Thin Capitalization Rules in Lithuania by Gencs Valters Law Firm
In 2009, Lithuania and other Baltic countries faced a difficult challenge combating financial instability. Lithuania increased most taxes to offset economic losses and bolster public finances in 2008-2009. However, 2010 has started with ease, as the tax burden has decreased. As a result, Lithuania remains attractive to foreign investors because of favorable tax planning opportunities.
Notably, the parties to the various transactions are expected to apply the transfer pricing principles, which are fully applied in Lithuania. In order that controlling persons do not breach the market price principle and the interest rates does not turn up to be dividends, Lithuanian Government introduced thin capitalization rules, detailing from what amount interest can be deducted and cases when it cannot be deducted.
Please find as below the rules of transfer pricing and thin capitalization.
I. Market Price and Economic Benefit
A. What is Market Price?
Transfer pricing in Lithuania is laid down in the laws and fully applied in practice. Its definition is laid down in law on Value Added Tax and Corporate tax law. Therefore open market value corresponds to the amount of consideration which a purchaser would have to pay for the goods or services to a supplier thereof at arm's length where each one of them is seeking maximum economic benefit for himself.
In the cases where the tax administrator has grounds to suspect that the taxable amount of the supplied good or service has been artificially changed, it will have the right to calculate the taxable amount. The taxable amount of the supplied good or service may be considered artificially reduced or increased in the case where upon giving due consideration to all conditions of the transaction the taxable amount does not correspond to the open market value of the good or service (it has been fixed having regard to an individual purchaser - related person, etc.).
The taxable amount is calculated, on the decision of the tax administrator, on the basis of the open market value determined in accordance with the methods approved by the Government of the Republic of Lithuania or an institution authorised by it. It is not applicable to the supply of goods or services effected for a consideration fixed by state or municipal institutions and agencies or in the international agreements of the Republic of Lithuania.
Law on Corporate tax sets the definition for the actual market price which considered as the amount for which assets may be exchanged or mutual obligations settled between willing independent buyers or sellers in a direct transaction.
B. Adjustment of Transaction or Economic Operation Value and Revaluation of Income or Benefits
Entities must recognise the amount which is in line with the actual market price of a transaction or economic operation as income from such transaction or economic operation and they must recognise the total amount of costs incurred during a transaction or economic operation which is in line with the actual market price of such transaction or economic operation as allowable deductions or limited allowable deductions.
Where the conditions created or prescribed by mutual transactions or economic operations between associated persons are other than those created or prescribed by a mutual transaction or economic operation between non-associated persons, any profit (income) that would be attributed, if no such conditions existed, to one of such persons but due to such conditions is not attributed to him, may be included in the income of that person and taxed accordingly.
II. Thin Capitalization Rules
Notably, all transactions in Lithuania should be in accordance with market value.
The Rules for the Requalification of Income or Payments approved by Lithuanian Government define the cases when income or payments must be requalified. It is important to note the qualification of interest on the Controlled Lent Capital.
Laws prescribe that the share of capital lent for remuneration to the Lithuanian entity by the controlling lender(s), which is in excess of the ratio 4:1 between such lent capital for remuneration and fixed capital, is qualified as controlled lent capital. We will further present the example of this rule.
The ratio between lent capital for remuneration and fixed capital set above is calculated as of the last day of the taxable period of the Lithuanian entity.
If lent capital is denominated in foreign currency, the ratio between such lent capital and fixed capital is calculated after conversion to litas (Lithuanian currency) by applying the official currency exchange rate announced by the Bank of Lithuania as on the last day of the taxable period.
Interest payable on the use of controlled lent capital shall be considered unrelated with the earning of income and shall not be deductible, for the purpose of calculating taxable profit of the controlled Lithuanian entity, from income of the Lithuanian entity. Currency exchange losses related to controlled lent capital are not deductible from income of the Lithuanian entity.
The above rule will not be applied if the Lithuanian entity proves that an equivalent loan might be taken on the same conditions between independent (unrelated) persons. Such proofs are normally presented in accordance to the Lithuanian Bank statistical data, providing interest rates and its market value of every month. The provisions of those rules will neither apply to financial institutions providing financial lease (leasing) services.
To present with an example, we may say that company's fixed capital is 150 EUR. And 700 EUR is the loan of controlling Company which is being unpaid. In case the above 4:1 principle is applied, then 150x4= 600, therefore 600 is the sum to which the company may attribute interest, and this interest enjoys the right of possible deductions.
Further to this, 700-600= 100 (the loan minus the sum to which the company may attribute interest equals to 100 which is sum from which the interest will be non-deductable). Therefore from 100 the interest will not be deducted and from 600 the interest will be deducted.
It is important to note that fixed capital in accordance to local legislation is the equity of a Lithuanian taxable entity as of the last day of the taxable period, excluding the financial result (profit/loss) of the taxable period concerned. For the purpose of calculating fixed capital, equity of the Lithuanian entity shall not include the revaluation result of assets transferred to it by the controlling lender, if such assets have been used by that Lithuanian entity for less than two years.
Regarding qualification of interest and rent payments it shall be noted that Interest payments related to profit, income or similar performance indicators (e.g. sales) of the Lithuanian entity and interest payable under debt-claims entitling the lender to exchange its right to interest with the right to the borrower's profit or a part thereof, also rent payments related to profit, income or similar performance indicators of the Lithuanian entity shall be qualified as unrelated to the earning of income and shall not be deductible, for the purpose of calculating taxable profit of the controlled Lithuanian entity, from income of the Lithuanian entity.