1. General information
With the deeper integration into the world economy, Ukraine increasingly mimics Western techniques in the sphere of tax planning. “Debt push-down” is one of such techniques widely employed by oversees businesses in the area of M&A that becomes more and more popular in Ukraine. The dept push-down covers the debt finance and is designed to achieve the deductibility of the interest expenses accrued on a loan attracted for the acquisition of a business.
The typical situation in which the debt push-down is used may be shown as follows:
In this scheme the Acquirer attracts the loan from the Lender for the acquisition of the shares in the Target Company involved in profit-making activities. The debt push-down allows the Target Company to decrease its corporate income tax payable out of the operating profit by the interest expenses incurred by the Acquirer. Hence, the recourse to the “debt push-down” makes the acquisition more effective from the tax standpoint.
2. Foreign experience
Although the debt push-down technique has its common application in foreign jurisdictions, it is considered to be a tax optimization tool and thereby exposed to anti-avoidance rules precluding it from being easily achieved. The technique might turn out to be extremely difficult to implement given its incompliance with the concept of business purpose extensively used in overseas jurisdictions. The matter is that in accordance with this concept in order to be qualified as a valid transaction for the tax purposes, the transaction must serve a bona fide business purpose, other than a tax purpose. To be frank, the purpose of the debt push-down in nothing else but tax saving, which seems to be absolutely incompatible with the indicated concept.
On the other hand, in some jurisdictions the debt push-down technique is virtually legitimized as a tax incentive. This is done through the existence of a fiscal unity regime extending over corporate income taxation. The regime allows a group of taxpayers (a parent company and its subsidiaries) to be treated as one single taxpayer and thus grants them the possibility to offset their income and expenses against each other. This denotes that the Acquirer as a parent company and the Target Company as its subsidiary are regarded as one single taxpayer eligible to offset its (originally, the Acquirer’s) interest expenses against its (originally, the Target Company’s) profits from the operating activities.
As a tax incentive, the fiscal unity regime may be given providing that a large number of conditions are met by the companies involved. For instance, in the Netherlands the fiscal unity regime is only allowed if the parent company holds at least 95% of the shares in the subsidiary. Other essential conditions are that the financial year of the parent company and the subsidiaries must be the same and such companies must be subject to the same tax regulations (according to the information available at http://www.hskwlaw.com/news/developments-concerning-dutch-fiscal-unity-regime-/).
If either the fiscal unity regime is not presented in a certain jurisdiction or companies concerned are unable to meet conditions required for its application, the enjoyment of the debt push-down is still possible through one of the following most general mediums:
(i) Merger
Under this option the Acquirer and the Target Company merger into one company. As a result, the newly formed company becomes the debtor on the loan attracted by the Acquirer and thereby the deductibility of the interest accrued on this loan is reached.
(ii) Transfer of assets
Under this option the assets producing the profit or the rights to utilize those assets (e.g. lease rights) are transferred from the Target Company to the Acquirer. Accordingly, the Acquirer itself attains the profit from the operating activities and offsets the interest accrued on the loan against such profit.
Due to the fact that, as mentioned above, the debt push-down technique is commonly considered as being at variance with the concept of business purpose, the implementation of the above options appears to be quite questionable from the tax perspective.
3. Almost silent Ukrainian laws
The Ukrainian tax law says roughly nothing. It neither contains any special provisions directly addressing the usage of the debt push-down, nor furnishes Ukrainian taxpayers with the fiscal unity regime.
Nevertheless, when it comes to the concept of business purpose, Ukrainian law may boast about certain accomplishments. First, the concept of business purpose established itself in the practice of Ukrainian courts and later on it was eventually honored a statutory foundation. For the present, the concept of business purpose is incorporated into the Tax Code of Ukraine.
Consequently, the first obstacle hindering the implementation of the debt push-down technique in Ukraine is the concept of business purpose. To gratify its requirements the debt push-down scheme must demonstrate a clear business reason (distinct from tax savings) for merger, transfer of assets or other means through which the debt push-down’s objective is going to be achieved.
The second obstacle seems to be the provisions of the Tax Code of Ukraine concerning the deductibility of expenses incurred by a taxpayer. In particular, pursuant to subparagraph 14.1.27 of Article 14 of the Tax Code of Ukraine deductible expenses are referred to as any kind of expenses incurred by a taxpayer in either monetary, proprietary or non-proprietary form for the purposes of its business activities.
