Tax Policy in Latvia on the Eve of Enlargement

Baltic Journal of Economics Autumn/Winter 2003

Tax Policy in Latvia on the Eve of Enlargement Daina RobeΩniece and Måris Jurußs *

The Latvian tax system is very young – only in its twelfth year of implementation – however, Latvia has succeeded in creating a viable and effective tax system in such a comparatively short period of time, in which the main fiscal aims (ensuring state budget revenue), are balanced with the use of taxes as an instrument of economic policy. Latvia has succeeded in doing so because, during the reorganization of the tax system in the mid90’s, new tax laws were developed according to the experience of developed democratic countries and taking into consideration advice from experts representing a number of international organisations. From this point of view it could be argued that Latvia, creating its tax system from the start, has had certain advantages over the “old” tax systems. After all, Latvia had the opportunity to become acquainted with best practice and avoid the mistakes that other countries had made earlier. This, however, does not mean that there have been no mistakes in creating the Latvian tax system. The rest of this paper will analyse the different types of taxes introduced in Latvia, and the impact of the impending EU accession. Taxes on Income There are two taxes on income in Latvia – personal income tax and the enterprise income tax, which form a united system. This means that: • in general, any person deriving income in Latvia is either taxable with personal income tax or enterprise income tax; • the same income is never subjected to both the income taxes at the same time. Latvian income tax laws have been formed according to the principle that: • the range of taxable persons and the tax base have to be wide; • the rate has to be comparatively low. The Latvian income tax system is comparatively neutral in terms of resources reallocation, as the laws create no special taxation advantages to one particular economic sector or another. The fact that quite a large number of reliefs has been granted under the enterprise income tax, furthermore, that the efficiency of the reliefs in terms of attracting investment or solving social problems is low, could be mentioned as a negative tendency o some extent. Therefore, in order to encourage entrepreneurship, it has been envisaged to gradually decrease the enterprise income tax rate to 15 per cent by 2004, and at the same time cancel separate former reliefs. * Daina RobeΩniece, Director of Tax Policy Department and Måris Jurußs, Deputy of Director of Tax Policy Department, Ministry of Finance, Latvia. 116

Tax Policy in Latvia on the Eve of Enlargement

The personal income tax rate of 25 per cent is also uniform to all payers and all types of income. It facilitates the administration of this tax. At the same time the problems characteristic to progressive income tax rate are absent – taxing income at a higher rate as a result of inflationinitiated increase in income, tax planning for applying a lower rate to income etc. Latvian income tax laws have been designed to eliminate traditional tax avoidance methods – there are provisions in the law regarding incomplete capitalisation, transfer pricing, governance in respect of transactions with low-tax and zero-tax states and jurisdictions. However, taking into consideration Latvia’s progress towards accession to the European Union, these provisions must be in compliance with the single market. In terms of personal income tax, it is necessary to address within the budget capacity the issue of increasing the exempt minimum, as the current level is the lowest not just among the Baltic countries but also among all EU candidate countries. Therefore its functioning in accordance with the envisaged objectives is not ensured. The generally accepted principles of both the European Union and OECD countries in terms of drafting laws have been taken into consideration during the writing of Latvian income taxes laws. The requirements of European Union directives are gradually incorporated into them in the sphere of direct taxation – both in respect of taxation of dividends and the application of income taxes laws during enterprise reorganization. In order to settle taxation issues at an international level, to avoid double taxation and prevent fiscal evasion, intense work has been carried out in concluding tax conventions. Latvia commenced work on concluding double taxation conventions together with both the other Baltic countries in 1992, and until the present moment negotiations with 47 countries have taken place for concluding tax conventions. At the present moment conventions with 44 countries have been initialed, 30 conventions have been signed and 26 conventions applied. Real Estate Tax The real estate tax reform that commenced in 1997 is still ongoing. The purpose of this reform is to ensure the simple and fair taxation of real estate, which means introducing a uniform tax rate of 1 percent, introducing a uniform tax base – the cadastral value of real estate – and covering a wide scope of payers of real estate tax - all persons that own real estate in Latvia. Tax reliefs provisioned for in the law are minimal and can only be granted by the municipalities, the budgets of which receive the tax income (the tax is payable into the budgets of municipalities at the full amount). In order to implement the reform in accordance with the above-mentioned principles, a real estate assessment authority has been created in Latvia. The analysis and recording of real estate transactions are made on a regular basis, and the data obtained is used in valuing real estate. The administration of the real estate tax has been fully transferred to municipalities since the 2000. Taking into account the fact that for purposes of calculating the real estate tax the cadastral value of real estate is determined by the State Land Service, the exchange of information between the State Land Service and municipalities is very important. The exchange of information is expanding and has also been considerably improved. The postponement of implementation of several stages of the reform is, however, a weakness of 117


