Long-Term Contracts Taxation

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Project finance entails a number of issues requiring a response from a tax lawyer. This article deals with long-term contracts taxation.

Project finance always involves construction. Even if in the focus is not a new transnational gas pipeline or a power plant of unprecedented scale, but a modest 10,000 square meters  shopping centre in one of the regional (oblast)  centres of Ukraine, no one can dispense with the knowledge of long-term contracts taxation.

It should be borne in mind that the law provides a special taxation regime for long-term contracts (concluded for a term exceeding one year).  The special regime relates to both "heavyweights" of the Ukrainian taxation system – corporate income tax and VAT.

The special regime for the taxation of long-term contracts had also existed before the Tax Code of Ukraine came in force.  However, the present regime appears to be quite different from the previous one. In addition to technical distinctions relevant to the calculation of taxes, it should be noted that the special regime for the taxation of long-term contracts became obligatory. It is no more at the discretion of taxpayers to use it or to refrain from its use. 

First of all, it will be expedient to outline the coverage of the special taxation regime. The special regime extends to cases where the relevant contract (i) provides for producing goods, performing works or rending services within a long-term (more than one year) technological cycle and (ii) does not provide for their interim (stage by stage) acceptance by the customer (paras 137.3 and 187.9 of the Tax Code of Ukraine).

In the "realm" of corporate income tax, the special regime affects a taxpayer-contractor (as regards project finance – the contractor being in charge of the construction project) only. The transactions on the part of the customer (real estate developer) are taxable under general rules.

The special taxation regime seems to be nothing, but the government’s care about its tax revenues during the discharge of long-term contracts. Had not this special procedure subsisted, the accrual method would have been applied and the income corporate tax would not have fallen due until the handling over of the result of the works to the customer. Just this very event triggers the recognition of income by the taxpayer-contractor (para 137.1 of the Tax Code of Ukraine).

The special taxation regime is an exception from the accrual method. The taxpayer being the contractor under a long-term contract must show income in each tax period (quarter) notwithstanding that the results of the works are not yet passed to the customer (developer). The income is to be computed according to the degree of the completion of the works, which is determined (i) by the ratio of the expenses incurred in the tax period to the total expected amount of such expenses and/or (ii) by the ratio of the services rendered in the tax period to the total expected volume of such services. Since the latter mechanism of calculating income is regarded with service provision contracts, it is unlikely to be extended to construction works. 

As for the expenses, the taxpayer-contractor is allowed to deduct expenses associated with the performance of the works under the long-term contract concurrently with the recognition of the above income.

Upon the results of the works are transferred to the customer, the contractor makes adjustments to his income. If the actually received income exceeds the amount of the income accrued in each preceding tax period concerned, the surplus is attributable to the income of the ongoing tax period. If, on the contrary, the actually received income is less than the amount of the previously accrued income, the deficiency reduces the income of the current tax period.

The "realm" of VAT also faces an exception. The special taxation regime for long-term contracts lays such contracts outside the well-known rule of "first event". Input VAT/output VAT arises at the date of transferring the results of the works under a long-term contract. This special regime seems to be favourable for the contractor, as it allows him to adjourn the recognition of the output VAT to the final stage of the performance of the contracts. However, when it comes to the customer (developer), things turn out to be the opposite. The customer appears to be placed in an extremely disadvantageous position. Despite the advance payments made by the customer in favour of the contractor, the former is not able to qualify for the input VAT deduction for a long period of time.

It is difficult to figure out what purpose the government pursued while putting long-terms contracts beyond the operation of the “first event” rule. Perhaps, by doing so it intended to protect the state budget from VAT refund claims of the customers (real estate developers). Had the "first event" rule been in effect, such customers would have been able to claim VAT refund out of the input VAT accumulated in the course of the construction (the advances paid to the contractor under long-term contracts). Albeit our system of the VAT administration diminishes the chances of getting the VAT refund in this situation almost up to the minimum, the government decided to save itself once again.

Apparently, the special taxation regime for long-term contracts is not the thing that taxpayers can undoubtedly benefit from. Sometimes it makes sense to frame a contract to the effect that it will not be treated as long-term one for tax purposes (say, to incorporate the interim (stage by stage) acceptance of the works into the contract).

New VAT-subsidies to Milk and Meat Producers

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As mentioned in my post of 28 December 2011, a new procedure for the discharge of VAT by processing enterprises involved in the production of dairy and meat products has been in operation since 1 January 2012.

The new procedure was introduced by the Law of Ukraine "On Amendments to the Tax Code of Ukraine Aimed at Supporting Agricultural Producers" of 22 December 2011 No 4268-VI (effective as from 1 January 2012). This Law restated para 1 of subsection 2 of Section XX «Transitional Provisions" of the Tax Code of Ukraine governing the procedure for subsidizing milk and meat producers at the expense of the VAT payable by enterprises engaged in processing the milk and meat purchased from such producers.

