Income tax

Basic income tax exemption requires cooperation

Sander Adamson

The new system for calculating the basic income tax exemption that comes into force next year requires a compromise to be reached between employees and employers. To do so, both sides must understand how they are affected by the new rules on claiming the basic exemption.

The implementation of the new system for claiming the basic exemption does not just require accounting systems to be reconfigured, it also presupposes close communication with employees. The new system does not make only payroll operations complicated, but it also complicates calculating and declaring the employee’s total income. To avoid unpleasant surprises, employers and employees must understand how the basic exemption is calculated. Once they understand the system, employee and employer can proceed to determine the most reasonable and mutually beneficial solution for claiming the basic exemption.

Up until the end of 2017, accounting for the basic exemption will continue to be simple; everyone gets the same basic exemption. But starting in 2018, the basic exemption will be progressive based on the individual’s total annual income. On one hand, employees will find it hard to forecast their exact total income for the year; on the other hand, employers must calculate the basic exemption individually for each employee, based on their salary. The individual approach will make payroll accounting complicated in companies with many employees or where employee earnings consist of both a basic salary and additional remuneration.

Payroll accounting will also be impacted by overtime and holiday pay, as a result of which people who earn the same gross wage will have a different net income depending on the period in which the overtime hours or holiday pay was paid out.

What is the average monthly income for the year?

Starting from 2018, individuals with a gross average monthly income of 1,200 euros or less (14,400 euros per year) will be entitled to a basic exemption of 500 euros per month (6,000 euros per year). If a person’s gross average monthly income exceeds 2,100 euros, all of their income is taxable – they do not receive any basic exemption. It is important to note that the average monthly income for a year includes all of a person’s income (salary/wages, bonuses, income from rent, capital gains from selling securities, interest income, pensions, etc.). Presumably people who earn additional income besides their salary will have to pay additional income tax after they have filed their personal income tax return.

Thus it will be harder for individuals to calculate their annual basic exemption, just as it will be more complicated for employers to calculate the basic exemption on monthly salary disbursements. For employers, it will be more complicated to account for the basic exemption for employees whose average gross monthly income is in the range of 1,200–2,100 euros. This is because those who earn over 1,200 euros a month will be entitled to receive 1 euro less basic exemption for each additional 1.8 euros they earn.

To avoid a situation where a natural person gets an unpleasant surprise due to an additional tax obligation when they file their annual tax return and the employer has an excessive administrative burden, it would be wise to agree with the employees on a uniform approach to the basic exemption.

No need to claim the maximum exemption

Under the amendment to the Income Tax Act, the basic exemption on monthly earnings will be calculated using the following formula: 500 – 500 : 900 x (payout – 1,200). The lawmakers kept the possibility of calculating a lower basic exemption for employees, but the employee has to specify the amount themselves in in the application provided to the employer. Both employees and companies stand to gain from agreeing on a smaller basic exemption. If a person has unused some part of their basic exemption from previous calendar months, offsetting takes place based on the natural person’s income tax return.

If a person works for more than one employer, they must choose one of the employers to calculate the exemption for them. If the person’s earnings from all employers is less than 2,100 euros per month, the person must file a personal income tax return in order to claim the entire basic exemption. The person’s annual basic exemption will start to be calculated based on the following formula: 6,000 – 6,000 : 10,800 x (total income – 14,400). If the result of the formula is negative, it is counted as zero.

Recommendations for simplifying calculation of basic exemption

Below are a few options on which the employer and employee can agree on to avoid additional administrative obligations or a situation where the person incurs an obligation to pay additional income tax after filing their tax return.

1. Not claiming the basic exemption at all

One possibility for simplifying wage accounting in 2018 is not to claim the basic exemption on monthly salary disbursements. That would mean that employees would get less pay each month, but receive a larger tax refund the following year.

2. Employer should categorize employees based on salary

The employer should group employees into the following brackets:

  • average monthly earnings less than 1,200 euros
  • average monthly earnings over 2,100 euros
  • average monthly earnings is between 1,200 and 2,100 euros

It would also be reasonable to count bonuses and supplementary pay in calculation of average earnings. Average monthly earnings can be calculated using the following formula: (12 x monthly salary + bonuses + additional remuneration) : 12.

