Taxes are an essential part of personal finance that people cannot afford to exclude from their financial budget. The European Union does not have harmonised tax laws - they vary from state to state. Member States have their own tax rules with their rates. Although the EU backed off from regulating taxes at the Union level, it has mandated that states not tax EU residents higher on gains from cross-border investments. They must treat it as a local income. Taxpayers should know a few fundamental elements of taxes.
Why do we pay taxes on investments at all?
States treat investment gains like any other income that needs to be taxed. However, taxpayers can arm themselves with the practical know-how of declaring and paying the income tax rate to avoid penalties for non-payment. Here is what you absolutely need to know about taxes in 2021:
- Types of taxes you may need to pay on your investment income
- Declaration of taxes and double taxation
- What happens if you don't file your taxes on investments
- Paying taxes in Estonia on investment income
Types of taxes you may need to pay on your investment income
The types of investment tax that are relevant for you are income tax, capital gains tax, and dividend tax. Income tax is when you pay on any income you earn-it could be a salary, rent, or interest earned from investments. You pay capital gains tax when you sell your assets, like real estate or your stocks. Dividend tax is paid on the dividend paid to a shareholder by a company. We will explain each of them in the following:
- Income tax: Income taxes are levied under a progressive structure, meaning the more you earn, the more you pay in taxes. Currently, Denmark has the highest tax on personal income at 55.9%. Hungary has the lowest tax rate on personal income at 15%.
- Capital gains tax: Capital gains tax is different in every member state. Some countries levy it, and some do not. Denmark has the highest capital gains tax at 42%. Finland and France levy 34% on the sale of assets. Belgium, Slovakia, Slovenia, Luxembourg, and the Czech Republic are some of the countries that do not levy a capital gains tax. Greece and Hungary levy the lowest capital gains tax at 15%.
- Dividend tax: Taxes on dividends vary from member state to member state in the European Union. Out of all the countries in Europe, Ireland has the highest dividend tax rate at 51%. Denmark's dividend tax comes at 42% and the UK's dividend tax comes at 38.1%. Estonia and Latvia do not levy taxes on dividends; instead, a corporate income tax of 20% is imposed when a company pays profits to its shareholders. At 5%, Greece has the lowest tax on dividends.
Declaration of taxes and double taxation
Declaration simply means declaring your income to the tax authorities to be taxed. Depending on your income, residence, duration and the local laws of your residence, you may pay taxes to your resident country or your birth country or both. This is known as double taxation.
Taxpayers must declare their income earned through investments to the relevant tax authority. There is no uniform standard for the declaration of taxes on interest. Some states require taxpayers to declare the taxes on their investments; others declare taxes on their behalf—Estonia being one of them. The declaration and the tax rates depend on the distinction between tax-residents and non-tax-residents. It is sufficient that the investor is a tax-resident to be subject to the specific state's tax declaration rules.
Residency can mean merely residing in the state and not necessarily being a citizen of it. All states usually agree that the tax residency requirement requires the investor to live in the state for more than six months.
You can check the tax rates and the declaration rules right here.
Due to the EU's free movement (goods, people, and capital), many Europeans are moving and investing their money in businesses across the border. Generally, residents will still be subject to their state of residence's tax rules, but they may have to pay taxes back home. It is called double taxation. A resident pays taxes on his investment income in his state and the state he is investing in or residing in. It is not unlawful, but it is an obstacle to the free movement of capital. Fortunately, most countries have agreements to avoid double taxation under bilateral treaties between two member states. The investor will need to claim relief from double taxation through evidence of residence and prior payment of taxes on other income (e.g. employment). Taxpayers need to contact the relevant tax authorities to find out what documents they need to submit.
