In practice, there are more and more cases when holding companies are challenged by the State Tax Inspectorate (hereinafter – the STI) on the grounds that the legal entity established in a foreign jurisdiction is only a formal, fake, intermediate, artificial entity whose main purpose or one of the purposes is to obtain tax benefits. In order to avoid the attention of the STI and to minimise potential tax risks, it would be advisable to minimise the circumstances on which the STI bases its position in tax disputes.
General comments
Taking into account the practice of STI and the factual circumstances assessed in tax disputes, when considering the possibility of establishing a holding company in Estonia or in another jurisdiction (hereafter referred to as a “holding”) and carrying out certain transactions through the holding, from a tax point of view, we recommend to pay attention to the following essential aspects (the list is not exhaustive):
- Evidence must be available to justify the strong commercial reasons for choosing a particular jurisdiction, and the tax benefits must only be secondary;
- The foreign company must have sufficient human and technical resources in the country of the establishment to carry out the activities in question (appropriately qualified staff, the use of assets necessary to carry out the actual economic activity in the country of establishment, etc.);
- There must be sufficient activity substance;
- Decisions relating to the activities of the foreign company must be taken in the country of establishment;
- The STI pays close attention to the analysis of how the money is “moving”, who is benefiting, what is the time lag between certain transactions/operations, what is the “ratio” between investment and return, etc., i.e. the STI assesses whether the money is being used for the activities of the foreign company, or whether the money is being “diverted” to other people under cover of one or other transactions/operations, etc.;
- It becomes difficult/impossible to defend the position that a foreign company is not an artificial entity in a tax dispute if: there are no valid commercial reasons why a company was needed in a particular jurisdiction; the foreign company does not have a place of business in the country of establishment; it does not have any “local” employees, or it only has them in a formal way (for the purposes of signatures), or the qualifications of these employees are not appropriate/sufficient for the specifics of the company’s activities; the holding company does not have the financial or other capacities to conduct its activities; decisions are taken by persons who are present in Lithuania; the bank accounts are managed from Lithuania, etc.;
- The biggest problem with tax disputes is that the substance of the foreign company is a judgement call, and there is no clear threshold beyond which a business structure is considered artificial, etc.;
- More and more often, one can hear that the STI is starting to strengthen its control over the inclusion of positive income into the Lithuanian tax base, and it is not clear how the various jurisdictions are treated in this respect (the State Tax Inspectorate is saying, to some extent, with “caution/reservation”, that, for example, the Estonian holding’s income might also be considered as positive income).
The most common “scenarios” that the STI initiates:
- The concept “substance over form” is applied, and the foreign jurisdiction is “thrown out” of the group structure/transactions for tax purposes;
- The STI does not recognise that intercompany dividends are tax-free in Lithuania;
- The STI takes the position that the shareholders, individuals in LT, have received a benefit and, therefore, are subject to Personal Income Tax (PIT);
- The STI recognises the permanent establishment in Lithuania and charges corporate income tax;
- The STI takes the position that positive income should be included in the Lithuanian corporate income tax or PIT base;
- Other.
Overview of tax disputes
To illustrate the position of the STI in relation to holdings, an overview of 3 tax disputes regarding the use of Estonian jurisdictions is presented below.
We would like to point out that the overview of the background of the cases is provided only to the extent necessary to understand the following: in which cases disputes arise in relation to the use of holding and what arguments are used by the STI.
Case No. 1
SITUATION
The dispute related to the right of LT company to exempt dividends paid by LT company to its shareholder, Estonian Holding, from a Lithuanian corporate income tax perspective. In this case, the State Tax Inspectorate applied the provisions of Article 69(1) of the Law on Tax Administration (“substance over form”) and challenged the right to apply the “participation exemption rule” (Article 34(2) of the Law on Corporate Income Tax) to dividends paid to Estonian Holding.
