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Annika Soom: Estonian tax environment is favourable for startups, but they are not using it to the fullest
Annika Soom: Estonian tax environment is favourable for startups, but they are not using it to the fullest
Recently, the Tehnopol Startup Incubator improved their official seminar programme by adding a new course for founders that covers the relations between organisational structuring and its long-term effects on tax burden and profitability for startups. The lecturer for the course is Annika Soom – one of the strongest tax advisers in Estonia, specialising in international tax law. In the following interview for Tehnopol, Annika gives her take on the importance of this topic and also provides some useful tips every founder should keep in mind when building an ambitious new company.
We are happy to share the initial interview, translated to English.
>> The original interview, in Estonian, is linked here.
Q: What is the Estonian tax environment like for startups?
The Estonian tax environment is quite favourable for startups, but unfortunately, they often don´t know how to use it for maximum advantage. Entrepreneurs know that the logic of the Estonian corporate income tax system is different, but this is often the end of their tax knowledge.
For many founders, it seems that taxes are a matter for the accountant, so there is no need to go any deeper. Or it’s an issue that will be addressed sometime in the future. In fact, the initial development phase of a company is when the head of the company should also think about whether and how taxes may affect their long-term plans. The way in which a startup develops its structure at the beginning, directly affects not only the company's tax burden, but also, for example, determines under what conditions and how profitably the owners have the opportunity to exit the company one day.
Although starting a company in Estonia is very easy and fast, it would still be worthwhile for each founder to think about the most reasonable structure for the company. While some structures facilitate changes in the future, others make it many times more beneficial to get the structure in place at the very beginning.
Q: Are there tax paradises in Europe for startups? Where do our startups mostly go, and where do they expand?
First, the answer depends on how to define a tax paradise. Of course, there are countries where there are favourable solutions for companies – tax treaties with useful wordings, low effective income tax rates, favourable tax treatment for research and development, and so on. Above all, however, it all depends on the highest tax expense for the startup – if the main income for the startup comes from intellectual property, for example, it is certainly more beneficial for such a startup to operate in a patent-box country with a low tax rate. However, if the business is very labour intensive, the choice is likely to fall in favour of a country with low labour costs. So, a single country where all startups would rush for tax reasons does not exist in Europe today.
As taxes are not the only factor in choosing the place of business, you should always look at the whole picture. A low tax rate and a good network of tax treaties can motivate a company to set up in that particular country, but if there is no labour force or the administration of the company is too complicated, these factors will be decisive instead. Given recent developments in international tax law, the ever-improving exchange of tax information between different countries, today a low tax rate alone is no longer enough to attract companies to a particular country. Business needs real substance, and the era of the so-called mailbox companies is over.
Q: What are the main mistakes that startups tend to make in the tax area?
Both startups and, in fact, entrepreneurs with a long history tend to pay too little attention to the relationship between the structure of the company and taxes. This can lead to very expensive problems, but ignorance often also misses out on legal opportunities to reduce or postpone taxation.
As the world of startups is changing very fast – a structure in place today may need to be redesigned in two months, the tax consequences of these changes are often considered a little too late.
Q: Tehnopol Startup Incubator programme now also includes your course on taxation and startup structuring. What are your expectations for this course?
The aim is to draw the attention of startups to the fact that, among other things, they should also think about taxes. As I emphasize during the course, the goal is not to make anyone a tax specialist – it is important for a company manager to get a sense of the big picture. That in case of on-boarding the new investor, in the context of an option agreement or restructuring the company, the tax regulation would work in favour of and not against the startup and the founder / owner. When it comes to taxation, it is many times more advantageous to check and seek advice in the planning phase than later during a dispute with the tax authorities.
Q: Many startups initially use option programs to remunerate employees. What are the responsibilities for the startup from the employee point of view?
Considering the Estonian regulations, the startup must definitely think about how and under what conditions the option agreements are formulated before granting the options. The tax regulations on options set out specific preconditions for receiving the tax benefit. If these conditions are not fulfilled, the share will no longer be tax-exempt and such an incentive package will quickly become very expensive for the startup.
