Hidden Profit Distribution in Bulgaria — What It Is & How to Avoid It

Definition of hidden profit distribution

Statutory definition

Under § 1(5) of the Supplementary Provisions of the Corporate Income Tax Act (CITA, or ZKPO in Bulgarian), “hidden profit distribution” means:

Letter (a): Amounts unrelated to the activity carried out by the taxable person or exceeding the normal market levels, accrued, paid or distributed in any form in favour of shareholders, partners or persons related to them, with the exception of dividends.

Two scenarios are covered:

1. Amounts unrelated to the business activity — expenses of a personal nature made at the company’s expense for the benefit of the owners or related persons. For example: personal travel, purchase of personal property, maintenance of personal residence.
2. Amounts exceeding normal market levels — expenses that are connected to the business but a portion (the excess above the market price) constitutes hidden profit distribution. For example: renting property from a partner at a price significantly above the market rate.

Letter (b): Accrued interest expenses on loans meeting three of the following four conditions:

1. The loan exceeds the borrower’s equity as at 31 December of the preceding year.
2. Repayment of the loan or interest thereon is not limited by a fixed term.
3. Repayment or interest amount depends on the existence or amount of the borrower’s profits.
4. Repayment of the loan depends on the satisfaction of other creditors’ claims or on dividend payments.

Such loans disguise what should be a capital contribution — instead of a capital increase followed by dividend distributions (subject to tax), the person provides a “loan” whose interest is a tax-deductible expense reducing taxable profits.

What is not hidden profit distribution

• Amounts distributed to persons who are not shareholders, partners or related persons (the expense may be non-deductible, but it is not hidden profit distribution).
• Amounts paid to owners that are returned to the company immediately (no real enrichment).
• Lawfully distributed dividends pursuant to a General Meeting resolution.

Penalties for hidden profit distribution

Dividend tax — 5 %

Hidden profit distribution is treated as a dividend under § 1(5)(c) of the Supplementary Provisions of the Personal Income Tax Act (PITA). A 5 % dividend tax is charged under Art. 38(3) of PITA.

For hidden distributions to legal entities, the tax is 5 % under Art. 194(1) of CITA (with exceptions under the Parent-Subsidiary Directive).

Property sanction — 20 %

Under Art. 267(1) of CITA, a taxable person that carries out hidden profit distribution is subject to a property sanction of 20 % of the amount constituting hidden distribution.

Exception: The sanction under Art. 267(1) is not imposed if, in the year of the hidden distribution, the person declared the amount in Part VII of the annual tax return under Art. 92 of CITA (Art. 267(2) CITA).

Non-deductible expense under Art. 26(11) CITA

Expenses constituting hidden profit distribution are non-deductible for tax purposes and are added back when determining the tax financial result (Art. 26(11) CITA). This means an increase in taxable profit and additional corporate tax at 10 %.

Cumulative financial impact

For amounts of EUR 50,000, the cumulative impact can exceed EUR 17,500, excluding interest.

Typical cases of hidden profit distribution

1. Personal expenses through the company

The most common scenario — the owner uses company funds for personal needs:

• Purchase of personal property (furniture, electronics, clothing).
• Payment of personal bills (utilities, personal property insurance).
• Personal travel disguised as business trips.
• Maintenance costs of personal residence or vehicle.

2. Interest-free loans to owners or loans at below-market rates

Providing interest-free loans from the company to shareholders or partners is one of the most frequent forms. Under Art. 16(2)(3) of CITA, the NRA treats such amounts as a short-term loan for which interest is due at the market rate. The unaccrued interest represents unrecorded revenue for the company.

3. Renting property from an owner above market price

When the company rents property from its owner at a price significantly above the market rate, the excess constitutes hidden profit distribution. The NRA may establish the market price through comparative analysis, valuation by a licensed appraiser, or data from real estate agencies.

4. Inflated salaries or fees to related persons

Remuneration that does not correspond to market levels for the respective position, qualifications and workload. The NRA analyses average salaries for the sector and region, the person’s qualifications and experience, and the actual work performed.

5. Invoicing services from related entities without actual performance

The company pays for “consulting services” to a company controlled by the owner without evidence of actual performance. Typical example: management consulting without minutes, reports or concrete results.

6. Advance withdrawal of dividends

The owner withdraws funds from the company before a General Meeting resolution on profit distribution. These amounts appear as receivables in the balance sheet. If they are not repaid by year-end or a dividend distribution resolution is not adopted, the NRA treats them as hidden profit distribution.

