Taxation in the Baltic States

Peter Feith / Maie Majak-Knöbl*)

Estonia, Latvia, and Lithuania offer favorable tax systems as well as low tax rates for foreign investors. What makes Estonia especially attractive is the zero percent corporate income tax on retained earnings. Special tax rates for small companies offered by Latvia (9 %) and Lithuania (5 %) also attract interest. Nevertheless, public debt in these three countries still remains relatively low.

Estonia, Latvia and Lithuania are three countries in North-Eastern Europe with a total territory of 175 000 km2 and a population of about 7 million. All three liberal market economies experienced a rapid economic boom in early 2000 s, with annual real GDP growth between 7,5 to 12%. The global economic crises at the end of the decade hit the open economies hard, with real GDP declining by 13-17% 2009 and unemployment surging into the double digits. However, the Baltic’s are on a good road to recovery.

In 2011, all three economies were growing rapidly again (Estonia 7,5%, Latvia 5,3% and Lithuania 5,8%).

Particularly strong were economic developments during 2010-2011 in Estonia. Export growth was strong, unemployment decreased to 11% in 2011 and Estonia introduced the euro as of January 1, 2011. Although similarly to the neighboring countries inflation remained high in 2011 (Estonia 5.1%, Latvia 4,2%, Lithuania 4,1%), recently inflation has declined to about the EU average. Estonia, with its lowest government debt level in the European Union (6,7%) and a small budget surplus continues to provide a stable and attractive business environment.

The Lithuanian and Latvian economies have also been recovering, but a bit slower and less consistent then in Estonia. The main problem remains high unemployment (14,8 % in Latvia and 15,3 % in Lithuania in 2011) and the need to reduce the budget deficit (4,2% in Latvia and 6,0% in Lithuania in 2011). Further consolidation is needed to diminish the budget deficit to the required 3% level for a planned euro accession in 2014. This is also needed to halt their rapidly rising public debt at about just over 40% of GDP.

Economic prospects for all Baltic States remain favorable for 2012, with GDP growth above EU average (0%), led by Lithuania (2,3%), followed by Latvia (2,1%) and Estonia (1.2%).

Overview of the taxation systems

Despite some general similarities like flat rates and low tax burdens (particularly in Latvia and Lithuania 28.1% and 29% of GDP respectively in 2011) tax policies diverge somewhat across the Baltic’s.

The Estonian tax system is one of the most liberal and simple systems in the world. Estonia is a European pioneer in income taxation having introduced flat income tax rates

*) Mag. Dr. Peter Feith is Managing Partner, Epsilon Finance Group, a business Consulting firm in Austria and Slovakia. Maie Majak-Knöbl, MBA, is Project Manager at IMG Business Solutions, an Enterprise Group represented in all three Baltic States.

in 1994 and a unique corporate tax system in 2000. Although in response to the economic crises some taxes were raised (VAT, excises, unemployment insurance), raising the overall tax burden (35% of GDP in 2011) closer to EU average, the main rates and principal approach has remained unchanged.

Corporate income tax (CIT)

There is no corporate income tax on reinvested profits. The resident companies and permanent establishments have to pay tax only on dividends and other distributed profits, fringe benefits; gifts, donations and representation expenses; and expenses and payments not related to business.

As there is no need, the corporate entities are not subject to tax depreciation rules. All distributions are subject to income tax at the grossed-up rate of 21/79 of the amount of taxable payment. The transfer of assets of the permanent establishment to its head office or to other companies is also treated like a distribution. As of January 1, 2009 dividends paid to non-residents are no longer subject to withholding tax at the general rate of 21%, irrespective of participation in the share capital of the distributing Estonian company. Only capital gains derived by non-residents from the sale of Estonian real estate or shares and liquidation proceeds of real estate companies are subject to a 21% tax. No traditional thin capitalization rules apply i.e. substantial debt financing at market interest rate is tax neutral.

Personal Income Tax

Residents pay tax on their worldwide income. Taxable income includes, in particular, income from employment (salaries, wages, bonuses and other remuneration); business income; interest, royalties, rental income; capital gains; pensions and scholarships and alimony payments received. Taxable income does not include dividends paid by Estonian or foreign companies when the underlying profits have already been taxed.

