A sole proprietorship transformed into a limited liability company will not benefit from the same preferences in Estonian CIT as newly established companies – according to the latest interpretation by the Director of the National Tax Information, which contradicts the previous stance of the Ministry of Finance.
What preferences are available in Estonian CIT for companies starting their operations?
Certain preferences concerning the eligibility for applying Estonian CIT and the tax rate are provided for in the first year of operation for taxpayers commencing their business activities. These entities have their employment limit reduced from 3 full-time positions to 1 full-time position in the first year of operation, and the income structure requirement is considered met in the first year as well. Furthermore, such taxpayers enjoy the lowest flat tax rate of 10% in their first fiscal year, regardless of their revenue.
Change in Tax Office’s Interpretation
So far, the Ministry of Finance and subsequently the National Tax Information believed that capital companies formed through the transformation of a sole proprietorship or personal partnerships are “start-up entities” eligible for the aforementioned preferences. This stance was presented, for example, in Tax Clarifications dated December 23, 2021, “Guide to the Flat Tax on Company Income” and in an interpretation by the Director of the National Tax Information dated July 20, 2022, under reference number 0111-KDIB1-1.4010.165.2022.2.AW, which stated that a business operator, after transforming into a limited liability company as a start-up entity, could benefit from the preferential flat tax rate of 10% on the taxable base. However, during 2023, additional individual interpretations began to challenge the right of entities formed through transformation to utilize these privileges, as evidenced by, among other things, the interpretation by the Director of the National Tax Information dated August 11, 2023, under reference number 0111-KDIB1-1.4010.307.2023.2.KM. The Tax Office justifies its position by stating that the transformation does not result in the legal existence of the entity coming to an end; it only involves a change in its organizational and legal form. The transformed company continues the business activities of the entrepreneur before the transformation, and it retains all the entrepreneur’s rights, which also extends to specific tax rights and obligations.
Does a limited liability company formed through transformation pay 10% Estonian CIT?
The stance of the National Tax Information cannot be agreed upon, and the sudden change in the interpretation of the regulations is surprising, especially in the context of the supposed intention of the Ministry of Finance to promote tax settlement through Estonian CIT. Many entities that have operated personal partnerships or sole proprietorships have decided to transform into a capital company precisely to take advantage of Estonian CIT. While there is unquestionably a succession of certain tax rights and obligations in the case of a transformation, a limited liability company formed through transformation is undeniably a new, separate taxpayer for corporate income tax (CIT) and is assigned a tax identification number (NIP). Previously, the entrepreneur operating the sole proprietorship was a transparent taxpayer, settling taxes with personal income tax (PIT). These arguments support the application of preferences in Estonian CIT for companies formed through transformation.
Taxpayers who have been formed through the transformation of a sole proprietorship into a limited liability company and are affected by the issue discussed above should request an individual tax interpretation of the CIT Act and challenge the stance of the National Tax Information in the regional administrative court.