Overview of corporate tax work over the last year
Before 2015, lawyers practicing tax law in Ukraine were generally involved in judicial work on challenging tax assessment notices, representation in criminal cases (white collar crime) and, to a much lesser extent, consultancy and structuring. Since the commencement of 2014, tax audits of business entities have been pulled up to prevent persistent abuses on the part of the regulatory authorities, which were a common practice under the former Yanukovych-Azarov regime. Thus, even such extreme steps have not drastically changed the situation and disputes with tax authorities continued in big quantities. The major projects in 2014, as in previous years, involved legal support of appeal procedures regarding tax assessment notices. Since 2014, a lengthy tax reform began to pick up steam; its key results that entered into effect as of 1 January, 2015 included a heavily changed concept of income tax which has been completely rewritten. In addition, following the recent developments in our country, i.e., armed hostilities in the Donbas region, the annexation of Crimea, execution of an association agreement with EU and efforts to get the country back on the path of democratic development, tax legislation has been amended to include provisions for a military contribution – a special and obligatory payment that, as a matter of fact, is equivalent to personal income tax. Also, the tax burden on farmers and subsoil users has grown, and preferential tax treatment of certain industries has been discontinued.
Key developments affecting corporate tax law and practice
Corporate tax general and key developments overview
Since January 2015, income tax in Ukraine has been completely revised at the legislative level. Most changes were made pursuant to the requirements of international lenders, such as the International Monetary Fund, EU and USA, and the demands of a society striving for fundamental changes after the Revolution of Dignity. New income tax comes together with the massive introduction in Ukraine of new tax concepts developed by the OECD, which, generally, comply with the initiative of BEPS, to address tax law issues and economic problems. At the same time, previously existing national solutions continue to be legally effective and to operate simultaneously with the new concepts (in fact, under certain circumstances the taxpayer itself must decide which regulations, old or new, to follow) or were supplemented by OECD concepts. It should be noted that Part 3 “Income Tax" of the Tax Code of Ukraine (“TCU" or “Tax Code"), that previously incorporated as many as 29 articles and counted 34,163 words, since 1 January, 2015, now consists of just 10 articles and 6,849 words. The regulatory framework for income tax shrank due to a number of factors, for the most part as a result of elimination of separate “tax" accounting which the businesses had to carry out along with traditional bookkeeping.
For example, before 2015, the Tax Code contained separate and special rules for determining financial results (profit or loss) for the purposes of levying profit tax, which from time to time have drastically differed from the rules set by IFRS or national accounting standards. In practice, the provisions, now cancelled by the TCU, compelled a company to separately keep accounting records – to determine financial indicators in accordance with accounting standards, and to maintain tax accounting – to determine financial results for tax purposes. Currently, the Tax Code contains rules pursuant to which, for profit tax purposes, financial results determined in accordance with accounting standards are adjusted either upward or downward. Income tax in Ukraine is charged at a rate of 18% of the tax base, which is the financial result determined in accordance with national or international accounting standards. The financial result from operations with securities and derivatives is determined separately and forms a separate tax base. At the same time, since 2014, profit from transactions with securities and derivatives is taxed at a rate equivalent to the base rate of 18% (prior to 2014, such profits were taxed at a special rate of 10%).
Taxation of non-residents and key developments in the taxation of permanent establishments
Income generated by non-residents from a source inside Ukraine is always taxed at 15%, unless otherwise provided by law, specifically:
- if a non-resident earns profit through its permanent establishment in Ukraine (profit is taxed at the base rate); or
- if a non-resident receives income in the form of revenues / other types of compensation of the value of goods (works, services) acquired from a resident.
