Estonian CIT under the new rules

The reform of Estonian CIT (sometimes called as “lump sum taxation”) under the Polish Deal, which began in 2022, allowed for a significant expansion of access to this form of taxation, e.g. by expanding the catalogue of entities eligible to apply Estonian CIT, reducing the flat rate on income, and abolishing the revenue limit. Thanks to the amendment to the legislation passed by the Sejm, which is to come into force from 1 January 2023, taking advantage of Estonian CIT may be even easier.

The changes introduced are certainly not revolutionary – but they may make more entities consider the decision to switch to Estonian CIT. The enacted provisions are mostly of a clarifying nature, they remove previous interpretative doubts in favour of taxpayers, which should be judged positively. On the other hand, there is also a change that taxpayers will not be happy about – as it further complicates the already difficult issue of accounting for expenses related to the use of personal cars.

Changes to Estonian CIT effective from 2023

Expenses related to the use of personal cars

According to the enacted amendments, 50% of the expenses related to the use of personal cars (including depreciation allowances) will be considered as ‘non-business expenses’ (constituting a separate category of income subject to Estonian CIT) if such car is not used exclusively for business purposes, but also for private purposes.

This regulation thus effectively introduces provisions similar to those already in place for so-called ‘hidden profits’. The difference is that the rules on ‘hidden profits’ apply only if the car is used for private purposes by a shareholder/partner or an entity related to the taxpayer, while the rules on ‘non-business expenses’ will apply to all other situations (i.e. where it is an unrelated party, such as an employee, who uses the personal car for private purposes).

On the one hand, the introduction of this type of regulation can hardly be seen as beneficial for taxpayers – as it formally broadens the scope of taxation. It is particularly painful that this kind of change results in the necessity to pay tax not so much in connection with the generation of income, but in connection with the incurring of an expense (which partly nullifies what is the main benefit and sense of Estonian CIT – i.e. the possibility to defer tax payment until the profit (not costs) is actually paid). On the other hand, the rules being introduced actually address the already existing uncertainties and, in this sense, at least eliminate the uncertainty surrounding the application of the rules faced by taxpayers applying Estonian CIT. This is all the more important as the rules on settlement and taxation of expenses related to the use of cars used for mixed purposes (business and private use) is, in practice, one of the more common and at the same time more difficult issues faced by Estonian CIT payers. Particularly problematic is the approach of the tax authorities pointing out that proving the use of the car exclusively for business purposes is possible only by keeping mileage records (which is not explicit in the regulations).

It is worth noting that the provisions being introduced will not apply to passenger cars used exclusively for business purposes; in such a situation, no tax obligation should arise (neither on account of ‘non-business expenses’ nor on account of ‘hidden profits’). It is also worth noting that the provisions in question (as well as the provisions on ‘hidden profits’) may also apply to other assets, not only passenger cars.

Extinction of liability for preliminary adjustment

Pursuant to the new provisions, the legislator also decided to clarify the regulation concerning the expiry of the liability for the so-called preliminary adjustment. The obligation to prepare a preliminary adjustment applies to existing taxpayers that opt for Estonian CIT. In practice, this is a kind of statement of accounting and tax differences regarding income and expenses – which the obligation to pay tax in the future may potentially be connected with.

The current legislation in force in this regard is unfortunately imprecise – as it explicitly provides that the obligation to pay tax on account of the initial adjustment applies to those taxpayers who have applied Estonian CIT continuously for less than 4 years and at the same time indicates that this obligation does not apply to taxpayers who have applied this taxation model for more than 4 years. Thus, the CIT Act lacks a regulation that would prejudge whether the obligation to pay the tax for the initial adjustment applies to those taxpayers who have applied the Estonian CIT for exactly 4 years – and it is worth noting that this may be one of the more frequent cases in practice (given that the standard period for which the Estonian CIT is chosen is precisely 4 years).

Fortunately, the changes being introduced eliminate doubts in this regard and are beneficial for taxpayers. This is because the new rules provide that for taxpayers applying the Estonian CIT continuously for exactly 4 years, the obligation to pay tax for the initial adjustment also ceases.

Minimum employment requirement – persons exempt from PIT/social security contributions

Another important and equally beneficial change is the modification of the provisions on the minimum employment requirement. One should remember that one of the conditions for the application of the Estonian CIT is the employment of at least three persons under an employment or other contract for at least 300 days in the fiscal year. This requirement is also deemed to be met where the basis of employment is not an employment contract, but a civil-law contract (e.g. a contract of mandate) – provided that the Estonian CIT taxpayer is obliged to collect PIT advances and social security contributions in connection with the payment of remuneration on this basis.