Kinds of double taxation
There are two types of double taxation, namely, corporate double taxation and international double taxation. Corporate double taxation is when a company pays taxes on its profits and its shareholders pay a dividend tax. The net income of a corporation is taxed as a corporate tax. When that same income is given to shareholders as a dividend, it is taxed again as a dividend tax. If you own shares in a company, this part is important to you. There are arguments for and against corporate double taxation. Opponents of corporate double taxation believe that since shareholders are the owners of a corporation anyway, taxing the same profit twice is unfair. However, proponents of double corporate taxation believe that a corporation is a separate legal entity from the shareholders and, hence, their incomes should also be taxed separately.
Dividends are taxed differently in the EU and it varies within member states. Most member states try to reduce double taxation either through shareholder tax credit for the taxes that a corporation pays (imputation system) or by taxing income separately based on its categories (schedular system).
International double taxation either affects multinational companies that operate globally or individuals who are earning foreign income in other countries. An investor's foreign income can be taxed in both the country where the income comes from and the country where the investor lives. Arguments against international double taxation are that it imposes an unnecessary burden on an investor and may discourage him from investing at all, causing the cost of goods and services to increase. Even the Court of Justice of the European Union (CJEU) admits that, although not illegal, international double taxation may hurt the fundamental freedoms that EU law protects.
What happens if you don't file your taxes on investments
Not declaring your income from investments will be deemed tax evasion. You will be exposing yourself to the threat of a financial penalty as tax evasion is illegal. Every member state has its own punishment that is proportional to the evasion.
Estonia considers tax evasion to be a crime and a misdemeanour, punishable by a monetary fine or imprisonment of up to 5 years. Hence, you need to declare your interest earned from your investments.
Paying taxes in Estonia on investment income
Taxes on income in Estonia are declared before payment, and taxpayers need not report them separately. It includes income made on investments. Estonia's mandatory income tax rate is 20%, and Estonian residents receive the net income on their investment. The rest receive the gross amount.
Under the conventions for avoiding double taxation and preventing fiscal evasion concerning taxes on income and capital between Estonia and other states, residents can claim a return from double taxation upon proving their residence. Both EU/EEA states and non-EU/EEA states are included in the Convention. (Check out the overview of bilateral convention and its future preparations).
Additionally, Estonia will treat an investor as a tax-resident even if they do not reside there. It is called a 'fictitious tax residency', and it is legal. An EU/EEA citizen/resident can register as a tax-resident to receive an Estonian Tax Identification Number to have the investment institution pay taxes on their behalf. They may or may not have to pay it again in their state (subject to the Bilateral Convention). Some investors may opt for this option if they wish to save time on the declaration. (Investors should contact the EMTA before applying for tax-residency).
However, the fictitious tax residency only applies to income made in Estonia from business income, casino winnings, earnings made from the rental profits from the property they own in Estonia, some licence earnings, dividends, interest from investment funds operating real estate, etc.
None of the scenarios apply to Quanloop. Therefore, the fictitious tax residency does not apply to income from Quanloop investments.
Taxes are an essential part of your investment. You have to pay taxes on your investment earnings because they are an income and will be treated as such. You may need to pay attention to 3 kinds of taxes for your investments: income tax, capital gains tax, and dividend tax. You have to pay income tax on the interest earned from your investment. You have to pay capital gains tax if you sell your investments. You only have to pay dividend taxes if you are a shareholder of a company and you receive dividends.
In order to pay the correct amount, you have to declare the income from your investments. Depending on your local laws, home country laws, and the existence of bilateral conventions, you may need to pay double taxes. If you invest outside the borders, you may have to pay double taxes on your dividends, or you may have to pay to both your home country and your current residence state. However, the European authorities generally try not to burden tax payers with double taxation because it hinders the basic European right to free movement of capital.
Taxes can be confusing for even experienced people because they are very complicated and people have trouble grasping the intricacies of taxes. All financial gains are affected by taxes, including investments. Due to a lack of harmonisation, people have to jump through hoops to ensure that they are paying their taxes correctly. Luckily, there have been initiatives to lower the tax burden at the Union level, and there are many platforms that now help with cross-border taxes on investments.