Transfer pricing and market price

Determining normal market levels

To establish whether an excess above normal market levels exists, the methods for determining market prices under § 1(10) of the Supplementary Provisions of TSIPC are used:

1. Comparable Uncontrolled Price Method — comparison with prices in transactions between unrelated persons under comparable conditions.
2. Resale Price Method — the resale price less the normal mark-up.
3. Cost Plus Method — cost price plus the normal mark-up.
4. Profit Split Method — allocation of the aggregate profit between related persons.
5. Transactional Net Margin Method — net profit calculated on an appropriate base (e.g. costs, turnover, assets).

Burden of proof

In a tax audit, the burden of proof for the market nature of prices lies with the taxpayer. We recommend maintaining up-to-date transfer pricing documentation including functional analysis, economic analysis (benchmark study), and justification of the chosen method.

NRA audit practice

Typical audit approaches

1. Analysis of settlement accounts — the NRA checks accounts 498 (other debtors) and 499 (other creditors) for unusual balances with partners and related persons.
2. Review of bank statements — transfers to personal accounts of owners without documentary basis.
3. Comparison of expenses with the business activity — expenses that do not correspond to the business purpose are flagged.
4. Analysis of prices in related party transactions — the NRA systematically checks whether prices correspond to market levels.
5. Review of travel expenses — the NRA requires evidence of business purpose (invitations, minutes, results of the trip).

Court practice

The administrative courts and the Supreme Administrative Court (SAC) have developed extensive case law on hidden profit distribution. Key holdings include:

• The burden of proof for the business connection of an expense lies with the taxpayer.
• The mere existence of a formal contract is insufficient — proof of actual performance is required.
• When determining market price, the NRA must use a correct method and comparable data.

How to avoid the risks

Preventive measures

1. Separate personal from business finances — do not use the company account for personal expenses.
2. Document every transaction with related parties: written contract with clear terms, justification of the market nature of the price, documents evidencing actual performance (protocols, reports, deliverables).
3. When providing loans to owners: enter into a written loan agreement, set a market interest rate, fix a repayment term, accrue and record interest monthly.
4. When renting property from an owner: obtain a market rent assessment, do not exceed the market price, retain the justification.
5. When setting remuneration for related persons: align with market levels for the sector and region, document the scope and quality of work performed, maintain job descriptions.

Declarative approach

If, despite all measures, hidden profit distribution has occurred, declare it voluntarily in Part VII of the annual tax return under Art. 92 of CITA. This:

• Avoids the 20 % sanction under Art. 267(1) CITA.
• Does not cancel the obligation for 5 % dividend tax.
• Does not cancel the tax financial result adjustment under Art. 26(11).

Advance dividend distribution

If the owner needs company funds, the safer approach is:

1. Forecast the annual profit.
2. Record the withdrawal as an advance dividend (receivable).
3. At year-end — the General Meeting adopts the annual financial statements and a resolution for dividend distribution.
4. Withhold and remit the 5 % dividend tax by the end of the month following the quarter of the resolution.
5. File the declaration under Art. 55(1) of PITA and Art. 201(1) of CITA.
6. Close the receivable from advance dividends.

Caution: Even with this approach, the NRA may charge interest for the period of use of the funds (from withdrawal to the dividend resolution) — as, for tax purposes, the company has provided an interest-free loan (Art. 16(2)(3) CITA).

Specific scenarios

Hidden profit distribution in sole proprietorships (ET)

Sole proprietors (ET) have no separation between personal and business property under Art. 56 of the Commercial Act. Nonetheless, for tax purposes, the NRA may classify certain personal expenses as non-deductible.

Hidden profit distribution in single-member LLCs (EOOD)

In single-member LLCs (EOOD), the risk is highest, as the sole owner has full control. The NRA pays particular attention to settlement accounts with the sole owner, payments to related companies of the owner, and management contracts with unusually high remuneration.

Hidden profit distribution in holding structures

For intra-group transfers (management fees, licence fees, intra-group financing), the risk of hidden profit distribution is substantial. Transfer pricing documentation is of critical importance.

Conclusion

Hidden profit distribution is a serious tax risk with cumulative consequences — corporate tax, dividend tax and property sanctions. Prevention requires strict separation of personal and business finances, documentation of every related party transaction at arm’s length conditions, and timely declaration. If your company conducts transactions with related parties, we recommend periodic internal review of these relationships and maintenance of up-to-date transfer pricing documentation.

This article is for informational purposes only and does not constitute legal advice. For specific questions regarding the tax treatment of related party transactions, please consult a qualified tax adviser or lawyer.

Frequently asked questions