In practice, doubts have arisen as to whether this condition can be considered fulfilled in the case of those taxpayers who employ the minimum required number of persons, but in respect of whom an exemption in PIT (e.g. for persons under 26 years of age) or social security contributions (e.g. for students) applies.

The new wording of the regulations dispels these doubts in a manner favourable to taxpayers. According to the new provisions, the condition of minimum employment on a basis other than an employment contract is deemed to be met as long as the Estonian CIT taxpayer in respect of at least one of the aforementioned charges (PIT or social security contributions) is remitter; it is irrelevant whether the Estonian CIT taxpayer, who is formally a PIT/social security contributions remitter, has actually collected these charges.

This change should be assessed definitely favourably – as it not only eliminates interpretation doubts and increases certainty in the application of the provisions, but is also, above all, in line with the purpose of the regulation itself. It is worth noting that the purpose of the introduction of the Estonian CIT regulation was, among other things, to increase employment, to encourage entrepreneurs to increase employment; hence, the minimum employment requirement was included in the regulation. At the same time, it is clear that the benefits of increased employment (reduced unemployment) do not result solely from their payment of PIT and social security contributions, but have a much broader, positive impact on the economy. The fact that certain preferences are applied to certain groups of employees/contractors should not be relevant in assessing whether the employment of, for example, persons under 26 years of age (statutorily exempt from PIT) is in line with the purpose of the provision. It is worth noting that this change is important insofar as it probably applies in practice to quite a large group of Estonian CIT payers that, after all, like other entrepreneurs, employ persons entitled to apply certain PIT/social security contributions exemptions (persons under 26 years of age, students). 

Deadline for payment of profit tax

Another change relates to the deadlines for payments of tax on distributed profit, income from profit designated to cover losses, advances on anticipated dividends and on distributed net profit income.

The current legislation sets the 20th day of the seventh month of the tax year as the time when the tax liability arises. Consequently, for companies/partnerships whose fiscal year is equal to the calendar year, the tax liability always arises on 20 July of the same fiscal year. The above regulation raised serious doubts and problems for those taxpayers who decided, for example, to pay an advance on dividends after this date (for example in October); then, as it were, they automatically incurred tax arrears on this account.

The introduced regulation introduces changes aimed at avoiding such ‘traps’. The new regulations provide that a taxpayer will have time to pay tax and submit a tax return by the end of the third month of the tax year following the year in which a resolution on the distribution of profit was adopted or – by virtue of applying the provisions on advance payments accordingly – a resolution on the payment of an advance payment.

Deadline for payment of tax on income from transformation

The legislator has also decided to clarify the deadline for payment of the tax due on the income from the transformation in full.

According to the current legislation, a single payment of tax due on income from transformation in full is made within the deadline for filing the CIT-8 return, i.e. the end of the third month of the year following the tax year in which the taxpayer earned income (loss).

The current wording of the regulations raises doubts as to the correct determination of the deadline for the single payment of the tax due on the income from the transformation. In particular, it is argued that the current provisions can be read in two ways – according to one interpretation, the deadline for payment of the tax would be at the end of the 3rd month of the first year of Estonian CIT taxation (“the end of the third month of the year following the tax year preceding the first year of lump-sum taxation”), while according to the other interpretation it would be at the end of the 3rd month of the second year of Estonian CIT taxation (“the end of the third month of the tax year following the first year of lump-sum taxation”).

The enacted legislation unambiguously resolves this issue by indicating that the deadline for payment of the conversion tax is the end of the 3rd month of the first year of lump-sum taxation.

The change introduced is obviously beneficial in the sense that it eliminates interpretative doubts regarding the application of the provision in question. However, the legitimacy of the taxation itself on the transformation and the current wording of the provision is a different matter, as discussed in more detail below.

Amendments of a formal nature

According to the planned amendments, the moment at which the ZAW-RD notice (notice of election to be taxed with lump sum on corporate income) must be filed in the case of a taxpayer converting to Estonian CIT during the ongoing fiscal year will also be clarified.

The enacted amendments indicate that the general rule (expressed in Article 28j(1)(7) of the CIT Act) according to which the taxpayer should submit the ZAW-RD notice by the end of the first month of the Estonian CIT year applies in such a situation. The literal wording of the current legislation might have suggested that this deadline is set differently for taxpayers switching to Estonian CIT during the fiscal year. On the surface, this change appears to be merely of clarifying nature and thus less significant; however, for taxpayers who wish to opt for Estonian CIT during the ongoing fiscal year, it is a provision of great significance (as failure to notice the changes introduced may result in a formal deficiency at the stage of opting for Estonian CIT, making it impossible to settle in this form of taxation for several months).

