Income from hidden profits part I – What are hidden profits?
Hidden profits as benefits made to related parties are one of the subjects of taxation under Estonian CIT. The introduction of taxation of this type of income is aimed at preventing untaxed distributions from the company equivalent to dividends.
Definition of hidden profits in the CIT Law.
As indicated in the CIT Law, hidden profits are any monetary, non-monetary, pecuniary, gratuitous or partially pecuniary benefits made in connection with the right to share in profit, other than distributed profit. The beneficiary of these benefits – directly or indirectly – is a shareholder, stockholder, partner, or entity directly or indirectly related to these entities or the taxpayer.
For the purpose of determining whether a given benefit constitutes a disguised profit, the “modified” definition of related party should be used, in which the amount of rights and obligations sufficient to consider the companies concerned as related is at least 5% (rather than 25% as for transfer pricing purposes).
Examples of hidden profits
The legislator indicates that hidden profits include, among others:
- the amount of a loan made by a taxpayer to a shareholder;
- interest, commissions, salaries and fees on a loan from a shareholder to a taxpayer;
- the excess of the market value of a transaction over its agreed price;
- donations, including gifts and offerings of any kind;
- representation expenses;
- interest on the capital share paid to the shareholder;
- profit allocated to supplement the shareholder’s capital share
- monetary and non-monetary benefits paid in the event of a reduction in the shareholder’s capital share.
It should be pointed out that this is an exemplary catalog and other benefits for the benefit of partners or entities related to partners may also constitute this category of income.
Hidden gains in tax explanations
Useful guidance on the categorization of benefits paid to related parties is provided by the Guide to Lump Sum Income having the nature of tax explanations stating that:
- a benefit considered a disguised gain is related to influencing the operations and decisions of a company taxed under Estonian CIT. Thus, benefits made in a group of related parties, having to do with, for example, the division of functions, transfer of know-how or consulting on management services, may fall into this category,
- hidden gain income does not include benefits performed without any influence of other related parties on the company’s action and decisions regarding such benefit. If the terms of a transaction with a related party, which falls within the taxpayer’s core business, are established on analogous terms to those of a transaction with unrelated parties, and the transaction is necessary for the business, it should not be considered hidden profit income. Thus, it is necessary to evaluate not only the price of the transaction, but also whether the transaction in question between unrelated parties would have occurred at all.
- as a general rule, hidden profit is benefits that result in a benefit to a related party of a company taxed under Estonian CIT.
It is also important to determine whether the shareholder has taken care to equip the company with the assets necessary for its business, whether the shortage of these assets is not the reason for the actions of recapitalizing the company (e.g., in the form of a loan, providing real estate).