Factoring and Debt Restructuring

Oleg P. Zagnitko

From the contractual law prospective, the factoring has been widely known but yet undefined area of activities for the Ukrainian business entities whereas current crisis makes it institutionalize swiftly. Generally, everyone was engaged in assignments and assumptions of the contracts, this one activity pre-dates the current codification of business and civil contracts effective as of 2004. 2001 Financial Services and State Regulation of the Financial Services Markets (SCRFS) that earlier defined the factoring as a financial service that must be provided primarily by the financial institutions. More importantly, the Civil Code defined that factor can only be a financial institution.

It took several years for the market to realize that assumption of the contract (particularly, debt claims) for consideration can fall under definition of the factoring. Consider the difference between: “replacement of the party to the obligation (creditor or debtor)” and “assignment of the monetary claims” for the funds… under the payment”.

The only material differences are (i) monetary form of the claim (rarely there is assignment of goods, in any event), and (ii) consideration, which may, arguably, include, discount, postponement, interest, etc. Thus, most of the debt restructuring may fall under the factoring definition.

The warning call from the SCRFS was the letter No.1139/11-8 of 5 October 2005 regarding the need of the debt purchaser to have capacity of the financial institution. Since the hit of the liquidity deficit in 2008, the debt restructuring transactions were in ever high demand. With regular activities on the debt assignment and significant aggregate amounts involved, the corporate entities, both resident and non-resident were accumulating the risks of being regulated by the SCRFS and, under the risk of illegality of the transaction for the lack of capacity of the debt acquiring entity (factor). On 3 April 2009, the SCRFS issued its ruling No.231 that qualified the discounting of the debts as a factoring. Some uncertainty, however, was added by the 2010 Act on Factoring¹ that has provided “other financial services” related to debt recovery in addition to what had seemed an exhaustive list of the financial services subject to regulatory supervision under the lex specialis.

One part of the SCRFS’ ruling No.231 seems controversial: it extends the capacity of non-entrepreneurial business entities to become the clients of the factoring services. The SCRFS (jointly with the National Bank of Ukraine and the State Committee of Ukraine on Regulatory Policy and Entrepreneurship) here is clearly at conflict with provisions of Section 1079.2 of the Civil Code, that excludes such subjects (e.g. credit unions) from the reach of the SCRFS.

Before the ruling, the banks and other companies could finance or re-finance the credit unions albeit under a different name, whereas now the SCRFS will try to supervise these types of transaction outside the banks or mutual investment funds. This ruling, however, can be a positive development for the taxation of such operations as discussed infra.

As to the corporate law prospective, the Civil Code clearly provided that factoring is a regulated activity to be provided by financial institution. The capacity to render factoring services went along the general status of the financial institution. Two recent developments have highlighted this trend.

First, the 2010 amendment of the factoring provisions in the Financial Services Act and the Civil Code² provisions can be seen from two angles. On one hand, they seem to clarify capacity of the factoring companies with respect to (i) the debt servicing/collection activities (soft, hard and legal), (ii) the strict requirement to be established as a legal entity and not an individual entrepreneur and, (iii) do not render services other than financial services; to many, however, the law and the doctrine was sufficiently clear. On the other hand, the legal provisions refer to specific capacity of the factor to (i) provide to the seller any consideration (including non-monetary — OZ) for the monetary debt claims, (ii) transact in debt claims; and (iii) accounting of the debt claims (including, without reservation, interest accrual). Comparing this precise regime of the factoring company to ambiguous provisions on other business activities, one cannot help concluding that the status of the factoring company would be the most beneficial for the purchase and services of the overdue debts.

Second development happened quite recently. On 15 February 2011, Parliament voted for an increase in the charter capital in banking financial institution by 60% over the next five years and this may significantly reduce the ability of the existing banks to enter new product lines. The non-banking financial institutions remained a neglected area for provision of the financial services, with the boost in 2008—2010 due to financial crisis in the stringed banks. Now, having in mind substantial increase in the initial capital, existing large banking groups or new players can plan the market entrance of the financial services market through non-banking financial institutions. The benefits of the non-banking status, in comparison to the laws on banks and banking are evident: lax capital requirements, simple registration and compliance procedures, wide range of the services that can be combined, limited or no requirement to the insider dealing. The regulator — State Commission on the Financial Services Markets (the SCRFS) has weaker requirements for the composition, wide range of services to overview and relatively less experience since 2001.

