. the equivalent of profit allocated to increase share capital;
7. donations, including gifts and offerings of every kind;
8. representation expenses;
9. additional contributions paid in the event of a merger or division of entities;
10. interest on a capital interest paid to a partner by the company;
11. profit allocated to replenish a company partner's capital interest;
12. monetary and non-monetary benefits paid in the event of a reduction in a partner's capital interest in the company.
In practice, taxpayers have difficulty determining what constitutes hidden profits; in particular, it is doubtful whether a company partner's invoicing the company for specified services constitutes a payment of hidden profits.
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