Can rental income be hidden profit? Traps of the Estonian CIT

The taxation of corporate income tax in the form of a lump sum on company income (so-called Estonian CIT or lump sum) has become a more accessible and attractive solution with the entry into force of the amendment to tax regulations under the so-called Polish Deal. The lump sum is an alternative form of taxation compared to general principles. To opt for it, several formal conditions must be met, but it is up to the taxpayer to decide whether to use it, as this form of taxation is optional.

The main assumption of Estonian CIT is to base taxation on the effective distribution of profit before taxation, mainly to the shareholder. However, the regulations do not limit taxation solely to dividends but also consider other forms of profit distribution, including benefits provided in connection with the right to participate in profit, where the beneficiary is a shareholder or a related entity (so-called hidden profits).

Hidden profits raise many doubts among taxpayers. An example could be a query to the Director of the National Tax Information (KIS) concerning a taxpayer who, along with their spouse, was a partner in a civil partnership primarily engaged in renting and managing real estate. At the time of the application, the aforementioned partnership was in the process of being transformed into a general partnership. The taxpayer also operated a sole proprietorship but intended to transform it into a limited liability company and switch to taxation according to the Estonian CIT principles. As part of the business, the applicant utilized properties rented from the civil partnership.

The taxpayer asked the Director of KIS whether the rent (assuming it would be determined on market terms) paid by the limited liability company for renting the property would constitute income from hidden profits subject to lump sum taxation under Article 28m (1) (2) of the CIT Act.

It is worth noting that according to the statutory definition, hidden profits include monetary or non-monetary, remunerated or non-remunerated, or partially remunerated benefits provided in connection with the right to participate in profit, other than distributed profit, the beneficiary of which, directly or indirectly, is a shareholder, shareholder, or partner, or an entity directly or indirectly related to the taxpayer or that shareholder, shareholder, or partner.

The applicant argued that in this situation, the mentioned rent would not constitute such income for the transformed company. The Director of KIS, in an interpretation dated October 12, 2022 (ref. 0111-KDIB1-2.4010.460.2022.2.AW), fully supported the taxpayer’s position. In the justification, it was indicated that Article 28m (3) of the CIT Act provides examples of transactions treated as such income. One of them is the surplus of the market value of the transaction specified in accordance with Article 11c over the established price of this transaction. This means that anything exceeding the market value of the transaction constitutes hidden profit subject to taxation. As stated in the application, the rental fees were determined on market terms, and their amount did not exceed the transactional values ​​concluded in similar agreements between unrelated entities. Therefore, the relationship between the parties did not affect the conditions of the agreements concluded between them.

The above interpretation by the Director of KIS will likely not resolve all doubts related to hidden profits in Estonian CIT, but it may be an important source of information for taxpayers in similar cases.