The Constitutional Court of the Republic of Latvia rules on limited rights to cover prior period losses

The Constitutional Court of the Republic of Latvia rules on limited rights to cover prior period losses.

On behalf of the Republic of Latvia, the Constitutional Court on May 20, 2011, examined the case on compliance of the Law on Enterprise Income Tax Section 14 (2) (3) with Constitution of the Republic of Latvia Article 91 and 105.

On February 9, 1995, the Parliament of the Republic of Latvia (Saeima), adopted the Law on Enterprise Income Tax.

The Law on Enterprise Income Tax provides to impose a tax on income gained from commercial activity, as well as provides the order of calculation and payment of enterprise income tax (hereinafter - EIT).

The Law on Enterprise Income Tax Section 14 (2) (3) establishes that:

“(2) If in a taxation period control of a commercial company or co-operative society is acquired by a person or a group of persons that previously did not control such commercial company or co-operative society, losses of pre-taxation periods of such commercial company or co-operative society shall not be covered in the taxation period or in subsequent taxation periods, if it is not specified otherwise in this Section.

(3) The provisions of Paragraph (2) of this Section are not applicable in cases where the commercial company or co-operative society in which a change of control has taken place maintains its previous type of ordinary activity, as conform to the ordinary activity of the commercial company or co-operative society for two taxation periods before the change of control, for five taxation periods after the change of control.”

The applicant – Limited liability company (hereinafter “the Company”) - holds that the Law on Enterprise Income Tax Section 14, (2) (3) infringes the Right to own property as guaranteed in the Constitution of the Republic of Latvia Article 105, and contradicts the principle of legitimate equality established in the Constitution Article 91.

            In 2007 control over the Company was gained by a person which had previously not been in control of this commercial company. The economic activities of the Company have reportedly caused losses, therefore in 2008 its mode of economic activity was changed and the applicant has lost right to carry losses caused in the previous mode of economic activity before the change of control to the next taxation period. The contested norms provide a different attitude against those payers of EIT, control of which has been gained by a person previously not in control, and which have changed their mode of economic activity. There is no objective and logical basis for the difference in attitude.

The contested norms are aimed at maintaining the mode of economic activity of a commercial company the same as before the change of control. However, this limit has no legitimate aim, as the profit of a commercial entity is dependant on its mode of economic activity. A commercial company needs to react quickly to the changes in demand and costs of production, and choose a profitable mode of economic activity. In the circumstances of an economic crisis, some modes of economic activity have caused losses, therefore, requiring swift changes in the main activities of the commercial company. If the commercial company simultaneously changes both - control and mode of the economic activity, it, as a tax payer, loses rights to cover losses of previous taxation periods, and, therefore, the EIT increases.

Therefore, the contested norms hinder development of economic activity, as these norms force commercial companies to choose – maintain an unsustainable mode of economic activity and the right to cover losses of the previous taxation periods, or change the mode of economic activity and pay more EIT.

The duty to pay EIT is a limitation on property rights and the contested norms can not affect the welfare of the company.

According to the above mentioned, the applicant asked the Constitutional court to evaluate, whether the prohibition on a commercial company, wherein both - the control and mode of the economic activity, have changed simultaneously, to cover losses from the previous taxation period is compatible with Article 91 and Article 105 of the Constitution.

The institution what adopted the contested act, the Saeima held that the contested norms do comply with legal norms of a higher legal force and asked the Constitutional Court to recognize it as constitutional. The contested norms have a legitimate aim – social welfare.

The contested norms allow businessmen, in the next taxation periods, to reduce the taxable income for the previous year losses. The losses transmission to the next taxation period is restricted with time period and the type of rising of losses and also when the control to commercial company is got by the other person and the type of economic activity is modified.