the reform. The postponement has been necessary, taking into account the planned reduction of municipality budget revenue, due to the reduction of the tax rate, and exemption of certain categories of real estate from the tax. This means that the tax on buildings and constructions is levied on the book or inventory value, and not on the cadastral value of the buildings and construction. A 1.5% tax rate is still applicable, and the tax is not levied on private houses and real estate belonging to institutions financed from the state budget. The legal aspects of the formation of dwelling rights have also not been completely settled in law, as well as some matters connected with the maintenance of blocks of flats. The mentioned drawbacks could create problems in the calculation and collection of the tax in 2004, when flats will also be subjected to real estate tax. Value added tax Value added tax and excise taxes in Latvia are based on EU requirements. Work on harmonization of these taxes is ongoing, and it is planned to bring the Latvian law into conformity with EU requirements in the remaining time period remaining before the EU accession. In compliance with 6th Directive (77/388/EEC) Article 12 3(a) a Member State may apply one or two reduced rates for goods and services specified in Annex H. For the moment, the Latvian Law on Value Added Tax provides two rates of value added tax: the general rate of 18 per cent and the reduced value added tax rate of 9 per cent for certain transactions. A VAT rate of 0 per cent is applied to export and transit deals. A reduced VAT rate of 9 per cent was introduced as of 1st January 2003 in order to harmonize the Latvian value added tax system with the 6th Directive (77/388/EEC) wherewith certain goods and services which are not compliant with the above directive are excluded from exemptions. A VAT rate of 9 per cent is applied to the following supplies of goods and services: • supplies of veterinary medicine; • special food for infants; • supplies of mass media; • accommodation provided by hotels and similar establishments; • supplies of water; • sewerage services; • collection, transportation and disposal services for household waste. As of 1st January 2004, a reduced VAT rate of 9 per cent will apply to the supply of books as well as certain approved medicaments. It should be noted that by providing single VAT procedures on books and medicaments produced in Latvia and those imported the distortion on competition will be eradicated. The increase in the cost of the above-mentioned goods and services will not have serious consequences on the purchasing power of the population. The VAT taxpayer has the right to deduct input VAT from the tax amounts indicated in tax invoices received from other taxable persons regarding goods and services for ensuring their own taxable transactions. 118

Tax Policy in Latvia on the Eve of Enlargement

It should also be mentioned that the VAT refund system for all non-resident legal persons, according to the requirements of the 8th and 13th VAT Directives, was introduced on 1st January 2003. By introducing this system Latvia has successfully fulfilled commitments undertaken within the pre-accession process to the EU. Problems connected with the administration of VAT are a continuing weakness. Cases of VAT fraud are mainly related to the refund of VAT overpayments. In light of this, the Finance Ministry and the State Revenue Service prepared amendments to the Law On Value Added Tax, which are envisaged as measures against VAT fraud. Amendments were effective from July 16, 2003. The so-called carrousel schemes, well-established in EU Member States, can also be seen in Latvia. The schemes involve not just individuals residing in Latvia, but also those residing in neighbouring countries. Thus the quick and effective exchange of information is very important in counteracting the use of such schemes. Work on improving information systems and the creation of the necessary databases to EU requirements has begun at the State Revenue Service, in order to be ready to become a part of a united system of exchange of information within the EU. Continuing work in the interpretation and implementation of the European VAT acquis, Latvia has also prepared a draft for amendments to the Law On Value Added Tax providing for a VAT application in European Single Market (intra-Community trade) that would be in line with the provisions of the 6th Directive (77/388/EEC). To meet the needs of the single market, the objectives of the new VAT system are as follows: - to be simple and modern; - to ensure equal treatment for all transactions and uniform application of provisions of 6th Directive; - to guarantee effective taxation and controls to maintain the level of VAT revenue; - to move to destination-based taxation (i.e. charging the tax in the country of destination); - to make it possible to abolish controls at tax frontiers. The European Single Market changed the way in which VAT is accounted for on goods moving between Member States of the EU. Thanks to the existing EU system, the free movement of goods within the Community could no longer be treated as import or export. VAT on import and export will be abolished and replaced by the new concept of VAT on intra-Community acquisitions of goods and on intra-Community supplies of goods. Because of that, before Latvia’s accession to the EU the most important priority for Latvia is the introduction of the VIES system. This system enables the authorities in each EU Member State to ensure that intra-Community transactions are properly recorded and accounted for. Excise Taxes One of the taxes that has undergone the biggest changes in Latvia is the excise tax, which was harmonized in respect of oil products, alcoholic beverages and tobacco articles and according to EU requirements by introducing a system of excise goods warehouses, the suspended payment of tax, implementing tax guarantees and other requirements set by the directives. Excise tax reform began in 1997 when work on drafting the new excise tax law began. Although all the necessary legislative documents had entered into force by 2000, the excise tax reform 119


cannot yet be considered complete, as the harmonization of tax rates is ongoing, and will be completed only in 2010 (in respect of cigarettes). The entire excise tax system is being improved. It is becoming more consistent with the principles accepted in the EU, and it will allow Latvia to integrate in the single market and administer the tax according to the same principles present in other EU member countries, at the same time as ensuring definite tax income to the budget. The main EU requirements already introduced in Latvia are a system of excise goods warehouses, excise tax suspension arrangements, excise tax guarantee system. and other requirements. However, at the same time some problems in the harmonization of excise taxation have to be noted. First, excise tax rates, as in the majority of other candidate countries, are lower than the rates set in the EU. This means that Latvia has to significantly increase the excise tax burden in the near future. As a result, the prices of these goods will increase, expenses will increase for enterprises as will the desire to avoid tax. An increase in illegally traded goods is anticipated. It should also be mentioned that the situation concerning the introduction of EU rates of taxation is different in each group of excisable goods. In general the rates have already been introduced on alcoholic drinks, although problems are expected in this sphere. As concerns excise tax on oil products, the rates will substantially increase on diesel fuel. This is largely down to the growth in value of the euro over recent years. The biggest problems connected with excise taxes for Latvia, as in other candidate countries, are those regarding the implementation of EU requirements on excise tax on cigarettes, since the requirements apply not only to the rate of tax, but also to the structure of the tax, procedure of price determination, and even trade with cigarettes. Latvia is the last of the three Baltic States to have introduced the combined rate of excise tax on cigarettes. The combined rate came into force on July 1, 2003. A lot of effort was taken in explaining and clarifying the new system to the tax administration and local businesses, in order to ensure that the tax is properly calculated, the maximum retail price is correctly determined and reflected, and the regulations on trade with cigarettes are observed by both the tax administration and businesses.

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