According to the Tax Code, taxable incomes of non-residents include interest, dividends, royalties, freight, revenues from engineering, leasing payments and rent, profit from operations with securities, income from the sale of immovable property, income from joint ventures in Ukraine, remuneration for educational, scientific, cultural and religious activities, insurance premiums, brokerage fees, commissions and donations. In a number of instances contemplated by agreements on the avoidance of double taxation (“Double Tax Treaty" or “DTA"), certain types of non-residents' income may be taxed at a lower rate. Whenever a non-resident wishes to reduce the tax rate by reference to a DTA, a non-resident who receives income should deliver to a resident who makes the payment a special tax residency certificate issued by the governmental authorities of a country that signed a Double Tax Treaty with Ukraine. It is worth noting that Ukraine has signed around 75 Double Tax Treaties. The Tax Code also prohibits incorporating provisions in agreements with non-residents which require non-residents to assume responsibility for paying taxes. The TCU gives a broader definition of the term “permanent establishment" (hereinafter referred to as “PE") compared to the definition recommended by the OECD Model Convention. Thus, according to the Tax Code of Ukraine, PE will, among the standard forms listed by OECD, be deemed formed once a server or a warehouse that is used for the supplying of goods, has been placed in Ukraine. It is worth taking into account that whilst there is no regulatory definition specifying a “server" in the tax legislation, under the Ukrainian law generally a “server" would refer to special purpose computer equipment. An important thing about PEs is that, according to Ukrainian law it includes residents who have authority even to conduct negotiations on behalf of non-residents, which results in an accrual of rights and obligations by such non-resident. It should be kept in mind that, if a Double Tax Treaty suggests a different definition of a PE, the definition of the PE contained in such DTA must apply.
Controlled foreign companies and disclosure of beneficial owners
Ukrainian legislation is silent as to the classic concept of controlled foreign companies; instead, for over 20 years Ukraine has had a stricter regime in place. Under the currency regulation and control regime, the acquisition of corporate rights in foreign companies by residents of Ukraine is viewed as a currency operation, i.e., an investment abroad. Currency operations, including investments abroad, must be carried out pursuant to the specific procedure that is prescribed in order to receive the appropriate individual licence from the National Bank of Ukraine (the “NBU"). Any violation of the currency regulation regime (by making investments abroad without obtaining an individual licence from the NBU) entails a fine in the amount of the investment made. Investing abroad also requires the annual reporting of information on assets and income (currency values) located abroad. Revenues received by a physical person from foreign companies, including in the form of a fringe benefit, are subject to personal income tax. In line with the anti-corruption strategy of the Government, a number of regulatory acts have been amended to require legal entities incorporated under the law of Ukraine to furnish information on their ultimate beneficiaries to the state registrar. Information on ultimate beneficiaries of legal entities should be published in the public register of legal entities and individual entrepreneurs. It is worth noting that, in practice, the requirements regarding mandatory publication of ultimate beneficiaries have not been fully complied with and therefore the term during which the information on the beneficiaries must be furnished has been prolonged until 25 September, 2015.
New regulatory approach and anti-avoidance rules
In addition to combining bookkeeping and tax accounting, the tax reform has also made significant changes to the transfer pricing concept and “anti-offshore" provisions of the Tax Code, introduced thin capitalisation of interest and supplemented the royalties taxation regime. Ukraine has for a long time lacked solid anti-avoidance rules at the legislative level; however, the doctrines of anti-avoidance have been effectively used over the recent years by courts and tax authorities. In most instances, governmental authorities apply the doctrines of unjustified tax benefit, reasonable commercial purpose (economic substance), primacy of the substance of a business operation over its form (substance over form) and actual existence of business transactions. Ukrainian tax authorities quite frequently and effectively contest the allocation of certain business transaction costs to the company's expenses, recognise some transactions as not valid and charge additional tax liabilities by reference to the above doctrines, including in courts.2 Since 2015, the profit tax reform has put in place an equivalent of anti-avoidance rules by launching a special monitoring regime in relation to business transactions with persons who could be earlier used in anti-avoidance practice.
Therefore, transactions with non-profit and charitable organisations and organisations for the disabled must be subjected to mandatory monitoring for compliance with the arm's length principle, and the tax treatment of charitable organisations, bookmakers and lotteries has been completely revised in the new profit tax regime.
Transfer pricing and anti-offshoring rules
Transfer pricing control in Ukraine (the “TP") must apply to transactions with related parties, including non-residents, and with residents of countries and territories which:
- levy profit tax (its equivalent) at a rate of 5 percentage points lower than the rate of profit tax in Ukraine (i.e., charge the profit tax at a rate below 13%);
- do not publish information on the owners of legal entities in register open to the general
- have not entered into an agreement on exchange of information with Ukraine.
