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:
- 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;
- 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.
- 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).
- 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.
