Profit distribution and dividend taxation

There are many goals of entrepreneurship: profitability, growth, competitiveness, customer satisfaction, innovation, social responsibility, etc. Profit can be distributed in different ways, but paying dividends is one of the most common ways. The purpose of this blog post is to give you an overview of the ways in which profit is distributed and how dividends are taxed.

Typically, companies have a calendar year as their financial year. The annual report must be submitted to the Commercial Register 6 months after the end of the financial year, which for most companies is 30 June.

Profit can be distributed in several ways:

Paying dividends: A dividend is money that a company pays to its shareholders (or owners). Dividends may be distributed to shareholders (or owners) as a one-time payment or in several instalments.
Reinvestment: A company may decide to reinvest its profits, meaning to leave them undistributed, in order to increase its value in the future. Retained earnings may also be used to increase share capital (or equity capital).
Share buybacks: A company may buy back its own shares in order to reduce the number of shares on the market and thereby increase the value of each share.
Debt reduction: A company may use its profits to repay debts, which improves its creditworthiness and reduces financing costs.

What you need to know about dividends

A company can pay dividends from the profits of previous years and only if the annual report has been approved. Therefore, dividends cannot be paid in the first year. The requirement must also be met that the company's assets do not decrease below the limit permitted by law, which is a minimum of 2,500 euros in the case of an OÜ.

Dividends paid

The shareholders make a decision to pay out dividends, the latter itself does not yet create an income tax liability. Income tax is paid on dividends after the payment has been made. Since the income tax on the dividends has to be paid next month, it is important to provide the information to the accountant on time.

Dividends received

Please note that the received dividends must also be declared on an ongoing basis. If your company itself has received dividends from someone, they must be declared. In general, income tax has been withheld from them and the declaration remains rather informative. Therefore, if dividends are paid forward from the company, they are generally already exempt from income tax or with a reduced income tax rate.

How to decide how much dividend to pay?

The decision on the amount of dividends depends on the company’s profit, financial position, and the agreement between the shareholders (or owners). Companies often have a dividend policy agreed in advance, but in practice decisions are usually made based on each specific year.
It is important to assess the company’s cash flow and financial position. Dividend payments should be sustainable, and the company should be able to continue its operations and investments even after paying dividends.

The final decision on whether to pay dividends should be made by the company’s management board or the general meeting of shareholders (or owners), depending on what has been agreed in the articles of association, taking into account the factors mentioned above. It is important to carry out a thorough analysis and, where necessary, consult an accountant or financial adviser to ensure that the decision is correct and complies with applicable laws while also serving the company’s best interests.

Taxation of profit

If you have decided to distribute profit through dividend payments, it is also important to take taxation into account.

In Estonia, dividends are subject to income tax, and taxation is carried out by the company paying the dividends. At present, under certain conditions, it is still possible to apply the reduced 14% tax rate, but in the ordinary course dividends are taxed at a rate of 20%. The obligation to declare and pay income tax arises for the company on the 10th calendar day of the month following the dividend payment.

Taxation regime for dividends effective from 2019

The new taxation of dividends has brought new challenges to accounting. As of this year, there are options for dividend taxation, which means that dividends may be taxable in your company at 20, 14 or 0 %.

Taxation of dividends 14% (+7%)

Accountants generally get over the initial shock easily once they have established that dividends paid to individuals are reported in gross amounts and dividends to companies in net amounts. Hello, how did such a genius come up with the system! If the above is reported in Appendix 7 of the TSD, then the individual's 7% income tax must be reported on INF1. Once you get through it once, it will be easier the next time.

Holdings through several companies

The system has become significantly more complicated for companies that have holdings through several companies. If holdings are held through several companies and there are many owners, then calculating and declaring the amount of income tax paid on dividends is already making accountants' hair stand on end. If your company has holdings in other companies from which dividends are paid, you need to contact the accountant of the company paying the dividends to find out what percentage of income tax has been withheld from the dividends received. While the situation is clearer with foreign dividends and information flows relatively well, the complexity lies in obtaining information for tax calculations from dividends received from Estonian companies. The complexity lies in receiving dividends at the same time from which income taxes at different tax rates have been withheld. Although the data of the Estonian company paying the dividend are entered in the e-MTA, such information is not passed through the Tax Board system to the recipient of the dividend. I sincerely hope that information that has already been entered into the e-MTA once will also automatically be passed on to the company receiving the dividends. Here is a recommendation for accountants: when paying dividends, if possible, add tax information to the payment order.

Decision to distribute dividends

The decision to distribute dividends is made in the net amount. In light of the new law, the net amount means the taxable amount at the company level. Therefore, if the dividends are taxed with 14%, the private person is also subject to 7% income tax, which is a tax withheld from the private person's income. At the level of a private person, the net amount that he receives in his bank account is then 7% less. Therefore, in the light of the new income tax law, the net amount no longer means the amount received in the account of a private person, but the net amount at the company level. You can find the approval of the annual report and a sample of the distribution of dividends here.

How to ensure that shareholders are treated equally

If your company has to apply all 3 different income tax percentages, then if there are more shareholders, the dividends should be distributed evenly to everyone in all tax categories. If some shareholders are paid a dividend in one month and others in another, a situation may arise where some receive a tax break and others do not. The moral of the story is that the simple income tax system has been made one step more complicated. Only foreign companies that can withdraw their income with 14% benefit from this. Estonian citizens can only feel the complexity of the system and the small tax increase that comes with 14+7% (a total of just over 20%) income taxation. Whatever the laws currently in force, specialists in their field will still be able to find a solution to any problem. If you have special requests that initially seem complicated, võta meiega ühendust ja leiame üheskoos lahenduse.

Summary

If you decide to distribute profit by paying dividends, it is important to remember that this must be done in accordance with the law and your company’s articles of association. You must also take your company’s financial situation into account.

Profit distribution and dividend payments are an important part of a company’s financial management. Paying dividends allows shareholders (or owners) to benefit from the company’s success and can also be an attractive way to earn income from an investment. However, it is important to keep in mind that profit distribution and the taxation of dividends are complex topics, and for that reason it is recommended to consult an accountant or tax adviser to ensure legal and tax compliance.

You can read more here: Dividends and related changes since 2018

We have also written on a related topic: What should be kept in mind when preparing a company’s annual report?