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Demystifying Basic Elements of Estonian Tax Policy
William H. Cronenberg
Attorney at Law
Estonian tax law is clearly one of the major attractions of having an Estonian company. Estonia has gained a lot of international attention and recognition for its tax and budgetary policies, not all of it positive. I feel that there has been a lot of misinformation and disinformation spread about the Estonian tax system in particular. Even in the elegantly simplified Estonian context, this is a potentially very complex subject. If you are in the position to consider creating an Estonian company, then it would be helpful to have a solid grasp of the fundamentals. Here I try to provide some context and perspective by analyzing two key and often cited features of the Estonian tax system that distinguish it from most others around the world: the flat income tax and the 0% corporate income tax rate.
I will now promptly contradict myself in the very next breath, and assert that Estonia actually has neither a flat income tax system nor a 0% corporate income tax rate. In the case of income tax yes, there is indeed only one taxable rate for income, currently 21%. In itself hardly remarkable, neither the lowest in the world nor even in the European Union for that matter. So what´s the fuss about that? Read on.
The reason I challenge the often used label „flat tax“ is that all Estonian income tax payers are entitled to a certain amount of income free of tax before that rate kicks in. Only income above that is taxed at the uniform rate of 21%. The justification for this is the same as for the classic graduated income tax rates in most industrialized countries: to provide tax relief to individuals at the lower end of the income scale. Ergo, Estonia actually has two income tax rates, 0% and 21%. Greatly simplified compared to many other systems around the world, but hardly the „pure“ flat tax formula some mistakenly assume. When the political discourse turns to using income tax policy to address imbalances in income distribution, at least up until now, the main public policy lever has been adjusting (i.e., upwardly revising) the amount earners can receive free of income tax.
As to the 0% corporate income tax, it should be more correctly stated that in Estonia there is no tax on retained profits and earnings at the corporate level in an Estonian company. Profits distributed to Estonian natural persons from an Estonian company pass to them as their personal income, and above their tax free exemption will be taxed at 21%. When foreign persons receive profit distributions from an Estonian company, we need to apply relevant international treaties and other rules to determine the tax outcome. The result may often be very tax efficient, but that is hardly guaranteed and is less the result of Estonian tax law than the operation of the applicable international legal framework.
One might well be wondering at this point that based on what I just explained, is there anything special or advantageous from a tax perspective about using an Estonian company? I would suggest to you that the answer is certainly yes. The Estonian approach to taxation is based on a quite different and in my experience unique philosophy compared to the rest of the world. This has important practical implications, and has not been without its share of controversy. I mentioned in my introduction that not all of the international attention given to the Estonian tax system has been positive. When Estonia was in the final stages of accession negotiations with the European Union, Estonia received fierce criticism from certain quarters for its unorthodox approach to corporate taxation. For a time it appeared as if Estonia would be forced to scrap its approach either in part or entirely. Fortunately, a solution was negotiated and as a result, the owners of an Estonian company can still elect to retain profits and earnings indefinitely without triggering Estonian income taxes. Now in some cases foreign tax authorities with jurisdiction over foreign owners might take a conflicting view, but that is quite another story. I plan to address the Estonian philosophical approach to taxation and some of the special considerations for foreign owners of Estonian companies soon in upcoming posts.