Publication

Several years ago, a regulation was included in the Latvian tax law “On Personal Income Tax” providing that, upon fulfillment of certain criteria, a loan to board members, employees or shareholders should be subject to personal income tax (hereinafter – PIT).

It should be noted that the regulation not only applies to loans to family members of employees, shareholders and members of the board, but also to transactions between individuals.

To reduce the potential negative consequences of a PIT when receiving a loan from closely related company, all of the following criteria must be met:

(1) the loan agreement must be signed in writing;
(2) the loan must be issued and repaid in the form of a non-cash payment;
(3) the loan must be repaid 6 months after the term set out in the loan agreement, but no later than within 66 months;
(4) the loan agreement should not exceed 60 months;
(5) the lender should not have any tax debts on the day the loan is issued;
(6) the maximum loan amount should not exceed 30% of the average gross salary for the last 12 months multiplied by 60. If the borrower-owner does not derive income from the lender, the maximum loan amount should not exceed the amount of the lender’s equity (company’s assets minus company’s liabilities) attributable to the borrower (in accordance with the last approved annual report);
(7) the total amount of loans granted to individual’s does not exceed the lender’s equity (in accordance with the last approved annual report).

If the lender is outside the EU or EEA and has been established or registered in a country with which Latvia has not signed a Convention for the avoidance of double taxation and the prevention of fiscal evasion (or the convention has not entered into force yet), or in a low-tax or a zero-tax country or territory, the loan agreement must be signed in the form of a notarial deed.

Experience shows that even when a loan agreement is signed, and its term is no longer than 60 months, it is sometimes forgotten that the maximum loan amount cannot exceed 30% of the average monthly salary of the employee in the past year multiplied by 60. In some cases, the company forgets that it has negative equity. In these types of situations, the loan initially does not meet the criteria set up in the law.

It is also important to mention that the tax administration and the Ministry of Finance have drawn attention to the fact that in case an agreement has been initially signed for, for example, 3 years, it is impossible to extend it to 5 years (60 months). Namely, if the loan is not repaid within 3 years (plus 6 months) as initially intended, the extension would not allow the taxpayer to avoid additional taxes. In such cases, we recommend requesting advance ruling from the State Revenue Service before extending the loan agreement.

It is important to distinguish between cases when the loan does and does not initially meet the criteria laid out in the law. This will probably determine who, and to what extent, will be liable for the tax payment if the loan, or any part thereof, is not repaid in full. If the loan initially meets the above criteria (it is signed in writing, the average salary requirements are met, the maximum term is 60 months, etc.), it would be the individual who would have to face the tax consequences in case the loan is not repaid in full.

For example, Investment Limited has lent EUR 30,000 to its sales manager for 60 months. The average salary of the sales manager in the past 12 months has been EUR 10,000. After 66 months the sales manager still owes the company EUR 5,000. In this case, the company shall report the sales manager’s income to the Tax Authorities (Valsts ieņēmumu dienests). The sales manager will have to pay a PIT from EUR 5,000 (the gross amount, i.e. the PIT will be calculated from EUR 5,000).

The regulation on tax consequences does not apply to small loans (up to EUR 1,500 per lender), loans between spouses and relatives (up to third-degree within the meaning of the Civil Law), and loans issued for medical or educational purposes.

It should be remembered that the Tax Authority is entitled to audit the loans that have been issued and received within the past 5 tax years instead of the past 3 tax years, as is the general practice.

It should also be remembered that all loans should include interest rates that correspond to the level of rates of an independent transaction market. Namely, the Law “On Personal Income Tax” provides for tax consequences for interest-free or reduced interest loans.

In view of the above, we encourage you to carefully assess the potential tax consequences when granting loans to your employees, shareholders, members of the board or their family members, and contact tax experts before entering into such transactions.