Dear clients and cooperation partners
This newsflash provides a brief overview and practical suggestions on topics relevant in the field of taxation:
1. REAL TIME TAX AUDIT VIOLATES THE LAW
According to a recent court decision, the Estonian Tax and Customs Board is violating applicable law when carrying out inspections. The court annulled an order where the tax authority launched an audit to inspect the ongoing fiscal period of a taxpayer before the due date of the tax declaration (real time tax audit). Under normal circumstances the Tax and Customs Board conducts ex-post reviews concentrating on preceding accounting periods.
In the particular case the Tax and Customs Board requested information on transactions to be concluded in the future so that the tax official could inspect transactions being concluded. On the one hand this approach is a welcome development enabling officials to gain further experience and practical knowledge and as a result we hope that statements in the line of “this seems to be practically implausible and/or undue as regards economic behaviour” will no longer be included in tax decisions. On the other hand this work shadowing is burdensome and may hinder the daily activities of inspected undertakings.
Moreover, these inspections lack legal basis. In particular, the Constitution affirms the principle of legality for the authority of the state. Accordingly, state authority may only be exercised in accordance with the law – public authority is only authorised to carry out activities clearly laid down by law. The law allows an ex-post review, and ex-ante verification may be conducted in exceptional circumstances only – e.g. regarding customs rules. Therefore, by carrying out ex-ante verification in the framework of regular tax review the tax authority is exceeding the powers conferred on it by law. In other words, the Tax and Customs Board is violating the law.
By conducting real time inspections the tax authority in theory verifies the correctness of future tax returns. Moviegoers remember the American science fiction movie Minority Report, where the main character was almost found guilty of a crime he was perceived to be committing in the future.
Although in the particular decision the court of first instance analysed clear shortcomings of the procedure as regards insufficiency of reasoning, the unlawfulness of real time tax audit becomes plainly evident in the decision. As we are aware of several such court proceedings, a decision by higher courts on real time tax control can be expected shortly.
We support the aim of the Tax and Customs Board to call fraudsters to order but wish the tax authority would act within the scope of the law. By operating outside the scope of the law, the tax authority does not itself differ from fraudsters. It is surprising that “the means justify the end“ mentality is still an acceptable practice for the Tax and Customs Board. It was not too long ago that the court declared inspections conducted without initiation of taxation procedure to be unlawful. In a similar situation under private law – conduct of an undertaking violates the law – compulsory dissolution would be considered.
2. DEADLINE FOR SALES TAX REFUND IS FAST APPROACHING
The sales tax, which was unexpectedly imposed in 2010 on all undertakings in Tallinn active in the retail sector, expired over a year ago. It is possible that for many the matter ended at that. At the same time several companies are still awaiting a final decision in proceedings regarding sales tax pending in court. The reason is that after a positive final decision by the court undertakings would feel increasingly confident to apply for a sales tax refund themselves.
Alas, the deadline for sales tax refund is fast approaching and will be be due before the final decision of the court. This is because the Tallinn Circuit Court is about to file the landmark case of Statoil, with a positive outcome as regards the taxpayer, with the Court of Justice of the European Union in order to obtain a preliminary ruling in the matter. The optimistic scenario sees the passing of a final judgement concerning sales tax by the beginning of 2015. By then it will be too late to apply for a refund of sales tax as that right will have expired in its entirety. We remind you that the first period expires on 22 July 2013.
Therefore, applications for a refund should be filed by that deadline.
It is likely that upon initiation of court proceedings, the court will postpone the proceedings until a preliminary ruling by the Court of Justice of the European Union is available. This has been the procedure in several similar cases. The practice can be seen as positive for different reasons. First, by aiding establishment of uniform case law and secondly, diminishing legal fees for new applicants – no running expenses are incurred by the applicant during suspension of court proceedings.
An additional argument for swift action, receiving undeservingly little attention, is the possibility to earn interest. It is perfectly understandable that late compliance with tax liabilities makes the taxpayer liable to pay interest. Therefore the reverse mechanism is also justified – the city is liable to pay interest as a result of unlawful collection of sales tax. This regulation is laid down by law. As is widely known, interest paid by the tax administrator is comparatively high, reaching almost 22% a year.
It is important to know that interest starts to accrue after 30 days as of filing an application for a tax refund. So it is clear that the earlier the application is filed, the higher the accrued interest.
If sales tax has been declared and paid, the tax returns need to be amended. Depending on the scope of the refund applied – the entire sales tax paid as opposed to sales tax paid on excise goods – collection of data needed for reassessing tax returns may require considerable time. Therefore, reassessment should not be done at the last minute.
Simultaneously with re-assessment of tax returns an application for refund of sales tax paid should be filed. Thereafter the city has 30 days to decide whether to satisfy the claim. Negative decisions may be disputed before an administrative court within 30 days as of receiving a decision. The maximum state fee for the proceedings is 750 Euros. After accepting notice of appeal the court is likely to postpone the proceedings until a preliminary ruling by the Court of Justice of the European Union.
