FIGHTING “ENVELOPE WAGES” NOW AND IN THE FUTURE

In recent years, the shadow economy index in Latvia has not decreased. In 2018, it constituted 20.24% of GDP, and in 2021 – 20.22% of GDP.[1] “Envelope wages,” or undeclared employment income (obtained through double-entry bookkeeping and tax evasion), constitutes a significant part of the shadow economy.

According to the SRS’s annual assessment conducted in 2020, the proportion of undeclared employment income in Latvia remains high. According to estimates by the State Revenue Service (SRS), approximately 17.5% of total employment income was paid as “envelope wages” in 2018, and 17.1% in 2020.[2] Although these figures suggest a decrease in “envelope wage” payments, this reduction is not substantial. Therefore, the fight against “envelope wages” has been set as an operational priority for the next two years. [3]

However, before delving into how the SRS plans to combat “envelope wages” in the future, it is useful to look back at how it is currently being done.

“THE GENTLE METHOD”?

At one time, the administrative court indicated that, to make claims about tax evasion, the SRS would need to conduct an in-depth inspection – an audit. A thematic inspection does not allow for such claims, as it only examines individual accounting documents.

However, in practice, it is increasingly common for conclusions that a taxpayer has evaded taxes, including paying “envelope wages” to employees, to be drawn precisely during a thematic inspection.

Although a thematic inspection report does not create tax consequences, in combination with enforcement measures (which the SRS is entitled to apply based on the thematic inspection report), i.e., seizing the taxpayer’s movable and immovable property, tax consequences do arise.

Let’s consider an example that happened to a company (let’s call it “A”) that provided cleaning services to its clients. Company A purchased cleaning services from a subcontractor (let’s call it “B”). The SRS conducted a thematic inspection at A, during which it hypothesized that A was involved in a tax evasion scheme, and B’s employees were actually A’s employees. Since B did not pay labor taxes for its employees, the SRS (considering them A’s employees) calculated the labor taxes that A allegedly failed to pay for its (i.e., B’s) employees in the thematic inspection report.

A’s surprise was great when he learned that, upon completion of the thematic inspection, A’s bank accounts were “blocked,” and clients were sent an SRS order to transfer the amounts they owed A for cleaning services to the state treasury. Instantly, A was left without liquid assets. Bills and employee salaries had to be paid, but there was no money. The choice was not wide. Either pay the labor taxes for (B’s) employees or file for company insolvency in court. To save the company, A decided to pay the taxes calculated (the “provisionally unpaid” taxes) during the thematic inspection.

In a conversation with SRS employees, I pointed out the impropriety of this situation. To make claims about tax evasion, a more in-depth inspection should be conducted, which can only be done during an audit, not within the framework of a thematic inspection. The SRS representative explained that the SRS acts this way within the framework of “consult first,” because an audit is less gentle. Namely, in cases where it is found that a company may not have fully or partially paid labor taxes for its employees, Article 31.2 of the Law “On Personal Income Tax” provides for the recovery of a penalty from the employer in the amount of three times the tax. Many taxpayers (i.e., employers) cannot pay such a large sum. In contrast, a thematic inspection allows taxpayers to rectify the violation, avoiding “drastic” penalties.

Although it must be agreed with the SRS representative that a thematic inspection is more advantageous for the taxpayer compared to the consequences of an audit, it also has its negative “side effects.”

1. A thematic inspection report is not an administrative act and, accordingly, cannot be appealed. Thus, the taxpayer has no opportunity to challenge the SRS’s claims in the thematic act that it has evaded taxes or paid “envelope wages”;

2. If a decision on the application of enforcement measures follows a thematic inspection report (i.e., the taxpayer’s movable and immovable property is seized, which in practice manifests as “blocking” bank accounts, registering prohibition signs in public registers, and sending orders to clients not to pay the taxpayer a single cent), you have the opportunity to challenge the legality of the application of enforcement measures to the Director General of the SRS and then also in court. However, in cases where the SRS makes such strong assumptions that you have evaded taxes or paid “envelope wages,” in most cases, the court decides not to revoke the applied security measures (with certain exceptions).

Furthermore, the court does not examine the case on its merits. That is, the court does not call witnesses, does not hear the parties to the proceedings in an oral hearing, and in principle does not try to ascertain whether “envelope wages” are actually being paid or not. This is not the court’s task in such complaint cases regarding enforcement measures. The court only assesses whether the enforcement measures have been applied lawfully and whether they are proportionate. Plus, the court examines such complaints only in one instance, which limits the taxpayer’s ability to achieve the annulment of the SRS’s decision on the application of enforcement measures.

1. Moreover, the taxpayer has limited opportunities to divide the tax amounts “provisionally” calculated during the thematic inspection into several payment periods. A thematic inspection itself does not create tax consequences, so there is nothing to divide into periods. The taxpayer must apply to the SRS with a request for voluntary fulfillment of tax liabilities, which allows for the division of amounts calculated during the thematic inspection for a period of up to 3 years (as opposed to 5 years if the SRS had conducted an audit).

A “GENTLER” APPROACH IN THE FUTURE TOO?

From 2023, neither data responsibility checks nor thematic inspections will exist. Instead, there will be a new type of inspection – tax control, which will essentially combine the currently existing types of inspections (except for audits). At least, this is what the draft law “Amendments to the Law ‘On Taxes and Fees'” submitted to the Cabinet of Ministers foresees.