The non-banking financial institutions (NBFI) cannot engage in the maintenance of current accounts and transfers between them (they can engage in cash transfers, however). This operation is reserved exclusively for the banks, and so NBFI have to rely on the banks in sensitive areas, such as cash handling, management and storing.

The relative financial strength of Ukrainian banks has also made NBFI mostly intermediaries between the bank and the customer in smaller or micro operations, where the banks could not built an economy of scale for itself. With the crisis, however, new market players were able to enter the market without support of Ukrainian bank capital and have been increasing their market share consistently.

In debt restructuring particularly, the factoring companies are expected to build an independent segment of the financial services markets with higher risks on the overdue debts. Traditional factoring of the debt claims before their maturity (forfeiting, etc.) will remain mostly the “area” of banks.

From the tax law prospective, 1997 provisions established positive taxation of any business entity engaged in “assignment of debt… for consideration…”³. With time it became evident that the laws on factoring were written for the bull market and the settlement of the overdue debt was not properly regulated by the law. Not before August 2009, however, Parliament managed to enact specific tax rules on assignment for the monetary claims that allowed the seller of the debt to deduct the loss as the expense. That is, the income and expenses on the monetary claims assumed by the taxpayer must be accounted separately from other operations. The original creditor (seller of the claims), after selling the claims to the factor (new creditor, buyer) will tax the positive difference as additional income or will deduct the negative difference as an additional expense. Claims under the loan agreements are accounted at balance value while the claims under other agreements — under “actual” value⁴.

The tax laws and, to a larger extent, commercial laws ignored the difference between factoring operations with non-due and overdue debts although these activities certainly pursue different business goals and have to bear different risks. Partially, the difference has been reflected in investment-like taxation of the factoring transactions by the acquiring entity (“factor”) and all subsequent entities. Under tax rules effective since 2009, the second creditor (factor) accounts for the margin from repayment or resale of the claim as a difference between the amounts received and paid at the purchase price. The negative margin is a loss, while a positive margin is taxable in gross income.

The above provision, however, fails to account for amortization related to its maturity: the market valuation rules decrease the discount on the face value of the debt with approaching of the time when it becomes due and the discount increases with time after it became overdue. Therefore, the seller (factor’s client) has no motivation to sell the debts earlier, because it always can deduct all the difference as an expense. Moreover, the tax provisions present a puzzle for a factoring company that acquires the portfolio of the overdue debts: it is unclear whether the factoring company should allocate the debt recovery (i) per each debt obligation existing (as the tax law suggests) or (ii) per total portfolio purchased (as allowed by the same rule of law and, generally, is the way the factor is inclined to go).

The Tax Code is notable in the changes it brought to the VAT regime of the operations with the debt claims. The earlier all-embracing definition of factoring as (see supra) has been repealed and, therefore, the factoring is currently defined in accordance with the law on financial services as well as with regulations by the SCRFS. As discussed above, this may seem that any assignment of the debt may be subject to VAT unless it involves a factoring company. Exemption from VAT will only apply to a transaction with debt (claims to third parties) as listed under second paragraph of Section 196.1.5 of the Tax Code (formerly second paragraph of Section 3.2.5 of the VAT Act):

— factoring of the claims on monetary claims and securities; and

— exchange of the claims for the money or securities.

It remains to be seen how broad the interpretation by the tax authorities of the second provision will be. However, the VAT provisions of the Tax Code apparently provide for the possibility of operations that would match factoring in everything but name. As an additional observation, the Tax Code follows the path of the SCRFS ruling No.231 of 3 April 2009 by extending VAT-exempt operations with securities. Namely, it now lists transactions involving assignment of the claims under the mortgage-backed loans. The income from factoring operations will also be included as a special part of the taxable income of the banking institutions.

¹ Amendments of Certain Legislative Acts of Ukraine On Factoring Act of 9 September 2010, Article 1(2) Part two.

² Amendments of Certain Legislative Acts of Ukraine on Factoring Act of 9 September 2010.

³ Value Added Tax Act, Section 1.10.

^{4 Taxation of the Profit of the Enterprises Act, Section 7.9.7, Tax Code of Ukraine, Section 153.3.5.}