The Latvian tax system has changed substantially in the past year, from introducing a progressive tax system for personal income tax, to taxing only company distributed profits with corporate income tax and allowing companies to reinvest without paying extra taxes.
The changes in corporate income tax (“CIT”) offer new opportunities and new risks. The main goal is to attract investors and develop manufacturing.
The profit of the company is not taxed by CIT until the distribution of dividends, and the tax rate will be raised from 15 percent to 20 percent. Furthermore, tax will have to be paid from expenses which aren’t related to the core business activities or hidden dividends (for example loans to a “mother company”). Distributed dividends are taxable only the first time.
Additionally, dividends received by a natural person—Latvian resident—are not taxable, if they are received from a company which is a CIT payer.
Even though there have only been minor amendments in the personal income tax law, the tax burden for the lower income workforce has significantly reduced, while the tax burden for the higher income workforce has increased.
2019 also brought further changes to the Latvian tax system, mainly changes in Controlled Foreign Company (“CFC”) laws and transfer pricing regulation. These changes aim to bring the Latvian legislation more in line with the EU Anti-Tax Avoidance Directive (“ATAD”) and base erosion and profit shifting ("BEPS") related measures.
The Organization for Economic Co-operation and Development (“OECD”) final reports on “BEPS” provide recommendations on designing domestic tax law and tax treaty provisions to eliminate BEPS opportunities. Many of these rules have an anti-avoidance element. The ATAD aims to implement the OECD recommendations in all EU member states, laying down anti-tax avoidance rules.
Controlled Foreign Companies
Companies that are part of the same group are generally taxed separately as they are separate legal entities. However, if a parent company has a subsidiary, the profits of the subsidiary are only taxable at the level of the parent company once the profits are distributed.
Depending on the residence state and tax treatment of the subsidiary, dividend income may either be fully or partly tax exempt or taxable with a right to credit a potential withholding tax levied at source. Thus, if a foreign subsidiary is located in a low-tax jurisdiction, the taxation of the profits of such entity may be deferred through the timing of the distribution.
In this regard, ATAD requires the EU member states to implement CFC rules that reattribute the income of a low-taxed controlled company (or permanent establishment) to its parent company, even though such income has not been distributed.
However, the EU member states have some leeway when it comes to the implementation of the CFC rules. In particular, legislators of EU member states may choose between two alternative options (passive income option v. non-genuine arrangement option) and have the option to exclude certain CFCs.
According to the Latvian CIT law, the taxpayer must include in its taxable base all profit derived from fictitious transactions by its CFC.
A foreign entity is considered as a CFC for the taxpayer if at least one of the following criteria is fulfilled:
- the taxpayer itself or together with its related entities directly or indirectly holds more than 50 percent of the shares or voting rights of the foreign entity; or
- the taxpayer itself or together with its related entities is entitled to more than 50 percent of the profit of the foreign entity.
A fictitious transaction is defined as a transaction where the main purpose is to gain a tax advantage and for which the foreign entity would not take on the risks or assets if it would not be controlled by an entity which performs substantial managerial functions in regard to these risks and assets.
However, this law does not apply if the foreign entity has a profit of less than 750,000 euros ($850,000) or if the income that has not been derived from the sale of goods or services does not exceed 75,000 euros. This exemption does not apply to foreign entities that reside in low tax territories according to Latvian regulations.
Transfer Pricing Regulation
The recent amendments to the Latvian law on taxes and duties aim to complete the implementation of BEPS Action 13.
With having the Country-by-Country Report regulations already implemented in July 2017 in accordance with Action 13, the new amendments provide guidelines regarding thresholds for master file and local file submission, documentation requirements and other requirements. These amendments apply to all transactions from the beginning of 2018 and submission of transfer pricing (“TP”) documentation in 2019.
The taxpayer, either a resident or a permanent establishment of a nonresident, shall submit TP documentation for transactions with:
- a related foreign entity;
- a related natural person;
- entities or persons which reside in low or no tax countries or territories;
- related resident if the transactional, commercial or financial relations occur within a single supply chain with this person.
In regard to transactions with aforementioned nonresident entities within 12 months of the financial year the taxpayer must voluntarily submit:
- Master file if at least one of the following criteria is met:
- the amount of related transactions exceeds 15 million euros;
- the revenue of the taxpayer exceeds 50 million euros and the amount of related transactions exceeds 5 million euros.
- Local file if the amount of related transactions exceeds 5 million euros.
In regard to transactions with aforementioned nonresident entities within one month of the request from the State Revenue Service the taxpayer must submit:
- Master file if the revenue of the taxpayer does not exceed 50 million euros and the amount of related transactions is over 5 million euros but does not exceed 15 million euros;
- Local file if the amount of related transactions is over 250,000 euros but does not exceed 5 million euros.
In regard to transactions with aforementioned resident entities within 90 days of the request from the State Revenue Service, with possible extensions of the term, the taxpayer must submit:
- Local file if the amount of related transactions exceeds 250,000 euros.
Transactions not exceeding 20,000 euros cannot be included in the local or master files.
It is important to note, however, that even transactions that do not meet the thresholds must be functionally and economically justified, i.e. they must follow the arm’s length principle.
Documentation regarding transactions of low value adding services which do not exceed 250,000 euros may be submitted in a simplified form within one month of the request from the State Revenue Service.
The new amendments also include the minimum requirements of the master and local files. The master file should include all information regarding the multinational enterprise (“MNE”) group, including:
- the organizational and legal structure of the MNE group;
- the description of the economic activity of the MNE group;
- information about intangible assets of the MNE group;
- inter-group financial activity of the MNE group; and
- financial statements of the MNE group.
Local files, on the other hand, include only the information regarding the controlled transaction of the taxpayer, including:
- information about the taxpayer and the related MNE group;
- information about every significant controlled transaction in which the taxpayer is a party; and
- financial information.
Also, the TP documentation must be submitted electronically with the search function available. The global file may be submitted in either Latvian or English, however, the State Revenue Service can request a full or partial translation from English to Latvian. There are currently no language requirements for the local file, however, it is expected that the requirement will be for it to be submitted in Latvian.
Furthermore, documentation must be revised every year, unless there have been no significant changes in the methodology used, in which case the TP documentation may be revised once every three years. Nonetheless, financial data must be revised every year.
The new amendments also include penalties for not submitting TP documentation or significant violations of TP requirements. In these cases the taxpayer shall pay 1 percent of the controlled transaction, but not more than 100,000 euros.
- The MNE group activity should be analyzed in relation to business activity in Latvia, with the view to potentially making changes to the organizational and legal structure of the MNE.
- After submission of the annual report and the last CIT return, automatically detailed information will be available to the tax authority, including the TP documentation which the company has an obligation to submit by December 31.
- All MNE group companies need to have substance, i.e. real business activity. Otherwise all payments to the company without substance can be taxed at 25 percent.
Jelena Bartule is a Tax Manager at BDO Latvia