New treaty exposed to retroactive effect
Two Baltic countries were happy to recently embrace a new treaty that was the result of lengthy negotiations and include some relevant changes for businesses. Since this column does not allow for an extensive revision of those changes, I decided to lift one of the features and bring in into the spotlights. Why this feature? Probably cause it sits at the crossroads of the tax sovereignty of countries, European law and reaches back to one of the most disputed principles in tax law.
There was a tax treaty in place between Estonia and Lithuania since 1993, and a new treaty was signed last October in Luxembourg. The result was that the old treaty ceased to be effective Jan. 1, 2006, and the new one entered into force Feb. 8. The new treaty includes as usual a number of articles that deal with the cross-border treatment of interests and royalties. The new articles can be considered less beneficial that the similar articles under the 1993 treaty when considered at the level of withholding taxes and the conditions required.
On a different track, Estonia has implemented the EU interest and royalties directive which includes provisions in order to avoid under certain conditions, the withholding of a source tax on interest and royalties paid between associated companies resident in the EU. The consequence of this interaction between Estonian domestic law (which implemented the EU directive) and the new tax treaty, Estonia is unable to withhold a source tax on interest and royalties in a relevant number of cases. Alternatively, Lithuania may tax interest and royalties paid to Estonian companies during a transitional period that ends on July 1, 2011 as an exception to the main principles of the Directive. Clearly a non-parallel applications of the same treaty.
The overruling by European law also has effect on the treatment of cross-border dividends. Here also, the treaty foresees a withholding tax. Nevertheless, both countries have implemented the parent-subsidiary directive and can therefore not withhold tax on dividends paid by a subsidiary to its parent company when the parent company holds at least 20 percent of the capital (which gradually will decrease to 10 percent in 2009) of the subsidiary paying the dividends.
Last year Estonia changed its domestic tax law to exempt dividends received by Estonian resident companies under circumstances (previously a credit system was used). The new treaty between Estonia and Lithuania is the first Estonian treaty to use the exemption method to eliminate double taxation. However, the credit method is still used to avoid double taxation on passive income which could potentially include dividends paid from portfolio investments, dividends paid to individuals, and interest and royalty payments.
