TALKING TAX: Optimization schemes in Estonia are justified

  • 2007-10-03
  • by Konstantin Kotivnenko [Sorainen Law Offices]
The Supreme Court of Estonia recently refused to review two decisions of the Tallinn Appeals Court regarding cases that involved capital-gains on a sale of securities after an individual transferred his securities to a legal entity as a non-monetary contribution and then sold out, pocketing the profit and avoiding taxes.

Currently, resident natural investors 's i.e., individuals 's are subject to income tax of 22 percent on capital gains realized from a sale of securities. The law provides for tax credit in cases where a resident individual is subject to income tax abroad. The same taxation rules are applicable in cases of taxation of the proceeds from a liquidation, payments related to redemption of shares and reduction of share capital.

The situation with resident legal entities, on the other hand, is tax-neutral. Estonian resident legal entities are not subject to income tax on capital gains realized from the sale of securities or other income as outlined above.

However, in order to optimize their tax burden, resident individuals transfer the securities to Estonia-controlled legal entities and later dispose of the securities in the name of the Estonian resident legal entities. As a result, the income tax is not lost and can be used for further investment purposes.

The Estonian Tax and Customs Board has aggressively attacked such tax optimization schemes, particularly in one Hansapank deal, and warned resident individuals that any transfer of shares as a non-monetary contribution to a controlled legal entity, and the later realized capital gains on the level of an Estonian resident legal entity, will be taxed on the level of a personal investment.

The decision of the Tallinn Appellate Court, though not accepted into the proceedings of the Supreme Court of Estonia, indicated that not every transfer of shares as a non-monetary contribution will be subject to reclassification under substance-over-form rules.
In order to survive the tax scrutiny, a transfer of shares as a non-monetary contribution to a legal entity must have an economic reasoning and cannot simply serve tax-evasion purposes. In particular, any such transfer must not have effect of a sole transfer of securities without further economic activities.
As a consequence, resident natural investors must be prepared to submit to the Estonian Tax and Customs Board proof regarding the economic activities of a legal entity (including agreements, communication with partners, business plans, etc.). If the proceeds from a sale of securities will be used further for generating profit, then the transfer of shares as a non-monetary contribution will be justified and avoid tax liability at the personal level of resident natural investor.

Konstantin Kotivnenko is a senior associate at Sorainen in Tallinn