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Concealment of actual employment relationship

General practice of interpreting the law, which is not considered to be a binding assessment of the Estonian Tax and Customs Board regarding the taxation of a particular taxpayer's particular transaction.

Tax liability also arises in the case of ostensible provision of services between companies in order to evade or pay less labour taxes.

The Supreme Court made three important judgements (the decisions 3-2-1-82-14, 3-3-1-25-15, 3-3-1-12-15), which support the Estonian Tax and Customs Board’s (tax authority) approach to the taxation of ostensible transactions. The mentioned judgements concern tax evasion relating to labour taxes, where the employee as a natural person had his/her remuneration transferred into the bank account of his/her company (the private limited company of a sole shareholder and a member of the management board). The employer did not have to pay labour taxes on the transfer of money as the employer and employee, instead of concluding an employment contract, had entered into a contract for the supply of services between companies. In such a way the employee increased the amount of money placed at the disposal of his/her company by the sum of labour taxes.

There have been similar cases where the companies related to the members of management or supervisory board, which had entered into contracts for the supply of management and consultation services, did not actually render the mentioned services, but instead, these services were rendered by the members of management and supervisory board as natural persons, while the remuneration was transferred into the bank accounts of their companies.

The main purpose for such a scheme is evading labour taxes and increasing financial resources at the disposal of an employee, i.e. the motive is financial gain. For example, according to the employment contract the chief executive’s gross wages are 3500 euros and the monthly net salary 2730 euros, so the total cost for the employer including taxes and payments is 4683 euros per month. If instead of the employment contract a contract for the supply of services is concluded, it will be possible to transfer the total sum of 4683 euros to the company of the chief executive (again the private limited company of a sole shareholder and a member of the management board) without paying taxes. In this way the tax liability can be postponed, which gives the chief manager an opportunity to use the money in his/her company at his/her discretion: either partly paying wages, paying dividends or spending it for other expenditures (e.g. car leasing etc.). However, labour taxes remain uncharged on the amount of 4683 euros which was transferred to the company for the provided services.

The Supreme Court confirmed that in such cases the tax authority is entitled to intervene and tax the transactions, taking into account their actual economic content.

Therefore, the tax authority draws attention to the fact that for tax purposes it is not enough that a concluded contract formally complies with the requirements of the applicable law, the actual content of the work must correspond to the contract as well. If an employee performs his/her professional duties, it is necessary to conclude an employment contract; if a member of management or supervisory board performs his/her functions, it is necessary to conclude a management board member contract or supervisory board member contract. The compliance of a contract with the actual content of the work done or service provided ensures the uniform taxation of all persons and enhances fair competition.

The tax authority expects the undertakings that have used such a scheme to improve their further tax performance following the decisions of the Supreme Court. For the purposes of making corrections and harmonizing relating practices the following frequently asked questions are provided below.
 

Questions and answers
 

1. What characterises an employment relationship and employment contract?
2. What characterises a contract for the supply of services?
3. What is the content of an authorisation agreement of a member of the management board and how is it different from an employment contract?
4. In which cases the contracts of management and consulting services do requalify into management board member agreements or employment contracts?
5. In which cases the provision of management and consulting services through a company is justified?
6. How to differentiate and tax the remuneration of a so called one-person-company (sole shareholder, member of the management board and an employee in one person)?

1. What characterises an employment relationship and employment contract?


Employment relationship is regulated by the Employment Contracts Act, which defines an employment contract as follows (section 1 of the Employment Contracts Act): on the basis of an employment contract a natural person (employee) does work for another person (employer) in subordination to the management and control of the employer. The employer pays to the employee remuneration for such work.

In other words an employment contract is an agreement between an employee as a natural person and an employer, on the basis of which:

  • the employee undertakes to work in subordination to the management and control of the employer, and

  • the employer undertakes to pay the employee remuneration and to ensure the working conditions provided for by the employment contract, collective agreement or law.

Verifying the correspondence between the legal relationship and employment relationship the courts have relied on the following:

  • who organises and manages the working process pursuant to the agreement
  • who determines the time, place and method of work
  • who pays for the work equipment
  • who takes the work-related risks
  • who gets the income or profit
  • whether the person doing the work is a member of the staff
  • whether he/she is in subordination to the management and control of the employer

All these criteria should be regarded and treated as a whole. When determining whether the relationship is an employment relationship, it is necessary to consider the relation of dependency between the employee and the employer: to what extent the employee is under the authority of the employer, in other words, how independent is the employee from the employer. The extent of dependency relationship between the employee and employer is the most important indicator that differentiates an employment contract from other civil law contracts. (RKTK 3-2-1-3-05)

2. What characterises a contract for the supply of services?


Authorisation agreements and contracts for services are contracts for the supply of services regulated by the Law of Obligations Act. By an authorisation agreement, one person (the mandatary) undertakes to provide services to another person (the mandator) pursuant to an agreement (to perform the mandate) and the mandator undertakes to pay remuneration to the mandatary therefor if so agreed. (Law of Obligations Act, § 619)

By a contract for services, one person (the contractor) undertakes to manufacture or modify a thing or to achieve any other agreed result by providing a service (work), and the other person (the customer) undertakes to pay remuneration therefor. (Law of Obligations Act, § 635)

Unlike employees who work under the management and supervision of an employer, mandataries or contractors act independently and at their own risk. The extent of independence of a mandatary’s or contractor’s activity differentiates the work relation under authorisation agreements and contracts for services from the employment relationship.

