The intensifying initiatives in global tax reforms like the Base Erosion and Profit Shifting (BEPS) initiative created by the Organization for Economic Cooperation and Development (OECD), along with many localized tax reform efforts, create a negative impact for multinational businesses. In addition, it is more popular that the countries implement Controlled Foreign Company (CFC) rules as well as General Anti Avoidance Rules (GAARs) in the tax legislation.
The above concerns not only large corporations but also medium and small-sized companies, including most companies owned and managed by Estonian e-residents, which in effect are under the scrutiny of the local and foreign tax authorities, making it harder than ever for them to manage their international tax operations.
Evidently, the environment is becoming more challenging, and the need to adopt a proper structure with adequate resources for companies becomes more in demand than ever before. Thus the importance of Economic Substance (or “substance”) has considerably increased in recent times.
Consequences of having no Economic Substance
If by any of the above-mentioned regulations, a foreign structure is found to lack substance, it could face a considerably higher tax burden as well as investigations by the tax authorities.
Contrariwise, the expression “Substance” does not normally appear in the actual text of Double Tax Treaties or any of the local legislation; thus, the concept of substance in a particular location can be open for interpretation – however, at the same time, the reason the foreign companies cannot afford to miscalculate.
Consequently, there are practical standards that can be followed to achieve the same.
Economic substance defined in Estonia
The typical definition of an entity having economic substance is that a transaction or entity located in a low tax jurisdiction must have an economic purpose and relevant infrastructure besides being created ‘artificially’ and only for the purpose of reducing tax liability.
Various steps can be taken to achieve this. This could be accomplished, for example, by ensuring that all entities (including holding companies) have a real physical presence in Estonia, with independent local offices and staff administering the day-to-day management of the company.
Further to the definition of substance (especially economic substance), the matter is open to interpretation and also largely lies in the interpretation of the authorities of the respective country.
We have prepared the description of the main factors that can be examined in search of substance.
The authorities normally will seek to find out whether the foreign entity located in low-tax jurisdiction has:
- It’s own (rented or owned) office space/premises / physical address;
- Qualified and knowledgeable directors and managers who are located and employed in Estonia;
- Other employee/s with relevant experience residing in Estonia;
- Employer status of the company and registration with the Estonian tax and customs board for Social Insurance where directors and/or other staff are employed (not only nominated);
- Its accounting records maintained in Estonia and the accounting work performed by local accountants;
- Operative local bank accounts, with local resident signatories/counter-signatories;
- Relevant assets located in Estonia (i.e., staff, equipment, and all other necessities which are normally required for doing business);
- The substantial involvement of local staff in the operations of the entity;
- An independent local email address and/or website;
- An independent telephone line.
With the above noted, it is increasingly important to make sure that the substance of an Estonian company is sufficient for foreign purposes. Another country is free to impose its own substance rules (e.g., as a result of local CFC rules). In such a case, the obligation will lie on the Estonia company (including its foreign beneficiaries) to demonstrate to the foreign authorities that the company is performing real business from Estonia.
Maintaining a Physical Office and Sufficient Economic Substance in Estonia
A concern often raised for maintaining a physical office is usually that costs for setting up an Estonian company will increase significantly. However, it is to be also noted that these costs can be minimized in various ways and that the substance will secure the clients from the additional tax burden.
At IBCCS, we are happy to assist our clients in achieving the appropriate “Substance” level required for their specific purposes and goals, ensuring that the costs incurred for the same will be maintained at competitive rates at the highest level of quality.
We can assist with setting up the relevant infrastructure, providing relevant elements for the purpose of the substance, as well as restructuring the company from the legal & tax point of view in order to eliminate the potential tax liability of our clients.
For your tailored-made “Substance” solutions, please contact Taavi Tammoja t.tammoja@ibccs.tax or our Tallinn office at estonia@ibccs.tax by email or call our office in Estonia directly on +372 674 2006.