According to Article 4 (2) (2) (e) of the Law on corporation tax, the taxable amount for corporate income tax also includes “the income which a taxpayer would have received or the expenditure which a taxpayer would have not incurred if commercial and financial relationships were created or established under valid conditions between two independent persons and if the value of the transactions made between the related persons (out of which one is the taxpayer) corresponded to the market price (value) which is calculated according to the methods determined by the Cabinet”.
This definition is taken from the internationally applied wording of the “arm’s length” principle and means that the revenue generated by related party transactions should not be below market value and the costs incurred should not be above the market value. This deficit / excess is treated as deemed distribution of profit and is included in the taxable base of the Corporate income tax.
So let’s say your company buys goods from an affiliate for 1,000,000 and resells for 1,100,000. The administrative and selling costs associated with the transaction are 50,000. By applying the net transaction profit method, it is determined that the operating profit margin must be 5%, so your company must earn at least 1,100,000 x 5% = 55,000. Accordingly, the value of the purchase price must be equal to or less than 1,100,000 – 50,000 – 55,000 = 995,000. This means that you have bought for 5,000 above the market value. This excess must be included in the CIT base and the payable tax will be 5,000 x 20/80 = 1,250.
2. Definition of related parties for CIT purposes
As the new Corporate Income Tax Act does not provide a definition of related companies, Article 1 (18) of the Law On Taxes and Duties must be taken into account, according to which: related persons – two or more natural or legal persons (except for capital companies the relation of which constitutes capital shares or stocks that are directly owned by the State or a local government) or a group of such persons related under a contract, or representatives of such persons or group, provided that at least one of the following conditions is present.
(1) They are parent and subsidiary commercial companies or co-operative societies
Definitions of parent companies and subsidiaries can also be found in the current Corporate Income Tax Act, but the definition is not included in the new law. Consequently, obviously, an explanation must be sought in the Annual Financial Statements and Consolidated Financial Statements Act.
The definitions given in Section 1, Paragraph one, Clauses 9 and 10 of the Annual Financial Statements and Consolidated Financial Statements Act are as follows:
- parent undertaking of a group of companies – a commercial company or cooperative society registered in the Republic of Latvia, a European economic interest grouping registered in the Republic of Latvia, a European cooperative society, or a European commercial company which controls one or several subsidiary undertakings thereof in accordance with the procedures laid down in this Act;
- subsidiary undertaking of a group of companies – a commercial company or cooperative society registered in the Republic of Latvia, a European economic interest grouping registered in the Republic of Latvia, a European cooperative society, or a European commercial company, or a commercial company registered in another country which is controlled by a parent undertaking thereof in accordance with the procedures laid down in this Law. Any subsidiary undertaking of a subsidiary undertaking of a group of companies shall be considered a subsidiary undertaking of the parent undertaking of that group of companies.
Acquisition of control is explained in Article 61 of this Act: “if such parent undertaking is directly or indirectly (with participation of one or several subsidiary undertakings of such group of companies) has acquired control in conformity with at least one of the following conditions:
1) it has the majority of stockholders’ or members’ voting rights (more than 50 % of the voting rights) based on the participatory capital in the relevant subsidiary undertaking (regardless of the amount of this participatory share);
2) it has the right to appoint or remove the majority of members (more than 50 % of members) of the supervisory or executive bodies of the subsidiary undertaking based on the participatory capital in the relevant subsidiary undertaking (regardless of the amount of this participatory share);
3) it has the right to exercise the prevailing influence in the subsidiary undertaking of the group of companies on the basis of a contract entered into together with other stockholders or members of the subsidiary undertaking or according to the articles of association of this undertaking (regardless of whether the parent undertaking does or does not have participatory capital shares in this undertaking);
4) majority of members of the supervisory or executive body of the subsidiary undertaking of the group of companies who have been in the relevant positions in the current reporting year, previous reporting year and until preparation of the consolidated financial statement have been appointed only as a result of use of voting rights of the parent undertaking of the group of companies;
5) it unilaterally controls majority voting rights of stockholders or members in the abovementioned subsidiary undertaking of the group of companies on the basis of the contract entered into with other stockholders or members of this subsidiary undertaking.
Examples of parent and subsidiary companies include.
(1) Direct participation, i.e. if company A controls more than 50% of company B;
(2) Indirect participation is formed when company A controls C indirectly – through holding company B;
(3) Indirect participation through two companies (A and C are parent companies and subsidiaries, A and B and A and D are also considered to be parent companies and subsidiaries). B and C will also be connected, only on a different basis. However, B will be linked to D and C will be linked to D on a direct participation basis (above 20%). However, it should be remembered that in order to determine whether A controls D, it is not necessary to multiply A’s shareholding (51%) by B’s shareholding in D (25%), as this may lead to the incorrect conclusion that A controls only 12.75 %.
(2) The share of the participation of one commercial company or cooperative society in another company is from 20 to 50 %, moreover, this parent and subsidiary commercial company or cooperative society shall not have a majority of votes. This, however, applies only in dealing with foreign companies.
Direct participation does not require specific comments. Thus, if company A holds at least 20% of the shares in company B, then they are related. It should only be remembered that in the Corporate Income Tax Act this criterion applied to transactions with foreign companies.
(3) More than 50 % of the value of the share capital or shares of a commercial company or cooperative society in each of these two or more commercial companies or cooperative societies is owned or by a contract or otherwise provides decisive influence in these two or more commercial companies or cooperative societies (majority) and to the same person and to that person’s relatives up to the third degree or to the spouse of that person, or with those persons up to the second degree
This point covers different situations, so it is always necessary to analyse if the companies are owned by relatives or in-laws.
Companies A and B are related on the basis that more than 50% is owned by Jānis and his spouse, but D and E are related because John and his relatives own more than 50% in these companies.
(4) More than 50 % of the value of the share capital or shares of a commercial company or cooperative society in each of these two or more commercial companies or cooperative companies is owned or by a contract or otherwise provides decisive influence in these two or more commercial companies or cooperative societies (majority), but not more than 10 of the same people
Under this criterion are companies controlled by unrelated companies (i.e. not related by marriage, relationship or marriage), provided that the number of such persons does not exceed 10.
(5) The same person or the same persons shall have a majority of votes on the boards (executive bodies) of these commercial companies or cooperative societies.
Company A has three board members: Jānis, Pēteris and Liene, and Company B Pēteris and Liene.
As two of the three board members in company A are the same as in company B, the conditions of the rule are met and companies A and B are related.
For board members, it is important to remember two things:
First, a board member is not considered to be a related party within the meaning of this article, for the reason that board members are a criterion for determining whether companies A and B are related, but the article does not provide that a board member is himself a related party.
Secondly, the right of a board member to represent the company separately does not yet indicate control over the company’s executive body (see Supreme Court judgment SKA-80/2014) and therefore, if board A has, say, Jānis, Pēteris and Liene, each with the right to represent the company separately, but in company B only Pēteris, the companies will not be related.
(6) individual (or his or her relatives up to a third degree, or the spouse, or those in the affinity of such a natural person up to the second degree) owns, directly or indirectly, more than 50 % of the value of the fixed capital or shares of the commercial company or the value of shares of the co-operative society or the natural person (or its relatives up to a third degree, or spouse, or with that person in the affinity of such person) a second step) with a contract or otherwise has a decisive influence in a commercial company or co-operative society.
This is a definition what previously was known as a “person related to a company. If transactions with a company are performed by its owner – individual, the market value of the transaction must be observed.