Prior to the amendments entered into force, the processing enterprises had paid VAT to the special fund of the state budget from which those funds had been subsidized to milk and meat producers with the ambit of the State Support to Cattle Breeding Budget Program.

Since 1 January 2012 the processing enterprises have had to remit to the special fund of the state budget the only part of the VAT due (for example, in 2012 - 30% in 2013 - 40%). The rest has gone to their special accounts opened with the bodies of the State Treasury of Ukraine.

The funds accumulated on these special accounts are disposed of by the processing enterprises themselves. The processing enterprises use these funds for paying subsidies to the agricultural producers catering them with milk and meat.

Thus, there has occurred the partial return to the system of paying subsidies to milk and meat producers existed before the enactment of the Tax Code of Ukraine. The return is partial because in the past all the VAT due not just part of it as now was directly transferred through special accounts by the processing enterprises to the milk and meat producers.

Doctrine of Due Care and Caution

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This seems logical to treat the doctrine of business purpose and the doctrine of due care and caution as two of the most important anti-avoidance tools in Ukraine developed by the court practice in recent years.

This article will talk about the doctrine of due care and caution. Unlike the doctrine of business purpose, this doctrine has not become part of the Tax Code of Ukraine yet. Nevertheless, this fact does not significantly diminish its high importance for tax litigation.

The Essence of the Doctrine

The doctrine applies to cases related to the recognition of VAT input/deductible expenses by a taxpayer who purchases goods (services) from problem (in terms of taxation) suppliers, including their counterparties in the chain of supply.

The doctrine provides the answer to the question whether such a taxpayer-purchaser should be held liable by depriving of his VAT input and deductible expenses in connection with the tax abuses committed by his suppliers or their counterparties.

The answer is as follows: the taxpayer-purchaser should not be held liable only if he showed due care and caution and he was not aware of the abuses of his counterparties.

To prove the familiarity of the taxpayer-purchaser with the abuses of his suppliers the reference can be made, for instance, to the following circumstances:

- the orientation of the taxpayer-buyer or his affiliates to the transactions predominantly involving counterparties breaching their tax liabilities, particularly in the case the transactions are entered into through intermediaries in the presence of direct contacts with manufacturers;

- the dealing of the taxpayer-purchaser with the supplier in one market segment where there are the stable relationships and all the participants are aware of the nature and the real intentions of each other in carrying out business transactions.

Starting Point

The first widely known mention of the doctrine of due care and caution occurred on 12 February 2008. This was the date of the resolution of the Administrative Chamber of the Supreme Court of Ukraine in case No 08/28brought by  "Metpromservis", LLC against the State Tax Inspection in Shevchenkivskiy District of the city of Zaporizhia.

In this case the Supreme Court of Ukraine found for the local State Tax Inspection, cancelled the ruling of the Highest  Administrative Court of Ukraine (issued  in favor of the taxpayer) and remand the case to the court of first instance for new consideration.

Overriding the ruling of the Highest Administrative Court of Ukraine, the Supreme Court of Ukraine made the following interesting conclusions:

- "... the violation of the tax liabilities by the suppliers of a purchaser may constitute the grounds for denying such a purchaser’s entitlement to tax benefit - VAT refund from the state budget if the tax authorities establish that the taxpayer (purchaser) acted without due care and caution and he had to be aware of the breaches committed by his suppliers ... ";

 - "Satisfying the claim the courts only referred to the availability of the VAT invoices issued by the suppliers. They did not take into account the fact that the claimant had been acquiring raw materials, particularly scrap metal, for a long time from intermediaries who regularly did not pay taxes, whose activities were of fake nature, who did not reside at their registered offices, did not file tax returns or filed “zero” ones, whose  registered owners (shareholders) and officers  did not acknowledge their involvement in their activities, and that the claimant, his suppliers and contractors had been trading in the same market segment in which there was the stable relationships and all the participants were knowledgeable about each other".

Borrowing from Northern Neighbor

The doctrine of due care and caution exists in the Russian Federation as well. One would like to believe that the Russians have borrowed it from us, but, unfortunately, things are quite the contrary.

In Russia, this doctrine has been actively used since October 2006 (the Resolution of the Supreme Arbitration Court of the Russian Federation dated 12 October  2006 No 53). In Ukraine the doctrine has found its operation only since February 2008 (the above-cited decision of the Supreme Court of Ukraine of 12 February 2008).

Doctrine and Practice of the European Court of Human Rights

It is worth noting that the issue of the liability of the taxpayer-purchaser for the tax abuses of his suppliers also finds its solution in the practice of the European Court of Human Rights, which is mandatory for the use in Ukraine.