The wording “incurred for the purposes of its business activities” results in the non-deductibility of the expenses sustained in connection with the purchasing (manufacturing) goods (works, services) for their further use in another party’s business activities. This provision might question the deductibility of interest expenses in the debt push-down scheme involving the merger between the Acquirer and the Target Company. This may happen, as within the “merger” scheme interest is accrued on the loan attracted and used in its own business activities by the Acquirer, but not in the business activities of the newly formed company attaining the operating profit and seeking the deductibility of interest expenses from this profit.
However, there exists an alternative stance based on the broad interpretation of the foregoing formulation. According to this stance the further use of goods (works, services) in a taxpayer’s own business activities must also cover their use in the business activities of its legal successors. This might justify the deductibility of interest expenses incurred by the Acquirer from the operating profit of the newly formed company being a legal successor of the Acquirer.
In this respect, the principle of conflict of interest ought to be mentioned. Under this principle stipulated by paragraph 56.21. of Article 56 of the Tax Code of Ukraine where the legal provision of the Code or any subordinate legislations or regulations passed based on that Code suggests the different interpretations of the rights and duties of taxpayers or the tax authorities resulting in the possibility to take decision in favor of both the taxpayers and the tax authorities, the decision must be taken in favor of the taxpayer. The indicated principle may be used by the taxpayer as an additional argument supporting the broad interpretation permitting the deductibility of interest expenses in the” merger” scheme.
The problem is that there are no publicly available positions of the tax and judicial authorities as to the application of subparagraph 14.1.27 of Article 14 of the Tax Code of Ukraine in respect of the issue raised above. This fact, combined with the bias of the Ukrainian tax authorities often giving their own interpretations of the tax laws in defiance of the original will of the legislature makes it extremely difficult to take advantage of the aforesaid favorable interpretation allowing the deductibility of interest expenses.
4. Variety of schemes
Schemes through which the debt push-down technique can be accomplished in Ukraine (provided that both the Acquirer and the Target Company are Ukrainian residents) as well as the accompanying comments are presented below.
Scheme 1 (merger)
As mentioned above, the merger of the Acquirer and the Target Company is one of the most common ways of the debt push-down used in oversees jurisdictions. Under this option, the Acquirer and the Target Company form a company to be a legal successor of them both. This company is simultaneously the borrower paying the interest on the loan and the owner of the assets producing the operating profit and thus may claim the deductibility of its own interest expenses from its own profit.
The merger of the two involved companies may be performed through either of the following means set out by the Ukrainian legislation (paragraph 1 of Article 104 of the Civil Code of Ukraine and paragraph 1 of Article 59 of the Economic Code of Ukraine):
(i) Joining the Acquirer to the Target Company;
(ii) Joining the Target Company to the Acquirer;
(iii) Merger of the Acquirer and the Target Company into a new legal entity.
Of those means, the most promising way in terms of effective tax planning appears to be joining the Target Company to the Acquirer. In this case the Acquirer continues to exist as a legal entity and as a consequence there is no reason to oppose the deductibility of the interest expenses on the ground that those are not linked with the taxpayer’s own business activities in view of its discontinuation. The other means go with the discontinuation of the Acquirer and thus may be more easily contested by the tax authorities referring to the aforesaid unfavorable interpretation of subparagraph 14.1.27 of Article 14 of the Tax Code of Ukraine.
Regardless of the above optimistic speculations about joining the Target Company to the Acquirer one should admit that it is not absolutely non-risky medium of the debt push-down technique. There is still the risk that the tax authorities reject the deductibility of the interest expenses alleging that they are no longer connected with the Acquirer’s business activities, as the shares for the acquisition of which the loan was raised by the Acquirer do not continue to subsist. Although this risk is much less that those emerging under the two other options, it ought not to be underestimated during the elaboration of the debt push-down scheme.
It should be borne in mind that the merger (joining) seems to be very complicated and time-consuming procedure that usually cannot be completed early than within 4 months. Furthermore, if the Target Company’s business activities are subjected to the licensing regime or require any other important permissions being issued by either the state or local authorities, then the implementation of the merger (joining) may be surrounded with the difficulties linked with the re-issuance of those documents.
