Taxation change – transactions between associated persons

On 20 October 2010, the Riigikogu passed an Act amending the Income Tax Act and associated acts, which also changed the definition of associated persons. One of the most important topics of that Act was taxation of share options, a brief summary of which was published in the June 2010 LMHB Newsletter.

While section 8 of the Income Tax Act applicable before 2011 provided an exhaustive list of persons considered to be associated, the new Act that entered into force on 1 January 2011 provides that all persons are considered as associated if they have a joint economic interest or if one person has a dominant influence over another. The exhaustive list applicable until now has been changed and will become illustrative.

Meaning of associated persons for the purposes of taxation

The concept of associated persons has essentially remained unchanged since the entry into force of the Income Tax Act on 1 January 2000, but its meaning has changed significantly over time. At first, the fact of being associated persons had a meaning only in very limited events: upon ascribing income of off-shore companies to Estonian residents, limitation of withdrawal of losses of self-employed persons, and adjustment of transaction values of legal persons and associated natural persons or non-residents. As of today, the meaning of associated persons has also expanded to other situations, such as transactions between associated legal persons and self-employed persons, payment of licence fee to non-residents, as well as in the area of value added tax where tax authorities are also granted the right to adjust the price of transactions between associated persons (taxable value).

Unofficially, the definition of associated persons is often used in determining a tax simply for the purpose of showing persons or a transaction by them in an unfavourable light and creating a favourable ground to ascribe a so-called “right meaning” to transactions by the taxpayer. This has been the case in well-publicized tax disputes (e.g. tax matters related to the takeover bid involving Hansapank shares) as well as in lesser-known disputes.

The legal meaning of associated persons has also changed over time and, with the change in definition of associated persons as of the beginning of this year, it is useful for undertakings to learn the changes, refresh their memory, and to recall that which has been well-forgotten.

In essence, all transactions by undertakings, both companies and self-employed persons, with associated persons must be made on market conditions. The concept “on market conditions” is still an expression widely used by lawyers and other advisers to indicate when tax authorities have the right to adjust the value of transactions between associated persons and to impose tax on the amount that the taxpayer would have received as income or the amount that the taxpayer would not have recorded as an expense if the transfer price was equal to the market value. Methods for determining market value have been established by the Minister of Finance by regulation, which is necessary reading for undertakings that plan to make or are making transactions with associated persons.

The main situations that often prove to be a stumbling block for taxpayers are so-called movements of assets between entities within a group where nothing else, apart from formal exchange of owners, changes for the group as a whole. Such transactions often include concentration of business property, equipment necessary for production or certain rights (intellectual property) into one group entity for the purpose of hedging risks or better managing business activities, as well as transfer of the operation of part of a business to another group entity. In these situations, attention should be paid to the transaction price because these transactions are made by legally independent taxpayers among whom any transfer of property (profit) may lead to income tax liability and, in the worst case, value added tax liability as well.

Consequences of legislative amendment

Until the end of 2010, the risks of these transactions were assessed, which required analysis of whether parties to a transaction were associated, verified by a nine-point test specified in the Income Tax Act § 8. If none of the conditions was met, the persons were not associated and the transaction did not have to comply with market conditions.

As of the current year, in addition to that test, an assessment is also required as to whether persons have a joint economic interest or whether one person has a dominant influence over another, irrespective of the conditions set out in the illustrative list. If the answer here is also “no”, only an unofficial usual tax procedure risk (rather than a tax risk) remains – whether a tax authority could find that the form of transaction is distorted and additionally substantiate its position by the fact that persons are associated when assessing that transaction. However, no formal tax liability has arisen from the fact that the persons are associated.

An important topic in the light of the new amendments is introduction of the concept of dominant influence as a condition for persons being associated. So far, the concept of dominant influence had no independent meaning in taxation legislation but it is an important concept, for example, in the area of competition law and in the context of the securities market. It requires particular attention to relations between shareholders where their mutual agreements may principally result in influencing a minority shareholder over a company, for example, agreements concerning formation of the management board and supervisory board, or granting veto rights to certain decisions, or guaranteed profit allocation. Ability of a person to participate in the management of another person is important here. As a result, a minority shareholder may also be associated with a public limited company and thereby end up in the focus of tax authority attention. In the light of the amendments, it is also worthwhile highlighting inclusion of domestic partners in the renewed list of associated persons. This certainly widens the set of taxable transactions and increases uncertainty in determining whether persons are associated.

To sum up, it may be said that the definition of associated persons is significantly wider as of the beginning of the current year, resulting in a wider set of transactions with which tax authorities may interfere by imposing taxes. This legislative amendment will certainly result in additional uncertainty, as the concept of an associated person is no longer defined through clear characteristics but will instead become an undefined legal concept. The amendment will give tax authorities a freer hand and force taxpayers to more thoroughly analyse whether persons are associated, and the possible consequences when making transactions. In the case of such general principles, it is difficult to give specific guidelines beforehand so that probably also here it will be up to judicial practice to draw a border between taxation related to the amendment and other principles applicable in tax law. In any case, it is clear that determining whether persons are associated is often quite a difficult task and will bring about significant uncertainty in relation to use of undefined legal concepts on establishing preconditions for creating tax liability.