If the employee’s average monthly earnings are over 2,100 euros a month but their monthly salary is under 2,100 euros, it would be necessary to explain to the employee that claiming the basic exemption will mean the employee will have to pay income tax the following year. Thus it would be easier not to claim the basic exemption every month in the case of such employees.

Example

Employee's monthly salary: 1,900 euros.

Employer calculates monthly basic exemption: 500 – 500 : 900 x (1,900 – 1,200) = 111.11 euros.

Employee receives bonus for the year in December: 3,600 euros (as the December disbursement exceeds 2,100 euros, the employer does not calculate the basic exemption for the month of December).

Employee’s average monthly earnings: (12 x 1,900 + 3,600) : 12 = 2,200 euros.

The employee’s obligation to recalculate the basic exemption for the following year: 6,000 – 6,000 : 10,800 x (12 x 2,200 – 14,400) = –666.67 euros (the result is negative so it is counted as zero – the person is not entitled to the basic exemption).

Based on the personal income tax return, the employee will have to pay additional income tax: 11 x 111.11 x 20% = 244.44 euros (December with its disbursement of over 2,100 euros, is not taken into consideration).

For employees whose average monthly earnings are under 1,200 euros per month, a monthly basic exemption of 500 euros can be calculated. The employee should be told that if they are also working for another employer or earning additional income, they may wind up paying additional taxes when they file their tax return.

Example

Employee's monthly salary: 900 euros.

Employer calculates monthly basic exemption: 500 euros.

Employee’s monthly salary from other employer: 400 euros.

The employee earns monthly income from interest: 120 euros.

The average monthly income for the employee: (12 x (900 + 400 + 120)) : 12 = 1,420 euros.

The employee’s basic exemption per year: 6,000 – 6,000 : 10,800 x (12 x 1,420 – 14,400) = 4,533.33 euros.

After filing their personal income tax return, the employee will have to pay additional income tax: (12 x 500 – 4,533.33) x 20% = 293.33 euros.

3. Payroll accounting for employees who earn a monthly average of between 1,200 and 2,100 euros

It is more complicated to claim a basic exemption for employees whose average monthly earnings are between 1,200 and 2,100 euros. It is particularly complicated for employees who are paid by the hour or who earn performance pay, due to which their monthly earnings vary.

As there are many variables concerning such an employee’s average monthly earnings, it is possible to invoke an exception set forth in the Income Tax Act where the employee can request that the employer calculate a smaller basic exemption. Employees have the right to file a new request each month regarding the basic exemption, noting an amount of basic exemption that is different from the month before. It is important to explain to the employees that it would be wise to file the request for the entire calendar year or effective until they get their next raise.

Such an understanding is beneficial for both the employer and employee. The employee will not necessarily have to pay income tax the following year and the employer would not have the obligation to change the calculation of basic exemption each month.

Example

Employee’s monthly salary: 1,100 euros.

Employee’s monthly bonus: 50–250 euros

Employee receives a bonus for the year in December: 1,500 euros (as the December disbursement exceeds 2,100 euros, the employer does not account for the basic exemption in December).

The employee’s maximum average monthly earnings: (12 x 1,100 + 12 x 250 + 1,500) : 12 = 1,475 euros.

The employee’s minimum average monthly earnings: (12 x 1,100 + 12 x 50 + 1,500) : 12 = 1,275 euros.

As at the start of the year, it is not known exactly how high the employee’s average monthly earnings will be, it would be wise to proceed from that individual’s maximum earnings for the purpose of claiming the basic exemption. The basic exemption for each month as requested could be 500 – 500 : 900 x (1,475 – 1,200) = 347 euros.

Reaching agreement on calculating a smaller exemption would make the work of the accountant easier in calculating monthly earnings and the individual will not have to pay additional taxes the next year; rather, they can get a tax refund in the amount of the exemption not claimed.

How can Grant Thornton Baltic help?

Every company’s payroll system is unique, and thus it is not possible to apply a uniform income tax accounting standard at all companies starting in 2018. Grant Thornton Baltic is gladly willing to analyse your payroll system and propose the optimum solution for your particular company.

We are prepared to introduce the new system to your finance department and conduct an in-house training for employees so that it would be possible to find a compromise that would benefit both employees and the employer. If interested, please contact our tax specialists: phone +372 626 4500, e-mail: tax@ee.gt.com.