Shareholders stand to lose money on dividends
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As an
effect of the corporate income tax change introduced by the Estonian government
effective 1 January 2018, shareholders may lose an undue amount of money
because of an easy-to-make mistake in how tax on dividends is calculated.
In and of itself, the tax change is simple. The government introduced a 14% corporate tax rate for regularly distributed profits, calculated as an average of the dividends disbursed over the preceding three years.
Because the measure is only one year old, the calculation in 2019 and still in 2020 is slightly different.
In practice, this means that the amount deemed equal to the average of distributed profits in that period will be taxed at 14% (i.e. regular dividend), while the remainder of corporate profits disbursed as dividends will be taxed at the previously generally applicable 20%.
Moreover, in the case of a dividend payment to a private tax resident in Estonia, in the case of the dividend taxed at the 14% corporate income tax rate, an additional rate of 7% personal income tax applies.
If the dividend is paid out by a single company and not coming from a subsidiary further down a corporate holding structure, the matter is not that difficult – though the calculations for accountants are made more complex. On the average calculated for regularly disbursed profits, 14% apply, and an additional private income tax rate of 7%. On the rest, 20% apply, with no added private income tax.
The situation changes as soon as subsidiaries are involved. Estonia used to apply the principle that all distributed profits should be taxed only once.
This is not the case anymore. A subsidiary can pay out a regular dividend to a parent company at 14% tax. But while no immediate private income tax applies, if this dividend is then paid out through the parent company to a private resident in Estonia, a 7% private income tax is still levied. There was no such tax before.
This has important implications for accountants and chief financial officers. Routined professionals will have no difficulty seeing that the new line-up of taxes means the subsidiary’s dividend is calculated in a slightly more complex fashion.
But entrepreneurs, used to the very straightforward 20% all around of earlier days, might fall into a trap at this point. In order to avoid the trap you need to consider the following.
Before the change introduced in 2018, calculating a subsidiary’s net dividend payment was simple. If, say, individual being the ultimate shareholder wished to receive €100,000 dividend in net, such there would have been no difference if such dividend was decided on the subsidiary level as €100,000 net or €125,000 gross. Either way the subsidiary paid €25,000 corporate income tax and the ultimate individual shareholder received €100,000 net dividend.
In practice dividends were and are often decided in net and not in gross amounts. As of this year, calculating in net amount would end up for the individual shareholder receiving less net dividend.
Under the new rule, if the same €100,000 net dividend is decided on the subsidiary level and all of it would be classified as regularly disbursed profits, the 14% corporate tax would be levied on the subsidiary level. At first glance the tax obligation seems to be decreased since 14% calculated from net €100,000 is €16,279. But there is a catch:
Because an additional private income tax of 7% is levied on the dividend as well when it is paid out to the individual shareholder, an added amount of €100,000 x 7% = €7,000 goes into the state’s coffers. This means that the individual shareholder would receive €93,000 net dividend, and not €100,000.
In other words, if the amount handed down to the parent by the subsidiary has become a habitually chosen number based on the 20% flat rate tax of earlier years. Taking into account the new system, the net dividend received by the ultimate shareholder through the parent is significantly lower if the profit distribution at the subsidiary level continues to be calculated based on the net principle.
In order to avoid receiving less net dividends, decisions about the profit distribution at the subsidiary level should be made based on gross and not net amounts. In the given example, the decision should be €125,000 gross, and not €100,000 net.
If this is all Greek to you, now is the time to talk to your accountant or CFO. Depending on the holding structure you’ve chosen for your businesses, you may stand to lose a substantial amount of money.
If you are not sure how to proceed, you can also get in touch with Priit Raudsepp, partner at Glikman Alvin LEVIN. You can reach him at priit.raudsepp@levinlaw.ee or on +372 686 0000
PS: Important addition for foreign shareholders. If a shareholder of an Estonian company is based abroad and is not an individual, then no 7% personal income tax applies. This means that in such situation, the Estonian tax obligation on regular dividends has actually decreased from 20% to 14%.