The list of such countries and territories (the “TP Blacklist") is published by the Cabinet of Ministers of Ukraine on an annual basis.3 However, Austria and Switzerland – the countries that do not comply with the abovementioned criteria – were controversially included in the TP Blacklist. Transfer pricing control suggests reviewing whether conditions of a controlled transaction comply with conditions of a comparable uncontrolled transaction between unrelated parties (the arm's length principle). If it has been discovered that there is a price disparity in a controlled transaction, tax authorities may decide to impose extra tax liabilities and, under certain circumstances, charge a fine. For example, a failure to include controlled operations in a controlled operations report will entail a penalty of 5% of the volume of transactions4 omitted from the report. In addition, legislators have been aggressively using the TP to discourage erosion of the tax base and relocate the 'profits centres'. According to the latest changes in the TCU, taxable financial results must be increased by 30% of the value of goods (works, services) acquired from residents of countries put on the TP Blacklist.5 This limitation does not apply (financial results should not increase) if the arm's length principle in a controlled transaction is complied with in pursuance of the TP rules.
Key developments affecting taxation of royalty
Historically, in Ukraine, only a limited amount of royalties payable to non-residents have been recognised as expenses. Accordingly, before the 2015 tax reform, royalties in an amount not exceeding 4% of the net income from the sale of goods (works, services) were recognised as expenses. After the tax reform, legislators retained this heavily criticised provision in the TCU; however, there is an option effective from 1 January, 2015, which suggests that restrictions stipulated by this rule may not be applied if the amount of royalties corresponds to regular prices as evidenced by the taxpayer under the procedure contemplated by the TP concept,6 or simply writing that the royalties are paid at arm's length. Furthermore, the highest degree of care must be taken when paying royalties to residents of countries found on the TP Blacklist. If the amount of royalties paid to a resident of a blacklisted country does not correspond to the level of regular prices, royalties may not be recognised as expenses. It should be noted that the tax reform has made significant positive changes to the definition of royalties by eliminating a long-existing conflict over the definition of services.
Introduction of thin capitalisation rules
Erosion of the tax base by extending loans from low tax jurisdictions through controlled nonresident entities has always been a mostly preferred technique in tax planning in Ukraine. From 1 January 2015, the tax reform put in place thin capitalisation rules. According to the recent changes, if the amount of a taxpayer's debt before related non-resident entities exceeds 3.5 times or more of the amount of such taxpayer's equity, only a limited amount of interest may be recognised as expenses, specifically: the taxable financial result must be increased by an amount by which the amount of paid (accrued) interest exceeds 50% of the company's financial result, not reduced by interest, depreciation and amortization (EBITDA).7 Or, in other words, should a thin capitalisation apply, expenses of a resident taxpayer in the current reporting period may include only the amount of interest not exceeding 50% of profit, without interest expenses. At the same time, the amount of interest that was paid to a non-resident but was not in fact included in expenses, can be included in expenses of the next reporting period8 (carried forward) in compliance with the foregoing rule. The amount carried forward to the next reporting period must be reduced by 5% of the original amount upon each such carry-forward. It is worth noting that a non-resident entity is deemed related to a resident taxpayer if the amount of such taxpayer's debt before such non-resident entity exceeds the amount of the taxpayer's net assets by 3.5 times or more. The foregoing innovations are intended to alleviate tax regulation – no thin capitalisation rules were in effect before the tax reform, and the above limitation applied in the case of receiving a loan from a related non-resident person.
Currency regulation applicable to loans received by residents of Ukraine from non-residents
It is necessary to take into account that Ukraine has in place a special regime of currency regulation that applies when residents of Ukraine receive loans from non-residents. In recent years, the requirement to obtain an individual licence from the NBU for receiving a loan from a non-resident has been cancelled. In addition to the previously described tax restrictions, there are two currency restrictions currently existing in Ukraine, specifically:
- registration of loan agreements with non-residents with the NBU; and
- capping interest rates on foreign loans to residents.
Therefore, all loan agreements with non-residents are subject to mandatory registration with the NBU; besides, legislation further requires incorporating in loan agreements a clause to the effect that the loan agreement may only come into force upon its state registration with the NBU. Any major amendments to loan agreements should be also registered. In all cases, this is for debtors who bear responsibility for the registration of loan agreement; however, in many instances such approach is not convenient, especially when it comes to transactions involving a bad debt. The second limitation is associated with setting a cap on interest rates on foreign loans by residents. In the case of receiving a convertible currency loan from abroad, the maximum interest rate on the loan, including all default interest and possible payments of sureties, must not exceed LIBOR + 750 basic points, or, in the case of fixed interest rate, 11% per annum for loans with a maturity of over three years; 10% per annum for loans with a maturity of one to three years; and 9.8% per annum for loans repayable in less than one year. Loans with a higher interest rate require an individual licence from the NBU.