STI’s position on Estonian Holding: the shareholder of LT company – Estonian Holding, was not the actual recipient of the dividends but was only an intermediary inserted into the structure of transactions, which would allow using the “participation exemption rule” set out in the article 34(2) of the Law on CIT. From the point of view of the STI, a tax advantage was obtained because the LT company did not apply withholding tax by paying dividends to Estonian Holding. Accordingly, applying Article 69(1) of the Law on Tax Administration, the STI taxed the EUR 9.3 million dividends paid to Estonian Holding at the source with Lithuanian corporate income tax.
REASONING OF THE STATE TAX INSPECTORATE
According to the assessment of the STI, there were grounds to apply the provisions of Article 69(1) of the Law on Tax Administration, as the shareholder of LT company – Estonian Holding – is considered to be an artificial entity. The artificiality is based on the following aspects:
- Estonian Holding was established in April 2012. Shortly after, in November 2012, Estonian holding acquired the shares of LT Co. for EUR 2 million following the receipt of funding from its shareholder, a Dutch company;
- The Dutch company is the management company of a Swiss-registered fund to which 8 natural persons have transferred their shares in LT Co.;
- Estonian Holding acquired the shares in the LT company in November 2012 (EUR 2 million was paid for the shares). Shortly after, in February and June 2013, the LT company distributed dividends in the amount of EUR 9.3 million to Estonian Holding. No withholding tax was applied, claiming that the “participation exemption rule” is met;
- On the same day that the dividend was paid to Estonian Holding, Estonian Holding transferred it to its shareholder, a Dutch company. The dividends were transferred to a bank account in Barbados (the Target Territory) as a loan. The same was done with the funds that the Estonian company acquired following the reduction of the share capital of the LT company. The loan was never repaid;
- The Dutch company transferred the received funds to a Swiss-registered fund;
- The Estonian tax authority stated that it was not possible to contact a representative of Estonian Holding (after sending invitations to all known addresses of the company’s registered office, they were all returned by post);
- According to the Estonian tax authorities’ databases, Estonian Holding has not declared receiving any dividends;
- There were no other significant movements in the bank account on which the dividends were received, indicating that no other activity was carried out;
- Estonian Holding had only one employee;
- Estonian Holding held only shares in LT company;
- The profit and loss accounts of Estonian Holding showed only the results of the financial investment activities related to the LT company, and no other income was generated by Estonian Holding;
- Dividends received by Estonian Holdings were not reinvested.
Case No. 2
SITUATION
65.98% of LT company’s shares were transferred to two Estonian companies. The latter two companies paid for the shares in LT company with the loans that were granted to them by the shareholders, LT natural persons. The Estonian companies received dividends from LT company and immediately transferred the money to the same shareholders, LT natural persons, as repayment of the loans. According to the tax authorities’ assessment, the LT natural persons avoided personal income tax obligations in Lithuania due to the transactions. The position of the STI is that the real purpose was to pay dividends to LT natural persons, but LT natural persons sought to take advantage of the intermediate economic transactions (intermediate Estonian companies) and to avoid payment of the PIT; therefore, the STI applied the provisions of Article 69(1) of the Law on Tax administration (“the substance versus the form”), and imposed personal income tax – EUR 62,200 plus late payment interest and penalties).
