Tax Considerations in M&A Transactions
The Ukrainian economy finds itself far from a stage of growth and has not recovered from the structural economic downturn. As a result, the local M&A market has no signs of visible growth, although investors occasionally witness small improvements. Nevertheless, the World Bank is forecasting that Ukraine will enjoy economic growth in 2018, which is expected to foster the local M&A market among foreign institutional investors.
Naturally, M&A transactions in Ukraine purport potential direct and indirect tax implications, which vary depending on the transaction’s structure and should eventually be scrutinized when making investments.
In general, most M&A transactions involving Ukrainian assets are structured at the level of foreign holding companies and imply the transfer of shares in a holding company, which owns the Ukrainian target. Such M&A structuring is common for Ukraine because of strict and prohibitive currency control regulations, which significantly limit the outflow of hard currency from the country as well as overall settlements in foreign currencies between local entities and individuals.
Furthermore, this type of M&A deals usually does not envisage Ukrainian tax issues, while taxation in the foreign jurisdiction involved is, as a rule, quite beneficial (e.g. capital gains are exempt from tax). Currently, Ukraine is not attempting to tax indirect transfers of Ukrainian assets, even though in most cases it may be reasonably argued that income (capital gains) arising from the deal has sources in Ukraine.
The corporate income tax (CIT) administration procedure currently in effect requires a Ukrainian entity involved into the deal, which will withhold the Ukrainian 15% tax from the income of the non-resident entity and pass it to the budget. Since no Ukrainian entities are normally involved on the buy or sell side in M&A transactions, the absence of such Ukrainian element provides that no person is responsible for tax collection under the noted local statutory rules. Notably, even if the seller is willing to repay the tax to the Ukrainian state budget, there is no a straightforward procedure in law for a non-resident entity to pay the tax.
Therefore, given the fact that most businesses in Ukraine are structured through foreign entities, the sale of a business at foreign level remains the most attractive option because of its regulatory and tax advantages.
Domestic M&A deals generally attract complicated issues of direct and indirect taxation, especially in the event of corporate mergers or asset deals.
The taxation regime applicable to share deals is the most straightforward. For corporate taxpayers capital gains arising from sale of securities are subject to CIT at the rate of 18%. CIT rules provide for special tax rules for separate accounting of transactions involving securities. The aggregate gains (net positive financial result) from transactions with securities increase the taxpayer’s profits subject to CIT. An aggregate loss (net negative financial result) is carried forward and set-off against gains from such transactions in future periods and does not affect other profits.
It should be noted that participatory interests in Ukrainian Limited Liability Companies are not regarded as securities. Therefore, the above separate accounting rules generally apply only to the stocks of Joint-Stock Companies. A loss or gain realized from transactions with participatory interests affect the general taxpayer’s profits of the reporting period.
Non-resident legal entities are subject to a 15% withholding tax in respect of capital gains realized on the sale of shares (stocks and participatory interests). Such capital gains may be exempt from taxation under the relevant applicable double tax treaty. The tax should be withheld and remitted to the budget by a resident company or a non-resident’s permanent establishment in Ukraine involved in the deal (if any).
Individuals (residents and non-residents) are taxed at an aggregate tax rate of 19.5% (18% personal income tax and 1.5% military duty) with respect to aggregate capital gains (so-called “investment profit”) from transactions involving both stocks and participatory interests.
The sale of shares and exchange of shares are not subject to VAT in Ukraine. The resulting change of shareholders does not affect taxation of the target company. The major drawback of share deals is that the buyer acquires a target company with its reputational, corporate, regulatory and tax track record. Even comprehensive pre-sale due diligence does not always reveal the tax and legal risks the buyer may experience on closing. At the same time, representations and warranties given by the seller under Ukrainian law would unlikely be enforceable in a local court in the event of any controversies.
M&A transactions involving assets are less common in Ukraine because of VAT chargeable at 20% on an asset transfer transaction. The VAT paid on an asset purchase (i.e. input VAT or VAT credit) is not in fact an expense and may be credited against VAT obligations of the buyer arising on its future VAT-able supplies. Nevertheless, businesses are more willing to accept historical risks associated with share deals rather than have a VAT-related cash outflow.
M&A transactions usually involve the purchase of fixed (non-current) assets. Upon their transfer the seller should charge 20% VAT on the purchase price, though the VAT base may not be lower than the book value of the asset. Should the purchase price be lower than the book value, the seller would still charge VAT on the book value while the buyer would receive input VAT only in relation to the purchase price.
