Latvian tax reform raises concerns with businesses

The Latvian Parliament (Saeima) has adopted legislation that will introduce corporate tax on the distribution of profits at a rate of 20%, replacing the previous withholding tax of 15% on dividends, from July 1 2018 The reinvested profit model would enable undistributed profits to be reinvested in companies untaxed, with the intention of encouraging the growth of new businesses and boosting the economy.

The new regime will mean that corporate tax will not have to be paid in advance, and a transition period of two years has been set for distributing accumulated profits, to which a 10% personal income tax will be applied.

Jānis Vucāns, chairman of the Saeima Budget and Finance (Taxation) committee said: “In order to implement the so-called largest reform measures, compensation mechanisms have also been established, and they mainly pertain to combatting the shadow economy and improving tax administration”.

The reforms have been a long time in the making, and Valters Gencs, founding partner of Gencs Valters Law Firm, who while head of the tax group of the Foreign Investors Council in Latvia proposed identical reforms 15 years ago, formation believes they are now “too late”.

He said Latvia is introducing the reforms to compete with the Estonian tax system. According to the Estonian model, corporate taxation is applied on the profit distribution of companies, and not on the profits earned by the companies. However, “the Latvian tax system hasn’t yet achieved the level of convenience of its neighbour state,” said Vita Liberte, managing partner at BDO in Latvia.

Despite being intended as a measure to increase competition, some corporates are unhappy with the changes. They are concerned it could increase the effective taxation rate and the administrative burden.

Leonard Yankelovich, founder and owner of Dartz Motorz, a car manufacturing company based in Latvia, told International Tax Review that the changes will harm the economy and prove unfavourable to businesses.“Let’s call it so-called reform, it’s just a way for the government to virtually solve budget issues,” Yankelovich said.

While the rate on distributed profits is set at 20%, the effective rate is likely to be higher because of the removal of tax incentives. “The number of tax discounts were decreased in production technologies, science and research and the large investment tax discount, which was designed to attract more investments, has been removed from the new law, keeping only the already approved investments eligible for a discount,” said Liberte.

Liberte points out companies are likely to end up paying 25% since “the expenses unrelated to a company’s activity are applicable to 20/80 of net payout formula, a significant bump from the current 15% corporate tax rate”. In addition, burdens on the cash flow may occur due to the “shifting of the corporate tax payments to each month and introducing more expenses to be taxed with the 20/80 rate,” Liberte said.

The introduction of the corporate tax on distributed profits will have an impact on transfer pricing as “the new law introduces anti-avoidance provisions,” said Jānis Čupāns, tax partner at Deloitte in Latvia. “Transfer pricing adjustments will be treated as deemed profit distribution and taxed at effectively 25% tax rate.” In addition, Čupāns said: “under certain conditions intra-group loans to parent or sister companies may be classified as hidden dividend distribution and hence taxed at effectively 25% tax rate.”

Despite reservations from some companies, the changes could encourage investment and development in certain companies. “The most substantial benefit for companies from the tax reform is the 0% rate for reinvested profits, therefore it is encouraging companies to invest in their development. Furthermore, the critically acclaimed advance payments for the corporate tax have been removed, thus decreasing the tax burden,” said Liberte.

The reinvested model may lead to new opportunities for start-ups. “The government anticipates that the new regime will bring positive influence on development of companies, will strengthen their capitalisation, as well as will attract investments,” said Čupāns. “However, as the concept of corporate income taxation will be completely changed, the actual effect can only be estimated in the long term.”

Even though, Latvia is pursuing a similar tax code to Estonia, its neighbour is somewhat ahead, having established its cash flow taxation in 2000. Liberte said Estonia’s regime is now two decades’ old and has had time to mature. “Its tax rates have been adjusted to boost investments in the country, for example, they plan to lower the corporate tax rate from 20% to 14% for companies who pay dividends on a regular basis,” she said.

Liberte said the biggest winner from the tax reform is the state. “The conditions for investors are made worse and a reduction in investments might be possible, thus damaging economic growth,” said Liberte. “Thus the new tax model doesn’t guarantee Latvia will gain a competitive edge.”