Concealing an employment relationship with an ostensible transaction

On the basis of the recent decisions of the Estonian Supreme Court (No. 3-2-1-82-14, No. 3-3-1-25-15, No. 3-3-1-12-15) paying a fee to employees or members of the management body on the basis of management, consultation and other service provision agreements (authorisation agreement) concluded between companies are in certain cases considered as concealing an employment relationship and therefore these authorisation agreements are ostensible. § 89(2) of the Estonian General Part of the Civil Code Act provides that an ostensible transaction is void. The basis of the taxation of an ostensible transaction is § 83(4) of the Estonian Taxation Act (ETA), which states that „ostensible transactions shall not be taken into account upon taxation. If an ostensible transaction is entered into in order to conceal another transaction, the provisions concerning the concealed transaction apply upon taxation“.

The transaction does not take place between the parties

The Estonian Supreme Court has found that the ostensibility of the transaction may also take the form that the transaction has not taken place between those persons, who are considered the contracting parties in the agreement. This means that the management and advisory services are not provided by the relevant companies who concluded the agreements, but by members of the board or employees as natural persons and therefore natural persons must be considered as the parties to the agreement. The prescribed taxes however must be paid and withheld on the payments made to natural persons (decision of the Supreme Court No. 3-2-1-82-14, para 36).

The economic substance of the transaction

In addition to the ETA § 83(4) another legal ground for imposing an additional tax is ETA § 84 i.e. the section for interpreting the economic content of the transaction. This section gives the tax administrator the right to assess the taxable person’s transactions on the basis of the economic interpretation principle, to give the transactions an assessment corresponding to their content and to determine the tax sum payable, depending on the economic consequences of the transaction.

Members of the management body cannot choose the form of providing the service

The Court has doubted the general understanding in Europe that the activity of members of the management body is entrepreneurship and on the basis of the principle of freedom to conduct a business members of the board can choose whether to provide the service as private persons, a self-employed persons or through their own company. Payments made to employees or members of the management body made on the basis of authorisation agreements with the content of an employment agreement must be taxed dependent on the content of the agreements, not the form of the agreements.

Cases are different

It must be taken into account in light of the court decisions, that each case is different and not all authorisation agreements with Estonian companies related to employees or members of the management body are automatically requalified as employment agreements. The Court has found that the laws do not prohibit the provision of the management or advisory services that are part of the duties of a member of the board through a company. Therefore, the fact alone that a legal person provides a management or advisory service is not the ground for assigning an additional tax obligation.

One must rely on evidence

In these cases the Court has given the tax administrator the right on recovery of additional tax, primarily taking into account the evidence gathered in each specific dispute. It has not been proved in the cases, that the makers of the disbursement had ordered the performance of specifically delimited duties within the framework of the mandate relationship and paid for them according to the volume of work and expenses. The circumstances identified in the proceedings refer to a constant performing of rolling duties with a specific monthly payment, which was carried out with the equipment belonging to the recipient of the service (office, vehicle, computer, software) and it is characteristic of an employment relationship (SC 3-3-1-25-15 para 7.5).

Content of authorisation agreements

The mandate relationship between the mandator (service recipient) and mandatary (provider of the service) is regulated by the Estonian Law of Obligations Act (LOA). The LOA § 619 provides that 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. The LOA § 620(2) prescribes that the mandatary must perform the mandate according to his knowledge and abilities and to the maximum benefit of the mandatory and prevent any damage to the property of the mandatory. A mandatary acting for the purposes of its economic or professional activities shall in addition apply the generally recognised skills of its profession.

The LOA § 621(1) provides that in the case the mandatary shall perform the mandate based on his professional skills or abilities, the mandator shall not provide specific instructions concerning the manner or conditions of performance of the mandate.

Content of an employment agreement

§ 1(1) of the Estonian Employment Contracts Act (ECA) regulating the employment relationship provides, that 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.

The Court has recognised the tax administrator’s right to requalify the service agreements into employment agreements and pursuant to this assign an additional tax on the justification that relations between the persons would rather qualify as an employment relationship than a mandate relationship.

Five facts from the court judgment

Five facts have been specifically highlighted in the court judgment (RK 3-3-1-25-15 para 2.4), on which the tax administrator based the requalification of agreements:
1) providers of the service were actually subordinated to the management and control of the recipient of the service;
2) the providers of the service were given directions by the recipient of the service;
3) the providers of the service used the property belonging to the recipient of the service;
4) reporting characteristic to authorisation agreements was not required of the providers of the service;
5) the working time of the providers of the services coincided with the general working time of the recipient of the service.

Payment of labour taxes

In case the ostensibility of the authorisation agreements and an actual employment relationship between the parties have been identified, the basis for calculating labour taxes on the remuneration paid on the basis of the authorisation agreement are the sums paid, from which value added tax is deducted if the invoice for the service is submitted with value added tax. The remaining sum is taxed as net salary. Labour taxes must thereat be paid by the maker of the disbursement, because the tax legislation of the Republic of Estonia does not allow transferring the duties of the payment and withholding of taxes pursuant to law to the employee. To avoid the double taxation of disbursements the recipient and provider of the service must adjust the calculation of tax by cancelling or amending the invoice and adjusting the value added tax declarations appropriately. Labour taxes are declared and paid by the recipient of the service.

Evidence of expenses

The requalifying of the entire remuneration paid into income from employment can be avoided by submitting evidence about the expenses related to entrepreneurship pursuant to § 12(3) of the Income Tax Act. Such expenses may be business trip, office, car, mobile telephone or other evidenced expenses.

Proving and reversing

To avoid the risk of requalifying authorisation agreements into employment agreements, when concluding and performing authorisation agreements it must be followed that the content of the agreement would correspond to the mandate provisions of the Law of Obligations Act and the terms of a mandate relationship. In case of a dispute with the tax administrator one must be ready to prove both providing the service as an independent service provider as well as the content of the services specifically provided. If the service provided on the basis of the authorisation agreement is qualified as ostensible, then in case of an ostensible transaction the contracting parties have the right to return what was received on the basis of the transaction and adjust the value added tax returns respectively.

You can find the explanation of the Estonian Tax and Customs Board about the taxation of ostensible transactions here in Estonian here.

Author: Katrin Allmäe, lawyer of 1Office Estonia