Amendments in Estonian Income Tax Act proceeding from the EU Directive on taxation of parent companies and subsidiaries
On 1 November 2016 the amendments to the Income Tax Act entered into force in Estonia adopting the amendments of the EU Directive No. 2011/96/EU on the common system of taxation applicable in the case of parent companies and subsidiaries of different Member States (hereinafter the Directive). The aim is to apply the general anti-abuse clause regarding the division of profits between parent companies and subsidiaries as well as to avoid double non-taxation with regard to hybrid loans.
As a result of these amendments the general anti-abuse clause entered into force with regard to the distribution of profits between parent companies and subsidiaries preventing the abuse of remissions established with the Directive. Additionally the dividends payable by a parent company that is an Estonian resident shall be subject to taxation if the payment is to be made at the account of dividends of a subsidiary and the subsidiary in its country of residence could deduct this amount from the taxable profit. This was considered to be necessary in order to avoid the double non-taxation of the payments received from the so-called hybrid loans (profit share loans) that can be handled as interest in one country but as dividend in another country.
According to the amendments, in Estonia the exemption shall not apply to such dividend or payment made from the equity of the company, the dividend of which has been received from a company who has the right to deduct this amount from the taxable profit. The limitation is based on the change of the Directive with the aim to avoid double non-taxation due to the different handling of hybrid loans in different Member States. This means that with regard to hybrid loans the Member State receiving the payment should follow the taxation system of the state which is the source of income. If the source of income is handling the payment as dividend, the exemption as provided in the Directive and the Income Tax Act shall apply. However, if the source of income is handling the distributed profit as interest and allows the deduction of the payment from the profit of the company, the received profit is subject to taxation in Estonia in order to avoid double non-taxation. Any business entity residing in Estonia must be ready to prove to the tax auditor that the subsidiary that had paid the dividend did not have the right to deduct the paid dividend from the taxable profit.
The law was also supplemented with the general anti-abuse clause provided in the Directive and enforced with the aim to avoid the violation of rights proceeding from the Directive and to safeguard the uniform implementation of the Directive in Member States. According to this provision, a company that is a resident cannot re-distribute the profit received from its subsidiary without the occurrence of tax liability in case of a transaction or chain of transactions which is not real since its main objective or one of the main objectives is obtaining a tax advantage.
The so-called principle of economic approach that has been established in the Taxation Act prescribes that if it is evident from the content of a transaction or an act that it has been performed for the purposes of tax evasion, conditions that correspond to the actual economic content of the transaction or act shall apply upon taxation. Such principle shall apply only in case the transaction has been performed with the aim of tax evasion.
Regarding the anti-abuse clause that entered into force as from 1 November 2016 it is unnecessary to determine the actual economic content of the transaction. If at least one of the main objectives of the transaction is to obtain a tax advantage that is contradicting the aim of the Directive, the business entity cannot use the exemption (i.e. to make the following tax-free payment of the profit in Estonia) without the need to re-qualify the transaction by the tax auditor. The new provision is also applicable in a situation where the aim of a transaction or chain of transactions is not full evasion of taxes but artificial achievement of more favourable tax consequences (for example, the tax payer has established an interim business entity without any economic content in a country which in the end enables to apply lower tax rate upon the payment of dividends).
One example can be a situation where a business entity that is Estonian resident is interested in making an investment into third country where tax exemption is applicable to profit and dividend within 10 years. By receiving dividend from the third country, the Estonian company would have the tax liability of 20 % upon paying forward this dividend, since exemption is applicable only in case the dividend or part of the profit of a company which was based on this, has been income tax included. Aiming to avoid the 20% tax liability, the business entity that is Estonian resident is establishing an interim subsidiary in some EU Member State where the 10% income tax rate applies to the business entity. Afterwards the subsidiary being a resident of the other Member State shall distribute the profit to the company that is the Estonian resident. According to the latest anti-abuse clause, in the given situation tax exemption cannot be used if the main purpose or one of the main purposes of founding the subsidiary was to obtain tax exemption.
Similar amendments of legal regulation for the implementation of Directive came into force earlier in Lithuania. As of 26 March 2016, Article 32 of the Law on Corporate Income Tax regulating the procedure for taxation of dividends and of other distributed profits was supplemented with a new paragraph providing the common anti-abuse rule.
Like in Estonia, the Lithuanian Law on Corporate Income Tax provides for the exceptions from the provisions of non-taxation of dividends applicable to the so-called arrangements (groups of companies).
With the said amendments, efforts are made to prevent the economically unreasonable tax planning at the EU level when patron companies are incorporated for the sole purpose of collecting dividends. Up till now, neither the Lithuanian Law on Corporate Income Tax nor the equivalent Estonian law provided any such safeguards; therefore, no assessment was usually given to the purpose for the disbursement of dividends. The existing case-law also provides that no legal act obligates the taxpayer, having to choose from among several options of legal conduct, to choose the one that would subject the taxpayer to the greatest tax obligation.
It should be noted that, according to the amendments, dividends disbursed to / received from foreign entities can be subject to taxation not only if it is established that the sole purpose of an arrangement (a series of arrangements) is to obtain the said tax advantage, but also if the obtaining a tax advantage is just one of the main purposes; therefore, tax authorities are given an opportunity to assess the specific cases. In turn, such freedom of assessment given to public authorities lead to some uncertainty in respect of taxpayers. Should tax authorities assess all facts and circumstances of specific situations and establish that a business structure uses an arrangement or a series of arrangements for purposes other than valid commercial reasons which reflect economic reality, they can be treated as not genuine and no preferential taxation of dividends shall apply.
The above-described amendments of the Directive has not yet been implemented in Latvia. However, given directive legal nature and the uniform implementation obligation of the member states, it is expected that amendments of the Law on the Enterprise Income Tax implementing the amendments of the Directive will be similar as they are in Estonia and Lithuania and that no different regulation would be introduced. Namely, it is expected that said amendments would also safeguard the EU single market and ensure that benefits of Directive would not be granted to businesses’ acting in bad faith.
Additionally, it should be noted that regulations with similar aim – to prevent the tax avoidance are already part of the Latvian Law on the Enterprise Income Tax. The law states that certain provisions of the Law on the Enterprise Income Tax granting various tax benefits to companies, shall not be applicable if it is determined that the company in order to acquire said benefits has transferred the legal address and that the main aim of the transfer of legal address or one of the main aims is to not pay taxes or to avoid the payment of taxes. Law further states that if the transfer of legal address is not performed due to a justifiable commercial reason, this may lead to an assumption that the main aim of the relevant activity or one of the main aims is to not pay taxes or to avoid the payment of taxes. With the term “transfer of legal address” it is understood an operation by which a European commercial company or European co-operative society, without terminating its activities and establishing a new legal person transfers its legal address from the Republic of Latvia to another Member State of the European Union or to the Republic of Iceland, or the Kingdom of Norway, or the Duchy of Luxemburg.
In the light of the abovementioned, it can be concluded that the Law on the Enterprise Income Tax already provide a level of safeguard from the economically unreasonable tax planning, however the implementation of the amendments of the Directive will more specifically target the parent companies and subsidiaries of different Member States and address the non-taxation of dividends applicable to the groups of companies.
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