Non-residents pay income tax on their income from Estonian sources. Income taxable in Estonia includes income from employment or government services provided in Estonia; income from business carried out in Estonia; part of interest received from Estonian sources that is above market rates; royalties arising in Estonia; certain types of capital gains; gains from disposal of assets located in Estonia; directors' fees paid by Estonian enterprises; and income of a sportsman or an artist from his activities in Estonia, pensions, insurance payments.

The tax rate is 21 % of taxable income. The withholding tax rate on royalties, payments to non-residents for services provided in Estonia, and on payments to non-resident artist and sportsmen is 10 %. Estonia has double taxation avoidance treaties with 48 countries.

Social tax

Employers pay social tax on payments in cash and in kind made to natural persons. Sole proprietors pay tax on their business income. The social tax rate is 33 % on cross salary. Employers pay an unemployment contribution of 1,4% and employees 2,8 % on cross salary.

Value added Tax (VAT)

VAT is levied on transactions with goods and services in Estonia and on the import of goods. The standard tax rate is 20 % of the taxable value; the reduced rate is 9% (books, newspapers, medicines, accommodations) and 0% in some cases (exports, intra-community supplies, vessels and aircrafts used on international routes). The VAT registration threshold is 16 000 EUR a year.

Other taxes

Other taxes include excise duties, gambling tax, land tax (0,1-2,5% of taxable value excluding buildings), customs tariffs, and heavy vehicle duty. Some insignificant local taxes like boat tax, advertisement tax, motor vehicle tax, animal tax also apply.

The Latvian tax system is not the simpliest one, however it cannot be discribed as very complicated as compared to old EU member states. Latvia has the lowest effective tax rate in the EU. The tax system in Latvia is still changing. In responce to the economic crises there have been several tax increases in recent years ( VAT, excises, social tax contributions, property tax), but also some decreases (personal income tax, microenterprice tax).

There are special economic zones in Latvia (Rezekne and Liepaja) and Free Ports (Riga and Ventspils) with tax privilages – tax rebates in special zones can be obtained 80-100%, on property tax, corporate income tax and VAT.

Corporate income tax

Resident companies are subject to 15% income tax. As of 2011, a reduced rate of 9% applies to micro-enterprices (annual income below 70,000 LVL ~ approximately 100 000 EUR, up to 5 employees and shareholders are indivduals).

Accelarated depreciation (10-70%) of fixed assets using declining balance method is used. No carry back, carry forward of losses is limited to 8 years; transfer of losses within the group is possible.

Thin capitalization rules: debt equity ratio 1:4 or 1,2 times short -term interest rate as provided by the Statistics Department; the “less favorable” of the two criteria applies.

Dividents are subject to income tax of 10%, interest payments are subject to 10% tax if payed to related parties (one company holds 25% of capital or voting rights in another comapny), 10% withholding tax also applies to managemnt and consulting fees, 5-15% to royalties and 15% on the payments to ‘off shore ‘jurisdictions ), 0 % for all payments to Lithuania. With certain exceptions, the taxation of a nonresident company’s permanent establishment in Latvia is similar to the taxation of resident companies.

Currently non-resident companies being residents in EU and EEA states are not subject to withholding tax on dividends, while in general dividends paid to non-residents are subject to 10% withholding tax. Interest payments to non-resident companies are subject to 10% withholding tax if the payer and the recipient are related parties, (5% for EU and EAA entities).

As of 2013 most of the withholding taxes will be abolished, except on the transfers to“off-shores”.

Personal Income Tax

Latvian residents are subject to taxation on their worldwide income. General flat rate of the income tax is 25%, and also includes self-employed. 10% tax rate applies to dividends, interest and rental income and insurance payments. Income from capital gains is taxed at 15%. The standard personal income tax also applies to non-residents. Taxation of non-resident individuals is limited to their activities in Latvia. The income taxed in Latvia includes, among others, dividends paid by resident corporations, interest payments and income from the disposal of capital assets. By way of exception, income of non-residents from the disposal of financial instruments is not subject to personal income tax in Latvia.

Latvia has double taxation avoidance treaties with 50 countries.

Social tax

In Latvia both employers and employees pay social security contributions. As of 2011, the employee contribution rate is 11%, while the employer’s part is 24,09%.

