The taxation of salaries paid to local employees of foreign embassies often raises questions in practice. In particular, it may be unclear why income tax is not withheld from the salary, why the salary is declared in Annex 1 to the TSD tax return using payment type 11, and why the employee must pay the income tax themselves.
As this tax treatment differs from the standard procedure, Grant Thornton Baltic asked the Estonian Tax and Customs Board for clarification. In this article, I provide an overview of the Board’s written position and explain how salaries paid to local employees of foreign embassies are taxed in Estonia.
Who does this special procedure apply to?
This article concerns local employees of foreign embassies who are Estonian citizens or permanent residents of Estonia and work in Estonia. It is important to note that this is not a general rule applicable to all employers operating in Estonia.
How are salaries normally taxed in Estonia?
As a general rule, when paying a salary, an Estonian employer must:
- withhold income tax;
- withhold the employee’s unemployment insurance contribution;
- withhold the mandatory funded pension contribution, where applicable;
- pay social tax.
Under the standard procedure, the employer handles all taxes arising from the salary payment. The employee therefore does not have to pay income tax separately on the same salary at a later date.
Why are embassies treated differently?
According to the Estonian Tax and Customs Board’s written clarification, foreign embassies apply the Vienna Convention on Diplomatic Relations when determining their tax obligations in relation to salaries. Under the Convention, a diplomatic mission acting as an employer is required to fulfil only social security-related obligations for employees who are nationals or permanent residents of the receiving state.
This means that the embassy:
- pays social tax;
- calculates and declares unemployment insurance contributions;
- withholds the mandatory funded pension contribution, where applicable.
According to the Tax and Customs Board, a diplomatic mission is not required to withhold Estonian income tax from an employee’s salary, as the Vienna Convention does not impose such an obligation.
Who pays the income tax?
Although the employer does not withhold income tax, the salary is still subject to taxation in Estonia.
According to the Tax and Customs Board, an employee who is an Estonian tax resident must:
- declare the salary received in their annual individual income tax return;
- pay the income tax themselves in accordance with the Income Tax Act.
The difference from standard payroll taxation therefore lies not in the taxation itself, but in how the tax is paid. Normally, the employer withholds income tax each time a salary payment is made. In the case of a local embassy employee, however, income tax is not withheld from the salary. As a result, the employee receives a correspondingly higher amount at the time of payment and settles their final income tax liability later based on their annual income tax return.
How is the salary declared on the TSD tax return?
The Tax and Customs Board has clarified that Annex 1 to the TSD tax return does not include a separate payment type code for diplomatic missions.
The following payment types are therefore used:
- payment type 11 for remuneration paid under an employment contract;
- payment type 19 for remuneration paid under a contract governed by the law of obligations.
In these cases, only social security-related tax liabilities are calculated for the diplomatic mission: social tax, unemployment insurance contributions and, where applicable, the mandatory funded pension contribution.
Can an embassy still withhold income tax?
Yes.
According to the Tax and Customs Board, some embassies do withhold income tax from their employees’ salaries. However, the Board emphasises that diplomatic missions are not required to do so. It is the employer’s decision. Practices may therefore vary between embassies.