It should be highlighted that VAT is charged only by entities registered for VAT. Generally, entities are obliged to register for VAT in Ukraine if their VAT-able supplies within 12 consecutive months exceeds UAH 1 million.
From the CIT perspective, the positive difference between the sales price and the net book value of assets adjusted for CIT purposes would constitute an income for the seller subject to CIT. The negative difference would constitute a capital loss generally deductible for CIT purposes.
The purchase of assets does not result in adverse tax implications for the buyer.
The buyer should recognize assets on its books at their cost (acquisition value), consisting of, in particular, the purchase price and other expenses directly related to the acquisition (e.g. installation costs). It should be able to depreciate their acquisition value for CIT purposes taking into account limitations set out in tax legislation for different fixed asset items.
Corporate mergers give rise to many complicated tax issues both for involved corporate entities and their shareholders.
Tax legislation does not provide CIT adjustments for corporate merger transactions. Therefore, the tax implications of these transactions depend fully on the accounting treatment. Generally, corporate mergers should not result in taxable income. However, in the event of difference in accounting policies the merging companies should align their accounting policies and approaches, which may affect their income or loss subject to CIT.
Generally, CIT overpayments may be transferred from the merged company to the surviving company. However, current CIT rules do not address the issue of transfer of tax losses. On this basis the tax authorities have claimed on several occasions that in the absence of such rules tax losses may not be transferred in corporate merger transactions. Following such a position, only deferred tax expenses may be transferred to the surviving company subject to proper documentary evidence of these expenses.
In our view, under fair interpretation of the law, tax losses may be transferred from the merged company to the surviving company. In particular, the surviving company is a universal successor of the merged company with respect to all its rights and obligations. Additionally, based on a local GAAP the buyer upon acquisition of the target, which results in its dissolution (i.e. in particular, in case corporate merger), recognizes in its books the target’s assets and liabilities. Generally, tax losses may be treated as an asset that may be transferred in the course of a corporate merger.
Furthermore, we are aware of recent court practice in favour of taxpayers. In court case No. 806/713/17 the courts of first and appellate instances confirmed right of Ready Garment Technology Ukraine LLC to recognize tax losses of merged Polonne Trousers Factory LLC. The court case is currently under review by the Higher Administrative Court of Ukraine. In another court case, No.804/410/17, the courts of first and appellate instances confirmed the right of Omega LLC to exploit tax losses of merged RTC LLC. The tax authorities failed to initiate review of the case by the Higher Administrative Court of Ukraine.
Under fair interpretation of the above cases, in the absence of tax limitations, surviving companies should be able to recognize the tax losses of merged companies. However, management of the surviving company should be prepared for tax disputes in this regard and decide whether the game is worth anything. If it is, then management may opt to play with forecasts by requesting a tax ruling on the transfer of tax losses and challenging it in court. Alternatively, it may opt to recognize the tax losses of the merged company and challenge tax charges stemming from an arguable overestimation of the tax losses by the surviving company.
Corporate merger transactions are not subject to VAT, transfer of assets and liabilities to the surviving company should not generally result in adverse VAT implications. Under current VAT rules an input VAT (a tax credit) of the merged company may be transferred to the surviving company. In practice, however, the tax authorities often attempt to challenge the non-VAT-ability of a local merger transaction.
The exchange of shares in the merged company for shares of the surviving company should be tax neutral for shareholders. However, at the present time there are no straightforward tax rules in this regard. For this reason, under an unfavorable interpretation of the law a capital gain may be realized by the shareholder if the value of received shares exceeds the value of cancelled shares. Such gains would be subject to 18% CIT in the hands of a resident legal entity or subject to 15% withholding tax if realized by a non-resident legal entity. Individuals would be subject to 18% personal income tax and 1.5% military duty in respect to realized “investment profit”.
To secure safe tax treatment shareholders may request an advance tax ruling from the tax authorities. However, there is hardly a real chance of getting a straightforward and practical tax ruling.
Given the described rules, M&A transactions and its tax implications depend largely on the transaction structure. From a regulatory perspective, the share deals are clear-cut and straightforward in terms of taxation while the corporate mergers are currently associated with statistically higher tax risks. However, these risks may also come with excessive rewards. For example, a profitable surviving company may be merged with a loss-making company and so reduce the tax burden for the future business.
By Pavlo Shovak, associate at Asters