TAX NEWS - DECEMber 2009

Latvia Tax: Thin cap rules to apply to residents and nonresidents

With effect for taxable periods beginning on or after 1 January 2010, Latvia's thin capitalization rules will apply to interest paid on loans from Latvian residents regardless of whether the lender is related to the borrower. The changes to the thin cap rules can significantly affect Latvian companies that have financed their investments through loans (except bank loans). To mitigate the adverse tax consequences arising from the new rules, companies should consider restructuring their financing models.

Changes to the Corporate Income Tax Law announced by the President on 4 November 2009 arose out of a dispute with the European Commission, which had instituted the first stage of the infringement procedure in 2008 on the grounds that Latvia's current thin capitalization rules discriminate against nonresidents since interest payments to Latvian residents are exempt from the rules. According to the Commission, nonresidents are discriminated against because restrictions on the deductibility of interest on loans from nonresidents made such loans more expensive than loans from residents; thus, other conditions being equal, a borrower would choose to obtain a loan from a Latvian resident and for nonresidents to compete with Latvian residents, nonresidents would have to grant loans at lower interest rates.

The amendments were passed to eliminate the discrimination against residents of EU/EEA countries and countries that have concluded a tax treaty with Latvia. However, rather than apply an exemption to loans from residents of such countries, Latvia has chosen not to exempt interest payments made to Latvian residents from the thin capitalization rules. As a result, restrictions on the deduction of interest will apply equally to nonresidents and residents.

Taxable income for tax periods beginning after 1 January 2010 will generally be increased by the higher of the following amounts:

- The amount of interest exceeding an amount calculated by applying to the average amount of debt 1.2 times the average short-term interest rate with credit institutions as of the last month of the tax period as determined by Central Statistical Bureau of Latvia; and
- The amount of interest proportionate to the amount of interest- bearing loans exceeding more than four times the equity of the company. For thin capitalization purposes, equity will be decreased by the amount of the revaluation reserve and other reserves not arising from the distributable profits.

The following exclusions from the application of the thin capitalization rules will continue to apply:

- Interest on loans from credit institutions resident in EU/EEA countries and tax treaty countries, as well as interest paid on loans from the Latvian Treasury and certain international credit institutions will be excluded; and
- The debt-to-equity ratio will not take into account loans from financial institutions resident in EU/EEA countries and tax treaty countries provided the loans or financial leasing are obtained from certain financial institutions that are supervised by the country's financial and capital market regulator.