The risks of undertakers (mandataries or contractors) as compared with employees lie in the fact that, for example, undertakers:

  • have their own work equipment (fixtures, communication, office, computer)
  • ensure the workflow of their business by themselves
  • receive remuneration only for a high-quality work and repair mistakes at their own expense
  • provide warranty for the performed works
  • train and certify themselves
  • take care of their accounting and staff
  • cover the costs of work stoppage, e.g. if a project is stopped
  • cover the costs of holiday pay and sick leave
  • pay for their benefits themselves
  • neither receive redundancy payments nor have any other rights of employees
     
3. What is the content of an authorisation agreement of a member of the management board and how is it different from an employment contract?


Subsection 31 (3) of the General Part of the Civil Code Act regulates the internal relations of a legal person and does not constitute a provision of the tax law which forbids rendering management and consulting services falling within the tasks of a member of the management or supervisory board via a company. The Supreme Court has explained that the relationship between members of the management board and a company is a mandate-like legal relationship (the judgment in the civil matter 3-2-1-103-08, 20). Pursuant to section 622 of the Law of Obligations Act it is presumed that a mandatary shall perform the mandate in person, but a mandatary also has the right to use the assistance of third parties in performing the mandate. The fact that a member of the management board may transfer neither his/her competency nor responsibility does not forbid the use of the assistance of third parties in performing the mandate. (RKÜK 3-2-1-82-14)

In the case of the companies related to members of the management and supervisory board the ostensibility of a transaction may be reflected in the fact that the management and consulting services were not provided by the companies who had concluded the relevant agreements, but by the members of the management and supervisory board as natural persons, therefore the legal consequence of the ostensible transaction is the fact that the counterparties of the agreements have to be regarded as natural persons. (RKÜK 3-2-1-82-14)

In the case of the companies related to employees the ostensibility of a transaction is reflected in the fact that on the basis of the content of the agreement this is actually an employment contract and therefore the authorisation agreement has to be requalified into the employment contract. According to the definition of employment contract as stated in section 1 of the Employment Contracts Act only a natural person can be an employee, so the requalification of an authorisation agreement into an employment contract automatically entails the replacement of a legal person by a natural person. (RKÜK 3-2-1-82-14)

4. In which cases the contracts of management and consulting services do requalify into management board member agreements or employment contracts?


On the basis of the judgement of the Supreme Court (RKHK 3-3-1-12-15) the circumstances which enable the requalification of the contracts of management or consulting services into management board member agreements or employment contracts may be described as follows:

  • companies that have provided services issue invoices to the recipients of services on a monthly basis and mostly for the same amount

  • companies provide services only or mostly for one recipient of service in a certain period of time;

  • the service that is provided to the recipient of service by its members of management board on behalf of companies is the consulting of the recipient of service in the tasks that they perform as members of the management board;

  • the contracts for the supply of services in question have the characteristics of employment contracts.

In its judgement (RKHK 3-3-1-12-15) the Supreme Court accepted that the above circumstances make it possible to conclude that the actual content of the transaction was employment and board member relationship between the company and natural persons.

5. In which cases the provision of management and consulting services through a company is justified?


As mentioned above the Supreme Court of Estonia has held that the fact that the member of management board can transfer neither competency nor responsibility does not forbid the use of the assistance of third parties in performing the mandate. Therefore, the fact alone that a legal person renders management and consulting services cannot provide grounds for the assessment of additional tax obligations. (RKÜK 3-2-1-82-14)

 Providing a management service through a company is deemed justified for example in the following cases,

  • if a separate holding company has been founded for the management of a group of companies, and the duties of the holding company’s staff involve the management and consulting of the members of the group;

  • if the members of the management or supervisory board do not work in this company on a daily basis, and the costs relating to their work are covered and the equipment needed for the performance of their functions is provided by the company that provides the service;

  • if a member of the management board has been appointed for a short time or he/she offers management services to a lot of companies (for example in the case of a substitution body, such as a liquidator or a trustee in bankruptcy). (RKHK 3-3-1-12-15)

On the basis of these circumstances the actual content of the transaction is the provision of management and consulting services through a company.

6. How to differentiate and tax the remuneration of a so called one-person-company (sole shareholder, member of the management board and an employee in one person)?


When providing management or consulting services or other services (e.g. acting, singing, organising events etc.) through a company it is necessary to bear in mind that a sole shareholder and member of the management board who alone provides services or is engaged in the economic activity of the company and receives remuneration for this work, has to be paid for his/her active engagement, either the fee of management board member, wages or other compensation depending on the type of work. A sole shareholder has also the right for passive proprietary income, i.e. dividends, but his/her active economic activity has to be taxed by all labour taxes.
 

09.11.2017