Value Added Tax (VAT)

A standard rate of VAT was increased to 22%, a reduced rate to 12% in 2011.

Starting from 2011, the list of goods and service for which reduced rates apply has been shortened. Currently it includes medications, veterinary medications, special equipment for children, energy supplied to private individuals and communication services. Some services (educational, medical, cultural) are taxed with 0%, as are exports. The VAT registration threshold has been increased to 35 000 LVL (approximately 49 800 EUR) in 2011.

Other taxes

Other taxes include excise duties, gambling tax, property tax (0,2 -1,5 % of cadastral value of land and buildings), natural resources tax (on use of natural recourses, pollution, a credit institutions fee, vehicle operating tax and company car tax.

The Lithuanian tax system underwent several changes in the last few years.

In 2009, a tax reform was introduced, aimed at collecting more revenue. The rates of major taxes- VAT, CIT, and social tax were raised. However, the heavier tax burden had negative effect, especially on small and medium sized businesses, several amendments into the laws were made in 2010-11 to pursue more business friendly policies.

Similarly to Latvia there are two special economic zones (Klaipeda and Kaunas) with tax privileges - companies investing 1 million euro into these zones are exempt from CIT for 6 years and have 50% reduction of CIT in next 10 years.

Corporate income tax (CIT)

The profit of Lithuanian companies is subject to an income tax of 15%. A reduced rate of 5% applies to small businesses (annual income below 1 million LTL ~ approximately 290 000 EUR and up to 10 employees).

Fixed assets are depreciated using straight-line method, for certain groups the double-declining method may also be used. No carry back, unlimited carry forward of losses (in case of losses from the transfer of securities and derivative financial instruments 5 years), intra-group transfer of losses is permitted.

Thin capitalization rules: debt to equity ratio 1:4 applies; interest-free loans are not included in controlled debt.

Generally, dividends received by a resident company are subject to corporate income tax at a rate of 15%. A participation exemption applies to dividends paid to a parent company holding more than 10% of the voting shares in the distributing company continuously for at least 12 months, provided the distributing company is not established or otherwise organized in a tax haven country. Interest payments and royalties are taxed with 10% rate. Capital gains, also from sale and lease of real estate, income from performing and sports activities and management fees, all are taxed at a 15 % rate. All payments to Latvia are not taxed.

There are a few differences in taxation of non-resident companies as compared to resident companies. A participation exemption in taxing dividends applies here as well; non-residents from EU and EEA countries pay no tax on interest and royalties.

Personal Income Tax

Residents are subject to personal income tax on their worldwide income. The general flat rate is 15%. A reduced, 5% rate applies to certain activities carried out by self-employed.

Noticeably, dividends received are in Lithuania taxed with a higher 20% rate. Interest income is taxed with a 15% rate. Capital gains are tax-exempt if derived from the sale of shares acquired before 1999, otherwise taxed as ordinary income (15%). Non-residents pay income tax on their income sourced in Lithuania. Basically same rates apply as to residents unless reduced under double taxation treaties. Similarly to Latvia, the sale of shares by non-resident is not taxed in Lithuania.

Lithuania has tax treaties with 48 countries.

Social Tax

In Lithuania, similarly to Latvia both the employers and the employees pay social security contributions. The employers pay 31% social tax, while social insurance contributions for employees is 9%.

Value added Tax (VAT)

Standard rate is 21%, a reduced rate of 9% applies to heating energy, books and non-periodical press, and a reduced 5% rate applies to medicines and medical products. The VAT registration threshold is 155 000 LTL (approximately 45 000 EUR).

Other taxes

Other taxes include excise duties, property (0,3 -1%) and land tax (1,5 % of cadastral value), natural resources tax, inheritance and gift tax, lottery and gaming tax.

Conclusion

As can be concluded from above, the Baltic countries have rather simple, flat rate tax systems. The other most significant similarity of the three is the investor friendliness.

Considerable effort is put into the introducing incentives for foreign investors, in Latvia and Lithuania also for small entrepreneurs.

Although in response to the economic crises some taxes were raised, in Latvia and Lithuania in particular, all three remain low tax countries with the tax burden well below EU average.

Appendix-Taxes at a glance