THE ESTONIAN MODEL EXPLAINED
Since Georgian Prime Minister, Giorgi Kvirikashvili announced his intention to move the Georgian corporate tax system to the "Estonian model," there has been a lot of discussion about what this means for businesses. In this article, Andrew Coxshall, Managing Partner of KPMG Georgia, considers this proposed change and its likely impact.
The main change envisaged by the so called "Estonian Model" is that the moment of taxation for corporate income tax (profit tax) will move from when profits are earned (based on a calendar year) to when they are distributed, which is at the discretion of the shareholders. As a result, while the rate of tax on corporate income will not change, profit that is kept inside the company will not be taxed. This should reduce corporate tax payments, stimulate investment and decrease corporate compliance costs.
Reduction in tax payments
The first key benefit for companies is that the amount of profit tax that most companies will have to pay will decrease because most companies do not distribute all of their profits in the short term. So, if a company currently generates profits of GEL 100 and distributes GEL 60 as dividends in the following year, under the current system the company would pay profit tax of GEL 15 GEL. Under the new system the company will only pay GEL 10.60 (60 x 0.15/0.85).
It is also hoped that since this is reducing taxes on retained earnings, that this will encourage companies to retain and re-invest their profits, thereby helping investment and growth in the country as a whole.
Reduction in workload for accountants but monthly reporting: a net benefit
The new system should also reduce the workload of accountants. However, this benefit is a little complicated. Currently, company accountants calculate their profits every year, in accordance with the regulations of the Tax Code of Georgia, and submit an annual declaration. Under the new system there will no longer be a need for an annual profit tax declaration.
This reduction in administration could be considerable. Calculating profits subject to corporate tax can be a complicated and time-consuming process. Under the Georgian Tax Code, fixed assets are put into various categories and depreciated over a certain number of years depending on the type of asset. In addition, certain expenses can only be charged when they are paid, rather than when they are accrued. These calculations often lead to differences between the values assigned to assets and liabilities by a company's internal accounting system and the tax value assigned to it by the tax authority. As a result, companies end up keeping two sets of records. Under the new system, this would be far less of a problem.
It's not all good news. Under the new system, companies will need to submit monthly tax declarations instead. Many people have asked, "Why do we need to submit tax returns on a monthly basis if tax is only due when dividends are paid?" The reason is that companies will now need to pay profit tax on the following on a monthly basis:
- Non-deductible expenses - these are expenses that are not allowable (and have never been allowable from a tax point of view) such as donations to non-charitable organizations, expenses without sufficient documentary evidence, penalties other than tax paid to the state budget, etc.
- Non-arm's-length transactions with related parties - if a wine producer sells 1,000 bottles of Saperavi with a retail price of GEL 15 per bottle to a related party for GEL 10 per bottle, the difference of GEL 5 per bottle would be subject to profit tax immediately.
- Loans to non-resident entities - if a company lends $2 million to a company registered in the Netherlands; the total amount of the loan will be subject to profit tax immediately.
- Loans to individuals - for example the company lends GEL 10,000 to an individual for two years, even if the interest rate is a market rate; the total amount of the loan will be subject to profit tax immediately.
- Free-of-charge supplies - for example if the company provides free-of-charge services to another entity; the market price of services rendered would be subject to profit tax immediately.
It may be difficult to imagine exactly what will be the net effect of reduced annual declarations versus increased monthly declarations. However, from discussions with people experienced in the Estonian tax system, they are confident that the Estonian system is quite a lot easier overall.
To give us some idea how much easier, the World Bank, in their Ease of Doing Business assessment for 2015, suggests that an average company in Georgia takes 362 hours to complete its tax returns in a given year. In Estonia, the annual total is only 81 hours, making it the 12th most efficient system in the world. This should, therefore, be a considerable time savings.
Reduction in disputes with the Georgian Revenue Service
Another expected consequence of the simplified administrative process is that it will reduce disputes with the Georgian Revenue Service. AmCham has been advocating for reform in the Georgian Revenue Service for many years, and improvements have been made. However, unwarranted disputes with the Georgian Revenue Service currently continue to be a significant business risk.
A simplified tax code that no longer requires companies to calculate profit, for tax purposes, will remove some of the most complicated elements of the tax-accounting system. It therefore seems reasonable to think that with fewer and less- complicated regulations, there will be less opportunity for differences of interpretation and the disputes that they bring with them.
