World tax globalization can reach Ukraine earlier than many people have expected.
To decrease the number of cases of the so-called jurisdictions “shopping” aimed at reducing the tax burden of Ukrainian companies by way of paying out passive income in favor of foreign companies, protocols to double taxation agreements have been signed on behalf of Ukraine over the past 3 years. These protocols are aimed at cancelling zero tax rates on non-resident income in respect of passive income paid from Ukraine. Such protocols were signed to tax agreements entered into with Cyprus, the Netherlands, Switzerland, the United Kingdom and other countries.
Also, in 2018, the Multilateral Instrument (MLI) was signed on behalf of Ukraine, which purpose is to simultaneously introduce changes to many tax conventions signed with countries that also expressed their desire to introduce such changes to the conventions entered into with Ukraine.
At the same time, none of the protocols signed nor MLI were ratified by the Ukrainian Parliament. Nonetheless, Ukrainian authorities never ceased their activities to reduce attractiveness of withdrawal Ukrainian companies’ profits to avoid taxation through foreign companies, which resulted in submission of the presidential draft law on tax on withdrawn capital to the Parliament. At the same time, the Ministry of Finance and NBU developed a draft law “On Amendments to the Tax Code of Ukraine to Implement the Plan to Prevent Base Erosion and Profit Shifting” (hereinafter the “BEPS draft law”) aimed at BEPS plan implementation in Ukraine. Moreover, BEPS draft law proposes introducing changes to the tax legislation of Ukraine in reading exceeding the obligations undertaken by Ukraine to implement this plan. Now therefore, there is a high probability that “traditions” of introducing changes to tax legislation at the end of the year followed by application of such changes from the beginning of the next year will be kept, as before.
Since the key novelties proposed by BEPS draft law can be fully implemented also with the introduction of the Exit Capital tax, this may indicate that the intention to replace “corrupt” income tax with the Exit Capital tax has not been forgotten. Novelties introduce to “tax turnover” such innovations as taxation of controlled foreign companies (CFC), constructive dividends and taxation of mediated sale of Ukrainian real estate through foreign companies. Special consideration is given to transfer pricing (TP) and issues connected with application of tax conventions.
The zest of BEPS draft law is the introduction of CFC taxation, which is designed to implement mechanisms to prevent withdrawal of capital using international structuring of business processes.
The basic principle of CFC taxation in wording proposed by BEPS draft law is that profits of CFC owned by Ukrainian residents-natural persons will be taxed in Ukraine in proportion to participatory interest of such natural persons in CFC capital. Moreover, if the annual income of all CFCs exceeds EUR 2 million, their profits will be adjusted according to the special rules stipulated by BEPS draft law.
The rules on taxation of CFC profits will not be applicable to all foreign companies. Profits of CFCs registered in countries, with which tax conventions are valid, and which are not included in the “offshore” list, will not be taxed in Ukraine. To be eligible for such an exemption, CFC must actually pay income tax at the effective rate of not less than 13% or 50% of its income, such CFC must be operating and complying with the related definition proposed by BEPS draft law.
Also, if annual income of all CFCs owned by a Ukrainian resident-natural person does not exceed EUR 1 million, then no additional taxation will be applied in Ukraine.
It is proposed to introduce special reporting for CFC, as well as material penalties for failure to submit thereof. In some cases, natural persons controlling CFCs will have to ensure preparation of CFC financial statements, which are not required by the legislation of the jurisdiction of CFC registration, or even to ensure preparation of transfer pricing documentation on CFC transactions.
In view of the contemplated changes, it is obvious that costs of maintaining and conducting business through CFCs will increase due to the necessity to comply with the tax rules in Ukraine. In some cases, ownership of CFC or accumulation of monetary funds in it may become unprofitable due to the higher rate of taxation of CFC income as compared to payment of dividends directly to the Ukrainian business owner.
Introduction of the concept of the so-called “constructive dividends” should be emphasized among the possible novelties. Difference between the amount of interest, royalties or payment for the supply of goods/provision of services paid to a “qualified” non-resident and the price related to the “arm’s length” principle will be considered equivalent to payment of dividends with the related obligation to pay CIT advance payments and non-residents income tax. The same rule will be applicable to sales of goods/provision of services to non-residents at prices not related to the “arm’s length” principle.
