Ukrainian Tax Code: Application Story
The Tax Code of Ukraine has already been in effect for one year. The document was supposed to introduce an ambitious reform for reaching an ultimate goal — making our country favorable for doing business. However, the pros and cons became evident only in terms of practical application of the Code’s provisions.
Driven so much by tax considerations, we arranged a panel of experts on the topic. Use of companies from foreign jurisdictions in cross-border transactions, assessment of new corporate taxation incentives, single-tax regulation and tax crime are the core issues for a set of independent opinions.
The introduction of the Tax Code significantly influenced the practice of corporate restructurings involving legal entities registered abroad. In particular, five below novels of the Tax Code seem the most relevant in this respect.
The Tax Code considerably restricted the deductibility of royalty expenses: e.g. only 4% of the royalty may be deducted when the payee is a non-resident, and no royalty amount is deductible at all when the payee of the royalties resides in an offshore jurisdiction, receives royalties for IP rights that initially belonged to a Ukrainian resident, is exempt from taxation of royalty income in its home country, or is not a beneficial owner of the royalty income.
In addition, the concept of beneficial owner, which is new to Ukraine, further dims the issue.
Starting from 1 January 2013 the Tax Code expands application of the arms length principle to transactions involving Ukrainian individuals. This outlaws the sale of corporate rights by Ukrainian individuals to their related parties at a price other than the arms length price.
Starting from 1 January 2013 the Tax Code expands application of the arms length principle to transactions involving Ukrainian individuals
Under the Tax Code it is uncertain whether an in-kind contribution of corporate rights into another company’s share capital would result in tax liabilities for a contributing individual. While the wording of the Tax Code does not essentially differ from the wording in the legislation applicable prior to 2011, tax authorities may be inclined to infer that such in-kind contribution would amount to taxable sale of corporate rights.
The Tax Code expanded the definition of permanent establishment of a non-resident, and now covers Ukrainian individuals authorized to act on behalf of such non-resident. Hence, the mere issuance of a power of attorney by a non-resident to a Ukrainian individual requires such an individual to register a permanent establishment of that non-resident in Ukraine, as well as to account for any income of such non-resident entity sourced from Ukraine.
The Civil Code was amended in unison with introduction of the Tax Code. It now allows invalidation of transactions incompliant with the interests of the state and society. Hence, transfers of corporate rights structured to avoid (or optimize) taxation carry a risk of being invalidated. Furthermore, when such non-compliance is willful the Civil Code envisages overly onerous consequences for the parties.
The above issues cause great deal of legal uncertainty for businesses engaging into cross-border transactions. The uncertainty is aggravated by the fact that interpretations of comparable preceding legislation were held by the tax authorities irrelevant for the interpretation of rules set out in the Tax Code. Accordingly, businesses are left to rely upon their own understanding of tax rules (which the tax authorities may later disagree with) or request tax consultations whose value for a taxpayer is rather limited.
Tax incentives are defined as exceptions to the general tax rules and intended to reduce the tax burden of taxpayers. According to international practice tax incentives include, inter alia, loss carry forwards for corporate profit tax (the CPT) purposes. A tax loss carry forwards is recognized to be one of the main elements in an effective tax system and is highly attractive to foreign investors. Pursuant to the provisions of the Tax Code of Ukraine CPT payers are technically allowed to deduct prior-year losses over an indefinite period of time. In addition, this position was supported by the Verhovna Rada Committee on Finance and Banking, Tax and Customs Policy. However, the State Tax Service of Ukraine issued a clarification letter, which imposes restrictions over the rule stipulated by the Tax Code. Thus, according to this letter the CPT payers could not deduct losses incurred in 2010 in the second quarter of 2011.
