Hot Issue (#12 December 2018)

Taxation of Permanent Establishment Financing in Ukraine: The Never-Ending Story

Vitalii Trachuk , Khrystyna Knygynytska

Not many foreign companies today would be brave enough to choose conducting business in Ukraine through a registered representative office for obvious reasons of legal uncertainty and scrutiny of the tax office.

Nevertheless, when the Ukrainian tax system was being formed, registration of a representative office was a rather favored option by foreign companies. For tax purposes, such representative offices would normally be registered as permanent establishments (PEs), even if they were to serve non-commercial purposes (i.e., to conduct merely preparatory and auxiliary activity for its head office).

Over the years, representative offices, especially those which claimed to have non-commercial status, probably became one of the most favorite objects of tax audits. In this context, the majority of PE tax disputes concern the financing that representative offices receive from their head offices for everyday needs.

Below we discuss the legal provisions and the tax offices position with regard to the taxation of PE financing and express our opinion on whether it is legitimate.

PE in Ukraine: a narrow view

While the Ukrainian definition of a PE was designed in line with international standards, its use in Ukraine continues to be rather limited.

PEs are often considered a synonym of commercial representative offices. In turn, such concepts as a dependent agent PE and services PE are not applied by Ukrainian tax authorities, despite being part of the definition of PE. The reason behind such practice may be the fact that only representative offices that are officially registered by the Ministry of Economic Development can be easily tracked and, therefore, remain on the radar of the tax authorities.

This has lead to an absurd situation where the significant majority of audits and tax assessments regarding PEs are held in respect of representative offices and the financing they receive. As a general rule, instead of attributing a fair share of profits (or losses) to a PE, the tax office claims that funds provided by the head office for sustaining the PEs operation should be taxed by corporate income tax (CIT) (or even VAT).

Although the discussion with respect to the definition of a PE and the attribution of profits is beyond the scope of this article, the fundamental concepts below, as developed by the OECD, are crucial for understanding the issue at hand.

Firstly, one should realize that a PE is not necessarily a representative office (registered or not). A pipeline, a warehouse, or a vending machine can easily create a PE without any formal registered presence of their foreign owner in Ukraine.

Secondly, and most importantly, profits should be attributed to a PE on the basis of a functionally separate entity approach, presupposing that a PE should earn income and incur expenditures at arms length as if it were a legally and economically separate enterprise in relation to its head office.

To sum up, Ukraine presently does not apply the full extent of the PE concept. The PE concept as such gives Ukraine the right to attribute and tax fair share of business profits derived by non-residents from their carrying out business in Ukraine. The PE should be taxed regardless of whether there is a registered representative office and regardless of the actual legal operations in which it is formally engaged, but on the basis of its hypothetical arms length remuneration for services rendered to its foreign head office.

An easy target

Unfortunately, the above fundamental rules are ignored by the Ukrainian tax
authorities. We are not aware of a single case where a PE was recognized without a foreign enterprise having a registered presence in Ukraine.

Moreover, we are almost completely sure that the tax office does not prepare a functional analysis to determine the arms length remuneration of a PE for the purposes of profit (or loss) attribution.

Instead of carrying out a thorough analysis, when it comes to the taxation of a PE, the tax authorities tend to see and tax only funds actually transferred to the PEs bank account.

While certain representative offices carry out full-scale business in Ukraine and, therefore, generate profit to sustain their operation, a significant part still heavily relies on financing from the head office. According to law, representative offices do not have effective access to other financing alternatives compared with Ukrainian legal entities (e.g., by way of charter capital injection or loan).

As a matter of established practice, the tax office treats the financing provided by the head office as income, thereby increasing the financial result of a PE as a separate taxpayer, which is subject to CIT.

Eventually, if a PE incurs deductible expenses in the period (such as paying salaries and wages, making payments under contracts with suppliers, etc.), the CIT base, created due to PE financing, may be significantly reduced. In practice, however, PE financing is rarely utilized within a single tax period and thus, the PE has to pay CIT.

In the context of the above-established approach, a legitimate question is whether PEs financing should be subject to taxation at all.

Clash of opinions

The issue is not that straightforward. There are opposing views with respect to whether a PE may be taxed on its financing.

As discussed above, the tax office has adopted the approach that funds provided by the head office to the PE are income of the PE, being non-recoverable financial aid. Examples of such a position can be found in numerous official letters issued by the fiscal authorities (see, e.g., Letter of the State Fiscal Service of Ukraine No. 295/6/99-99-15-02-02-15/ of 23 May 2017 and Letter of the State Fiscal Service No. 1008/6/99-99-15-02-02-15/ of 14 March 2018).

Although there is no absolute consensus in court practice as to the treatment of PE financing, the non-recoverable financial aid approach is still pursued by the tax authorities and often prevails (see, for example, the Ruling of the Kyiv Appeal Administrative Court, of 7 December 2017, Case No. 2-16434/12/2670).

There is a second, alternative, view.
The opponents of the fiscal position consider the PE and its head office as a single enterprise, based on Ukrainian civil and commercial law and refuse to recognize the transfer of funds between them as a taxable transaction.

In other words, this position effectively rests on the refusal to recognize a PE as a separate taxpayer. A few recent court cases demonstrate that certain judges do, in fact, support such a view (see, for example, the Ruling of the Kyiv Appeal Administrative Court of 17 April 2018, Case No. 826/13953/15 and Ruling of the Higher Administrative Court of Ukraine of 5 October 2015, Case No. 2-8878/12/2670).

