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Estonia abolishes corporate income tax

02.12.1999

Estonian Parliament adopted on December 15, 1999 a new Income Tax Act which became into force from January 1, 2000. The most important change is that the income of Estonian companies is no longer taxed on the condition that it is invested within the company.

Instead the legislator chose to tax more stringently any and all payments away from the companies (excluding of course payments in the normal course of business between Estonian companies and non-offshore foreign companies). For example, all payments, including official dividends but also any unofficial profit sharing arrangements remain to be taxed at the rate of 26/74 on top of the sum of net payment.

For the purposes of more stringent tax rules, the legislator improved considerably the definition of related persons, included a definition of low tax territories, included rules concerning taxation of income earned by legal entities situated in such low tax territories, improved rules concerning allowed deductions of business costs for individuals and foreign legal entities, improved considerably rules for payment of taxes upon fringe benefits, gifts, donations and reception costs, dividends and other profit sharing arrangements, costs not related to taxpayers business and other payments not related to business of Estonian companies and improved rules concerning the taxation of permanent establishments of foreign legal entities.

Below I will give short descriptions of these changes and amendments.

1. Definition of Related Persons

The new law provides that persons are related to each other for example in the following cases:

• one person owns more than 10% of shares, votes or rights to profits in another person;
• persons belong to one corporate group;
• individuals are related to each other;
• person owns together with other persons related to him more than 50% of shares, votes or rights to profits in another person;
• persons are under common control by one person;
• persons own collectively more than 25% of the shares, votes or rights to profits in another person;
• members of the board (or a body replacing the board) are the same;
• individual is a relative to members of the board or other directing or controlling bodies of a legal entity.

Thus, the definition of the related persons is quite overwhelming and may be even too much so, specially with regard to declaring persons who own collectively more than 25% of the shares, votes or rights to profits in another person as related persons.

2. Low Tax Territories

Low tax territories are foreign countries or parts thereof, where no tax or a tax lower than 2/3 of the Estonian tax applicable to business income of Estonian individuals, has been established for taxing income earned or distributed by legal entities.

Persons situated in low tax territories, but receiving more than 50% of their annual income from production of goods in such territories or chartering ships registered in such territories are not considered to be situated in such territories.

Government of Estonia is entitled to adopt and amend a list of countries and territories which are automatically excluded from the low tax territories. The government has adopted a list of 27 countries at this point.

Any services provided to Estonian residents by legal entities situated in low tax countries, are taxable at the rate of 26% all of which must be withheld by the payer of the services fee. This rule applies irrespective of where the services are provided i.e. services provided outside Estonia are also taxable by Estonia.

3. Income earned by legal entities situated in low tax territories

Any income earned by such legal entities, is taxed by Estonia, provided that the legal entity is controlled by Estonian residents and regardless whether the entity has distributed its income or not.

Such legal entities are considered to be under the control of Estonian residents if the latter own individually or jointly, directly or through related persons at least 50% of the shares, votes or rights to profit in such low tax territory legal entities.

Income of such foreign legal entities is considered taxable income of an Estonian resident, if in addition to the control by Estonian residents, a particular resident owns at least 10% of the shares, votes or rights to profits in such person.

4. Allowed deductions of business costs

As the corporate income tax for Estonian companies is abolished, allowance of deductions for business costs has a direct influence only upon individuals and foreign legal entities.

Among other things, the following costs can not be deducted from taxable income:

• income tax;
• local taxes; 
• legal fines and interests on late payment of taxes; 
• value of property subject to special seizure; 
• increased rate (as opposed to normal rate) pollution fees and pollution damages; 
• costs made at the account of non-taxable support; 
• gifts and donations, unless income tax has been paid by the payer of such sums; 
• losses due to the transfer of property to related persons; 
• losses due to the sale of property that was purchased from related persons.

5. Taxes upon fringe benefits

Employers pay income taxes at the rate of 26/74 upon fringe benefits provided to employees. Fringe benefits include among other things:

• payments for housing costs; 
• payments for car usage costs, above allowed levels; 
• insurance costs, if such are not foreseen by law; 
• provision of loan below interest rate fixed by the Ministry of Finance (currently 8%); 
• sale or exchange of assets or services below market prices; 
• purchase of assets or services above market prices; 
• release of debt, unless collection costs would exceed the sum of debt.

6. Taxes upon gifts, donations and reception costs

Estonian companies pay income taxes at the rate of 26/74 upon all gifts and donations to individuals and non residents.

Certain exceptions apply and taxes are not payable upon donations to NPO's (non profit organizations) entered into a special list.

Estonian companies pay income taxes at the rate of 26/74 upon reception costs of guests or business partners of a legal entity.

A sum equal to 2% of social tax basis sum for each month is excluded from taxation under these rules.

7. Taxes upon dividends and other profit sharing arrangements

Estonian Companies pay income taxes at the rate of 26/74 upon all dividends or other profit sharing arrangements paid to individuals and non-residents.

In addition, the same amount of tax is payable upon payment of any sums or upon any other benefits to persons entitled to a share of profits. Such benefits can be for example:

• sale or exchange of assets or services for a price lower than market price; 
• purchase of assets or services for a price higher than market price; 
• release from debt, unless costs of collection would be higher than amount of the claim; 
• lending in breach of loan prohibition rules under the corporate laws (loans to parent companies, except for 100% parents under certain conditions).

Tax department is entitled to revaluate transactions between Estonian companies/ non-residents related to each other and Estonian companies/resident individuals related to each other on the basis of similar transactions between unrelated parties. In such cases either the income that the tax payer would have received or the cost that the taxpayer would have carried if the correct values would have been used, is taxed at the rate of 26/74.

8. Taxes upon costs not related to taxpayers business and other payments not related to business of Estonian companies

Estonian companies pay income taxes at the rate of 26/74 from all costs not related to its business and any other payments not related to its business.

For example the following costs are unrelated to the taxpayers business:

• annual membership fees and accession fees of NPO's, participation in which is unrelated to taxpayers business; 
• payments with regard to which a taxpayer does not have an original invoice; 
• costs for purchasing of services not necessary for taxpayers business.

For example the following other payments are unrelated to taxpayers business:

• acquisition of property not necessary for taxpayers business; 
• acquisition of securities or shares issued by legal entities situated at low tax territories; 
• payment of late payment fees or liquidated damages without judgement by courts or arbitration to legal entities situated at low tax territories; 
• lending or making prepayments or otherwise acquiring claims against legal entities situated at low tax territories.

Persons who are obliged to pay taxes under sections 5-8 herein, must prepare income tax declarations and pay taxes with regard to the last calendar month by the 10th day of the next calendar month. This means that the taxing period is changed from more usual year, to a calendar month.

9. Taxation of permanent establishments of foreign legal entities

A non resident legal entity which has a registered (with the Tax Department) permanent establishment in Estonia, pays income taxes on the account of such permanent establishment as an Estonian company (subject to certain limited exceptions). This means that there is no income tax, but all payments away from the permanent establishment are taxed as described above.

For example transfer of assets brought to Estonia for such permanent establishment are taxed at 26/74 rate upon their transfer away from Estonia, unless there is a market value payment for these assets. All payments to the headquarters or other units of the same legal entity are taxed similarly unless there is a market value return payment. All payments to third persons without receiving any payment in return are taxed similarly.

In conclusion, Estonian business circles and government are very excited about this courageous initiative. Hopes are high with regard to attracting new business into Estonia. Although the governmental promotional work has started rather slowly, Estonia welcomes foreign investors more attractive than ever. The fastest decision makers have already increased production in their Estonian subsidiaries. 

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