Friday, June 3, 2011

Doubtful Deductibility of Expenses Related to Advance Payment

Among many other issues accompanying the entrance into force of the Title III "Corporate Income Tax" of the Tax Code of Ukraine (the “Tax Code”) one can notice the issue on the deductibility of expenses related to the income recognized in accordance with the Law of Ukraine “On Corporate Income Tax” (the “CIT Law”).

Suppose that before 1 April 2011 (the effective date of Title III "Corporate Income Tax" of the Tax Code) your company received an advance payment for goods to be delivered and included this payment into its gross income pursuant to the “first event” rule laid down by the CIT Law. The company had not managed to buy those goods from its suppliers by 1 April 2011 and thus did not include their value into its gross expenses according to the above-mentioned “first event” rule. 

The Tax Code does not provide for the “first event” rule anymore, replacing it with the accrual method. According to this method deductible expenses are recognized in the same reporting period in which the income from the sale of the respective goods is recognized. 

Since in our situation the income was determined by the company before the introduction of the accrual method, it can be held that the company did not determine its income in the meaning of the Tax Code. As a result, the Ukrainian tax authorities believe that the company is disallowed to deduct the expenses related to that income (Integral Base of Tax Knowledge published on the State Tax Administration of Ukraine’s website in category 110.07.03).

It well appears to be unfair for the taxpayer not to declare the expenses related to the income recognized. On the other hand, the Tax Code, unfortunately, contains no provisions allowing a taxpayer to deduct the expenses forming the cost of goods if the income derived from those goods is not recognized pursuant to the Tax Code.

The taxpayer is put in the situation where it either must risk by deducting the expenses at issue or to concur with the position of the Ukrainian tax authorities and to suffer an extra tax burden. If the former way is chosen the probability of success appears to be rather theoretical, as there are no direct legal provisions supporting the deductibility. The maximum what the taxpayer can do is to refer to the rule of law provided by the Constitution of Ukraine. The rule of law is construed by the Constitutional Court of Ukraine as the maxim vesting the court with the right to decide based on equity if the applicable legislation appears to be unfair. However, given the current state of the Ukrainian court practice, the likelihood of the application of the rule of law is almost a delusive hope.

There is also an alternative option which seems to be more appropriate from the tax risk management point of view. The parties cancel the agreement under which the advance was paid, the seller returns the advance to the buyer, and finally the parties enter into the same new agreement. In this case the seller based on p140.2 of the Tax Code reverses its previously recognized income and forms the income and the related expenses pursuant to the Tax Code on the basis of the new agreement.

There is the risk that such a “maneuver” may be considered as being inconsistent with the tax legislation, as the tax authorities submit that the above p140.2 is only applicable to the income formed pursuant to the Tax Code. Nevertheless, this risk seems to be much lesser than one discussed above.