Fate Still Favors Developer-Venture Investor Tandem ~ U-Tax Blog

Saturday, February 4, 2012

Fate Still Favors Developer-Venture Investor Tandem

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One of the most popular means of tax planning in the construction industry appears to be the use of investment funds (hereinafter – the "IF"). The scheme is quite simple and relies on corporate income tax exemptions enjoyed by the IFs.

The underlying idea is to "transport" the profit from a real estate developer paying corporate income tax on a general basis, to the IF commanding significant exemptions from this tax. Neither the income of the IFs from the operations with their assets nor the income accrued of the IFs’ assets is subject to corporate income tax in Ukraine (para 136.1.9 of the Tax Code of Ukraine).  In other words, the IFs can qualify as today’s Ukrainian tax-free havens.

The developer sells at an artificially low price (covering its costs and securing the minimum profitability) the real estate objects to the assets of the IF controlled by such a developer. In most cases this scheme is harnessed before the end of the construction and the interest in the unfinished real estate objects rather than finished real estate objects are transferred to the assets of the IF.

As a rule, the practice resorts to venture IFs. The assets of these IF are exposed to the less stringent requirements as compared to other types of IFs, which makes their usage within such schemes rather convenient.

After the purchase of the real estate objects (proprietary interests in them) from the developer the IF (the company managing its assets) sells them at a market price to the end customers and accumulates the profit. The latter, as noted above, is completely exempt from corporate income tax.

On top on that, the resulting profit may safely be taken away from the IF by dividends distributions to its investors (typically, companies affiliated with the developer). IFs are exempt from advance corporate tax payment accompanying dividends distributions (para 153.3.5. of the Tax Code of Ukraine).

Prior to the sale of the real estate objects (proprietary interests in them), the developer exercises their securitization – conversion into securities. The securitization serves at least two functions, inasmuch as:
  1. Defers the moment at which the VAT becomes payable by the developer. The supply of securities is not subject to VAT (para 196.1.1 of the Tax Code of Ukraine). Consequently, the developer faces the VAT payable after the buy-back (redemption) of the securities from the end customers and the transfer of finished real estate objects into their ownership;
  2. Is necessary for the observance of the legislation regulating IFs. This legislation does not provide a clear answer to the question whether the assets of IFs may comprise the proprietary interests in unfinished construction objects (in most cases these very items are sold within the scheme), but quite clearly indicates that the assets of IFs may embrace the various types of securities.
The securitization may be accomplished through the variety of different means. Of these, the allotment of special-purpose bonds (redeemable by transferring real estate objects into the ownership of their holders) appears to be the most transparent one. Among more confusing schemes there are those related to the allotment of options, usual bonds or even promissory notes, which are somehow tied to real estate objects.

After the completion of the construction the end customer obtains the title to the finished real estate object from the developer. This is achieved either by way of the buy-back or redemption of the securities acquired by the end customer from the IF (its asset management company).

In spite of its comparative simplicity and high tax efficiency, the scheme under consideration is not free from significant risks, the two most important of them are outlined below.
  1. Transfer pricing. As mentioned above, in order to ensure the operation of the scheme the real estate objects (securities tied to them) ought to be sold to the assets of the IF at prices lower than the market-based prices. To put it differently, if the tax authorities are able to apply transfer pricing rules, the developer will be compelled to recognize the income based on a market price as well as to pay a fine and default interest. Even if the tax authorities fail to prove that the developer and the IF (its asset management company) are related parties, there still seems to be the legal grounds for the application of transfer prices. For example, having regard to the considerable tax benefits granted to IFs practically exempting IFs (their asset management companies) from corporate income tax, the tax authorities may view IFs as non-payers of this tax and apply transfer prices (para 153.2.3 of the Tax Code of Ukraine).
  2. Business purpose test. The practice of Ukrainian courts has been intensely soaking up the doctrine of business purpose over recent years. This doctrine even deserved to be placed on a statutory footing (para 14.1.231 of the Tax Code of Ukraine). According to the doctrine in order for a transaction to qualify as "valid" for tax purposes, it needs to bear a reasonable economic reason (business purpose) other than obtaining tax benefits. It can be assumed that where the tax authorities can demonstrate that the securities were transferred to the assets of the IF solely for the purpose of reducing the tax burden, the developer can run into a set of troubles. These may include additional corporate income tax liabilities, fine, default interest and depending on the amount of the tax underpaid even the criminal responsibility for the developer’s management.
Fate still favors developer-venture investor tandem. Despite the fact that the aforesaid schemes have been employed by almost every other developer for many years, the search into the Unified State Register of Court Decision showed no examples of the tax authorities’ reaction to such "optimization" solutions.

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