Revised CIT regime provides potential benefits and opportunities for shareholders
Latvia’s income tax regime underwent a major tax reform in 2018 that introduced a conceptually new corporate income tax (CIT) framework, which offers potential benefits and opportunities for shareholders.
The revised CIT system is based on the principle that tax on corporate earnings is deferred until the time profits are distributed. Consequently, retained earnings are not subject to tax. The corporate income tax rate is 20% (an effective rate of 25%).
There generally is no withholding tax on dividends, except dividends paid to nonresident companies located in a country or territory designated by Latvia as a low-tax or tax-free territory. A 20% withholding tax will apply in these cases.
The tax law provides a number of tax allowances related to profit distributions.
According to the CIT law, a company is entitled to reduce the amount of dividends included in its taxable base for the tax period in such amount as it
- Has received dividends from another enterprise that is a corporate income taxpayer in its country of residence; or
- Has received dividends from which tax has been withheld in the country of disbursement.
An exception applies to dividends received from a person located, set up or established in low-tax or tax-free countries or territories.
The application of flow-through treatment to dividends is not always clear since it is affected by various factors, some of which are addressed in relevant publicly available binding rulings issued by Latvia’s State Revenue Service.
Tax-free capital gains
A Latvian company can reduce its dividend tax base for a given tax period by an amount equal to the gains derived from the alienation of shares that have been held directly for at least 36 months at the time of alienation. Thus, if a Latvian company has held the shares for three years, it generally can distribute the capital gains as dividends tax-free. However, this benefit is not available for artificial arrangements, where the alienation is of shares of: a nonresident company located in a low-tax or tax-free territory or a company that owns real estate located in Latvia that accounts for more than 50% of the company’s assets in the current or previous tax year.
Where the above tax relief applies to dividends paid out of capital gains derived from the alienation of shares: (a) if the dividends are received by an individual, the dividend income will be subject to personal income tax; and (b) if the dividends are received by a company, the dividends will not be taxed at the company level.
Retained earnings accumulated up to 31 December 2017
A transition period was introduced following the 2018 reform that provides for a CIT exemption on dividends paid out of retained earnings accumulated before the tax reform. It is possible to distribute such retained earnings (i.e., retained earnings representing profits accumulated up to 31 December 2017) in a tax-neutral manner without time limitation. This allowance was introduced because retained earnings will already have been taxed in previous tax periods. Latvia uses the first-in, first-out method of accounting for profit distributions as dividends. Thus, dividends from retained earnings accumulated up to 31 December 2017 are exempt from CIT, but subject to personal income tax if the shareholder is an individual.
The State Revenue Service has published guidance on the tax implications when retained earnings are distributed as dividends to a shareholder that is a legal entity and then distributed onwards to an individual. In that situation, there is no personal income tax on the dividend income in the hands of the individual.
Companies in Latvia can enjoy several tax reliefs on the distribution of dividends. The revised CIT system should be beneficial for both young companies that reinvest their profits in their own development and holding companies that can benefit from the ability to distribute dividends onwards tax-free.