One other major change is that under the current system, companies that make losses for tax purposes can carry these losses forward for 5 years, although this period can be extended for up to ten years. A tax loss can be generated if the company makes operating losses but it can also generate a tax loss by taking advantage of the option to depreciate fixed assets 100% in the year of acquisition. However, under the new system, companies will not be able to carry forward losses and hence the new system removes a tax benefit.
Also, companies with accumulated tax losses as of the implementation date of the new system may lose these tax losses, and will incur a charge in their next set of financial statements.
It is hard to judge the overall impact of this change, but it does open the possibility that start-ups, which generally lose money in the first few years will lose out.
That said, the loss of the ability to carry forward losses needs to be seen in the context of the new system, and should be manageable.
Financial statement implications
As the Estonian model has only recently been proposed, accounting professionals in Georgia are still learning what these changes will mean for companies' financial statements. Fortunately, the system has been in place in Estonia for many years, and hence some application issues are straightforward. However some of the transition issues are currently being debated. One point is clear: deferred tax assets and liabilities will no longer appear in companies' financial statements because the accounting base and the tax base for assets and liabilities will be the same under the new system.
Less clear is the issue of when to recognize a tax liability. At the current time, the profit tax payable can be calculated and is recognized as a liability for that year. Under the new system, should a liability be recognized when the distribution is made or when it is declared? Current thinking is that a liability should only be recognized when the dividend is declared.
Transitional provisions: How to treat profit tax payments already paid when distributions are made
Another major issue when thinking about the law is how one will transition from one system to the next. Transitional provisions have not yet been finalized and may well change before the bill becomes law. One major issue is that if a company has made taxable profits in the past and paid profit tax but has not previously distributed dividends, it does not make sense that the company should now have to pay profit tax on those dividends.
In the current draft of the legislation, there is a provision that basically says that if one paid profit tax on profits earned from 2012 to 2016, but not yet distributed those profits, then the tax paid can be set-off in full. 2012 is the current statute of limitations for prior tax periods.
However, there may well be companies out there that made good profits in the years up until 2012 but did not pay out dividends and then, for whatever reason, did not make profits since that time. If they now wanted to pay out a dividend, they would end up being taxed twice on the same profits.
Transitional provisions could also be a lot more complicated if the transition happens mid-year. The first version of the law that was proposed by the government suggested that the new system would come into effect on July 1, 2017. However, after intense consultation with its members and experts, AmCham agreed that this could create a range of negative unintended consequences. AmCham has therefore been engaging in discussions with the government at the highest level to try and secure a change to the proposed law, so that it comes into force from January 1 2017. On March 21 in a meeting with the finance minister, the government accepted AmCham's concerns and the law will not come into effect in 2017.
Getting the Legislation Right
Currently, Estonia is the only country in the world that has adopted this system. When the system was introduced, there was a lot of confusion about whether Estonia had become a tax haven. In addition, there was concern about whether or not the double tax treaties that Estonia had signed were still valid. Estonia has made several amendments to the legislation since it adopted this form of corporate profit tax in 2000. This means Georgia has a good model to follow but great care is needed in drafting the legislation, and amending other legislation, to ensure that the new system really does follow the Estonian model.
Overall, it would appear that there are many positives to adopting the Estonian model, including a reduction in tax payments, increased incentive to invest, lower compliance costs and fewer expected disputes with the Georgian Revenue Service. The negatives of losing carried-forward losses and any transition confusion therefore seem modest by comparison. Ensuring that the legislation is of a very high standard is vital to address the various issues identified - as well as those that will be identified in the future.
Communication about the new system, within Georgia and with its trading partners, is essential to ensure that companies and shareholders are not disadvantaged by the new system. This is also important to make sure the reform is understood clearly by the international community to avoid Georgia being labeled a tax haven. However, if applied diligently and carefully, we hope that these changes may be a considerable addition to Georgia's reputation as a good place to do business and should encourage investment and growth from old businesses and new.
Andrew Coxshall has over 27 years of experience in audit, accounting, tax and advisory services in more than 10 countries around the world.
He is a Fellow of the Institute of Chartered Accountants in England and Wales, a member of the Chartered Institute of Taxation, is a Registered Auditor in Georgia and has an MBA from Herriot Watt University in Scotland. He is also the Tax Chair of the Commercial Law and Tax Committee of AmCham.
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