The Principal Purpose Test in Ukraine: What does it Mean for Tax Planning?
The era of "old-school" tax planning and structuring in Ukraine is set to come to a natural end with the introduction of the principal purpose test (PPT).
On 23 July 2018, Ukraine finally signed the Multilateral Convention to Implement Tax-Treaty-Related Measures to Prevent Base Erosion and Profit Shifting (MLI). The MLI serves the purpose of implementing four Base Erosion and Profit Shifting (BEPS) Actions developed by the OECD in 2015 (i.e., Action 2 (Hybrid Mismatches), Action 6 (Treaty Abuse), Action 7 (Avoidance of Permanent Establishment Status) and Action 14 (Improving Dispute Resolution)). Each Action's implementation would require extensive analysis deserving a separate paper (or even a treatise). In this article, we merely provide a high-level analysis of Action 6 (treaty abuse), the implementation of which is, beyond any doubt, the greatest challenge in the MLI context.
The MLI, in line with Action 6, prescribes the States to implement, with a view to combat tax planning arrangements that seek unlawful treaty benefits, a principal purpose test (a general anti-abuse provision) and/or a limitation-on-benefits rule (a US-inspired specific anti-abuse rule). Since, pursuant to its official MLI Position, the State of Ukraine did not agree to implement the limitation-on-benefits rule, we focus only on the PPT.
What is the principal purpose test?
The PPT is not a new concept in international tax law. The OECD and some jurisdictions have long ago deduced the PPT from Article 1 of the OECD Model Tax Convention on Income and on Capital; however, the test as such was rarely formulated in a clear manner. The introduction of a uniform approach to and the mandatory nature of the PPT through the MLI significantly changes the rules of international tax planning.
The PPT, as prescribed in the MLI, denies tax benefits under a particular double tax treaty (DTT) "in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit".
In other words, if tax benefits, afforded to cross-border arrangements or transactions by virtue of a DTT, are one of the main purposes of the transaction, they should not be made available to the taxpayer. The common example (see graph below) includes a special purpose vehicle registered in a jurisdiction that has a favorable DTT with Ukraine (e.g., Cyprus), which serves the primary purposes of: (i) receiving dividends from a Ukrainian subsidiary; and (ii) subsequently remitting these to another foreign entity (registered, e.g., in the Netherlands). In such a case, it is clear that the principal purpose of the transaction (transfer of dividends) is to benefit from a reduced withholding tax rate on dividends under the respective DTT. Thus, such a reduced withholding tax rate would be denied to the intermediary (special purpose vehicle) in the given example.
It is worth noting that the above example is an extreme one (though not uncommon). To refuse granting treaty benefits, the tax authorities need not prove that such benefits were the "sole" purpose of the transaction, but merely a "principal" one. In other terms, if tax benefits constitute a serious factor when structuring cross-border arrangements or transactions and their absence would affect the taxpayer's decision in that regard, it may be argued that treaty benefits are, indeed, one of the principle purposes of such an arrangement or transaction. This conclusion would still stand even if the transaction has a valid commercial reasoning. Conversely, tax benefits would be preserved, provided such a valid commercial reasoning were to outweigh the tax benefit anticipated.
Upon the completion of the international and domestic procedure of entry into effect, the MLI is expected to amend the listed DTTs of Ukraine, including treaties with Cyprus, Luxembourg and Belgium, by introducing a clearly formulated PPT. International business planning arrangements benefiting from such DTTs would, therefore, require substantial review. This is especially relevant for doing business in Ukraine, bearing in mind that about 27% of its overall investments are made from Cyprus.
How does it work?
How, in practice, should one assess whether the transaction (or arrangement) has a principal purpose of obtaining tax treaty benefit? The MLI suggests recourse to "all relevant facts and circumstances", which is a rather broad statement. The official OECD commentaries advise to analyze each transaction (or arrangement) on a case-by-case basis.
We believe that, in its nature, the PPT is a subjective test, for it considers, first of all, the purpose of the transaction (or arrangement). Which evidence may establish a purpose sought by the parties to the transaction? It is our understanding that tax authorities (or the taxpayer) may resort to correspondence between taxpayers and their advisors, internal correspondence of the taxpayer, or any other official/non-official statements specifying the motives or aims of the taxpayer in terms of entering into suspicious transactions or implementing questioned arrangements.
However, the mentioned evidence is rather difficult to obtain for the tax office.
In fact, the direct proof of a motive or purpose is likely to be discovered only within the framework of criminal proceedings on tax evasion.