REASONING OF THE STATE TAX INSPECTORATE
According to the assessment of the STI, there were grounds to apply the provisions of Article 69(1) of the Law on Tax Administration (“substance over form”). The STI based its position on the following circumstances:
- The individuals were the sole shareholders and directors of the Estonian companies and were therefore fully aware of the legal consequences of their actions: they knew that when the Estonian companies would be the shareholders, it would be possible to make use of the “participation exclusion rule” (Art. 34(2) of the Law on CIT), and that the dividends paid out by the LT company would be exempted from Lithuanian tax;
- The Estonian companies were used only to distribute dividend flows. This conclusion is supported by the following considerations:
- The Estonian companies entered into contracts to acquire shares in the LT company in December 2013, the deferral of payment was agreed until March 2014, but the payments for the shares were only made after the LT individuals granted loans to the Estonian companies in September 2014;
- Shortly after the payment for the shares (October 2014), the LT Company’s shareholders’ resolution of May 2014 was reversed and a dividend of EUR 0.5 million was distributed to shareholders;
- The time lag between the granting of loans to Estonian companies, payment of dividends and the repayment of the loans was extremely short (Estonian companies paid for their shares in September 2014 and received their first dividends in October 2014);
- The Estonian companies had no real economic activity either before or after the conclusion of the contracts for the sale and purchase of the shares in LT, had no staff and no administrative premises, and had neither the financial nor the technical capacity to pay the seller for the shares in LT company in accordance with the terms and conditions set out in the contracts;
- Negotiations on the terms of the transfer of shares were not carried out with Estonian-registered companies, but with LT individuals who acquired the intermediate Estonian companies. Estonian companies were acquired one week before the share purchase transactions were concluded, although the negotiations lasted for five months;
- LT natural persons were linked both to LT company itself (held managing positions) and to its previous shareholders;
- The sale price of the shares in LT company was significantly lower than the amount of dividends received over the following three years (Estonian companies paid EUR 0.19 million for the shares and received dividends of EUR 0.41 million).
Case No. 3
SITUATION
The STI challenged a very long, complex scheme involving a large number of economic transactions. The essence of the transactions in “simple” terms can be described as follows:
An LT individual, through a related person, sold shares in a highly profitable LT company (‘LT company 1’) free of personal income tax. As a consequence, the latter company was hung under another LT company (“LT company 2), the shares of which were subsequently acquired by the same individual by way of a gift from a related person. Prior to the acquisition of the shares in LT Company 2, this company was “inflated” with liabilities, the beneficiary of which eventually became the same LT natural person. Shortly after the acquisition of LT Company No. 2, one part of its shares was sold to an Estonian company (In 2012, the shares were sold for LTL 50 million, with the payment for the shares deferred until 2063), and the other part was contributed to the Estonian company’s share capital. The Estonian company was subsequently reorganised.
According to the tax authorities, the purpose of the transactions for the transfer of LT Company 2 was to increase the Estonian company’s authorised capital, to create large financial liabilities for its shareholders in the accounts of the Estonian company, and then, on the basis of those liabilities and the interest earned on them, to derive income from the affiliated company that would not be subject to personal income tax. The aim was also to receive tax-free dividends from Lithuania. The tax authorities applied the provisions of Article 69(1) of the Law on Tax Administration (“substance over form”), calculated EUR 5.7 million of payable PIT (plus interest and penalty) and reclassified the liability as Class B instead of Class A, i.e., they decided that it was the natural person (the beneficiary) and not the LT company that should pay the personal income tax.
REASONING OF THE STATE TAX INSPECTORATE
On the application of the provisions of Article 69(1) of the Law on Tax Administration (“substance over form”):
- The Estonian company was not intended to create a new business or to develop or expand an existing business, as the Estonian company was owned by the same shareholders after the share swap through a reorganisation, had no operations, no employees, and its main income came from dividends from one of the companies;
- The purpose of the series of transactions is to create large financial liabilities on the books of the related company and to enable to receive tax-free income.
Transfer of liability for personal income tax (reclassification of Class A income as Class B income):
- The State Tax Inspectorate stated that, on the one hand, Article 69(1) of the Law on Tax Administration does not automatically give the right to allocate the relevant tax liabilities to persons other than those explicitly specified in the relevant tax law, on the other hand, “in the absence of special provisions laid down in the tax laws, the obligation of the person withholding the tax to withhold the tax from the taxpayer and to pay the tax to the budget, as laid down in the tax legislation, may be transferred to the taxpayer referred to in the relevant tax law, in the event that a failure to do so would be in breach of the principles of equality of the taxpayers, fairness, universal admissibility, honesty, and/or would be inconsistent with the criteria of reasonableness and justice, which the tax administrator must also respect”. In the present case, it has been established that the taxpayer was not only a shareholder during the period at issue but also, together with other associated persons, controlled, was in a position to influence and had the power to influence the decisions of the companies, i.e., acted as a leader of closed organisational structure. It also concluded that the payment of the disputed income was in the sole interest of the shareholder.