The best way to protect business is to appeal to an administrative court and file a claim against the tax assessment notice
Hence, those CPT payers, which declared in the second quarter of 2011 the low tax amount accompanied by loss carry forwards, faced extraordinary tax audits conducted by tax inspections. As a result of the conclusions of tax audits old losses of such taxpayers were cut off and, therefore, extra CPT liabilities were accrued. The issue completely contradicts the Tax Code and exceeds its limits. Moreover, such illegal behavior by the tax authorities creates a real barrier for foreign organizations to invest in Ukraine and develop local economies. In such circumstances, the best way to protect business is to appeal to an administrative court and file a claim against the tax assessment notice.
Fairly speaking, in 2011 business did not much succeed in developing effective structures with regard to tax optimization of transactions with payers of the single tax. The straightforward wording of sub-clause 139.1.12 of Clause 139.1 of Article 139 of the Tax Code does not offer any chance for maneuver with respect to increasing the deductible expenses associated with purchases of goods (works, services) from individual entrepreneurs who have the status of single-tax payers.
In practical terms, it appears that the last resort for individual entrepreneurs striving to continue their cooperation with companies that are taxed on a common basis is to refuse from the benefits of the simplified taxation system. By switching to the general taxation system, individual entrepreneurs enable legal entities to increase the deductible expenses and thus vlower their taxable income. But such method of “optimization” put a considerably heavier tax burden on entrepreneurs because instead of a fixed monthly payment they have to shoulder the individual income tax at the standard rate of 15% or 17%. It would also result in additional expenses for compulsory book-keeping.
It appears that the last resort for individual entrepreneurs striving to continue their cooperation with companies that are taxed on a common basis is to refuse from the benefits of the simplified taxation system
It is further worthy of note that companies operating on a common taxation basis may continue to purchase works and services from single-tax paying entrepreneurs, but have to bear in mind the tax consequences provided by sub-clause 139.1.12 of the Tax Code and to structure their balance sheets so as to exclude the goods and services of single-tax payers.
Evidently, single-tax payers who are engaged in IT business and their clients were granted the possibility to maintain their business relations without any restrictions subject to exclusions of the confronting sub-clause 139.1.12 of Tax Code.
The previously available options of tax optimization, such as reducing payroll taxes, or transferring money to entrepreneurs’ bank accounts for converting it into cash, or lowering taxable income by purchase of goods or services from single-tax payers, have now ceased to exist.
Recently, the number of criminal cases related to crimes in the area of taxation has been really growing. However, it can hardly be explained by the desire of law-enforcement agencies to eradicate crime. Actually, it relates to more mundane reasons.
The main objective of the tax police has been defined as an effort to replenish the state treasury with additional funds. Therefore, the main purpose of the tax crime investigation is not to punish the guilty, but to recover unpaid money to the budget.
It is well known that criminal responsibility for tax evasion in accordance with clause 1, Article 212 of the Criminal Code only applies to those offenders who fail to pay to the State the amount that is a thousand times larger than the social tax benefit (currently, it equals UAH 470,500). And the punishment of imprisonment provided for in clauses 2 and 3 of the same article will not be valid from 17 January 2012, the date on which the On Amendments to Several Legislative Acts of Ukraine concerning Humanization of Liability for Offenses in the Sphere of Economic Activity Act of Ukraine comes into effect. According to Article 58 of the Constitution of Ukraine, laws and other legislative acts are not retroactive, except in cases when they mitigate or cancel liability.
In this regard, small businesses are not very often on the radar of the tax police. The fiscal law enforcement agency focuses on big taxpayers, as well as participants of standing “minimization” arrangements that are identified in the course of tax audits. Efforts by law-enforcement agencies (not only the tax police, but sometimes also the prosecutor’s office, Economic Crimes Departments of the police, and SSU) are traditionally focused on identification of so-called “conversion centers” that are used to withdraw “cash” assets and to minimize taxes. Founders of “conversion centers” are usually prosecuted under Article 205 of the Criminal Code (fictitious business), and their customers – under
As law-enforcement agencies step up their efforts in this area, even law-abiding businesses are at risk of being involved in investigations.
To avoid this, one should carefully approach tax planning and consider all the possible risks when choosing a system of tax optimization, as dimensions of lawfulness are quite vague in this area.