In the case of "Bulves" AD v Bulgaria (para  71 of the judgment dated 22 January 2009) the European Court of Human Rights took view that does not fall foul of the doctrine of due care and caution: the VAT payer should not be held liable for the abuses committed by his suppliers, if he does not have knowledge of those abuses or the means to obtain such knowledge.

What should taxpayers do?

In view of the operation of the doctrine, it is advisable for good faith taxpayers to create evidence confirming the expression of due care and caution when choosing the suppliers.

The smallest, but very necessary and important thing that every taxpayer should do before entering into any supply contract is to check his suppliers with regard to their tax “integrity” through the electronic databases available on the official website of the State Tax Service of Ukraine. Those databases encompass: the Database of VAT Payers, the Database of Cancelled VAT Payers Certificates, the Database of “ Non Bona Fide” VAT Payers, and the Database of the Places of Mass Registration of Taxpayers.

Everything else depends on the resources and imagination of the taxpayer. One can, for example, ask the certified copies of the supplier’s registration documents, the copy of the passport of the signatory of the supply contract, the letter specifying the number of the supplier’s personnel, the availability of the fixed assets, the size of his warehouse and office space, his actual location, etc. In other words, the idea is to gather as much as possible information attesting real, not fake nature of the supplier’s business.

The documents collected in the course of the inquiry, including the screenshots made while ​running the suppliers through the State Tax Service of Ukraine’s electronic databases should be kept in electronic and /or hard form taking account that a dispute with the tax authorities may arise.

The ideal decision seems to be the adoption of internal regulation (policy) governing the examination of the suppliers with reference to their tax “reliability” embracing the list of responsible employees, examination procedures, documents storage procedures and so on.

In Lieu of Conclusion

Apparently, the implementation of the doctrine of due care and caution has loaded taxpayers at least those of them concerned with minimizing their tax risks with a great deal of new work related to the need to check the tax "integrity" of the suppliers. However, it is difficult to view this doctrine as something out of the ordinary. The doctrine appears to be in  line with the practice of the European Court of Human Rights and offers more or less a fair balance between public and private interests in the fight against tax evasion.

The main problem today is the vague criteria of due care and caution resulting  in the material risks for taxpayers.  Hopefully, this gap will be filled in the future by the clarification of the Highest Administrative Court of Ukraine.

Expenses Related to Unified Tax Payers: No Return Back

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Although the provisions of the Tax Code of Ukraine (para 139.1.12.) prohibiting corporate income tax players from including the value of goods (works, services) purchased from individuals-unified tax payers into the expenses (except for IT services) were repealed, the complete return to the good old days when the recognition of such expenses was performed almost without any restrictions, did not happen.

Under the new unified tax assessment rules, which came into force on 1 January 2012 (sections 291-300 of the Tax Code of Ukraine), not all unified tax payers are eligible to supply goods (works, services) to corporate income tax payers.

Whereas the third group of individuals-unified tax payers (paying the unified tax as a percentage of their revenue) enjoys no restrictions, the second and third groups of such taxpayers (paying the unified tax at low fixed rate) are rather confined in terms of the list of their activities and customers.

Number of the group of individuals-unified tax payers	The list of permitted activities	Possible customers (to whom the goods (works, services) may be supplied)
І	Trading goods at retail markets	No restrictions
	Personal services	Only to people (not businesses)
ІІ	Services, including personal services	Only to people (not businesses) and unified tax payers
	Production and/or sale of goods	No restrictions
	Restaurant business	No restrictions

There naturally arises the question as to what consequences may experience a corporate income tax payer that buys works or services from the unified taxpayers of the first and second groups at variance with those limitations.

In this respect, the legislature demonstrates a "noble silence", and therefore everything is in the hands of "pious" tax officials. In view of their usual arsenal of tools, it can be assumed that they either try to cancel the respective expenses of the corporate income tax payer or to charge it as an alleged tax agent of the unified tax payer with the additional tax liabilities on personal income tax. There is also the possibility that the tax authorities resort to these two methods simultaneously.

Although the legality of the above measures constitutes a big question, it does not make much sense once again to tempt the fate.

Another important point surrounding the cooperation with unified tax payers is that the corporate income tax payer is obliged to file along with its usual corporate income tax return the list of incomes and expenses obtained/incurred while dealing with the unified taxpayers (para 152.3 of the Tax Code of Ukraine, which entered into force on 1 January 2012).

To date, the model for the aforesaid list of incomes and expenses has not been approved yet, but I believe that by the end of the first quarter of 2012 the State Tax Administration of Ukraine will have coped with this not difficult task.