The work stoppage due to the raging pandemic in Europe has created tax risks for Baltic construction companies active abroad because their commercial revenue might be taxed there instead of their home country.
Why is it important that activity on a construction site lasts less or more than 6 months?
Many Baltic contractors operate on a cross-border basis in Finland, Sweden, Norway and other nearby countries – by supplying and assembling houses or working directly for local end-customers. It is common that some construction companies aim to keep their presence at each specific construction site below 6 or 12 months. This is trending due to the fact that the duration of the construction site determines how the contractor’s income is taxed:
- If construction activity is shorter than the timeline (for example in Finland, Sweden and Norway this is 6 months), then the contractor pays corporate income tax from its corporate income based on Baltic taxation rules. Since the profit of a private limited company is only taxed when distributed in Estonia and Latvia, this is without a doubt a more desirable outcome. The Lithuanian domestic tax regime may in many aspects be more beneficial. So many contractors use the model where that timeline is not exceeded.
- If construction exceeds the timeline, a private limited company has to start paying income tax on its profits in that foreign country and register a permanent establishment there. There is usually no obligation to pay double income tax in Estonia, Latvia or Lithuania, but, understandably, it is also not possible to postpone the tax obligation as you see fit in terms of Estonian and Latvian regimes.
“Sorry, the workers have COVID and the operation is delayed: not our fault”. Is that enough?
The duration of construction sites is undoubtedly beginning to delay due to illness, movement restrictions as well as the slowdown of supply chains. That has raised a question for many: what happens if under those circumstances it is necessary to spend more time on site and the 6-month line is crossed? For the most part, this is a problem for those whose business consists of shorter construction projects or who intend to balance on that 6-month line.
One can find many articles about the virus as force majeure in contractual relations, enabling one party to excuse itself from breaching contracts. In that sense the delay in supplying building materials or handing over work does not allow the use of legal remedies. Additionally, demanding contractual penalties – at least according to the standard terms stipulated in Baltic regulations – is out of the question in the case of force majeure.
In terms of tax liabilities, the situation might not be as pleasant for contractors. Recently, the OECD – an international body which directs states on how to divide taxation rights between them – published an analysis of the impact of COVID-19 on the application of tax agreements. The risk for construction companies is obvious. The analysis emphasised that the duration of a construction site should be taken into account irrespective of whether the work is delayed due to the crisis. Work stoppage created by the crisis is a so called ‘temporary interruption’ that does not stop the time-recording of the construction site.
Although this is an OECD analysis and the Baltic and Nordic countries might have a different understanding of it, it does clearly bring out the rising risk for construction companies by stating that “Corona” is not a magic word that allows them to avoid permanent establishment.
How much does it cost to cross the 6-month line?
The significance of the risk can be demonstrated by the following example. An Estonian private limited company (OÜ) plans to end construction and refining works within 5 months, but due to supply difficulties and illness of workers or movement restrictions, construction is delayed to 7 months. Activity on such a construction site will create a permanent establishment in the country for that OÜ (assuming that the deadline in the payment agreement is 6 months, as is the case in Finland, Sweden and Norway), which means in terms of taxation that the OÜ will be treated the same as the local companies of that foreign country.
If the OÜ earns 70,000 euros in profit with this project, then in the case of a 5-month project it should not be taxed until distribution of profits. The OÜ can keep the profit tax-free and reinvest it, while any remaining profit should be taxed at 20% income tax at the moment of distribution of profits. However, if the project now lasts 7 months and the foreign state applies annual corporate income tax at a rate of 24%, then the OÜ should pay 24% income tax from the 70,000 euros profit. This means that tax will fall due earlier and at a higher rate.
What to do?
Companies operating cross-border should keep themselves informed in terms of what their country’s direction in that matter will be. If the direction is not to count work stoppages created by the virus as an excuse, then it should be seriously considered and calculated whether it is less expensive to finish the project with a bigger workforce or utilise alternative solutions that are possible in the given situation.