Regulations on Estonian CIT introduced in 2022

It is worth noting that the amendments just enacted are yet another significant modification of the Estonian CIT regulations in force since 2021. Indeed, one should not forget the veritable revolution that took place with effect from 1 January 2022; the changes introduced at that time fundamentally reformatted the entire regulation of lump-sum income. It is worth recalling that the regulations introduced at that time included such significant ones as: 

• expansion of the category of eligible entities – by allowing the application of the Estonian CIT to limited partnerships (spółka komandytowa), limited joint-stock partnerships (spółka komandytowa-akcyjna) and simple joint-stock companies (prosta spółka akcyjna),
• reduction of the tax rate – both for small taxpayers and start-up taxpayers and for other taxpayers, the tax rate was reduced by 5%, respectively to 10% (small taxpayers and start-ups) and 15% (others)
• abolition of the limit on maximum allowed revenue – the limit in 2021 was PLN 100 million per year, no longer in force from 2022,
• abolition of the minimum capital expenditure requirement – which was arguably one of the more significant/beneficial changes, given that, this requirement was an actual barrier to ‘entry’ into Estonian CIT for very many taxpayers, but also due to the very vague wording,
• abolition of the rule according to which, when the application of Estonian CIT is terminated, profits earned during this period are automatically taxed – this change allows the basic premise of Estonian CIT to materialise, according to which profits earned during the period of application of this taxation model are only taxed when distributed.

All these introduced changes have made the Estonian CIT – which turned out to be a kind of legislative failure in the first year of the legislation (2021) – definitely gain in popularity. According to the latest data the Ministry of Finance has recently boasted about, the number of taxpayers using this taxation model has increased to approximately 7,000. Undoubtedly, therefore, the changes introduced in 2022 turned out to be appropriate, reasonable and, in practice, they allowed this form of taxation to be used by many taxpayers. In this context, the changes that have just been enacted, which are to come into effect as of 1 January 2023, should in principle be assessed positively too. In the vast majority of cases, they eliminate interpretation doubts that have arisen on the grounds of the regulations currently in force, address the risk of uncertainty in the application of the law and, as such, should contribute to even greater popularity of this form of taxation. 

Postulates for further changes

Thus, while positively evaluating the changes made in the last year, one should at the same time express the expectation that this is not the end of the process of “fixing” the regulations on Estonian CIT and activities aimed at enabling an even larger group of taxpayers to apply this form of taxation, as well as increasing legal security related to its application. There are still areas that either require some modifications or, even if there is no absolute need for such changes, it would be worth considering them as factors to further increase the popularity of this form of taxation.

The regulations which, despite the changes already made, will probably still cause many doubts and bring more harm than good (not only from the perspective of taxpayers, but also of the State Treasury), are primarily the regulations on ‘hidden profits’. Without questioning, in principle, the need for certain regulations in this area, there is, unfortunately, little doubt that the current provisions – in particular the general part of the definition of ‘hidden profits’ – are extremely difficult to apply and their interpretation causes huge doubts and problems for taxpayers and probably also for the tax authorities. This is also confirmed by the emerging, although still relatively few, rulings/advance tax ruling in this respect.

Other regulations causing numerous doubts include those concerning the so-called taxation on transformation. The amendments that have just been passed address one doubt (concerning the deadline for payment of the tax on this account), but do not touch in any way on the not very precise provisions establishing the prerequisites for taxation.

When thinking of a change that could, in turn, probably make a fundamental contribution to increasing the popularity of Estonian CIT, one should point to the regulations concerning the requirement of the so-called simple shareholding structure – i.e. the provisions relating both to the prohibition of owning subsidiaries by an Estonian CIT taxpayer and to the provisions excluding the possibility of choosing this form of taxation by companies/partnerships whose shareholder/partner are not exclusively natural persons. It seems that, after more than 1.5 years of legislation, this particular condition appears to be too restrictive, artificially limiting the possibility for many taxpayers to apply the Estonian CIT. Understanding some of the assumptions behind the introduction of this type of regulation (limiting the possibility of using this form of taxation by large international capital groups), it seems that there is room for reasonable modifications of these regulations, which will certainly translate positively into the number of taxpayers taking advantage of the Estonian CIT.