How to finance a Latvian company in future

The new Corporate Income Tax Act into force on 1 January 2018. One of the declared goals of the corporate income tax was to facilitate the companies’ capitalization and thus, “reinvesting” of the profits earned. Therefore, the corporate income tax is payable only when the dividends are distributed or if the company incurs expenses which are considered to be profit distribution.

Basically, every business may have two sources of funding, i.e. funding by use of equity (own capital) and use of borrowed capital. In theory and in practice, the funding by equity is considered as more expensive in comparison with a borrowed capital as the investor takes on bigger risks and thus expects a larger return. The borrowed capital is perceived as less risky and thus it is cheaper, it also decreases the tax burden as a deductible expense from the income taxable with the corporate income tax.

Thus, with the new corporate income tax, the considerations in connection with company’s funding also changes. At first, it is clear that the borrowed capital, at least partially, loses its conventional “cheapness”, and does not influence the taxable profit anymore, thus, in theory, the way of funding the company would not make a difference from the point of view of the investor. Does this mean that investors would further give preference to equity financing to the borrowed capital?

In this article read how the new tax may influence the decision making of Latvian and foreign investors in connection with funding Latvian companies.

Latvian investor 

A Latvian investor Jānis Bērziņš establishes a company (the capital of establishment of which we will not take into account for simplicity). The company needs a funding of 1 000 000 euros. Jānis wishes to receive a return of 10% per year from the investments, meaning, 100 000 Euros (let us assume that such a return is adequate). For evaluation of various scenarios, in each of them, we will evaluate the effective tax rate, i.e. the total tax burden against the amount the investor receives after tax (net).

1. Investment into fixed capital

So, if Jānis invests 1 000 000 euros in the share capital of the Latvian company to ensure the required return, the company has to pay 100 000 euros in annual dividends. As a result, the payable corporate income tax is 100 000 x 20/80, thus – 25 000 euros. Effective tax rate is 25%.

2. Loan financing

If 1 000 000 euros are funded as a loan, personal income tax at a rate of 20% will have to be witheld from the loan interest. Meaning, if Jānis wishes for the company to pay 100 000 as interest for the loan, he will receive 80 000 (net sum) and will pay 20 000 as personal income tax. The effective tax rate will still be 25%. So far, the law ensures an equal attitude towards both the equity capital and the loan financing.

But, the two things have to be taken into account:

• Allowable interest amount (thin capitalization);
• Transfer pricing – the market value of the interest transactions.

 Thin capitalization

In accordance with the new law the taxable base of enterprise income tax includes interest payments in proportion to that, in what amount the average amount of debt obligations (of which the interest payments are calculated) of the financial year exceeds the sum that is equal to a quadrupled taxpayer’s equity amount (at the start of financial year) in the annual report that is decreased by the reserve of reevaluation of long-term investment and other reserves that have not occurred as a result of division of profit gained. Meaning that in the situation as this, practically all interest will be included in the tax base and a tax will have to be paid, meaning 100 000 x 20/80 = 25 000 Euros. In order to not apply this rule, the investment into the capital has to be structured so that the ratio of the equity to borrowed capital is at least 1:4. Meaning that an investment of a million has to be structured foreseeing that the fixed capital is at least 200 000 and the borrowed capital – 800 000.

1. Transfer pricing

Adjustment of the transaction’s market value has to be taken into account. In this situation, a 10% interest rate may be above the market value (assuming the market value is 8%), but since the tax is already paid from the whole sum of the interests, it is believed that such an adjustment is not to be done a second time. But, if the equity and borrowed capital are structured appropriately, this adjustment will be applied. And thus, the interest expenses will not be allowed to exceed the market value, for example, 8%.Thus, to maximize the return from investments as a loan, Jānis would have to make an equity of 200 000 euros and to comply with the market value of interest. Meaning that the same 25% are paid effectively in tax, which would be if Jānis would invest in the fixed capital.

Funding through a loan	(EUR)
Investment into the equity  by complying with the proportion of debt-to-equity ratio  (4:1)	200 000
Loan	800 000
Interest rate in the market value	8% (64 000)
Remaining return from investments is paid in dividends	36 000
Personal income tax of interest	12 800
CIT on dividends	9 000
Jānis receives the net amount	87 200
Total sum of taxes	21 800
Effective tax rate	25%

As a result that the same 25% are paid effectively in tax, which would be if Jānis would invest in the equity.

Foreign investor

The same situation, except this time the investor is James Brown from Narnia.

1. Investment into fixed capital

James invests 1 000 000 euros in the company’s share capital. The company pays 100 000 euros in dividends, this the payable tax is 100 000 x 20/80, meaning 25 000 or, effectively – 25%.

But a problem arises here. In James’ state of residence, Narnia, this income is treated as income of dividends, and it will be taxed by personal income tax (dividends tax), let’s say at a 10% rate. But, since the tax paid in Latvia will not be considered as dividends tax (instead – corporate income tax), the tax paid in Latvia will, probably, not be possible to be used as a tax credit.

Funding with an investment in fixed capital	(EUR)
Investment in the share capital	1 000 000
Dividends	100 000
CIT	25 000
Tax in the foreigner’s state of residence – Narnia (10%)	10 000
Total tax burden	35 000
James receives (net)	90 000
Effective tax rate (tax/net income)	38,8%

This means that James will pay additional 10% as Narnia’s personal income tax from the sum of dividends received. Thus, the effective tax burden will be 35 000 Euros or 38.8% (35 000 : 90 000)

2. Loan financing

In case of a loan, all the same rules apply to residents and individuals, meaning:

• Thin capitalization;
• Transfer pricing;
• Personal income tax from interest income.

Respectively, to decrease the tax burden, the share capital has to be structured, and the one has to comply with the transfer pricing rules: