Many companies are inclined to switch to the Estonian CIT tax system, which offers significant tax savings. However, they often wonder if they risk being subject to the tax on so-called “hidden profits.” In this article, we will break down the concept of hidden profits and explore whether businesses should be concerned.
What Are Hidden Profits?
The Estonian CIT system is designed so that a company’s earnings are only taxed when they are distributed to shareholders. Therefore, the company is not subject to CIT as long as the profit remains within the company. However, the legislator has introduced a few exceptions to this rule, including hidden profits, to prevent the transfer of profits to shareholders under the guise of transactions other than dividends. For such transactions, which ultimately lead to the distribution of profits in ways other than dividends, the tax authorities require real-time taxation at rates of 10% or 20%.
Hidden profits are a special category of events subject to taxation in a company that has chosen Estonian CIT as its tax system. They include payments made in connection with the right to share in profits, other than shared profits, where the beneficiary, directly or indirectly, is a shareholder, shareholder or related entity (Art. 28m, para. 3 of the CIT Act). The category of events that constitute hidden profits is open-ended and covers transactions that ultimately result in the distribution of profit in a manner other than dividends. By way of example, the legislator has mentioned the following amounts that will constitute hidden profits:
- The amount of a loan granted by a company to a shareholder.
- Interest, commissions, remuneration, and fees on loans granted by a shareholder to a company.
- The equivalent of a profit intended to increase the share capital.
- Donations, including gifts and all kinds of offerings.
- Representation expenses.
- Subsidies paid in the event of mergers or divisions of entities.
- Interest on equity held by a shareholder, paid by a company.
- Cash and non-cash benefits paid in the event of a reduction in a shareholder’s equity in a company.
- Compensation awarded to a shareholder-employee in excess of 5 times the average monthly salary in Poland, as calculated by the Central Statistical Office (GUS).
What is Hidden Profit?
Hidden profits, in a sense, represent a “penalty” tax for the company. As a result of their occurrence, the tax is paid not only by the shareholder on the income received but also by the company. The tax rate depends on the taxpayer status held by the company: 10% (small taxpayer) or 20% (other taxpayers). The tax is paid on a current basis – by the 20th day of the month following the month in which the payment, expenditure, or benefit was made.
Which Benefits Will Not Be Hidden Profits?
Before opting for the Estonian CIT system, it’s advisable to check available individual interpretations or inquire about your specific case. Common areas of doubt usually revolve around a shareholder’s B2B relationship with the company, non-cash benefits under Article 176 of the Commercial Companies Code, or leasing assets to the company. Generally, it is accepted that if services provided by the shareholder are essential to the company’s business and market conditions are met, no hidden profits will be generated. However, it’s important to exercise caution and remember to provide the company with appropriate assets from shareholders. In many issued individual interpretations, the Director of the National Tax Information confirmed the existence of hidden profits in situations where the company did not own significant assets or fixed assets and had to use subcontracting/leasing of assets from shareholders in order to provide its own services. If shareholders did not ensure the company was adequately equipped with the necessary assets and personnel and the company was heavily reliant on shareholders, then hidden profits were likely to exist. An extreme example would be a situation described in an individual interpretation (Ref. 0111-KDIB1-1.4010.187.2022.1.BS), in which the Director of the National Tax Information ruled that fees for leasing a stonemasonry workshop constituted hidden profits, even though the rent had been determined on market terms. In the authority’s view, the fact that the company did not have its own stonemasonry workshop and forklift, which are necessary for carrying out business activities and had entered into contracts for leasing a stonemasonry workshop and leasing a forklift with operator from its shareholders, led to the conclusion that shareholders had not provided the company with the necessary assets for its business operations.
Are Non-Cash Benefits Considered Hidden Profits?
According to Article 176 § 1 of the Commercial Companies Code (hereinafter referred to as the “CCC”), if a partner is to be obliged to make repetitive non-cash benefits, the partnership agreement should specify the type and scope of such benefits. Under Article 176 § 2 of the CCC, the partner’s remuneration for such benefits to the company is also paid by the company, even if the financial statements do not show a profit. This remuneration cannot exceed the prices or rates accepted in business transactions. These provisions of the Commercial Companies Code allow a partner to be obliged to provide repetitive benefits to the company in exchange for compensation. These benefits should not concern managerial activities, which should continue to be performed as part of the functions of a board member.
In a resolution dated May 23, 2022 (reference number 0111-KDIB2-1.4010.337.2022.2.AR), the Director of the National Tax Information pointed out that: “Since the conditions of services provided by the partners of the Limited Liability Company in the form of repetitive benefits are market-based (the determination of compensation at a market level is, moreover, a requirement directly arising from the provisions of the Commercial Companies Code) and these services are necessary as support services in the implementation of the company’s activities, it should be concluded that the remuneration paid to the partners of the Limited Liability Company for the aforementioned repetitive benefits will not constitute hidden profits.”
Hidden Profits – Is There Anything to Worry About?
Generally, it can be assumed that if a company conducts business activities with its own assets and a partner only complements the company’s resources by renting an office to the company or providing specific B2B services based on their qualifications and experience (e.g., accounting or technical services) – the company should not be concerned about hidden profits if the price for these services has been set at a level close to the market rate.