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Loan interest taxation changed again

02.05.2004

The last major change in debt interest taxation was introduced on 1 January 2004. Now, on 1 May 2004, the interest taxation underwent significant changes again. On 20 May 2004 the Estonian Parliament passed an Act amending inter alia the Income Tax Act of 2000 (the “Amendment Act”). Most of the amendments enter into force retroactively from 1 May.

Taxable Events

Until the beginning of May, income tax was charged on all loan interests paid by the Estonian state, local governments and Estonian residents, except:

• If the interest payee was a resident legal entity of Estonia; or
• If the interest payee was a non-resident credit institution subject to financial supervision and not located in a low-tax territory; or
• Interest on government bonds or on loans taken or guaranteed by the government; or
• Interest on debt instruments or their depositary receipts quoted on a stock exchange in Estonia or any member state of the European Economic Area.

Starting from 1 May 2004 interest on loans is taxable only if:

• The interest payees are resident physical persons of Estonia; or
• The interest payable to non-residents exceeds the market interest payable on similar debt instruments at the time the payment liability is created and the interest becomes due.

In the latter case only the difference between the interest earned and market interest payable is subject to taxation. Although with this amendment the number of taxable events grew smaller, some problems still subsisted or even surfaced.

As a rule, the interest payer is to withhold the interest (in the case of discount bonds the interest is to be declared and income tax to be paid by the interest payee). Under the previous legislation one could argue that the interest payers was required to keep account of their interest payees other than in the case of government bonds and quoted debt instruments. After the changes, the interest payers are in any event required to keep account of the legal form and residency of the beneficial owners of interest in order to sort out Estonian resident natural persons.

Notification of Interest Payees

The amendments formulate a procedure for notification of interest to natural persons in accordance with the EU directive 2003/48/EC. The said procedure will be brought into force with separate legislation and will be applicable to the interest payable as from the effective date of the legislation. According to the said procedure the interest payer will report to the Estonian Tax Board the data of direct physical payees of interest or of paying agents, if interest is paid to a person, who distributes the interest among the beneficial owners of interest.

Definition of Excessive Interest

It is hard to tell how the market interest is determined and how high the interest can be in order not be subject to taxation. Nonetheless, it should be remembered that the purpose of the exception to non-taxation is to prevent tax avoidance. Therefore, the Estonian Tax Board should be allowed to tax the interest difference only where there is no economic justification to the application of that high interest in the relationship between unrelated persons. According to the explanatory memorandum to the Amendment Act, income tax is not charged on interest, which at the time of contracting for the loan meets the market conditions but exceeds the rates prevailing at the time of interest payment. Such a situation may arise, for example, with a fixed-rate-interest long-term loan.

Other

Among other things the amendments introduced from 1 May 2004 also specified the definition of interest by providing that the sums calculated on debt commitments and by which the debt commitment is increased (the so-called capitalised interest), are also regarded as interest. Capitalised interest must be declared and the income tax thereon must be paid by the interest payee. Once again it is concretised that late payment interest and liquidated damages are not regarded as interest.

 

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