An undoubted advantage of the lump sum tax on corporate income, also known as Estonian CIT, is that income is not taxed until it remains in the company or is allocated to its further development. The purpose of introducing this solution into the Polish legal system was to ensure the development of companies. However, according to the Corporate Income Tax Act, the Estonian CIT tax liability does not only arise in the event of dividend payments to shareholders.
Pursuant to Article 28m, paragraph 1 of the Corporate Income Tax Act, in addition to dividends, the following are also subject to taxation:
- profit intended to cover losses arising in the period preceding the lump sum taxation period
- hidden profits (income from hidden profits)
- expenses unrelated to business activity (income from expenses unrelated to business activity)
- the excess of the market value of the assets taken over or contributed as a non-cash contribution over the tax value of these assets (income from the change in the value of assets) – in the case of a merger, division, transformation of entities or contribution as a non-cash contribution of an enterprise or its organised part
- the sum of net profits achieved in each tax year of lump sum taxation in the part in which these profits were not distributed profits or were not allocated to cover losses (income from net profit) – in the case of a taxpayer who has ended lump sum taxation
- As indicated in the Guide to Lump-Sum Tax on Corporate Income, published by the Ministry of Finance, the subject of taxation under the lump-sum tax system is, in principle, the effective distribution of profit by an entity subject to lump-sum taxation, primarily to its shareholders. However, the regulations are not limited solely to the taxation of dividends but also cover other forms of distribution of net profit generated during the lump-sum taxation period.
The questionable items on the aforementioned list certainly include hidden profits. In Article 28m, Section 3 of the Corporate Income Tax Act, the legislator defined them as monetary, non-monetary, paid, gratuitous, or partially paid benefits, made in connection with the right to participate in profits, other than distributed profits, the beneficiary of which, directly or indirectly, is a shareholder, stockholder, or partner, or an entity directly or indirectly related to the taxpayer or to such shareholder, stockholder, or partner.
In the aforementioned Explanations, the Ministry of Finance indicated that income from hidden profits arises from any benefits related to the taxpayer's operation within a group of related entities, the beneficiary of which is a partner or other entity related (directly or indirectly) to the taxpayer (company) or its partner. For a benefit to be considered hidden profits, it must be related to influencing the actions and decisions of the company subject to the lump-sum tax. In other words, the benefit must directly or indirectly result from arrangements between related entities, regardless of their form. A benefit considered hidden profits, in which a partner of a company subject to lump-sum taxation is a party, may be assessed in the context of a benefit equivalent to a dividend. Such a benefit will arise, among other things, when the taxpayer, by performing one or more legal acts, achieves the same economic effect as would be achieved by distributing profits in the form of a dividend.
The Director of the National Tax Information also commented on whether a given benefit constitutes a hidden profit or not in numerous individual interpretations.
In the interpretation issued on May 13, 2022, ref. no. 0111-KDIB1-3.4010.58.2022.2.IM, the interpretation body stated that intangible services, including consulting services, do not constitute hidden profits if:
- the remuneration will be determined on market terms
- the relationship between the company and the shareholder will not affect the terms of the transaction
- remuneration is due for services actually provided.
However, in the interpretation issued on January 25, 2022, reference number 0111-KDIB1-2.4010.554.2021.2.AK, the Director of the National Tax Information Service found that the rent paid to a shareholder by a company for the rental of real estate necessary to conduct its business activity does not constitute income from hidden profit, if the above-mentioned conditions are met.
Similarly, if the above-mentioned conditions are met, the price of purchasing goods from a related entity for the purpose of their further resale by a distribution company will not constitute a hidden profit, as stated by the Director of the National Tax Information in an individual interpretation of February 16, 2023.
Tax on hidden profits will also not apply to the use of company cars by employees and management board members if they are not partners (interpretation of January 11, 2023, reference number 0114-KDIP2-1.4010.183.2022.1.PP). However, this does not mean that in such a situation there will be no tax liability for lump sum taxation on corporate income.
The legislator also indicated that remuneration paid to a shareholder for performing work under an employment contract or serving as a management board member will not be considered hidden profit. However, it is important that the monthly remuneration paid does not exceed five times the average monthly remuneration paid in the company for this purpose, and that it does not exceed five times the average monthly remuneration in the corporate sector.
In the case of company cars, it's worth noting that tax will apply to their private use, both by partners (hidden profits) and by other individuals (expenses unrelated to business activities). The tax base in such a situation will be 50% of the costs incurred in using the car.
Estonian corporate income tax (CIT) is an interesting alternative to traditional corporate taxation. It brings real benefits to many taxpayers. However, it requires them to carefully consider each expense to determine whether it may trigger a tax liability.
This article is for informational purposes only and does not constitute legal advice.
Legal status as of February 27, 2023
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