There must be at least three years between the conclusion of the option agreement and the exercising. This is quite a long period during which so much can change in a startup. However, these changes may not automatically affect option agreements. Therefore, it is important that the startup option programme is well thought out and clearly understood by all parties.
In practice, most problems tend to occur in the course of exit or when it is time to exercise the option. It is important for the startup to ensure that the option is not exercised too early or to a greater extent than agreed. As exit before the options are exercised allows for a partial tax exemption, it is also important to determine what happens to the rest of the option – who bears the tax cost.
Q: What should a startup take into account when raising capital? How do foreign investors change the situation for the company?
On the tax side, consideration should be given to how the new investment is involved. There are many alternatives – such as increasing share capital and loans – and they all have their own tax consequences.
However, a structure that may be a good solution for a company and its natural person shareholder may not be beneficial for a legal person owning the shares. Even a small and insignificant detail at first glance can lead to a high cost or a significant tax gain.
When it comes to on-boarding foreign investors, it definitely adds an international layer for the company. In other words, in addition to Estonian tax law, future decisions must also take into account how one or another action relates to a foreign investor and his or her taxation.
Q: Sometimes an investor may put pressure on a startup to move to its legal space. What should be considered if the startup decides to do so?
In such a situation, the startup should considered very precisely which functions and assets move to the other legal space and which remain in Estonia. Often, such a move means that only certain functions move away from Estonia, but the Estonian unit also remains in some form.
The redistribution of assets and functions, as well as risks means that the parties have to price their transactions correctly. It is often assumed that, as these are companies controlled by the same people, such movements are like "lifting from one pocket to another" that taxes are not relevant at all. However, this view is mistaken. On the tax side, some of the riskiest transactions are between related parties, as these transactions are the easiest to manipulate – moving profits to low tax rate jurisdictions and causing losses in high-tax countries. Such transactions come to the attention of the Tax Board very quickly these days.
Given that a change of jurisdiction usually involves the movement of high-value assets, proper pricing is very important. Improper pricing – such as free delivery – can ultimately be very expensive for a company. In addition, it is important to think about how leaving Estonia is structured – whether there is a sale of assets, a cross-border merger or a combination of different options. As always, any such move has its own tax consequences for both the relocating startup and its shareholders. And what works for the company may not be the best solution for the owners. As a one-size-fits-all solution may not exist or may not be realistic at a reasonable cost, it is important to find a balance. This means both between the interests of the various parties and, in fact, between different areas of law. Tax law does not exist on its own but always in conjunction with other areas of the law.
Q: What should be considered for exits? What are the most common mistakes or risks?
In the case of an exit, it is very important who is the seller. The tax consequences are radically different depending on whether the seller is a natural person, a legal person or foreign individuals. Therefore, before exit, it is necessary to think about which structure is the most reasonable from the seller's point of view. Much depends on what the seller wants to do with the money received – if the goal is to invest, then it is probably most profitable to sell the shareholding as a legal person. However, if the proceeds are to be used for private purposes, the choice is likely to be in favour of the seller as a natural person.
However, the picture becomes more complicated when there is only a partial exit. In this case, a lot also depends on what the future plans are for the remaining shareholding.
Q: What is the difference in tax matters if the founder of the startup is an individual or a company? Is it possible to change this over time?
The difference is considerable. As the taxation of individuals and companies is different, so are the tax issues faced by the natural person and legal person as an owner ofthe startup. One simple example – if in the case of Estonian legal persons, it is possible to defer the income tax liability until distribution of profit, then in the case of a natural person it is usually not possible. However, the tax period for a natural person is a calendar year and the obligation to pay income tax arises only on 1 October of the calendar year following the tax period. In other words, in a situation where a natural person sells his or her share in a startup in January 2022, he or she will not pay income tax from the profit received until October 1, 2023. This is almost a year between receiving the profit and paying the actual tax. In the same example, however, a legal person would incur a tax liability as early as February 2022, provided that the proceeds from the sale of the startup were distributed immediately as dividends.