Tax control will be initiated by sending the taxpayer a notification of the start of the inspection, with which the SRS will inform about identified discrepancies or violations and invite them

to rectify them. In turn, if the SRS identifies significant discrepancies in the declaration of remuneration, the notification of the start of tax control will also include the tax amount calculated on an estimated basis and late payment interest, which the taxpayer will have to pay into the budget within 30 days or provide explanations. Similar to thematic inspections currently, penalties will not be calculated at this stage.

Although the draft law stipulates that before sending such notifications (with SRS calculations), the SRS must have sufficient evidence that there are reasonable doubts about the risk of “envelope wages,” and the calculated tax amount by the SRS must be adequately substantiated, it is currently difficult to judge how this will actually unfold in practice.

Currently, it is only known that if the discrepancies/violations are rectified within the 30-day period and the labor taxes determined on an estimated basis are paid, or if the taxpayer provides explanations (which the SRS deems sufficient and justifying the declaration of low wages), the SRS will terminate the tax inspection without issuing a decision.

However, if the taxpayer does not cooperate with the SRS, does not voluntarily rectify the discrepancies/violations (which also means not paying the amount indicated in the notification), or if the SRS wishes to obtain other information in addition to the existing information, the SRS will continue the tax control and, within its framework, issue a tax bill, with which it will calculate additional payments to the budget, including a penalty. However, the draft law stipulates that the penalty will henceforth be applied at 100% of the tax amount payable to the budget (compared to the current 300%).

ESTIMATED BASIS – AVERAGE “TEMPERATURE” IN THE PROFESSION

Currently, the draft law foresees that the criteria for issuing a tax bill on an estimated basis will be:

a) the average monthly remuneration for the profession;

b) the average monthly hourly rate in the industry; and

c) the average monthly number of working hours per job in the previous year.

Namely, if an employee’s remuneration, hourly rate, or the number of hours worked is less than 80% of the average monthly remuneration for the respective profession (or the average monthly hourly rate in the industry or the average monthly number of working hours per job) – the SRS will include its calculated amount payable to the budget on an estimated basis in the notification of the start of tax control.

This amount will be calculated as the additional mandatory state social insurance contributions (VSAOI) and personal income tax (IIN) payable to the budget from the difference between the taxpayer’s declared employee remuneration and 80% of the average monthly remuneration for the respective profession in the industry (taking into account the average monthly hourly rate and the average monthly number of working hours per job).

The foreseen procedure, however, raises concerns among taxpayers, as it is unclear how the SRS will determine the average remuneration/rate in professions where significant differences in salaries are observed, for example, in the IT sector, citing as an example the salaries of SRS employees in IT specialist positions – from EUR 900 to 1300 before taxes, which is significantly lower than in the private sector.

Employers who primarily employ low-skilled labor are also concerned, as the statistics on remuneration paid to these employees are affected by individual employees who regularly do not show up for work, resulting in lower figures than the industry or profession average.

It should be noted here, however, that the draft law stipulates that the SRS will still take into account the employer’s explanations for why an employee is paid a lower salary than the industry average. For example:

a) if the employer explains that employees are also employed by another employer. If the SRS, upon verifying the explanation, finds that employees are employed by several employers, their total number of employment hours reaches the average monthly number of working hours per job, and their total income exceeds the industry-defined remuneration, then this will be sufficient for the SRS not to issue an additional tax bill;

b) if lower remuneration is explained by the seasonality of work, for example, in agriculture or certain construction sub-sectors.

These are, of course, not (and should not be) the only cases where the payment of lower remuneration is justifiable. For example, the Constitutional Court, in its judgment No. 2011-16-01 of April 20, 2012, indicated that a low average remuneration for employees compared to that paid by other companies in the same industry could be considered a circumstance indicating possible tax evasion. However, the Constitutional Court also noted that regulatory acts do not prohibit paying a lower salary than the industry average or engaging subcontractors for contract execution. In the court’s view, there can be various reasons why a company pays its employees lower remuneration than the average for the respective industry. For example:

1. relatively low remuneration may be found in newly established companies or in companies that have not been actively engaged in economic activity for some time;
2. regional salary differences, meaning that companies in Riga usually pay relatively higher salaries than in other regions of the country;
3. the employment of part-time employees can reduce the overall average remuneration paid to employees.

Although the draft law promises that the SRS will evaluate each case individually, taking into account the specifics of the particular profession, it is currently difficult to judge whether and how well-founded the SRS’s assessment will be.

HOW TO KNOW HOW MUCH TO PAY IN SALARY?

I cannot stop asking myself whether such a solution does not violate the fundamental rights guaranteed to employers by the Constitution – to know their rights, including being informed about their duties. In a lawful democratic state, it is not permissible to impose a legal obligation on a person whose existence the person is unaware of. The possibility of receiving an additional “tax bill” based on the industry average salary, in my opinion, contradicts the fundamental right to know.

The draft law, however, stipulates the SRS’s duty to ensure publicly available information on the average monthly remuneration for the respective profession of employees, the average monthly hourly rate in the industry, and the average number of working hours per month per job in the previous year.

The fight against the shadow economy is very important and significant for raising the welfare of the entire society. However, does this mean that times have come when private individuals (employer and employee) will no longer truly be able to freely agree on the amount of remuneration, and small businesses will have to be able to pay employees as much as large companies pay their employees?

Time will tell, as the draft law still needs to be considered by the Saeima.

Yours, Alisa