It must be stressed in this context that although the PE and its head office are certainly not separate legal entities under Ukrainian civil legislation, they are, by law, separate taxpayers as per the Tax Code of Ukraine.

From a practical standpoint, in light of the present circumstances, it might be recommended that taxpayers apply the first (non-recoverable financial aid) approach. Otherwise, a dispute with the tax authorities is almost inevitable. But is this approach in line with international understanding of the PE concept? Are any of the discussed approaches fair and lawful?

To tax or not to tax?

It would take quite a great deal of time and space to actually analyze this issue in detail. This article serves a different purpose.
It is the intention of authors to merely stimulate further discussions on this matter, and that is why below there is only a brief explanation of their professional opinion on the legality of taxation of PE financing in light of the OECD standards.

In short, we believe that PE financing should not be taxed as non-recoverable financial aid. It is our opinion that PE financing may be taxed only provided, and to the extent, that it may be considered a fair arms length remuneration for services rendered (products provided) by the PE to its head office. In other words, one must apply the above-mentioned functionally separate entity approach (endorsed by the OECD as the Authorized OECD Approach), which attributes only arms length remuneration that the PE would obtain if it were a separate and distinct enterprise.

For instance, if the PE were to provide maintenance services to customers of the head office (which sells cars to such customers), income attributable to the PE would be in total equal to the remuneration paid to a separate and independent entity that would otherwise provide such maintenance services. Accordingly, if and to the extent that the PE financing provided by the head office is equal to such arms length remuneration, it should be considered the PEs income. The remaining amount should rather be considered an investment of the owner of the enterprise (the head office) to the PE (which, according to accounting principles, cannot be taxed).

We have to remember that testing a PE for arms length remuneration is not only a matter of checking the status of financing. It is rather an analysis of the fair remuneration of the PE as such.

A PE may generate profit or loss without actually obtaining funds from its head office (under the functionally separate entity approach). Moreover, a PE may also exist without formal registration of a representative office and direct financing. That being said, the rendering of services by such a PE to its head office should also be done based on fair remuneration.

In such circumstances, application of the functionally separate entity approach becomes especially crucial for the effective application of the PE concept and targeting Ukrainian profits of non-residents which currently remain untaxed.

The answer already exists

It should be noted that the tax authorities have already started to take the first, but so far, modest steps in understanding the fair taxation of PEs.

In a recent official letter, the tax office argued that PE financing may be subject to VAT as remuneration for services provided by the PE to its head office (see Individual Tax Ruling No. 2323/6/99-99-15-03-02-15/ of 20 October 2017). Of course, the said letter issued by the tax office is certainly far from providing a comprehensive understanding of PE financing taxation, but it follows sound logic. In fact, depending on the nature of the services rendered by the PE for the benefit of its head office, they, indeed, may be subject to Ukrainian VAT at 20%.

Unfortunately, this approach was completely rejected by the Ministry of Finance in its most recent general tax ruling (see Order of the Ministry of Finance of Ukraine No. 673 of 3 August 2018).

This does not give evidence of the incorrectness of the approach itself, but demonstrates that the Ukrainian tax authorities should develop more solid and deeper rules to apply it.

What seems, at first glance, to be rather burdensome to adopt, actually already exists. In line with current Ukrainian fiscal policy, PE financing is already subject to transfer pricing regulations (see Individual Tax Ruling No. 853/6/99-99-15-02-02-15/ of 2 March 2018).

This approach enables functional analysis to be carried out in respect of the role of the PE in the enterprises overall business (to determine the mentioned fair arms length remuneration).

For example, provided that (i) the head office transfers UAH 3 million to its Ukrainian PE as financing, but (ii) the transfer pricing analysis shows that the arms length remuneration for the services rendered by the PE to its head office comes to UAH 1 million, fair taxation should be as follows:

UAH 1 million treated as an increase in profit (tax base for CIT purposes) and can be subject to VAT at 20% (depending on the type and location of services rendered by the PE);

UAH 2 million is treated as a capital increase and does not generate profit or loss.

Difficulties may arise if the Ukrainian registered PE did not select a first (direct) model of taxation, but the second or third. Under the Tax Code of Ukraine, the second model (separate balance sheet model) and the third model (0.7 coefficient model) are incompatible with the functionally separate entity approach. As a result, the above-suggested mechanism of taxation cannot be applied.

It is our understanding that under the separate balance sheet model, PE financing should be neglected entirely, for it presupposes the treatment of the PE and its head office as a single entity. The third model does not specify the mechanism of income attribution at all, thereby not allowing any precise conclusions to be drawn. The third model merely dictates the method of PE expenses calculation. Thus, it is possible that the strict reading of the third model would, indeed, necessitate the treatment of PE financing as income.


To conclude it is advisable that businesses, to be on the safe side, treat PE financing as taxable income. Otherwise, they could face the need to engage in disputes with the tax authorities. Businesses should also be aware that their presence in Ukraine may lead to taxation regardless of whether or not they actually registered a representative office. Yet, the risk of the tax authorities cheking an unregistered PE is rather low in light of current practice.

At the same time, it is strongly recommended that tax policy makers reconsider their approach to PE taxation as such, applying the functionally separate entity approach. This should erase any issues with respect to the fairness of the PE taxation financing in principle. It may also be an effective tool to increase tax revenues at the expense of companies conducting business in Ukraine without proper registration and correct determining of profit.

Khrystyna Knygynytska
is an assosiate at Baker McKenzie Kyiv

Vitalii Trachuk
is an assosiate at Baker McKenzie Kyiv

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