This is just one example where owning the shares of a startup as a natural person and as a legal person has different tax consequences. However, there are many of them – the difference is very clear in the context of transactions – under what conditions new investors can be on-board and what tax consequences the sale of a shares will bring. If the shares of a startup are hold as a natural person, it is later possible to change it and, for example, to create a legal person through a non-monetary contribution. The opposite – from a legal person as a shareholder to a private individual – is also possible, but generally many times more expensive.
We are happy to share the initial interview, translated to English.
>> The original interview, in Estonian, is linked here.
Q: What is the Estonian tax environment like for startups?
The Estonian tax environment is quite favourable for startups, but unfortunately, they often don´t know how to use it for maximum advantage. Entrepreneurs know that the logic of the Estonian corporate income tax system is different, but this is often the end of their tax knowledge.
For many founders, it seems that taxes are a matter for the accountant, so there is no need to go any deeper. Or it’s an issue that will be addressed sometime in the future. In fact, the initial development phase of a company is when the head of the company should also think about whether and how taxes may affect their long-term plans. The way in which a startup develops its structure at the beginning, directly affects not only the company's tax burden, but also, for example, determines under what conditions and how profitably the owners have the opportunity to exit the company one day.
Although starting a company in Estonia is very easy and fast, it would still be worthwhile for each founder to think about the most reasonable structure for the company. While some structures facilitate changes in the future, others make it many times more beneficial to get the structure in place at the very beginning.
Q: Are there tax paradises in Europe for startups? Where do our startups mostly go, and where do they expand?
First, the answer depends on how to define a tax paradise. Of course, there are countries where there are favourable solutions for companies – tax treaties with useful wordings, low effective income tax rates, favourable tax treatment for research and development, and so on. Above all, however, it all depends on the highest tax expense for the startup – if the main income for the startup comes from intellectual property, for example, it is certainly more beneficial for such a startup to operate in a patent-box country with a low tax rate. However, if the business is very labour intensive, the choice is likely to fall in favour of a country with low labour costs. So, a single country where all startups would rush for tax reasons does not exist in Europe today.
As taxes are not the only factor in choosing the place of business, you should always look at the whole picture. A low tax rate and a good network of tax treaties can motivate a company to set up in that particular country, but if there is no labour force or the administration of the company is too complicated, these factors will be decisive instead. Given recent developments in international tax law, the ever-improving exchange of tax information between different countries, today a low tax rate alone is no longer enough to attract companies to a particular country. Business needs real substance, and the era of the so-called mailbox companies is over.
Q: What are the main mistakes that startups tend to make in the tax area?
Both startups and, in fact, entrepreneurs with a long history tend to pay too little attention to the relationship between the structure of the company and taxes. This can lead to very expensive problems, but ignorance often also misses out on legal opportunities to reduce or postpone taxation.
As the world of startups is changing very fast – a structure in place today may need to be redesigned in two months, the tax consequences of these changes are often considered a little too late.
Q: Tehnopol Startup Incubator programme now also includes your course on taxation and startup structuring. What are your expectations for this course?
The aim is to draw the attention of startups to the fact that, among other things, they should also think about taxes. As I emphasize during the course, the goal is not to make anyone a tax specialist – it is important for a company manager to get a sense of the big picture. That in case of on-boarding the new investor, in the context of an option agreement or restructuring the company, the tax regulation would work in favour of and not against the startup and the founder / owner. When it comes to taxation, it is many times more advantageous to check and seek advice in the planning phase than later during a dispute with the tax authorities.
Q: Many startups initially use option programs to remunerate employees. What are the responsibilities for the startup from the employee point of view?
Considering the Estonian regulations, the startup must definitely think about how and under what conditions the option agreements are formulated before granting the options. The tax regulations on options set out specific preconditions for receiving the tax benefit. If these conditions are not fulfilled, the share will no longer be tax-exempt and such an incentive package will quickly become very expensive for the startup.
There must be at least three years between the conclusion of the option agreement and the exercising. This is quite a long period during which so much can change in a startup. However, these changes may not automatically affect option agreements. Therefore, it is important that the startup option programme is well thought out and clearly understood by all parties.