We hope that in a state governed by rule of law taxpayers dare to stand up for their rights. Tallinn city government awaits expiration of taxpayer claims. As it has become clear that further delay is unfounded, applications for refund of sales tax should be filed immediately.
3. SHOULD TAX LIABILITY BE PAID BY MANAGEMENT BOARD MEMBERS?
Recent case law favours the actions of the Tax and Customs Board where payment of tax liability is required from a management board member. This legal basis has existed for some time. In the light of the new decision it is worth considering whether sufficient precautions have been taken to avoid liability for third party debts.
A recent ruling of the Supreme Court concerns liability of management board members. In order to become liable, a management board member must firstly fail to fulfil their obligations through deliberate action or by gross negligence. Secondly, the failed obligation must arise under tax law. Thirdly, the tax liability must be a result of breach of obligations by the management board member. In other words a causal interaction must be established between creation of tax liability and breach of obligations. To avoid creation of sudden tax liabilities, management board members must ensure fulfilment of their obligations with all due diligence.
The case is important as the Supreme Court “pardoned” several Tax and Customs Board shortcomings. The inconsistency of the tax administrator in defining the nature of violations did not give grounds for annulling the decision – in some situations the administrator merely expressed concern over negligent behaviour yet at the same time it was established that the violations had been intentional.
Often a claim against a management board member is preceded by a claim against the undertaking. In practice it is not uncommon that a tax claim alleges violation of the obligation to exercise due diligence but further liability claims allege intentional violation of obligations by a management board member. The court ruled that breach of the obligation to exercise due diligence cannot be the basis for intentional violation of tax law. The court further explained that the Tax and Customs Board is entitled to draw different conclusions in different cases as regards the nature of violations.
Moreover, the court clarified that tax claims need not be separately challenged before challenging the liability claim. Objections concerning the contents of a tax claim may be presented upon challenging a liability claim. For the purposes of clarity it should be noted that a tax claim cannot be annulled merely by challenging a liability claim.
The position concerning division of the burden of proof arising from a claim should be viewed with caution. In the context of fiscal procedure the investigative obligation is laid upon the Tax and Customs Board. Therefore, the Tax and Customs Board must identify the circumstances increasing and also decreasing tax liability. However, the court ruled that failure by the Tax and Customs Board to identify a number of relevant circumstances cannot be considered a decisive factor. The Supreme Court upheld the claim and ruled that the appellant had failed to prove that the tax administrator’s assessment was incorrect. Therefore, a considerable burden of proof is laid on the taxpayer.
Even though the Supreme Court issued several negative conclusions from the standpoint of the taxpayer, broad generalisations cannot be drawn in the light of this decision. According to the courts, violations by the taxpayer were substantial and presumably these violations could amount to fraud. Therefore, management board members must exercise due diligence in carrying out their obligations.
In order to avoid creation of personal liability, it is vital to ensure correct accounting for taxation purposes and to avoid suspicious invoicing.
4. CAUTION! PERMANENT ADDRESS OF MANAGEMENT BOARD MEMBER IN FINLAND MAY GIVE GROUNDS FOR PERMANENT ESTABLISHMENT IN FINLAND
Finland is entitled to tax the business income of Estonian undertakings only if an Estonian undertaking maintains a permanent establishment in Finland. The Finnish tax authority has become increasingly active as regards identifying permanent establishments. In comparison with previous practice, the new practice is increasingly aggressive and testing the borders of legality.
A good example of this forceful practice is identifying a permanent establishment merely because a management board member has a Finnish address. As the Finnish Supreme Administrative Court ruled two decades ago, a place of residence and home office located at the same address may constitute a permanent establishment of a foreign undertaking managed from that address. The Finnish tax authority has used that ruling as the basis for its practice by which a permanent establishment is identified when a management board member of an Estonian undertaking merely notifies the Finnish tax authority or any other Finnish register of their Finnish address. The reasons for presenting a Finnish address may be manifold: amongst other things, a Finnish address is a prerequisite for obtaining a tax number without which even access to building sites in Finland is virtually impossible.
Having a contact address in Finland does not necessarily mean the management board member is residing in Finland. Even if a management board member does reside in Finland, in the majority of cases management of the company is not conducted from that place of residence. In making claims the Finnish tax authority has not looked into activities actually taking place at declared addresses nor has the authority identified actual places of residence of management board members. The existence of a Finnish address has been sufficient to identify a permanent establishment. In assessing the amount of tax the data on generated turnover included in the annual accounts have been taken into account. In making claims no further information has been requested from the taxpayer, nor has the taxpayer been involved in the decision making process. On some occasions the claim has not been communicated and an undertaking becomes aware of the proceedings only when the Estonian tax authority has, at the request of its Finnish colleagues, arrested the bank accounts of the undertaking for collection of tax assessed.
Some claims under the new practice have already been successfully challenged and annulled, but the frustration, expenses and loss incurred via recovery of nonexistent debt are not compensated. Undertakings should exercise caution upon submitting information regarding addresses to the Finnish authorities, for whatever reason, as well as make sure that sufficient proof exists and is available as regards the actual place of residence of members of the management board.
