Estonia: Court rules on fraudulent form of work

​A legal loophole allowing companies to avoid paying employment taxes has been closed by the Estonian Supreme Court. It has ruled that companies can no longer present certain employment relationships as service agreements. The Estonian Tax and Customs Board now has the right to oblige companies using this practice to pay employment taxes. 


The Estonian Supreme Court has made three decisions (No. 3-3-1-12-15; No. 3-3-1-25-15; No. 3-2-1-82-14) that support the view of the Estonian Tax and Customs Board (EMTA) that, in some cases, service agreements between companies can be considered fraudulent forms of employment, set up to avoid paying employment taxes (in Estonian).

Fraudulent service agreements

The cases heard by the Supreme Court related to situations where a board member of a company had provided management, consultation and other services for the company, acting as a separate legal entity rather than having an individual employment contract or authorisation agreement. Had the board member been hired on such a contract or agreement, the employer would have had to declare and pay social tax (33% of gross wages) and unemployment insurance premiums (0.8% of gross wages). However, since the person was instead hired as if they were a separate company, neither the worker nor the employer had to pay employment taxes. The pay due legally belonged to the board member's company, and the board member was able to choose how much to take as salary and how much as a shareholder's dividend. Dividends are not subject to social tax and unemployment insurance premiums.

Disadvantages of the scheme

While the situation might seem to benefit both the employer and the board member, in reality, the scheme has many disadvantages for them as well as for the whole economy and social system. For example, people who do not declare taxes and who take their pay as dividends lose social protection, meaning they:

  • are not covered by health insurance;
  • lose out on pension benefits as the size of a pension depends on a person’s pensionable service and previous earnings, which are calculated on the basis of social tax payments and funded pension payments;
  • are not entitled to receive unemployment benefit.

Tax avoidance also affects the sustainability of the social  system as a whole, since social tax is used for funding pension insurance and state healthcare for all. Companies who pay employees in this way also have an unfair advantage over companies that comply with the law since their costs are lower.

Identifying fraudulent agreements

However, not every service agreement is fraudulent. The court ruled that service agreements between companies can be considered as a valid employment relationship if a legal entity works as a subordinate to the management of another company. Subordination is a strong indication of an employment relationship. According to the Employment Contracts Act (in Estonian), an employee is a person who works for another person (an employer) in subordination to the management and under the control of the employer, with the employer paying the employee for such work.

Other indicators that the court ruled could be used as a basis for reclassifying service agreements as employment contracts included: 

  • the service provider invoices the client for the same amount every month;
  • the service provider provides services only, or mostly, to one client;
  • the person who provides the service is also on the management board of the company receiving the service;
  • the service agreement has elements similar to an employment contract (such as fixed hours and being under control of the employer).

The Supreme Court’s judgement supports EMTA’s position that a contract must formally meet the requirements of the law but that the nature and content of the work must also be in accordance with the contract.

The court decision gives EMTA the right to change a service agreement to an employment contract if it identifies an actual employment relationship between the parties. Taxes on all pay must then be declared and paid.

Next steps by EMTA 

EMTA announced that it would contact companies that appear to use the fraudulent scheme, asking them to change their practice. Most are small companies, but EMTA stated that it would start with bigger companies whose tax payments would bring higher revenue (in Estonian). There is no information on how many companies could be using the scheme. More than 23,000 companies (almost 25% of all companies) did not declare labour taxes in 2015, although this figure includes inactive companies and those without employees. So far, EMTA has contacted around 200 companies (in Estonian).

EMTA’s main goal is to help companies to improve their practice through guidance rather than punishment. They have published guidelines explaining the characteristics of an employment relationship and when is it appropriate to use service agreements between companies (in Estonian).

Concern over threat to economic freedom

Many organisations and members of the public supported EMTA’s mission to collect taxes and expose fraudulent schemes. Some concern has been expressed, however, that EMTA is interfering with economic freedom, since providing services through private limited companies is legal, and there are no rules about how much business income owners should pay themselves as salary or take as dividends.

Much debate also revolved around the reasons for using such schemes, which led many to conclude that the taxation of labour and capital is uneven, with the latter at an advantage. Proposals to solve this include the suggestion of the Estonian Service Industry Association (ETK) that dividends should be subject to social tax if a person’s annual wage is less than three times the annual national minimum wage (in Estonian).

Most proposals have focused on the need to establish a social tax ceiling. However, the Estonian Employers' Confederation (ETTK) argued against this, saying that a ceiling presumes that entrepreneurs pay the highest wage possible, while, in reality, it is in their interest to pay the lowest in order to increase the company’s profit (in Estonian). ETTK also said that, although it is wrong that many people use dividends alone as their income or use business income for their personal costs, it is difficult to determine:

  • how much salary they should pay themselves;
  • how to distinguish between active and passive income;
  • which costs are actually personal costs.


Despite the heated discussions and some negative feedback, EMTA went ahead with its case. It is not the first time EMTA has implemented drastic measures to increase tax revenue and reduce fraudulent practices. In 2014, the employment register was created, obliging all employees (including volunteers) to be registered.

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