In practice, this means that as long as the funds generated remain in the company and are allocated for development, the company does not pay CIT. This mechanism favors the reinvestment of profits and building the company’s capital.
At the same time, however, the use of Estonian CIT requires good knowledge of regulations. It is particularly important to understand the concept of the so-called hidden profits, which in practice is one of the main sources of tax risk.
How does the Estonian CIT work?
Estonian CITThat is lump sum from companies’ incomeis based on several basic principles that distinguish it from the classic taxation model. Above all:
- Tax appears only at the time of distribution of profit – as long as the company retains the funds generated and allocates them for development, the obligation to pay tax does not arise.
- Tax settlements are simpler – the company does not keep separate tax records regarding tax revenues and costs. The basis for settlements is the financial result determined in accordance with the Accounting Act.
The tax rates are:
- 10% – for small taxpayers and entities starting their businesses,
- 20% – for other taxpayers.
In practice, this means that the system rewards development-oriented companies that do not plan to regularly distribute profits to shareholders.
Hidden profits – why did the legislator introduce this concept
One of the key elements of the system Estonian CIT is the institution of hidden profits. The regulations introduce it to prevent situations in which partners or related entities try to withdraw money from the company. in a manner other than through formal dividend payment.
Hidden profits then services provided by the company to: :
- partners,
- shareholders,
- shareholders,
- entities related to these persons, which in fact constitute a form of transferring the company’s profit to them, although formally they are not a dividend.
If the tax authority finds that a given transaction meets this definition, its value is taxed under Estonian CIT as if it were a distribution of profit.
The most common examples of hidden profits
In practice, the catalog of hidden profits is wide, but there are several situations that appear particularly often in the analyzes of tax authorities.
Purchasing goods or services at inflated prices
If the company purchases goods or services from a partner or related entity at higher than market prices, the excess over market value may be considered a hidden profit.
Financing private expenses of partners
This category may include, among others:
- purchase of luxury cars used mainly privately,
- financing private travel,
- covering expenses unrelated to the company’s business activities.
If the expense has no real business justification, the risk of it being classified as a hidden profit increases significantly.
Preferential loans for partners or related entities
Providing loans on non-market terms – for example at very low interest rates – may also be considered a form of profit transfer.
Benefits to family foundations
Risk also occurs when the company transfers funds to a family foundation whose beneficiaries are partners or entities related to them.
Consequences of discovering hidden profits
If the tax authority finds that a given transaction constitutes a hidden profit, the company will be obliged to pay a lump sum on the income companies from the value of this benefit. In practice this may mean:
- the need to pay corporate income tax,
- charging interest for late payment,
- in some cases also tax sanctions.
Particularly risky are situations in which the company’s actions may be considered conscious tax avoidance.
How to reduce tax risk?
Entrepreneurs using Estonian CIT they should take care first of all for transparency and market nature of the transaction. In practice, this means a few basic rules:
- applying market prices in relations with related entities,
- documenting the business justification for the transaction,
- accurate recording of services provided to partners or related entities,
- analyzing unusual expenses before they are incurred.
In many cases, it is also helpful to consult the planned activities with a tax advisor in advance.
Is Estonian CIT still profitable?
Despite the indicated risks, Estonian CIT remains an attractive solution for companies focused on development. Its greatest advantage is the possibility deferral of taxation until the actual distribution of profit, which allows you to allocate a larger part of the funds for investments.
An additional benefit is the simplification of tax settlements – the company relies primarily on accounting data, without the need to keep extensive tax records.
At the same time, however, entrepreneurs should remember that using this form of taxation requires: particular caution in relations with partners and related entities. It is in these areas that the problem of hidden profits most often arises.
However, a well-planned settlement model and conscious management of intra-group transactions allow you to effectively limit this risk and fully exploit the potential of the Estonian CIT.
Author: Artur Kuc, Junior Accountant, Aider Polska (MDDP Outsourcing)