In and of itself, the tax change is simple. The government introduced a 14% corporate tax rate for regularly distributed profits, calculated as an average of the dividends disbursed over the preceding three years.
Because the measure is only one year old, the calculation in 2019 and still in 2020 is slightly different.
In practice, this means that the amount deemed equal to the average of distributed profits in that period will be taxed at 14% (i.e. regular dividend), while the remainder of corporate profits disbursed as dividends will be taxed at the previously generally applicable 20%.
Moreover, in the case of a dividend payment to a private tax resident in Estonia, in the case of the dividend taxed at the 14% corporate income tax rate, an additional rate of 7% personal income tax applies.
If the dividend is paid out by a single company and not coming from a subsidiary further down a corporate holding structure, the matter is not that difficult – though the calculations for accountants are made more complex. On the average calculated for regularly disbursed profits, 14% apply, and an additional private income tax rate of 7%. On the rest, 20% apply, with no added private income tax.
The situation changes as soon as subsidiaries are involved. Estonia used to apply the principle that all distributed profits should be taxed only once.
This is not the case anymore. A subsidiary can pay out a regular dividend to a parent company at 14% tax. But while no immediate private income tax applies, if this dividend is then paid out through the parent company to a private resident in Estonia, a 7% private income tax is still levied. There was no such tax before.
This has important implications for accountants and chief financial officers. Routined professionals will have no difficulty seeing that the new line-up of taxes means the subsidiary’s dividend is calculated in a slightly more complex fashion.
But entrepreneurs, used to the very straightforward 20% all around of earlier days, might fall into a trap at this point. In order to avoid the trap you need to consider the following.
Before the change introduced in 2018, calculating a subsidiary’s net dividend payment was simple. If, say, individual being the ultimate shareholder wished to receive €100,000 dividend in net, such there would have been no difference if such dividend was decided on the subsidiary level as €100,000 net or €125,000 gross. Either way the subsidiary paid €25,000 corporate income tax and the ultimate individual shareholder received €100,000 net dividend.
In practice dividends were and are often decided in net and not in gross amounts. As of this year, calculating in net amount would end up for the individual shareholder receiving less net dividend.
Under the new rule, if the same €100,000 net dividend is decided on the subsidiary level and all of it would be classified as regularly disbursed profits, the 14% corporate tax would be levied on the subsidiary level. At first glance the tax obligation seems to be decreased since 14% calculated from net €100,000 is €16,279. But there is a catch:
Because an additional private income tax of 7% is levied on the dividend as well when it is paid out to the individual shareholder, an added amount of €100,000 x 7% = €7,000 goes into the state’s coffers. This means that the individual shareholder would receive €93,000 net dividend, and not €100,000.
In other words, if the amount handed down to the parent by the subsidiary has become a habitually chosen number based on the 20% flat rate tax of earlier years. Taking into account the new system, the net dividend received by the ultimate shareholder through the parent is significantly lower if the profit distribution at the subsidiary level continues to be calculated based on the net principle.
In order to avoid receiving less net dividends, decisions about the profit distribution at the subsidiary level should be made based on gross and not net amounts. In the given example, the decision should be €125,000 gross, and not €100,000 net.
If this is all Greek to you, now is the time to talk to your accountant or CFO. Depending on the holding structure you’ve chosen for your businesses, you may stand to lose a substantial amount of money.
If you are not sure how to proceed, you can also get in touch with Priit Raudsepp, partner at Glikman Alvin LEVIN. You can reach him at priit.raudsepp@levinlaw.ee or on +372 686 0000
PS: Important addition for foreign shareholders. If a shareholder of an Estonian company is based abroad and is not an individual, then no 7% personal income tax applies. This means that in such situation, the Estonian tax obligation on regular dividends has actually decreased from 20% to 14%.
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