Scheme 2 (voluntary winding-up)
Under this scheme the Acquirer being the shareholder of the Target Company makes its decision on the latter’s voluntary winding-up. After the creditors’ claims are satisfied, the assets producing the operating profit pass into the Acquirer’s ownership. The Acquirer uses the respective assets while carrying out its own business activities thereby attaining the operating profit itself and reducing it by the interest expenses.
Like the “joining” scheme, the scheme under consideration does not contemplate the discontinuation of the Acquirer, which protects it from the risk associated with the aforementioned unfavorable interpretation of subparagraph 14.1.27 of Article 14 of the Tax Code of Ukraine. At the same time, similarly to the referred scheme, the scheme at issue is not free from the risk of challenging the deductibility of the interest expenses by the tax authorities in relation to the cancelation of the shares for the acquisition of which the loan was attracted. However, as stated above, this risk do not seems to be as essential as the others.
The winding-up of a company appears to be complicated and time-consuming exercise that generally takes not less than 4 months to be completed. Additionally, if the Target Company holds licenses or other important permissions granted by the state or municipal bodies, the Acquirer may face a number of impediments linked with the rather bureaucratized process of their re-issuance.
Scheme 3 (transfer of assets)
Under the instant scheme, the assets producing the profit are transferred from the Target Company to the Acquirer. The usage of such assets in the Acquirer’s business allows it to derive the operating profit and reduce that profit by the interest expenses accrued on the loan.
The transfer of the assets may be accomplished through any manner not forbidden by the law, including sale, lease, contribution into the Acquirer’s share capital, etc.
Taking into account that the scheme at hand is not related to the discontinuation of either the Acquirer or the Target Company, all the above indicated risks associated with the statutory requirement to secure the connection between expenses of a certain taxpayer and its business activities are not relevant for this situation.
Attention should be drawn to the fact that within the scheme in question the debt push-down’s object may merely be achieved provided that the price established for the transfer of the assets is kept on a certain level. Otherwise, it might trigger tax implications that even overcome the positive effect of the debt push-down technique.
For instance, once the lease option is chosen, it will be essential that the margin between the operating profit derived by the Acquirer from the leased assets and the rent charge payable by it is equal to or even higher than the interest expenses accrued on the loan. If not, the only part of the interest expenses will be deductible, which does not make the scheme effective.
In the case with the sale and the contribution into the share capital things are even more sophisticated. The point is that, in their majority, the assets being transferred to the Acquirer are made up of fixed assets and intangible assets, the corporate income tax consequences of whose sale or contribution into another company’s share capital are defined by paragraphs 146.13 and 146.14 of Article 146 of the Tax Code of Ukraine and directly contingent on the price (value) at which they are sold (contributed into the share capital). If this price is equal to or less than their book value, there is no taxable income for the Target Company. But if the price exceeds the book value, the respective difference will represent the taxable income of this company.
Moreover, it worth noting that the sale of assets (their contribution into the share capital) is VAT taxable transaction and may cause the output VAT of the Target Company to increase.
Pursuant to paragraph 1.20 of Article 1 of the Law of Ukraine “On Corporate Income Tax” (according to the Transitional Provisions of the Tax Code of Ukraine this paragraph remains in force until 1 January 2013) the Acquirer and the Target Company are subject to usual (transfer) pricing rules as related parties. Accordingly, the tax consequences of the transactions entered into by them are to be defined not on the basis of the price fixed by the parties, but on the basis of the fair market price established under the procedure prescribed by the law.
The application of the usual (transfer) pricing may seriously obstruct or even make impossible the implementation of the debt push-down technique within the scheme under consideration, since its accomplishment is only reasonable when the parties may fix the price for the assets on a certain level. If notwithstanding the above hindrances one still decides to resort to this scheme, he must make sure the thorough financial analysis of the companies engaged displaying the appropriateness of the contemplated debt push-down solution and prepare the solid rationale bolstering the price to be used in the relevant transaction.
Like the above indicated schemes, within the scheme at hand the Acquirer might also face a set of difficulties accompanying the re-issuance of the Target Company’s licenses or other important permissions.
