In the case of very attractive taxation under the flat tax system (known as Estonian CIT), it is necessary to carefully assess the situation with a tax advisor before transitioning to this tax form and exercise caution when using it. For example, cases are examined by the tax authorities where “expenses unrelated to business activities” are qualified as potential income subject to taxation under the flat tax on company income. In a recent tax interpretation, the Director of the National Tax Information confirmed that penalty clauses, in most cases, will not be subject to Estonian CIT.
Why can penalty clauses be subject to Estonian CIT?
As an introduction, a company taxed under Estonian CIT remains, in principle, tax-exempt until the distribution of profits among shareholders. However, certain events within a company can fall under the categories of “hidden profits” or “expenses unrelated to business activities” and, ultimately, lead to taxation. Taxpayers who pay penalty clauses and have chosen Estonian CIT risk qualifying expenses related to these penalties as expenses unrelated to business activities. Such a qualification imposes an obligation to pay tax on expenses unrelated to business activities, at a rate of 10% or 20%, by the 20th day of the month following the month in which the service was provided as part of the penalty clause.
When will penalty clauses not be subject to Estonian CIT?
The matter in question in an individual interpretation (No. 0111-KDIB1-2.4010.257.2023.1.END) concerned a company that, in light of rising fuel prices in anticipation of the consequences of the war in Ukraine, signed a contract to purchase auctioned timber at a price five times higher than the previous market price. Currently, the demand for timber has dropped, and it can be purchased at a price approximately half of that contracted by the company. In this situation, the company did not accept the contracted timber and incurred penalty clauses amounting to 10% of the earlier auctioned timber’s value.
In the opinion of the applicant, in such circumstances, expenses related to penalty clauses are, in principle, associated with revenue generation and revenue source security because the purpose of incurring these expenses is to avoid implementing an unfavorable contract. The contract itself was entered into to generate revenue and is undoubtedly related to business activities. The company’s flexible response to market realities affecting the timber production industry reflects an inherent characteristic of business activity, distinguishing it from other types of activities, namely its profit-oriented nature.
The Director of the National Tax Administration agreed with the applicant that such penalty clauses do not meet the criteria for taxing these expenses under the flat tax on company income. The actions of the taxpayer are economically justified and rational for business purposes. Expenses related to such penalty clauses are incurred in the course of the company’s primary business activity, demonstrating a connection with the conducted business activities. Consequently, Estonian CIT remains tax-attractive even in such complex economic situations.