The details of the defense tax that will take a bite out of corporate profits appear to be rife with inequality and unfairness, and a closer look reveals situations where taxes must be paid by those who haven’t turned an actual profit.
Grant Thornton Baltic’s Partner, and Head of Tax Kristjan Järve and Sworn Auditor and Partner Martin Luik explained on the Äripäev business daily's radio programme “Kasvukursil” the inequities that will arise with the legislation and described options for reducing tax liabilities.
The defense tax
The draft defense tax act has passed the first reading in the Parliament. The tax would currently consist of three components: 2 per cent on corporate profit starting in 2026, 2 per cent on sales from 1 July 2025, and 2 per cent on personal income from 2026. The tax will be valid till the end of 2028 according to the draft act.
As an example of one problem, Luik noted that it has become customary to recognise investment property using fair value model – i.e. to appraise the property every two or three years. In an inflationary environment, Luik said real estate will generally rise in assessed value. That rise will have a direct influence on profit for the period, which under the new draft act will be taxable. Thus companies may find it worth postponing revaluation or finding an appraiser to assess it at as low a value as possible.
Järve noted that other jurisdictions around the world with a corporate profits taxation system usually do not take gains and losses from revaluations into account.
In addition, said Järve, companies may wish to change their accounting policies and move to the cost model to recognise investment property, especially if the property was acquired earlier and later appraised at a higher value. Another option would be to reduce profit for the period via depreciation, Järve added. “If the real estate ends up ultimately being sold, that will yield actual funds from which the income tax can be paid on the gains”.
Järve said the most significant problem is accounting profit in a situation where there was no actual expense or income. At times, there may not be an available cash flow that can be used to pay the tax expense.
Still, cautions Järve, in the eyes of the law, it would seem shady to switch to a different accounting method right before a change to tax legislation if there is no other motive than tax avoidance.
“Whatever a business as a tax payer does, there has to be some sort of economic substance or goal,” said Järve. If the reasoning is opaque or lacking, the Tax Board is within its rights to intervene according to Järve.
“One would hope that the two per cent won’t change all that much for everyone to look to start applying very aggressive accounting policies to shrink the tax base,” said Luik.
Luik admits that accounting policies do provide for a number of options for manoeuvre room in doing just that. But, he says he hopes that transparency and recognition at fair value will continue to rule the day. “So there wouldn’t be double accounting, one system for the Commercial Register and another for internal use or the bank.”
The new legislation would also lead to confusion regarding loans from owners. If individuals grant a company that they own a loan at zero interest rate, an ostensible profit is created as a result of discounting (calculation to find the market value or present value of the loan), which will increase the company’s tax base.
Let’s take an example where the owner, acting as an individual, grants a company a 10-million-euro loan for 10 years at zero per cent interest at a time when the market interest rate is 5 per cent. As a result, there’s an on-paper profit of 4 million euros, on which the company would have to pay 2 per cent tax, even though that money doesn’t actually exist and will not come in.
Järve said the impact of discounting will be cancelled out by the end of the loan period, yet if the loan is granted at a time when the defense tax comes into force – 2026–2028 – it may inflate the tax burden. “It creates this uneven playing field,” said Järve. Järve said owners should be counselled to grant loans at fair value.
A number of curious situations also arise from whether a company uses the Estonian financial reporting standard (EFS) or international financial reporting standards (IFRS).
The first example indeed involves loans. If an owner acting as a private person grants the company a loan at zero per cent interest, EFS rules require that the loan be discounted right away, said Järve. Under IFRS, it transfers directly to owners’ equity. “There’s a situation, then, were the 2 per cent tax must be paid under Estonian standards, but not under IFRS, since it is not considered profit for that period,” said Järve. In the final reckoning, too, the total tax hit in each case is different.
A conflict also arises in revaluation of non-current assets, said Luik. Under IFRS, revaluations are very common, but they generally aren’t used in EFS.
In local accounting, the general arrangement is that if a company has bought real estate for business activity and is using it, it will generally be depreciated. But say, the Tallinna Kaubamaja Group, which uses the international standard, has developed a 100-million-euro revaluation reserve under equity. That’s an increase in value but is recognised directly in equity not in profit for the period. Furthermore, assets that are written up will depreciate and the depreciation expense increases in subsequent periods. Thus, the group’s net profit for the period and the taxable amount both decrease.
Järve says the biggest problem with the draft legislation is that it lacks legal clarity. “The accounting policies are different, with a different logic and influence.”
Although Järve says there is hope that lawmakers will provide more detailed guidance, he doesn’t recommend that businesses procrastinate – advance payments will start to be calculated already based on 2025 profit. Järve said companies should get together with an accountant or auditor and examine what influence the new system will have on the company’s business model, structure and other aspects.
“In many cases there may not be any good solution or economic justification for significantly reducing the tax base, but at least this will bring awareness and provide an understanding of the influence it will have,” he said.
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