Taxation of the mediated sale of Ukrainian real estate
It seems that the developers of BEPS draft law were inspired by the Indian experience at Vodafone case regarding taxation of income from the mediated sale of assets that would be taxed when sold directly. In case of BEPS draft law adoption, profits of non-residents from the sale of Ukrainian real estate or of the rights to its long-term lease by selling corporate rights in foreign companies will be subject to taxation in Ukraine. And to gain control over such sales, special rules will be introduced, according to which a non-resident acquiring corporate rights in a foreign company, which cost by 50% or more results from Ukrainian real estate or the rights to its long-term lease, will act as a tax agent of a non-resident selling such corporate rights and should be registered with the Ukrainian tax authorities before conducting first payment for the acquired investment asset. And it will be possible to apply administrative arrest of property for violation of these rules by a non-resident.
At the same time, the Tax Code does not take precedence over tax conventions, and not all current conventions provide for an ultimatum taxation of income of non-residents from the sale of shares or corporate rights in companies that own Ukrainian real estate.
Adoption by the Verkhovna Rada of the BEPS draft law proposed by the Ministry of Finance will introduce significant changes to TP rules. The changes will affect both criteria determining relatedness of the parties, expansion of the range of taxpayers, to which TP rules apply, increase in the list of controlled transactions, rules for certain methods application, and the reporting that Ukrainian companies will be required to submit.
TP rules will become applicable to agricultural producers paying flat tax and supplying their products to non-residents. It is also proposed to enshrine in the Tax Code the doctrine of a business goal in transactions with non-residents. Even if transactions are not controlled for TP purposes, expenses in favor of non-residents without a business goal will increase taxable profits. And the results of controlled transactions will not be taken into account in case of non-availability of a sensible economic reason for such transactions conduct. The same consequences will occur if the transaction does not provide for an increase of the taxpayer’s assets, or if the tax authority finds that one of the main goals of the controlled transactions is to avoid paying certain amount of taxes. We can only hope that the tax authorities will not abuse these provisions and that the reasons for the additional charges on this basis will not be absurd. However, it is obvious that the number of tax disputes related to this novelty will increase.
BEPS draft law provides for the introduction of three-tier structure of reporting for TP purposes, which will include TP documentation (Local File), global TP documentation (Master File) and country-by-country report. It should be noted that there is some discrimination for Ukrainian business – reporting by country will have to be prepared at lower turnovers (EUR 50 million) than that for foreign businesses (EUR 750 million). Considering the significant penalties for failure to submit TP reports to the extent required, in case of BEPS draft law adoption, it will be necessary to take the new rules for submitting TP reports very seriously.
Application of tax conventions
In case of BEPS draft law adoption, companies cooperating with such from jurisdictions that do not have clauses on beneficial owner in tax conventions can catch a break. The tax authorities will not be able to charge them additional obligations due to “non-beneficiary nature” of the income recipient.
But if there is a reservation in the tax convention, the rules are tightened. It is planned to bring requirements for the beneficial owner at the legislative level, namely, performance of essential functions, lack of transfer of income further, availability of appropriate resources for the use of assets and risk coverage. This, in its turn, will affect the already well-established judicial practice regarding the “beneficiary nature” of sub-licensors with exclusive licenses, as well as provide a regulatory background for the actions of the tax authorities aimed at challenging the legality of tax conventions application that are actually being performed.
Also, Ukrainian companies will be able to apply tax conventions with countries of the beneficial owners origin, despite the fact that actual payments are made to other non-residents. In their turn, non-residents will be required to prove their “beneficiary nature”.
It is likely that BEPS draft law placed in public access for public comment will undergo significant changes before becoming a law. However, the vector chosen by the Ukrainian authorities in the direction of counteracting income tax base erosion can be traced quite clearly and will unfailingly entail additional expenses for businesses related to taxes and/or administration thereof. Even if there is a more liberal version of BEPS implementation in Ukraine, it is advisable to think now about the impact of BEPS draft law provisions on existing business structures and to prepare for possible changes or to close the planned transactions prior to new tax rules introduction.