Lasse Lehis, Erki Uustalu, Helen Pahapill, Inga Klauson
The Compatibility of the Estonian Corporate Income Tax System with Community Law
The Estonian corporate income tax system (hereinafter ‘CIT system’), effective from 1 January 2000, has merited substantial interest from tax law scholars by virtue of its peculiarity and difference from traditional CIT systems. This article is intended to give an overview of the advantages and drawbacks of the Estonian CIT system and to examine the compatibility of this system with the relevant EC law.
The article starts with presentation of the background of the Estonian CIT reform in 2000 and the reasons for the reform. It demonstrates how beneficial the new CIT system is both for the state and for the taxpayers. Furthermore, the article focuses on the problems associated with the Estonian CIT system and provides analysis of the compatibility of the system with EC law, especially Directive 90/435/EEC on the common system of taxation applicable in the case of parent companies and subsidiaries in different Member States1 (hereinafter referred to as ‘the Parent-Subsidiary Directive’). Also, the relevant European Court of Justice (ECJ) case law is examined. Thereafter, changes in the Estonian CIT system for 2009 are discussed. Finally, the article introduces the CIT reform of 2008 in Moldova, in which the country decided to make its CIT system similar to the Estonian one and describes the essay competition in Germany concerning deferred taxation.
The version of the Income Tax Act (hereinafter: ITA) that took effect on 1 January 20002 was the third Income Tax Act in Estonia following the nation’s regaining of its independence in 1991. Until 1 January 1994, personal income tax and corporate income tax were stipulated in two different acts. On 8 September 1993, the Estonian Parliament had passed a new Income Tax Act, which regulated both personal and corporate income tax; this took effect on 1 January 1994. However, this act had been amended 34 times since then, and some of these changes undermined the taxable base, rendered application of the Income Tax Act ineffective, and threatened to distort competition3. It was, therefore, necessary to draft a new Income Tax Act.
On 1 January 2000, the new Income Tax Act came into force that stipulated the unique CIT system of Estonia. The main difference of the Estonian CIT system from traditional systems is that profits are not subject to tax at the moment when they are earned. Instead, taxation is deferred until the distribution of profits. Additionally, expenses not related to business and, therefore, not deductible in traditional CIT systems are subject to tax in the Estonian CIT system. Consequently, the difference from the traditional expression of the system is only technical (the timing of tax liability); however, the Estonian CIT system is easier to comply with both for taxpayers and for the tax administration4.
The aim of the CIT reform of 2000 was to facilitate the development of enterprises and attract investors. This objective was undoubtedly achieved, as the profits of the companies have grown significantly5. Furthermore, because of the CIT reform, the unequal treatment of different legal persons was eliminated, since all tax incentives were abolished. As a result of the reform, there are no special rules favouring certain economic sectors, giving an incentive for investments in certain regions, or special tax incentives for foreign investors.
The main merit of the Estonian CIT system is that it is simple and easy to both understand and administer, by virtue of its minimum number of exceptions and deferral of taxation of profits from the moment when they are earned till their distribution. Such a difference in timing enables preservation of all substantial elements of a traditional CIT system and at the same time to reduce considerably the number of technicalities from that required in a traditional CIT system.
Under a traditional system, in order to establish the taxable amount, the commercial profits are, first of all, calculated according to the accounting rules; then they are adjusted on the basis of the tax rules (e.g., certain expenses increase the taxable amount). In Estonia, distributed profits reflect the commercial profits and, additionally, non-deductible expenses are taxed on the cash basis. So, the only difference seems to be in timing; however, the Estonian CIT system has a considerable advantage - there is no need for amortisation and depreciation rules.
Moreover, since the Estonian Commercial Code6 stipulates that profits can be distributed with the proviso that there are no losses from previous years (§ 276 of the Commercial Code), there is no need for special rules regulating carrying forward of losses. If the company has losses from previous years, the profits cannot be distributed and, therefore, are not subject to tax.
Additionally, the distributed profits and payments taxable on the corporate level are not subject to personal income tax on the level of the recipient. Therefore, double taxation is fully avoided. Furthermore, as natural persons do not have a liability to declare such payments, the number of tax returns submitted, as well as that of possible mistakes and corrections of tax returns, is reduced. Consequently, the administrative burden and compliance costs are also reduced. Because of these advantages, most corporate taxpayers are satisfied with the Estonian CIT system and would not like it to be changed7.
Discussion of the problems that might emerge from the Estonian CIT system as effective from 1 January 2000 arose long before the system was implemented. Most of the anticipated problems did not, however, occur, and those that did take place were promptly eliminated. This section of the paper provides an overview of the expected and actual problems associated with the Estonian CIT system and the way in which they were solved.
Before the new Income Tax Act was passed, one of the concerns was that Estonia would be regarded as an offshore tax haven. The reason for this was a mistaken understanding of the Estonian CIT system, which, unfortunately, still prevails to some extent among tax law scholars. According to this misunderstanding, the CIT rate is considered to be 0% and the distribution tax is said to exist in Estonia, which is not correct, as one can see on the basis of the description above.
Regardless, the Estonian tax system does not have any of the features distinctive of tax havens. Firstly, corporate profits are always subject to CIT upon distribution, and the tax rate is 21% in 2008 (to be 20% for 2009, 19% for 2010, and 18% as of 2011). Moreover, there are no isolated so-called ‘ring fencing’ regimes, and domestic and foreign income are treated equally in Estonia. All companies are liable to pay taxes and to render their accounts, and penalties are imposed on companies in breach of these liabilities. Additionally, the Estonian tax authorities exchange information concerning Estonian residents and income derived in Estonia. Finally, the ITA stipulates a number of anti-avoidance rules, concerning, for example, transfer pricing, controlled foreign company (CFC) rules, and taxation of hidden profit distribution8.
One more concern of those who mistakenly considered the Estonian CIT rate to be 0% was that Estonia might have problems with tax treaties, because the subject-to-tax condition is not fulfilled. Although the Estonian CIT rate was 26% in 2000 and, therefore, the subject-to-tax condition was met, problems arose with the double taxation treaty between Estonia and Latvia9. As a result, a new tax treaty was made applicable in this connection from 1 January 200210. The main difference between the two treaties is that the newer treaty stipulates the limited right of the source state to tax dividends, interest, and royalties that were taxable only in the state of residence according to the previous treaty. Furthermore, the initial tax treaty enabled elimination of double taxation using both the credit and exemption method. The new tax treaty lays down only the credit method.
Originally, the ITA provided for tax-exemption of distributed profits if they were paid to resident companies with a view to eliminating double taxation. Profits distributed to non-residents were subject to tax. However, as the tax treaties contain a non-discrimination clause, the ITA was amended, and since 1 January 2003 the profits of companies have been taxed upon distribution without regard for the residence of the recipient. So, the problem of unequal treatment of residents and non-residents was solved, and currently the tax liability of a company distributing profits does not depend on the recipient11.
In dealing with problems associated with the Estonian CIT system, another of its posited drawbacks is worth mentioning. This disadvantage is that dividends do not constitute taxable income of natural...