By 1 January 2019 several important changes to the Estonian Income Tax Act are to be expected. Although the exact wording of the new law is not yet agreed, we can provide some insight into the draft law published in April this year.
In April 2018, the Estonian Ministry of Finance published its plans for changes to the Estonian Income Tax Act with the purpose of introducing measures against aggressive tax planning as proposed by EU Directive 2016/1164. This brings the following well-known concepts to Estonian tax laws: taxation of excessive borrowing costs (thin capitalisation), CFC and exit tax. Amendments are also being made to the general anti-avoidance regulation (GAAR), enabling the tax authorities to more easily set aside different legal structures (such as debt pushdown) and follow the principle of substance over form in a more resolute manner.
As the exact wording of the new regulation is not yet agreed, we can only provide some insight into the current version of the draft bill. Nevertheless, changes to the Estonian Income Tax Act will surely be implemented by 1 January 2019.
Thin cap according to the planned changes to the Estonian Income Tax Act
A well-known problem has been that profit generated by profit centres is shifted to some other entity through excessive interest costs. To give an example, an Estonian profit centre that receives a loan must pay loan interest. According to the planned changes to the Estonian Income Tax Act, loan interest is deemed to be not economically justified (not related to the business of the borrower) when it exceeds certain thresholds. As a result, excessive interest payments will attract corporate income tax. This targets Estonian entities with a high ratio of interest costs and which are profitable. Real estate developers may be one focus group for this regulation.
The following three criteria are taken into account in assessing whether loan interest is excessive or not:
- Excessive borrowing costs exceed EUR 3,000,000. Excessive borrowing costs means the amount by which the borrowing costs of an entity exceed the profit it makes from interest and equivalent sources. In addition to ordinary loan interest, a variety of payments with similar economic content will be taken into account as well (eg payments from convertible bonds, financing costs of a finance lease). Earning high interest income enables the entity to stay below the threshold. As the threshold is quite high, the new rules are designed not to affect smaller entities.
- Excessive borrowing costs exceed 30% of EBITDA. The law provides a formula for calculating EBITDA. This excludes income which would be tax-exempt upon distribution (eg participation exemption dividends which can be paid tax-exempt under section 50 sub-section 11 of the Estonian Income Tax Act).
- Profitability of the entity paying interest. If an entity paying interest has negative profitability and excessive borrowing costs that exceed EUR 3,000,000 and 30% of EBITDA do not exceed losses, there will be no need to pay tax. However, if the borrowing costs exceed losses, income tax liability may kick in to the respective extent. If the entity has been profitable, income tax falls due on excessive borrowing costs over EUR 3,000,000 and 30% of EBITDA.
Exceptions
A taxpayer that is a member of a consolidated group for financial accounting purposes can apply one of the following exceptions if it is more tax efficient compared to the above:
- Excessive borrowing costs are not taxed if the taxpayer can demonstrate that the ratio of its equity over total assets is equal to or higher than the equivalent ratio of the group (a 2% difference is allowed). This applies if the whole group is financed heavily with loans and there is no reason to assume that the purpose of financing the Estonian entity is to shift profits. To apply this exception, the assets and liabilities must be assessed based on the same methods for the whole group.
- This exception enables application of a higher monetary threshold to excessive borrowing costs as described above. This is calculated based on excessive borrowing costs related to third parties, group EBITDA and EBITDA of the entity.
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