The growth of the prime interest rate – a by-product of inflation – also affects taxation
It’s been well reported that the European Central Bank has been raising the key interest rate since July 2022 in an effort to control inflation. Starting in 2015, Estonia enjoyed a 0% base rate but from this year it has hovered around 4%.
Often people neglect to consider that the same key interest rate affects not only businesses' loan capability and finances but also taxation.
The 0% base rate made it quite widespread for employees or management and supervisory board members to be granted loans by companies, since it was more economical than going to a bank. Therefore businesses could in effect offer employees loans at 0% interest rate.
Under the Income Tax Act, a loan given to an employee is a fringe benefit unless the interest rate at the time that the interest was paid was twice the interest rate published as described in subsection 94 (2) of the Law of Obligations Act[1]. That published rate is actually the most recent ECB interest rate on the main refinancing operations, measured at 1 January and 1 July. Since the key rate was 0% for years, 2 times 0% is still 0% and such an approach was acceptable in the letter of the law.
In early 2023, the rate rose suddenly to 2.5% and was 4% as of 1 July. Thus, a 0% interest rate loan for employees or management is no longer acceptable from a taxation point of view and companies would incur the obligation to tax the interest income foregone as a fringe benefit, since it is a transaction that does not conform to market conditions.
If an interest tare other than the market rate is charged on a loan and the parties have agreed that the interest is to be paid at the end of the loan, the taxation of the fringe benefit also arrives as the loan expires. If interest is paid continuously, the tax obligation on the fringe benefit is incurred at the time that the interest is paid. For interest-free loans, the fringe benefit is to be taxed at least once a year, at the end of the year. The fringe benefit tax expense is about 66.2% of the income forgone, since social tax must also be paid.
From the company’s perspective, it is a better idea to charge market rate interest than to pay the taxes on interest not charged. It should also be noted that the definition of employee is broader in the context of fringe benefit. It is not just a person working on the basis of an employment contract but also includes officials, members of management and supervisory bodies, and natural persons who sell goods to an employer over a period longer than six months and also natural persons who work or provide service on the basis of a contract for services, authorisation contract or other contract under the law of obligations.
The first step businesses can take is to review current loan agreements and bring them into conformity with market conditions – such as by linking the interest rate to twice the interest rate specified in subsection 94 (2) of the Law of Obligations Act.
The current 4% key interest rate may not be reflective of the actual market interest rate if it is considered that the rate to be paid must be at least double that – 8%.
The solution lies in the fringe benefit provision itself. The Income Tax Act provides a possibility of proceeding from market conditions as well, which can also be a basis for charging a lower interest rate. For example, the tax authority has stated in explanatory material that if a company has provided a housing loan at an interest rate conforming to market conditions, but which is under two times the interest rate applied by the ECB on the main refinancing operations, the employer does not incur tax obligation since the interest rate meets market conditions.
The statistics published on the Bank of Estonia website concerning interest rates on loans granted to Estonian domestic households organised by category of loan and currency are also a helpful resource for evaluating fringe benefits and determining interest on loans granted to employees at market conditions[2].
Tax authorities are devoting more scrutiny to transactions with related parties, including with shareholders and management members, and are trying to reclassify transactions for the purpose of taxation. One should be especially attentive when granting loans to shareholders/partners where the difference between the profit allocation and loan may be extremely insubstantial, especially if there are no written agreements between parties.
To sum up: it is a good time to review loans granted to employees and management and supervisory board members, and the interest rates on such loans. If necessary, amend the loan agreement and enter into written agreements regarding granting the loan, interest charged and the repayment. Grant Thornton Baltic’s lawyers are glad to help prepare and amend contracts.
If you have similar challenges and questions, please contact our specialists.
