Estonian CIT – When and How to Recognize Hidden Profit?

It may seem that when a company chooses the flat-rate income tax for companies (commonly known as the Estonian CIT), it stops paying income tax advances, making current tax settlements simple. Nothing could be further from the truth. Accountants and lawyers are troubled by hidden profits as a special category of taxation. Numerous individual interpretations have been issued on the topic of “hidden profits,” enough to fill a substantial volume. The greatest difficulty lies in identifying events that generate hidden profits, but calculating the tax amount can also be a headache.

What Are Hidden Profits

Hidden profits are a category of taxable events in a company that has chosen the Estonian CIT as a form of settlement – these are benefits provided in connection with the right to share in profits, other than distributed profit, whose beneficiary is, even indirectly, a shareholder or a related entity (Article 28m, Section 3 of the CIT Act). The catalog of events constituting hidden profits is open and pertains to transactions that ultimately lead to profit distribution in ways other than through dividends. The legislator has listed the following amounts as examples of hidden profits:

The amount of a loan (credit) granted by the company to a shareholder or related entity;
Interest, commissions, fees, and charges on a loan (credit) granted by a shareholder to the company;
The equivalent of profit allocated to increase the share capital;
Donations, including gifts and various types of offerings;
Representation expenses;
Remuneration granted to a shareholder employed under an employment contract or commission agreement, in the part that exceeds the equivalent of five times the average monthly salary according to the Central Statistical Office (GUS).

Before choosing the Estonian CIT as a form of taxation, it is worth checking available individual interpretations or submitting an inquiry regarding your specific case. Common areas of concern include cooperation between the shareholder and the company in a B2B relationship, loans, or renting assets to the company.

Purchase of Services from a Partner

Generally, it is assumed that if the services provided by the partner are essential for the company’s business operations, and if market conditions are maintained, hidden profits will not arise for taxation. However, it is important to be cautious and ensure that the company is equipped with the appropriate assets by the partners. In many individual interpretations, the Director of the National Tax Information Office has stated that hidden profits arise when the company lacks its own significant assets, fixed assets, and has to rely on subcontracting/leasing assets from partners to provide its services. If partners have not ensured that the company has the necessary assets, employees, and the company is “dependent” on the partners, then hidden profits are likely present. However, in an interpretation dated April 12, 2024 (no. 0114-KDIP2-2.4010.178.2024.2.IN), the Director of the National Tax Information Office concluded that if:

The remuneration paid by the company to the partner’s firm is set at a market level;
The relationships between the parties did not affect the conditions of the services provided;
The partner’s firm also provides services to other entities (not just the company);
The provision of services arises from the company’s actual business needs;

then the partner’s remuneration does not constitute hidden profit.

Property Rental

As a rule, property rental by a partner should not constitute taxable income. To illustrate this, if a transport company has its own transportation assets, employees, parking lot, and only rents an office from the partner on market terms, there is no reason to establish income from hidden profits. An extreme case is described in an individual interpretation (no. 0111-KDIB1-1.4010.187.2022.1.BS) where the Director of the National Tax Information Office determined that fees for leasing a stone-cutting plant constitute hidden profit, even though the rent was set on market terms. According to the Authority, the fact that the company did not have its own stone-cutting plant or forklift, which are essential for its business operations, and entered into a lease agreement for the stone-cutting plant and forklift services from its partners, leads to the conclusion that the company’s partners did not ensure the company had the necessary assets for its business operations. In other rulings, authorities note hidden profits where an entrepreneur, before transforming the business into an LLC, withdrew the property to private assets and then rented it to the company formed from the transformation. It is worth noting that tax authorities are alarmingly broadening the definition of hidden profits beyond – in the author’s opinion – the literal wording of the law. Authorities often refer to the guide to the flat-rate income tax for companies published by the Minister of Finance on December 23, 2021, which provides general explanations of tax law provisions and their application – indicating that in the company-partner relationship, it is important to assess whether the partner ensured the company had the necessary assets for its business operations and whether the lack of these assets is the reason for actions such as recapitalizing the company in forms other than contributions (e.g., loans, property rentals). A negative answer to this question leads to the conclusion of hidden profits. However, the Voivodship Administrative Court (WSA) in Łódź, in a judgment dated March 23, 2023 (case no. I SA/Łd 137/23), stated that the law does not address the issue of equipping or not equipping the company with the necessary assets.

estoński cit

Loans to Related Entities

It might seem that granting a loan by a company that has chosen the Estonian CIT to another, even loosely related company (e.g., through one of several shareholders), should not create negative consequences. Unfortunately, according to a literal reading of tax regulations, the entire amount of the loan capital constitutes hidden profit for taxation. However, in case law, there have also been opposing views that not every loan granted to a related entity will constitute income from hidden profits, especially if the loan agreement specifies that the transaction is necessary due to the related entity’s capital needs related to its business operations, and the loan is not transferred solely for consumption purposes (non-final judgment of the Voivodship Administrative Court in Gliwice dated May 12, 2023, case no. I SA/Gl 93/23). At present, however, this is not a commonly shared view, and granting a loan to a related entity is a significant tax risk factor.

Tax Rate and Settlement Deadline

Once we identify transactions that generate hidden profit for taxation, we must determine the tax base, rate, and pay the tax on time. According to the CIT Act, the tax base is the sum of income from hidden profits determined in the month when the benefit was provided or the payment or expenditure was made. It should be emphasized that the tax burden falls on the company (not the shareholder who, for example, provided the company with assets in exchange for rent). The tax rate is 10% or 20%, similar to the calculation of the tax due on dividend payments, and depends on whether the company meets the criteria of a “small” taxpayer. The company is required to pay the flat-rate tax on hidden profit income by the 20th day of the month following the month in which the payment, expenditure, or benefit was made.

Gross or Net?

A problematic issue is whether hidden profits should be calculated based on the gross or net amount. Currently, the dominant view is calculation based on the gross amount – for example, in the interpretation dated December 14, 2022 (no. 0111-KDIB1-1.4010.696.2022.1.AND), it was indicated that when determining the value of hidden profits from using company cars for mixed purposes by shareholders, the gross amount should be considered, including VAT shown on invoices documenting operational expenses. Similarly, the Voivodship Administrative Court in Gdańsk, in a final judgment dated July 25, 2023 (case no. I SA/Gd 491/23), ruled the same.