What the case concerned
The judgment was delivered in connection with a complaint lodged by the taxpayer against an individual tax ruling issued by the Director of the National Tax Information Service. The taxpayer requested an individual interpretation as to whether the rent he would receive from the company, in which he is the sole shareholder and a member of the management board, for the lease of property used by that company in its business activities constitutes hidden profit within the meaning of Article 28m(1)(2) of the CIT Act (and, consequently, whether the company will be obliged to pay a flat-rate CIT in connection with the rent payments).
In the application for an interpretation, the taxpayer assured that the rent would be determined on an arm’s length basis, i.e. on terms that would be agreed between unrelated parties, and that the mutual links would not affect the terms of the lease agreement to be concluded.
Position of the National Tax Information Service
In the interpretation issued, the Director of the National Tax Information Service did not share the applicant’s position and held that the rent paid in the circumstances described above constitutes hidden profit within the meaning of Article 28m(1)(2) of the CIT Act.
As is apparent from the position presented by the authority, the establishment of market terms for the transaction does not in itself mean that there is no activity constituting hidden profits. Thus, in the authority’s view, the nature of this activity must still be assessed, and in particular whether it would result in the rent received by the applicant (a partner in the company) not being subject to Estonian CIT. In the case in question, the authority stated that if the applicant had ensured the company was equipped with the necessary assets, he would not have received rent for leasing those assets. The authority therefore concluded in this case that the rent paid by the company to the applicant constitutes hidden profits. Although it should be noted in passing that, on the basis of such a factual scenario, the authority decided to issue an interpretation at all, as we are aware of cases where, in similar circumstances, the authority simply refused to issue an interpretation, considering that the transaction was aimed at tax avoidance.
The Administrative Court did not share the authority’s position
The Provincial Administrative Court in Łódź presented a position entirely different from that of the authority. In the Court’s view, the authority had, for the most part, focused on the artificial nature of the lease transaction described in the application, overlooking other significant aspects highlighted by the applicant, namely the market-based nature of the rent, the mitigation of operational risk, and the possibility for the company to manage other properties in the future. In the Court’s view, therefore, in the circumstances of the case, there are no grounds for treating the rent paid by the company as hidden profits. All the more so as Article 28m(3) of the CIT Act, which contains a general list of activities that ‘in particular’ meet the definition of hidden profits, does not refer to activities related to leasing or similar activities.
Estonian CIT regulations require clarification
This ruling is not yet final. However, the dispute in question highlights the need to clarify the provisions on Estonian CIT, not only with regard to the list of activities constituting hidden profits. Unfortunately, at present, every transaction between a company and a shareholder requires a thorough analysis to determine whether it qualifies as hidden profits. At the same time, the matter is not resolved by the tax clarifications issued by the Ministry of Finance, which frequently use concepts not derived from current legislation and which sometimes serve as a kind of ‘loophole’ for the tax authorities, as, for example, in this case through the resulting concept of ‘a shareholder equipping the company with assets necessary for its business activities’. Changes in this regard are therefore necessary, as otherwise not only the concept of hidden profits but also other ambiguous concepts contained in the Estonian CIT regulations will remain a source of long-standing disputes between taxpayers and the tax authorities.
Frequently asked questions
Is rent paid by a company to a shareholder always treated as hidden profit?
No, the administrative court indicated that rent paid does not have to be recognized as hidden profit if it meets certain conditions. Key is establishing market conditions for the transaction and the lack of artificial nature of the contract. In such a situation, there are no grounds for subjecting this benefit to flat-rate CIT.
On what basis did the tax authority consider rent as hidden profit?
The tax authority argued that the shareholder provides the company with assets necessary for conducting business, which in their view excludes the right to receive rent. They determined that such a transaction aims to avoid taxation, despite the fact that rental conditions were market-based. However, the court found that such an approach is too one-sided and ignores other legal aspects.
Does establishing market rent rates protect against classification as hidden profit?
Yes, establishing prices on market principles is an important argument against recognizing the benefit as hidden profit. The court emphasized that the mere market nature of a transaction does not automatically mean that hidden profits are being distributed. Provisions regarding Estonian CIT are still ambiguous and require caution.
What are the main problems with current provisions regarding Estonian CIT?
The provisions require clarification, which means that every benefit between a company and shareholder requires thorough analysis in terms of hidden profits. Current tax explanations often use concepts that do not exist in the statute, which creates risk of disputes with authorities. This may lead to long-term tax conflicts for entrepreneurs.
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I specialize in Polish tax law, particularly income taxes, as well as international tax law. My experience includes, among others. providing ongoing tax advisory services, preparing legal and tax opinions, drafting requests for individual interpretations, conducting tax reviews. I gained professional experience in Warsaw law firms.
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