That is why the tax office is likely to use objective evidence in order to determine the principal purpose of the transaction. Such objective evidence may include the complex structure of the transaction (or arrangement), the tax benefits obtained as a result of its implementation, absence or insignificance of commercial rationale, etc. This evidence is much easier to obtain.
The conclusion regarding the abusive nature of the transaction may be drawn from the comprehensive analysis of objective and/or subjective evidence surrounding the case. According to the OECD, the tax office is not required to provide conclusive proof of such abusive nature, but should merely prove that it is "reasonable to conclude" that the transaction (or arrangement) had a principal purpose of obtaining tax treaty benefits. Although the initial burden of proving the abusive behavior of the taxpayer rests with the tax office, the applicable standard of proof is rather low (i.e., "reasonable basis to conclude").
It should be also noted that the PPT would be satisfied by the taxpayer if "it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions" of the DTT. It follows that even if the tax office provides enough evidence to fulfil the "reasonable basis" test, the taxpayer may rebut the argument by establishing the compliance of the transaction (or arrangement) with the purpose of the DTT and intentions of its State Parties. As of today, it is not entirely clear how the taxpayer is going to prove this point. We can only hope that this question will be answered by authoritative court practice.
PPT and other anti-abuse rules
The PPT crosses the roads with another anti-abuse rule of a rather specific nature, namely the "substance" requirements.
The "substance" requirements are well-known to taxpayers all over the world, serving an effective mechanism of denying domestic and treaty tax benefits to those seeking them without properly contributing to the economy of the respective country. The "substance" requirements are formulated either in a DTT (in the limitation-on-benefits rule) or in the domestic law of a particular jurisdiction.
It is usually presumed that the company has "substance" in a jurisdiction, provided it assumes risks and has a sufficient number of employees, assets, including office, equipment, etc., in order to be able to conduct its ordinary business activity. Some countries, such as the Netherlands and Luxembourg, have prescribed particular substance thresholds to determine whether a holding company qualifies for certain tax benefits. In terms of PPT, the presence of "substance" in the intermediary's jurisdiction may be an effective tool to rebut the claims of alleged abusive behavior of the taxpayer. Yet, the PPT does not consider substance as conclusive proof demonstrating that the transaction (or arrangement) was executed in good faith. Other facts would still have to be taken into account.
The PPT also must be clearly distinguished from a domestic general anti-avoidance rule (GAAR).
In some countries, such as Poland, the PPT may operate simultaneously with a GAAR. Depending on the scope of the GAAR, it may sometimes conflict with the PPT. In that respect, it is crucial to understand that PPT may be applied only with regard to benefits under the DTT and thus, cannot affect domestic tax incentives.
In Ukraine, the GAAR as such is not formulated in the law. Nonetheless, tax authorities often apply the doctrine of "sham transactions". Under this doctrine, the transaction is recognized as void in case it lacks commercial reasoning or is performed only on paper. We would like to emphasize that the PPT will in no way supersede this doctrine. First, because it operates only on the treaty level and second, since it does not affect the validity of the transaction per se. Unlike the "sham transactions" doctrine, the PPT influences only the tax treaty perspective of the transaction.
Ukraine as an intermediary jurisdiction?
Finally, the PPT (which will be included in Ukrainian tax treaties) might be applied not only in Ukraine, but also in the other State Party to the respective DTT. That is, if Ukraine is used as an intermediary or holding jurisdiction, the PPT may affect the tax treatment of the transaction in the source country.
For instance, provided Ukraine is used as an intermediary jurisdiction for a company receiving royalties from, e.g., Germany, the PPT may deny the tax benefits with respect to such royalties under the applicable Ukraine-Germany DTT. Of course, presently, Ukraine is not usually considered as a holding or intermediary jurisdiction. However, this may change in the near future in light of the possible introduction of the Exit Capital Tax.
Points to remember
Given the significance of the upcoming changes, many tax disputes involving multinationals operating in Ukraine may mushroom once the PPT enters into effect.
The complexity of the process and amount of time that may be needed to align corporate models with the new approaches in international taxation necessitate multinational companies taking proactive steps.
The application of the PPT is a rather complicated process, requiring a detailed analysis of the transaction or arrangement in question. The upcoming court practice is likely to shed light on many unexplored issues in that respect.
The PPT will operate on both sides of the transaction, meaning that not only the Ukrainian tax office, but also foreign tax authorities, may seek its application. Once again, international tax planning, as a concept, is transformed and, in order to continue its existence, will have to comply with the new rules.
Khrystyna Franchuk, lawyer at Baker McKenzie Kyiv
Vitalii Trachuk, lawyer at Baker McKenzie Kyiv