The summer of 2018 will see the introduction of a super-simple tax regime for one-man businesses – but the details of it undermine Estonia’s reputation for clever and efficient solutions, Andrei Tuch writes.
When Jüri Ratas’s left-leaning coalition took over in Estonia a year ago, the most immediate and impactful initiative was a series of changes to the country’s famously straightforward tax code. But while changes to the income tax credit have generated a lot of confusion, another policy seems on the surface to be tailor-made for the sort of skill-based small businesses that the country’s e-residency programme is trying to attract.
The entrepreneurship account (ettevõtluskonto) is a new concept, a special type of bank account opened for an individual person with no corporate status. Any money deposited into that account is subject to an automatic deduction of 20% (up to a total of €25,000 a year, and 40% for anything above that). The deduction goes to the tax authorities, and then the state has no more questions to you regarding that income. If at least €1,300 a month comes into the account, you are even eligible for national health insurance.
The downside is that you cannot write off your business expenses – but a professional services provider, who rents out their time, knowledge and skills, the digital nomad from the e-residency recruitment posters, wouldn’t be put off by that.
Given that e-residency is an individual, not corporate status – starting a company as an e-resident is easy but not mandatory – the self-evident question is: can an e-resident open an entrepreneurship account? Looking at the law as written, it seems that the answer is yes (and curiously, this type of account can be offered by any bank in the European Economic Area, not just in Estonia). But when you start looking into the details of how operating under this regime would work, you soon find where the other shoe has dropped.
The key aspect is a small change to the Income Tax Act, saying that an invoice paid under this scheme is not a tax-deductible business expense. (It’s often said that Estonia has no corporate income tax, but that’s not quite true: the tax on distributed profits is kept equivalent to personal income tax.) So if an individual uses an entrepreneurship account to provide services to a company, the invoice amount is taxed at 20% on the company’s end, in addition to the 20% automatic deduction on the individual’s end.
The reason for this non-obvious provision is understandable – it is a safeguard against businesses “optimising” their payroll taxes by having employees just use entrepreneurship accounts instead of employment contracts. From the viewpoint of revenue base management, it makes all the sense in the world, it’s an elegant and low-maintenance solution for preventing tax avoidance.
An additional administrative burden
However, from the policy viewpoint, it massively diminishes the impact and value of the entrepreneurship account as a concept. This company-side tax is applied selectively – yes on services, no on sales of physical goods. But as the scheme pointedly does not allow the individual to write off any material costs, it was always much less useful for a manufacturing or trading business.
As a freelance, part-time provider of professional services – in my case, translation – my fixed costs are near zero. I am happy enough swallowing the amortised cost of my computer and the electricity it uses, if in return I get a hassle-free 20% tax rate instead of the usual payroll-plus-VAT of an invoice issued through a friendly translation agency.
(Currently, a net payment of €100 to me is approximately a €217 invoice to my customer. Whether the extra money would be a reduction in my rates or would go straight into my pocket, is for me to negotiate with my customers – but an economic boon in any case.)
However, this kink in the entrepreneurship account scheme not only raises the total tax wedge on professional services to something far higher than the headline figure, it actually creates an additional administrative burden on the paying legal entity. A pre-2018 transaction may come with a high tax burden, but it has the advantage of being very simple for the customer: pay the invoice and you’re done, no more obligations on your end, and you can write off the VAT. From next year, if I suggest to a customer that I invoice them as an individual using my entrepreneurship account, they have to get their bookkeeping to represent that money differently from every other business expense. Not to mention the lack of enthusiasm on the part of Estonia’s retail banks to invest in developing these new accounts – the law does not require anyone to offer them.
Because the business-side tax does not apply to sales/purchase transactions, we may see a resurgence of “optimised” deals where I, as a translator, sell to my customer a physical CD containing a text file, and the rights to the translation are included for free.
The tax is also not applied to transactions (of any kind) between physical individuals. This was the original impetus behind the scheme – a way to legalise payments for odd jobs, like fixing a broken pipe or doing some construction work on your house. But such transactions will remain essentially untraceable to the Tax Board, and since the scheme also does not allow the plumber/builder to write off the cost of his tools and materials, there is no incentive to use the account and pay any tax at all, instead of cash-in-hand work as happens now.
Nor is the scheme useful for invoicing companies outside Estonia. Yes, you could absolutely write a contract that says, “I am responsible for all my tax obligations stemming from the receipt of this payment”, but a cornerstone of e-residency is that profit must be taxed where it’s generated, not where the recipient is registered. Estonia has – rightly – been very careful to not turn into an electronic tax haven. If a German customer pays into your Estonian entrepreneurship account, Estonia might be satisfied with taking 20% off the top, but that doesn’t mean Germany’s tax authorities are done with you.
The entrepreneurship account scheme could have been the killer feature that made e-residency a lot more attractive – if not for its practical implementation. Alas, the real world strikes again.
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The opinions in this article are those of the author. The cover image is illustrative (Shutterstock).
