09 Sep 2015 Estonian Tax Law
It is the dream of many a tax advisor to obtain for a client indefinite deferral—a state where income is built up, but the tax burden on that income is never recognized. Many sophisticated international tax structures try to create such deferral for U.S. tax purposes. The very best of these structures also create deferral of foreign taxes.
For U.S. taxpayers, one such structure is to operate their international businesses through an Estonian holding company. As long as the Estonian entity’s income is retained or reinvested in international businesses, the income of the foreign businesses it holds should receive a very low rate of tax. The reason this works is because of unique aspects of Estonian and U.S. tax law, which are discussed below.
How Estonian Tax Law Applies
Estonia imposes no income tax on corporations’ retained and reinvested earnings. Rather, only dividends and deemed dividends are taxed—and even then, this tax is paid by the dividend-paying corporation, not the recipient shareholder.(1)
Because of this rule, profits can easily be moved tax-free within a corporate family via interest, royalties, and other non-dividend payments. This can lead to deductions for non-Estonian foreign companies while creating untaxed inclusions in Estonia, which can reduce foreign taxes outside of Estonia. However, care is needed to ensure these payments comply with foreign anti-abuse rules.
Further, because of Estonia’s tax treaties, many countries will tax at a low rate payments going from them to Estonia. It is unusual for a country with a potentially zero-rate of taxation to have as extensive of a tax treaty network as Estonia. And where other countries do tax payments going from them to Estonia, Estonian law often allows these paid taxes to reduce the amount of tax on future Estonian dividends.
Therefore, if a U.S. multinational uses an Estonian holding company to hold its foreign businesses, and structures its intra-group payments intelligently, it can achieve very low effective rates of foreign taxation. But it could still face immediate U.S. taxation if it does not plan right.
Treatment of Estonian Entities under U.S. Tax Law
The U.S. tax law generally allows for the deferral of income retained and reinvested by an Estonian holding company, and thus will not tax the income until it is repatriated into the U.S. However, the U.S. tax law does have anti-deferral rules which could cause immediate U.S. taxation on income earned by the Estonian company.
Certain income earned by a foreign company, including certain passive income or income earned via related parties, will be considered Subpart F income. U.S. shareholders of companies with Subpart F income can be subject to immediate taxation on Subpart F income, on the theory that Subpart F income often is income that U.S. shareholders strategically shifted to avoid taxes.
However, there are many ways to ensure income is not treated as Subpart F income. One can use statutory exceptions essentially designed to show the income shifting was part of a justified business strategy, rather than just tax avoidance. Other strategies include the so-called “check the box” strategy, where multiple related parties are seen as a “merged” single entity for U.S. tax purposes. Income that flows between these “merged” parties is disregarded for U.S. tax purposes, and therefore cannot be Subpart F income.
Thus, with careful planning and in spite of U.S. tax laws, the Estonian holding company structure can produce successful deferral of both U.S. and foreign taxes.
Help Setting Up Your Tax-Favored International Structure
International tax structures like these can produce great tax savings. But they are neither simple to set up nor to manage. If you are interested in designing an international tax structure right for your business, you should speak with an experienced tax law attorney today. At the Royse Law Firm, we represent individuals in the Los Angeles, San Francisco, and Palo Alto areas and look forward to hearing from you.
(1) If the dividend were to go to a U.S. individual shareholder, it could potentially get qualified dividend treatment, causing the shareholder to only pay 23.8% tax on the dividend to the U.S.Disclaimer: This blog and website are public sources of general information concerning our firm and its lawyers, as well as the information presented. They are intended, but not promised or guaranteed, to be correct, complete, and up-to-date as of the date posted. This blog and website are not intended to be, and are not, sources of legal opinion or advice. The materials, information, and communications on this blog and website do not apply to any particular person, entity, or situation, and do not apply to you or to your specific situation. You will need to consult with an attorney and/or other appropriate professional about your specific situation. Thank you.