Hidden profits in Estonian CIT - doubts increasing 

Hidden profits

According to the CIT Act, hidden profits are defined as any profit-sharing consideration, other than distributed profits, the recipient of which, directly or indirectly, is a shareholder or an entity directly or indirectly related to the shareholder or the taxpayer.

At the same time, the legislator has listed examples of categories of expenditures that should be considered as hidden profits. These include, among others:

• the amount of the loan (credit) granted by the taxpayer to the partner,
• interest, commissions, remuneration and fees on the loan (credit) granted by the partner to the taxpayer,
• benefits made to a private or a family foundation, an entity equal to such a foundation and a trust,
• the equivalent of profit allocated to increase the share capital;
• donations, including gifts and offerings of any kind,
• expenditure on representation,
• surcharges paid upon merger or division of entities,
• interest on the capital share paid to the shareholder by the company,
• monetary and non-monetary benefits paid upon reduction of the shareholder's capital interest in the company,
• remuneration granted to the shareholder-employee exceeding the equivalent of 5 times the average monthly remuneration for work according to the Central Statistical Office,
• 50% of depreciation and expenses related to assets used for mixed (business and non-business) purposes.

Moreover, the legislator in the published tax explanations cites other examples of consideration that should be regarded as hidden profits. These include in particular:

• business trips of the partners not related to business operations,
• repairs to fixed assets belonging to the partners,
• benefits to related parties without business substance (e.g. empty Cyprus companies),
• the excess of the price paid to the partner over the market value of the transaction,
• general consultancy services performed by related parties,
• payment of profit bonuses to board members - shareholders.

General criteria for hidden profits

The catalogue of hidden profits is not closed and all transactions with shareholders and other related parties should be considered in view of a number of general criteria.

Taking into consideration the scope and definition provided by the legislator, hidden profits may arise according to the shape of the following factors:

• the link of the consideration to the right to a share in profits,
• the link to exercising influence over the taxpayer's actions and decisions,
• the personal nature of the consideration,
• the way in which the consideration is provided,
• the relationship of the provider with related parties,
• marketability of the transaction with the related party,
• the business substance of the related parties providing the consideration,
• the extent of the consideration received from related parties and the relation thereof to the taxpayer's business.

However, the more the consideration paid to the shareholder is related to the right to share in the profit and results from the shareholder's influence on the operation of the company rather than market demands, the more likely it is that the consideration in question is to be regarded as hidden profit.

The market nature and the way in which the consideration is provided also affect the legitimacy of recognising the hidden profit from related parties. If the consideration in question is of a personal rather than market nature and associated with the personal benefit of the partner, then there is hidden profit.

Considerations paid before switching to Estonian CIT

At the same time, it remains unclear how expenses incurred before switching to Estonian CIT and settled over time by the taxpayer should be treated. One such category could be, for example, lease preliminary payments. Often these types of expenditures may be of large values, and large tax may arise with large expenditures.

The way these expenses are recognised under the Estonian CIT regulations is still ambiguous. On the one hand, the legislator requires to make a so-called pre-adjustment to equalise the tax result with the balance sheet result, while on the other hand, the definition of hidden profits explicitly refers to any consideration of which the partner is the recipient. How, then, one should treat a consideration that was paid before switching to Estonian CIT, and which the taxpayer settles over time (e.g. by means of accrued expenses RMK or depreciation) and which continues to be of benefit to the partner? Is the RMK deduction equal to the consideration provided to the partner, or does the hidden profit only include the expense incurred during the lump-sum taxation period?

Under Estonian CIT, the tax and accounting result is equalised and, as a rule, differences in the way expenses are recognised should not occur. A literal interpretation of the legislation therefore leads to the conclusion that deductions from either RMK or depreciation, although incurred prior to switching to a lump sum, should be included in hidden profits.

The above approach is at odds with the disbursement of hidden profits, which is notably the case in the example of lease preliminary fees discussed above. An approach in which the taxpayer taxes only the actual expense (cash outflow) as hidden profit, instead of the interim benefits (equal to the RMK allowance), therefore seems possible.

However, so far, no line of interpretation has been formed on this subject by the administrative courts or the National Tax Information (KIS) Service. A conservative approach, nonetheless, dictates to treat time-settled expenses as the tax base.

Not only partners

The second source of hidden profits is transactions with related parties. Most often, only the surplus of the market value over the transaction price will be considered as hidden profit. The legislator also pays attention to the type of consideration provided and its scope. If the consideration is provided by a fictitious, empty entity, the actual purpose of which was to optimise taxation or to receive a portion of the taxpayer's profit without the payment of dividends, such consideration will constitute hidden profit. A similar effect will be produced by intangible services that cannot be economically justified and have little connection to the business.

Transactions with certain related entities explicitly indicated in the CIT Act, such as private foundations, may prove problematic. Although on the grounds of Polish law there is no such entity as a private foundation, it is uncertain what type of foundation the legislator had in mind. Therefore, if a taxpayer makes transactions with a foundation that may be considered a related entity, it may seem reasonable to include the full value of transactions made with such an entity in the hidden profits.

Interest upon misclassification

If the taxpayer misclassifies the consideration and does not charge tax on the hidden profit, it will be necessary to correct the return for the year in which the hidden profits should have been taxed. Moreover, the company will be in tax arrears, upon which there will be penal tax interest. It should be noted that at present it is as high as 16.5% annually.

Simple taxation problematic

Accounting for Estonian CIT, despite the significant limitation of the scope of the applicable provisions, requires a thorough tax analysis. Within only a few pages of Estonian CIT provisions, the legislator has included a number of interpretative doubts that are still unresolved. Particular attention should be paid to the analysis of transactions with partners and related parties. When recognising the tax base, taxpayers should pay attention to a set of general criteria that create hidden profits. It is not enough to refer to the law and the tax explanations. Taxpayers should consider each of the consideration provided to the partners.

If there is no uniform line of rulings by the KIS, it is reasonable to apply for an individual interpretation of tax law in the most problematic cases. If the KIS confirms the taxpayer's position, it will also become possible to correct the tax base retroactively and apply for a tax refund without the risk of a conflict with the tax office.