Other schemes
Theoretically, the debt push-down may be also achieved by transferring the debt on the loan from the Acquirer to the Target Company with the compensation paid by the former to the latter for the acceptance of that debt. As soon as the transfer is closed, the Target Company becomes a debtor and thereby may decrease its operating profit by the interest accrued on the loan.
However, since the loan was raised and used in the Acquirer own business activities, there is almost no chances to justify that it is connected with the business activities of the Target Company (the necessary condition for the deductibility). This indeed prevents the scheme from being an effective debt push-down solution.
Further, in accordance with Article 520 of the Civil Code of Ukraine a transfer of a debt can be performed subject to the creditor’s consent. Therefore, if the Lender objects to the transfer of the debt, it may not be effectuated.
5. If a non-resident involved?
Suppose that the Acquirer is a non-resident. Is it possible to reach the deductibility of the interest expenses in this case from the standpoint of the Ukraine tax law? Regrettably, the answer to the raised question seems to be rather “no” than “yes”.
As mentioned above, the fiscal unity regime through which the cross-border debt push-down may be achieved in foreign countries (e.g., in Luxemburg this regime extends over the branch of a non-resident company which is subject in its jurisdiction of establishment to a corporate tax comparable to Luxemburg corporate income tax) is not presented in the Ukraine. Nor may the debt push-down be accomplished via the merger scheme, as the Ukrainian legislation does not permit a cross-border merger (joining).
The voluntary winding-up of the Target Company leading to the conveyance of the assets to the non-resident Acquirer as well as the direct transfer of the assets to the non-resident Acquirer is feasible, but not sensible, as does not bring about the deductibility of the interest expenses. Once having received the assets into its ownership, the non-resident Acquirer can derive profit from these assets by either of the following manners:
(i) Operating the assets on its own (in the most cases it is not achievable, inasmuch as the registration of a permanent establishment is required);
(ii) Registering a permanent establishment in Ukraine;
(iii) Passing the assets into trust or lease of a third party being a Ukrainian resident.
Under the options (i) and (iii) the income of the non-resident Acquirer, but not the profit as the margin between income and expenses may be in accordance with Article 160 of the Tax Code subject to corporate income (withholding) tax. Hence, there is no hope to qualify for the deduction of the interest expenses. Under the option (ii) the permanent establishment by virtue of paragraph 160.8 of Article 160 of the Tax Code is viewed as a taxpayer independent from the non-resident Acquirer and on this ground will most likely be disallowed to reflect the latter’s expenses in its own tax accounting.
As stated above, the scheme aimed at the debt transfer is not worth to be implemented due to the very high risks and the accompanying difficulties. Moreover, if a non-resident is engaged this scheme will be even additionally complicated with the necessity to comply with the requirements of the Ukrainian currency legislation. For example, the Degree of the President of Ukraine No 734/99 dated 27 June 1999 “On Governing the Procedure for Raising Loans by Residents from Non-residents and Appling Punitive Sanctions for Breaches of the Currency Legislation” requires the registration of foreign loans by the National Bank of Ukraine.
6. In lieu of conclusion
In sum, the debt push-down is a relatively new tax planning technique borrowed from Western jurisdictions that allows the deductibility of interest expenses accrued on the loan attracted for the acquisition of a business. Like many other jurisdictions, in Ukraine the debt push-down technique is considered to be a tax optimization tool and thus subjected to special attention of the tax authorities. To challenge the employed debt push-down solution, the tax authorities will most likely resort to the doctrine of business purpose or contest the connection between the taxpayer’s business activities and interest expenses required by the law as a prerequisite to their deductibility. Compliance with the doctrine of business purpose may be achieved on condition that the solid rationale exhibiting a clear business reason (different from tax savings) is prepared. Since the tax provisions determining the deductibility of certain expenses based on their connection with the taxpayer’s business activities lack clarity, it might be advisable to obtain in advance an individual tax consultation covering the respective issue.
Unfortunately, there are no universal solutions for the realization of the debt push-down technique in Ukraine. None of the above-presented schemes is free from the significant risks and must be thoroughly analyzed prior to its application.
It is believed that the implementation of the fiscal unity regime existing in other jurisdictions as a tax incentive legitimizing the debt push-down technique into the Ukrainian tax legislation would increase the investment attractiveness of our country and therefore be of benefit to the national economy.