The Saeima indicates that the aim of contested norms is to lighten the tax burden and, in the same time, not to allow to evade taxation. Keeping the companies basic type of economical activity is carried out as economically justified deal and the risk is decreases that change of control could be used as false decreasing of a taxable income and EIT. Furthermore, keeping the basic type of the commercial activity for a longer period, guarantees that work places shall be preserved in the industry.

The legitimate aim is not possible to reach with other ways. Thereby, the contested norms reasonably limit the human right to own property.

            The Ministry of Finance of the Republic of Latvia indicates that, in the case of the change of control in the commercial company, other, more considerate tools of covering losses, can not be used. It is acknowledged also by the uniform foreign experience in this matter, namely, several EU member states in the case of carrying forward losses if the change of control of the commercial entity has occured, are set even stricter limits or the loss transfer generally is prohibited (such as Finland, Germany).

The Constitutional court considered that the contested norms are considered as a restriction of ownership and, in order to establish whether the particular restriction is lawful, the Constitutional Court investigated:

1)      whether the restriction of ownership is established by law,  

2)      whether it has a legitimate aim,

3)      whether it is proportional with the legitimate aim.

In the case is no dispute that the restriction is established by law, and contested norms are adopted and announced in the appropriate legal procedure.

The Constitutional Court accepted that taxes implement fiscal function and provide income in national budget. Using this income, the state can function and guarantee the fundamental rights. Taxes are determined to ensure the welfare of the society.

On the one hand, the legislator has a right to use one’s own discretion for the public well-being of the necessary framework, but on the other hand, the legislator has an obligation to provide the appropriate mechanism to achieve compliance with this regulation.

The contested norms are aimed to limit the unreasonable lessening of the EIT taxable income and thus set the public welfare interests. So, the contested norms have a legitimate aim - protection of public welfare and the contested norms are suitable for the reaching the legitimate aim.

            The limitation of rights in the contested norms is permissible if it is necessary, and if there are no other means of equal efficiency which would limit fundamental rights less.

In evaluating, whether the legitimate target can be achieved in a different way, the Constitutional court emphasized that a softer measure includes only such measure what could achieve the legitimate aim to the same extent.

The Constitutional Court noted that the legal regulation of other states can not be directly applied in resolving specific questions within the Latvian legal system, with the exception of specific instances noted in law. The analysis of comparative law must always take into consideration the legal, social, political, historical and systematical context.

The contested norms are directed to increase the national budget and also directed to the tax reducing for the companies, which, after the change of control, have kept the basic type of economic activity. So, with the less restrictive measures, the legitimate aim could not be achieved in the same quality.

The Constitutional Court found that the principle of equity before the law prohibits the state institutions to pass such norms that allow differentiating treatment to persons in equal and comparable situations without good reason. The principle of equity before the law allows, and even demands differentiating treatment of persons in different circumstances, as well as allowing differentiating treatment of persons in equal circumstances if an objective and logical basis exists.

            The contested norms provide different treatment for persons who are in equal and comparable conditions. However, a company which has changed the control, has no right to decrease the taxable income for losses of previous period of taxation, but companies, which after change of control have kept the basic type of economic activity, have right to count out the losses which have been before period of taxation.

Such a different treatment has an objective and reasonable basis. The right to decrease the taxable income for the losses of previous taxation period is only to company which keeps the previous basic type of economic activity. The companies suffer losses basically in the long time activities. Therefore, there is a link between two elements of calculation of EIT – long time activity and losses. If there is the causation between immutable company`s long time activity or the basic type of activity and losses, then noticing the losses of previous taxation period with the EIT calculation of taxable income is a logical precondition for decreasing the EIT.

According to the above mentioned, the Constitutional court held that the contested norms comply with the Article 91 and Article 105 of the Constitution and the norms does not infringe the Right to own property and does not contradict the principle of legitimate equality.

Valters Gencs

Tax Attorney & Founding Partner

Gencs Valters Law Firm, Riga

T: +371 67 24 00 90

Email: valters.gencs@gencs.eu