Professional content

Hostility towards investments - Taxation levied on dividends

12.2.2012 Andri Gunnarsson og Páll Jóhannesson

The Icelandic tax system has taken significant changes, which have been characterised by more boldness than foresight, but such rapid and ill-considered tax changes have directly driven companies with substantial tax revenues from the country. Enactment of the so-called 20/50 rule, affected investments in own business enterprise in a particularly unfavourable way and has had significant impact on almost all small and medium enterprises in Iceland so now residents are punished for investment and job creation with increased tax burden.

As many are aware of, significant changes have been made to the Icelandic tax system from January 2009. When the bank system collapsed with associated impact on the Icelandic economy, it was foreseeable that the Treasury would suffer substantial loss in income. As previously criticised by the authors, changes of the tax system the last three years have been characterised by more boldness than foresight. Rapid and ill-considered tax changes have directly driven companies with substantial tax revenues from Iceland, increased interest expenses of resident enterprises and had direct affect on investments in the economy. The aforementioned changes have little to do with raising tax rates but instead result in more technical changes that have been made to the tax system. It is clear that many of these technical changes to the tax system are the ideal of politicians within the Ministry of Finance rather than the need for increased revenues as they more likely result in a substantially reduced income. Numerous experts and stakeholders have warned the government of these changes with extensive and detailed reasoned observations, which unfortunately have been ignored. 

In the wake of the economic crises that followed the collapse of the banks, unemployment in Iceland has increased and investment in the economy reached historical down fall. Despite this, a new Act no. 128/2009 was passed at the end of 2009, which made investment in own business enterprise particularly unfavourable, and furthermore, at the beginning of summer 2011, another new Act no. 73/2011, added to the disadvantage. Generally, these law changes are referred to as the 20/50 Rule. In brief, the rule includes that dividends distributed to individuals in own business, which exceeds 20% of tax equity, shall be taxed so that 50% is considered wages and 50% as capital. This new rule has had significant impact on almost all small and medium sized enterprises in Iceland.  

On the contrary, most countries levy much lower tax on capital gains than standard wages, in order to encourage investment, reward risk-taking that may lead to creation of employment. As a general rule, when capital income tax rate is high, it is possible to deduct various items, such as interest expenses from the capital income rate, but when it is lower, deduction is not available. 

Last summer, changes were made to the 20/50 Rule in that way that dividend payments were taxable as wages but the company that paid the dividend were not allowed a deduction from the income tax. Thus, the actual taxation becomes higher, which further increases the positional difference between investments in own company and other investments. 

With regard to the above, the amendment of the law cannot be said to have equalised status of workers and those who have income from self-employment since such alignment had already occurred by raising tax on capital income and corporate income. 

The impact of the 20/50 Rule creates incentives for funding companies with loans rather than equity and to invest in bonds and deposits rather than business management, but the latter is likely to create new jobs and raise wages. Therefore, it is obvious that 80% increase in taxation on investment in own business enterprise has affected the economy. Consequently, it would be desirable to abandon completely the 20/50 Rule and instead review rules on calculated remuneration in conjunction with the actual profit of companies.