Employee company car expenses as hidden company profit? A pitfall in Estonian CIT

Companies that have opted for taxation under the corporate income tax on distributed profits, known as the Estonian CIT, are only required to pay tax when profits are distributed as dividends. Article 28m of the CIT Act specifies that income subject to taxation under the Estonian CIT includes the following:

1. the amount of net profit earned during the period of Estonian CIT taxation, to the extent that such profit has been allocated by resolution for distribution to shareholders or partners, or to cover losses incurred prior to the Estonian CIT period (income from distributed profits or profits used to cover losses);
2. the amount of hidden profits (income from hidden profits);
3. expenditure not related to business activity (income from non-business-related expenditure);
4. the surplus of the market value of acquired assets or those contributed in-kind over their tax value (income from asset revaluation) – in the event of mergers, demergers, conversions, or in-kind contributions of an enterprise or an organised part thereof;
5. the total of net profits earned in each tax year under the Estonian CIT to the extent that they were not distributed or used to cover losses (income from net profit) – in the case of taxpayers exiting the Estonian CIT scheme;
6. revenue and costs that, under accounting regulations, should have been recognised in the profit and loss statement but were not (income from undisclosed economic operations).

Interpretative doubts concerning point 2

Point 2 of the above provision has raised the most interpretative doubts among taxpayers. According to paragraph 3 of the Act, hidden profits include monetary and non-monetary benefits, paid or unpaid, provided in connection with the right to share in the profits, other than distributed profits, the direct or indirect beneficiary of which is a shareholder or a related party, in particular: loans granted by the company to shareholders together with interest, commissions, fees, and benefits provided by the company to a private or family foundation.

However, this definition is not precise (using the term “in particular”) and does not include a closed list of benefits that would give taxpayers certainty as to which specific benefits qualify as hidden profits.

Application for a tax ruling on the use of company cars

A limited liability company owning a fleet of several dozen passenger cars used exclusively by its employees submitted an application for an individual tax ruling. According to the company’s internal regulations, employees are also allowed to use these cars for private purposes outside of working hours. The company inquired whether expenses and depreciation related to these vehicles would constitute hidden profits under the Estonian CIT regime.

According to the applicant, the use of passenger cars by employees does not constitute hidden profit, and therefore, such usage should not be subject to Estonian CIT taxation.

Ruling by the Director of the National Revenue Information

The authority issuing the ruling stated that since the employees using the cars are not shareholders or related entities, the expenses and depreciation do not meet the definition of hidden profits under Article 28m(3) of the CIT Act. However, the costs of mixed-use vehicles (i.e. used for both business and private purposes) were classified as non-business-related expenses under Article 28m(1)(3) of the CIT Act.

The tax authority noted that the amount subject to Estonian CIT taxation in such cases is specified in relation to hidden profits. Pursuant to Article 28m(4)(2)(b) of the CIT Act, hidden profits include 50% of the expenses and depreciation related to the use of passenger cars and other specified assets not used exclusively for business purposes.

The authority concluded that due to the similarities between hidden profits and non-business-related expenses, and in the absence of specific provisions on determining the proportion of expenses related to mixed-use cars (without keeping vehicle mileage records), by analogy, 50% of such expenses should be treated as non-business-related and taxed accordingly.

Furthermore, the fact that the employer increases the employee’s taxable income by the value of the non-monetary benefit (i.e. the right to use company cars) does not, according to the tax authority, change this interpretation.

What next?

This ruling may signal a concerning trend of extending the provisions on hidden profits to other similar benefits where the beneficiaries are persons connected to the company but not explicitly listed in Article 28m(4)(2)(b) of the CIT Act (e.g. employees). The interpretation issued by the tax authority has, rather than clarified, further deepened the doubts of shareholders of companies taxed under the Estonian CIT. They must now consider not only whether a benefit constitutes hidden profit, but whether it may, by analogy, fall under the category of income subject to tax under other points of Article 28m of the CIT Act.

The article refers to the ruling dated 6 July 2022 issued by the Director of the National Revenue Information, ref. no. 0111-KDIB1-2.4010.205.2022.2.AK.