In practice, most problems tend to occur in the course of exit or when it is time to exercise the option. It is important for the startup to ensure that the option is not exercised too early or to a greater extent than agreed. As exit before the options are exercised allows for a partial tax exemption, it is also important to determine what happens to the rest of the option – who bears the tax cost.
Q: What should a startup take into account when raising capital? How do foreign investors change the situation for the company?
On the tax side, consideration should be given to how the new investment is involved. There are many alternatives – such as increasing share capital and loans – and they all have their own tax consequences.
However, a structure that may be a good solution for a company and its natural person shareholder may not be beneficial for a legal person owning the shares. Even a small and insignificant detail at first glance can lead to a high cost or a significant tax gain.
When it comes to on-boarding foreign investors, it definitely adds an international layer for the company. In other words, in addition to Estonian tax law, future decisions must also take into account how one or another action relates to a foreign investor and his or her taxation.
Q: Sometimes an investor may put pressure on a startup to move to its legal space. What should be considered if the startup decides to do so?
In such a situation, the startup should considered very precisely which functions and assets move to the other legal space and which remain in Estonia. Often, such a move means that only certain functions move away from Estonia, but the Estonian unit also remains in some form.
The redistribution of assets and functions, as well as risks means that the parties have to price their transactions correctly. It is often assumed that, as these are companies controlled by the same people, such movements are like "lifting from one pocket to another" that taxes are not relevant at all. However, this view is mistaken. On the tax side, some of the riskiest transactions are between related parties, as these transactions are the easiest to manipulate – moving profits to low tax rate jurisdictions and causing losses in high-tax countries. Such transactions come to the attention of the Tax Board very quickly these days.
Given that a change of jurisdiction usually involves the movement of high-value assets, proper pricing is very important. Improper pricing – such as free delivery – can ultimately be very expensive for a company. In addition, it is important to think about how leaving Estonia is structured – whether there is a sale of assets, a cross-border merger or a combination of different options. As always, any such move has its own tax consequences for both the relocating startup and its shareholders. And what works for the company may not be the best solution for the owners. As a one-size-fits-all solution may not exist or may not be realistic at a reasonable cost, it is important to find a balance. This means both between the interests of the various parties and, in fact, between different areas of law. Tax law does not exist on its own but always in conjunction with other areas of the law.
Q: What should be considered for exits? What are the most common mistakes or risks?
In the case of an exit, it is very important who is the seller. The tax consequences are radically different depending on whether the seller is a natural person, a legal person or foreign individuals. Therefore, before exit, it is necessary to think about which structure is the most reasonable from the seller's point of view. Much depends on what the seller wants to do with the money received – if the goal is to invest, then it is probably most profitable to sell the shareholding as a legal person. However, if the proceeds are to be used for private purposes, the choice is likely to be in favour of the seller as a natural person.
However, the picture becomes more complicated when there is only a partial exit. In this case, a lot also depends on what the future plans are for the remaining shareholding.
Q: What is the difference in tax matters if the founder of the startup is an individual or a company? Is it possible to change this over time?
The difference is considerable. As the taxation of individuals and companies is different, so are the tax issues faced by the natural person and legal person as an owner ofthe startup. One simple example – if in the case of Estonian legal persons, it is possible to defer the income tax liability until distribution of profit, then in the case of a natural person it is usually not possible. However, the tax period for a natural person is a calendar year and the obligation to pay income tax arises only on 1 October of the calendar year following the tax period. In other words, in a situation where a natural person sells his or her share in a startup in January 2022, he or she will not pay income tax from the profit received until October 1, 2023. This is almost a year between receiving the profit and paying the actual tax. In the same example, however, a legal person would incur a tax liability as early as February 2022, provided that the proceeds from the sale of the startup were distributed immediately as dividends.
This is just one example where owning the shares of a startup as a natural person and as a legal person has different tax consequences. However, there are many of them – the difference is very clear in the context of transactions – under what conditions new investors can be on-board and what tax consequences the sale of a shares will bring. If the shares of a startup are hold as a natural person, it is later possible to change it and, for example, to create a legal person through a non-monetary contribution. The opposite – from a legal person as a shareholder to a private individual – is also possible, but generally many times more expensive.