5. POSSIBLY THE FIRST DECISION ON NON-MARKET INTEREST RATE
Recently the Circuit Court gave an award shedding light on the issue of interest on intra-group loans. Bearing in mind the lack of sufficient case law in this field, the decision is of great importance.
In this case a prepayment made by a subsidiary to the parent undertaking was transformed into a loan in 2004. Annual interest on the loan was set at 3.5 %. The loan was granted without security and for a period of 10 years. Based on statistics of credit institutions made by the Bank of Estonia, the tax administrator ruled that the market yield in the given sector was 4.7% so that the taxpayer had to pay additional income tax of 2500 Euros for 2004. At the same time the interest on loans granted by banks and paid by the taxpayer was 4.64% to 6.25%. The average interest on deposit for 2004 was 2.19%. The court ruled that those deposit rates were not appropriate and the tax administrator was right to rely on statistics provided by the Bank of Estonia. The court also found that there is no valid proof about the difference between interest rate levels of the Estonian kroon and the Euro.
The tax administrator is expected to be encouraged by the decision and proceed with reviewing interest rates between related persons. As the assessed tax was only 2500 Euros and the main focus of the case was on other tax issues, not all aspects of transfer pricing were addressed or weighed. Thus, even if in the future a tax is assessed based on statistics made by the Bank of Estonia, the decision of the Circuit Court should not be regarded as undisputable. In this regard it is important to note that as of 1 January 2014 the rule in subparagraph 29 (7) of the Income Tax Act under which income tax is charged on interest if it significantly exceeds the amount of interest payable on a similar debt obligation under market conditions will become void. In the future “taxation of interest” will be settled by transfer pricing and the current rule will only apply to interest paid by real estate funds.
6. PROVISION OF MANAGEMENT SERVICES BY COMPANIES OWNED BY MANAGEMENT BOARD MEMBER
Recently, the Circuit Court gave an award in relation to a tax assessment by which the tax administrator imposed tax on an company (the principal) for a purchase of services from companies owned by a member of the management board (the agents). The tax administrator alleged that contracts concluded with the agents are ostensible and were concluded to conceal employment contracts previously in force, the members of the management board were subordinates of the majority shareholder, the majority of the agents had not paid remuneration to members of their management boards and all contracts concluded with the agents were identical. As the agents also provided services to other companies, the tax administrator ruled that payroll tax cannot be imposed on dividends paid to members of the management board, i.e. reclassification of dividends was ruled out by provision of services to other companies. The court did not address all aspects of the matter and did not issue guidance in all questions as it found that, in addition to the principal, the agents and members of the management board should have been included in the tax audit, and as a result, annulled the tax assessment. A small victory for taxpayers, but the tax office wished to reinstate the tax audit.
7. SALE OF REAL ESTATE AND APPLICABLE VAT
The new VAT rules on the sale of property have been in force for over a year. However, these have yet to gain wide acknowledgement and mistakes are often made when applying the rules. The obligation to pay VAT should not be overlooked when buying or selling real estate. Moreover, all notifications should be timely submitted: mistakes may be costly. For these reasons we will point to some of the main aspects of the new rules.
In April 2012 amendments to the Value Added Tax Act came into force establishing a reverse charge mechanism on taxation of real estate for which inclusion of VAT is voluntary. VAT inclusion is voluntary when an immovable corresponds to the following three criteria:
- it does not constitute a dwelling,
- it does not constitute an empty plot in sense of the Planning Act and
- it is being sold after first occupation or re-occupation.
Generally, adding VAT is voluntary in case of industrial real estate.
When including voluntary VAT a reverse charge mechanism is applied where:
- the seller does not include VAT transferrable to the state in the purchase price but
- VAT is declared and immediately deducted as input VAT by the buyer.
VAT inclusion is necessary and reasonable in situations where costs have been incurred or investments have been made by the seller over the past decade as regards the immovable in respect of which the seller applies for a refund of VAT from the state. If VAT is not included in the purchase price on sale of an immovable, the seller will have to adjust the input VAT deducted during this period. Previously deducted input VAT which may not be deducted as a result of the adjustment will have to be refunded to the state.
When implementing the new rules, note that voluntary VAT inclusion requires prior written notification to the Tax Authority. The Tax Authority has not specified a separate format or set procedures for submitting notifications. Notification in a freely chosen format has to be sent to the Tax Authority by mail. In practice, the Tax Authority has accepted digitally signed and e-mailed notifications.
Often the seller is not aware of the obligation to notify and the issue only arises upon preparation of a VAT declaration. Typically real estate transactions are preceded by intense rounds of negotiations in the midst of which notifications may simply be overlooked. Therefore, it is not uncommon that notifications are submitted late.
The law does not indicate consequences for delays. In the worst case scenario the Tax Authority may assume that the prescribed conditions for VAT inclusion were not fulfilled and require adjustment of input VAT.