By Ivo Vanasaun and Mait Riikjärv

The Estonian Parliament passed a series of amendments to the Income Tax Act on 26 March 2008 to ensure full compliance with the EC Parent-Subsidiary Directive. Included are changes to the tax on gross distributed profits, advance payments of tax and the general abolition of withholding tax on dividends, interest and royalties paid to nonresidents.

The Estonian income tax rate in 2008 is 21% on gross distributed profits (21/79 on net dividends or other payments). The rate reduces to 20% on the gross amount (20/80 on the net amount) in 2009, 19% (19/81 on the net amount) in 2010 and 18% (18/82 on the net amount) as from 2011.

Compatibility with Parent-Subsidiary Directive

Before Estonia’s accession to the EU in 2004, the European Commission took the position that the corporate income tax payable on profit distributions constitutes a withholding tax on dividends which is prohibited by article 5 of the Directive. The Commission’s position was based on the European Court of Justice (ECJ) decision in the Athinaiki case (C-294/99). According to the EU Accession Treaty, Estonia committed to make the necessary amendments to its domestic law by 31 December 2008 at the latest.

The recent amendments include some technical changes but the substance of the law remains the same. The Estonian government opted instead to rely on several decisions of the European Court of Justice (ECJ) (namely, Epson (C-375/98), Océ van der Grinten (C-58/01), Test Claimants in the FII Group Litigation (C-446/04) and OY AA (C-231/05)), all of which support Estonia’s position that the Parent-Subsidiary Directive does not regulate the first taxation of income arising from the business activities of a subsidiary. According to the Estonian authorities, the corporate tax cannot be characterized as a withholding tax on dividends because it is payable by the Estonian subsidiary and not by its shareholders.

Tax practitioners have diverging views as to whether the new law is fully compatible with the Parent-Subsidiary Directive. At the same time, many Estonian businesses are seeking ways to distribute untaxed retained earnings they have accumulated over the past nine years. As a result, the amended law is expected to come before the ECJ even though it is not clear whether European Commission will challenge it. The pending ECJ decision in the Burda case (C-284/06, a case involving the German taxation of cross-border dividends under its old imputation system), may also bring some clarity to the situation.

Main Amendments

Under the amendments, the main principle of the law remains unchanged, with only the distributed part of profits being taxed.

The new law also provides that as from 2009, the taxable period will be a company’s financial year rather than a calendar month, as is currently the case.

Additionally, Estonian resident companies will be required to make advance payments of tax calculated on the basis of the average actual taxable payments (dividends, nondeductible expenses, taxable gifts, transfer pricing adjustments) made during the previous three years. Under the new rules, a company is usually required to make two advance payments of tax, plus a final payment. However, the amendments do include transitional provisions for the years 2009-2011.

Under the new law, the distribution of retained earnings will suffer a higher tax burden if paid out in the course of a liquidation, redemption of shares, reduction of share capital or a share buy-back. Such payments will be subject to corporate income tax at the applicable rate (set out above) to the extent they exceed monetary or non-monetary contributions previously paid to the company. The company itself will have to pay corporate income tax on the excess portion.

The new rules will have many adverse effects, because the amended corporate tax:

The amendments do include positive news, however. As from 2009, Estonia will almost completely eliminate withholding tax on dividends, interest and royalties paid to nonresidents. As an exception, withholding tax will continue to be imposed if interest paid to a nonresident substantially exceeds the arm’s length rate for similar debt (only the excess portion of the interest payment will be taxed). Withholding tax on dividends and royalties will be completely abolished.

In addition, Estonian resident companies will benefit from an automatic participation exemption in respect of dividends received from EU Member States, Switzerland, Iceland and Norway. No minimum holding period or shareholding percentage will be required (a 15% participation is currently required). For dividends from other countries, proof of corporate tax or a dividend withholding tax payment still will be necessary. Unfortunately, no participation exemption will be granted in respect of foreign or domestic capital gains (unless realized from a subsidiary’s liquidation, redemption of shares, reduction of share capital or a share buy-back).

The above rules also will apply to Estonian permanent establishments of nonresident companies.

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