Tax climate in Ukraine
As described above in sufficient detail, profit tax laws and regulations in Ukraine represent an extremely strict stance taken by legislators with regard to international tax planning, vague tax base erosion and 'profit-centre' shifting into low tax and offshore jurisdictions.
Tax authorities that, during the Yanukovych-Azarov regime, collected revenues into the State Budget for the purpose of personal enrichment of the “Family", employed repressive approach to dealing with the business. Generally, each 4th tax audit resulted in a criminal charge on purely formal grounds with the purpose of exerting pressure on business owners. Unfortunately, after the regime was brought down, tax authorities have continued to act in much the same way, and continue the pressure despite the Government's moratorium on tax audits. The Ukrainian Parliament, from time to time, debates on international tax planning. As offshore companies have been actively used by politicians of the ousted regime for corruption and bribery, companies from offshore and low-tax jurisdictions are perceived by the public as 'corruption vehicles', untrustworthy and not to be relied on; to achieve their own goals, many politicians used to frequently and actively speculate on such perceptions and come up with various, mostly populist, legislative initiatives, for example, they suggest denouncing a double tax treaty between Ukraine and Cyprus. Generally, despite the fact that the 2014-2015 tax reform broke the ice in what concerns the narrowing of excessive powers of tax authorities in respect of resident taxpayers and that the Government made a number of key decisions aimed at combatting corruption in the tax bodies, the level of pressure that tax authorities exert on business remains fairly high, and the State Fiscal Service continues to pay the closest attention to operations of residents with non-residents.
Developments affecting attractiveness of Ukraine for holding companies
Ukrainian tax legislation is silent on participation exemption for foreign legal entities; therefore, dividends received from abroad by a legal entity that is a Ukrainian tax resident must be recognised as taxable income of the receiving resident entity. Besides, the individual licensing regime that the NBU has in place for equity investments abroad also applies to legal entities; therefore, using Ukraine as a jurisdiction for incorporation of a holding company is immensely inconvenient. Also, certain other aspects of currency regulation (registration of loan agreements) render impracticable the use of Ukrainian companies for setting up companies for intra-group financing purposes. In tax structuring, Ukrainian companies are only used as operating companies.
Industry sector focus
The two fastest growing industries of the Ukrainian economy are the agrarian and IT sectors. At the same time, both sectors have been experiencing an increased fiscal pressure. Overall, the increased tax burden is mainly caused by two factors: First, the country faces a colossal crisis, including the armed conflict, the outcome of which for the economy is comparable to what has happened upon the collapse of the Soviet Union, which resulted in a need to replenish the state budget. Second, the execution of an association agreement with the EU put Ukraine under the obligation to remove state aid from its policy. The agricultural industry in Ukraine is traditionally excluded from paying income tax. Prior to the launch of the tax reform, agricultural enterprises paid a fixed agricultural tax – a single tax at a rate calculated depending on the total area of the taxpayer's agricultural land. The tax reform increased agrarians' tax liabilities by an average of 3-6 times. Ukrainian Parliament is now actively discussing steps on having the agricultural sector included in the general taxation system.
Until recently, the IT sector enjoyed major tax preferences: IT companies were almost nontaxable. After signing the association agreement with EU and launching the tax reform, IT companies no longer have tax benefits and are subject to taxation on general grounds which, given the overall situation in the country, stir active debates in the IT community over business migration matters.
The year ahead
In the years 2015-2016, Ukraine will face a period of stabilisation and completion of active reforms. In addition, over these years the governmental anti-corruption strategy should yield results, and leading international analysts expect that Ukraine's economy will overcome recession by 2016 and start to grow. If tax and anti-corruption reforms succeed, Ukraine will achieve economic prosperity. What business at this point badly needs in Ukraine is the restriction of the punitive approach from tax authorities (tax police) and the formation of an effective law enforcement system.