Taxation of dividends 2023 and the 2025 tax reform

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Spring is here, which means it’s the time that many companies reporting their financial results have made the decision to pay out dividends. This brings up a number of questions for management and financial teams. We try to answer the most frequently asked ones below.

Basis for distributing dividends

The first and most important thing is to remember that dividends may be paid out only from retained earnings from previous periods and the precondition for paying dividends is an approved annual report and a shareholder resolution to distribute dividends. If a company receives a dividend and wishes to redistribute it to their shareholders, they must have enough retained earnings from previous periods to do so, or else the dividends will have to wait until the next financial year.

In practice, shareholders quite often will want to distribute profits from the ongoing financial year or from a financial year for which the accounts have not yet been approved. Here a problem arises with declaring and paying dividends. First of all, distribution of such earnings does not meet the definition of dividend set forth in the Income Tax Act, and due to that fact alone it should be declared as a profit allocation. Secondly, upon receiving a profit allocation, even if income tax has already been levied on it, a legal-person shareholder is not entitled to redistribute it tax-free. As a result such an approach is not the wisest for legal-person shareholders and to avoid an unfavourable outcome, it is better to wait until the annual report is approved and then make the decision to distribute dividends or use some other way to receive the funds earlier.

Taxation of dividends

In Estonia, the corporate tax rate for dividends is the 20% income tax rate on the gross amount (i.e. 25% from net payment). If a company pays dividends regularly – every year or at least once every two years – they incur the right to levy a 14% income tax rate on the average taxed (gross) dividend for the previous three years. Here it should be remembered that if lower-tax-rate dividends are distributed to shareholders who are natural persons, they are subject to an additional 7% income tax rate that is withheld from the natural person’s income. An exception is that, under tax treaties, residents of some jurisdictions enjoy a lower, 5% income tax rate or even a tax exemption.

Equal treatment in regard to distribution of dividends

Due to the income tax withholding requirement for disbursements made to investors who are natural persons, another problem comes up: what if a company’s investors are a mix of legal persons and individuals. The problem is equal treatment of these persons from the standpoint of taxation. 

On one hand, it might seem that the easiest way is to decide that the net dividend amount is paid out proportionally for everyone and the withheld income tax ends up being an additional expense. This also seems logical if it is the initial distribution of the profit. But from that point on, if legal-person investors distribute their profits onward to natural persons tax-free, they still have the duty to withhold income tax on all disbursements made and as a result, the final dividend recipients receive less.

Thus the company should always analyse the optimal way to distribute dividends so that the beneficial owners do not wind up in worse position than the ones who receive the dividends upon initial distribution.

Tax exemptions and incentives for redistribution of dividends

If a company has previously received dividends from a company in which it had at least a 10% holding at the instant at which the dividends were received, and the dividends were taxable or paid from taxed earnings, the company has the right to redistribute the dividends tax-free.

If an Estonian company’s holding in a company paying the dividend was less than 10%, it does not have the right to redistribute the dividends tax-free. But the Estonian company does, upon redistributing the dividend, incur the right to deduct income tax paid in a foreign country from their payable income tax.

In both cases there is an important prerequisite: the dividends must be reported on Annex 7 of the TSD tax return. Otherwise, the Estonian tax authority will have no information that the dividends exist, and upon demand of the tax authority, Estonian companies must also be able to submit a certificate on income tax paid abroad.

Other observations

It should definitely be borne in mind that Estonia uses a cash-based taxation system – a decision to pay dividends by itself does not incur the obligation to pay income tax although the decision should already be recognized in financial accounts.

Regardless of the fact that the topic of distribution of dividends seems largely logical, even simple, many questions do come up in the case of more elaborate structures. Grant Thornton Baltic tax advisers are always ready to help.

The future

Pursuant to the new government’s coalition agreement, the income tax rate for companies will rise to 22% effective 1 January 2025. In addition, the reduced 14% rate on regularly paid dividends will be abolished – foreign owners will lose the most when this step is taken.

Thus, from January 1st 2025, a flat 22% rate will apply to (gross) dividends paid from own profits and other profit allocations. At the same time, the deferred (cash-based) corporate income tax system that Estonia is notorious for will remain in force, according to current plans.

There is currently no detailed information on the potential transitional provisions to be applied with regard to the three years’ average taxation base of dividends that currently are subject to a 14% discounted rate. Considering the principle of legitimate expectations, it would be proper if the balance of discounted rate dividends accumulating could be used to some extent after 2024 as well. But the preliminary unofficial information does not give much hope to businesses in this regard. It is expected that the draft law and related implementing provisions will become clear in early May, and then companies can better plan how much dividends to distribute and pay out in 2023 and 2024.

To sum up, we can expect increased dividend payments in the next 18 months, especially by foreign-owned companies.