TALKING TAX: How thin is capitalization in the Baltics?

  • 2006-09-07
  • By Tomas Davidonis
In financing subsidiaries, corporations face a dilemma: debt finance or equity finance. In general, company laws in the Baltic states do not require that companies receive significant capital contributions. From a business perspective, debt financing might have more advantages compared to equity financing.

As a rule, the return of debt could be ensured in an easier and faster way than equity contributions. Furthermore, debt financing might be more beneficial in terms of taxation. For instance, interest normally is deductible in determining the corporate income tax due by the borrowing company, which is not the case in dividend distribution.

Governments usually criticize companies for being meagerly capitalized and have established a set of measures to prevent this 's or the so- called "thin capitalization regulations."

It is not surprising that intercompany debt financing is a relevant issue for the Baltics, and over the years the governments of Lithuania, Latvia and Estonia have introduced respective restrictions for thin capitalization. However, the manner of those instruments and their application may differ depending on the country.

Lithuania and Latvia's thin capitalization rules are rather similar, and in brief they can be characterized as follows:

If a company's debt capital exceeds its equity four times (which might be adjusted by certain reserves), interest representing the excess is disallowed for deduction. Interest-free loans are not included into debt capital.

From the point of view of the recipient of the interest, interest is taxable under general rules, i.e., it is not qualified as deemed dividend.

On the other hand, the rules are not identical and contain a number of rather significant differences. One could say that Lithuania's thin capitalisation rules are of broader application.

Both Lithuania and Latvia have other restrictions that may apply on loans granted to resident companies. For instance, Latvia applies a general rule against excessive interest deductions. Under that rule, interest that exceeds an amount equal to the weighted-average debt capital multiplied by 1.2 times the average commercial short-term credit interest rate is not deductible.
Estonia does not have the "classical" thin capitalization legislation.

Payment of excessive interest will be, however, subject to withholding tax if paid to non-residents or treated as an expense not related to business activities if paid to resident tax payers.
Consequently, the thin capitalization regulation is one of the key elements investors operating in or entering Baltic markets need to familiarize themselves with. Furthermore, investors should be aware of specifics in thin capitalization regulations of each country before making debt financing arrangements.

Tomas Davidonis is a senior associate at Sorainen Law Offices in Vilnius