Jurisprudence of New Supreme Court on Tax Litigation with International Component

On 26 March 2019, I was pleased to conduct a LIGA-ZAKON webinar on the topic of  the jurisprudence of the new Supreme Court in tax disputes with an international component.

In particular, the webinar was devoted to the two most common categories of tax disputes with an international element:

- disputes concerning the application of the concept of  beneficial owner; and

- disputes on transfer pricing issues.

Below is a very brief summary of the findings of the seminar:

As to beneficial owner

- It is pleasant that the new Supreme Court keeps abreast with a global trend. In general, it adheres to the "broad economic approach" couched   in 2014 in the well-known case of Donbassaero (http://reyestr.court.gov.ua/Review/38106136).

- All the cases found by us at the level of the new Supreme Court have been resolved in favor of the taxpayers (for example: http://www.reyestr.court.gov.ua/Review/77312120, http://www.reyestr.court.gov.ua/Review/77197100     and http://www.reyestr.court.gov.ua/Review/75879124).

- Interestingly, in the latter case the taxpayer leveraged a report of the Cypriot Office of  Deloitte as evidence. According to the findings incorporated in the report, the Cypriot recipient of income in the form of interest was the beneficial owner of the income. It was not even guessed before that the "Big Four" could  provide such services.

- The reason for such a "crazy" success of taxpayers in the new Supreme Court is really simple. So far, tax officials, at least at the level of those cases that have already been considered by the new Supreme Court, have not managed to collect information attesting that the foreign recipient of income is limited in its right to determine the further economic fate of the income.

- Undoubtedly, at the level of the lower courts there have been some examples where taxmen managed to demonstrate proper "perseverance and diligence" and carried out exchanges of information with the tax authorities of other countries. However, to the satisfaction of taxpayers and to the great regret of tax officials, in many cases, the courts do not take into account the results of such exchanges of tax information pointing out to the limitation of a foreign recipient of income in the right to determine its further economic fate.

- The courts consider the above evidence as inadmissible for formal reasons, the main of which is, as a rule, the lack of legalization (apostilation) of a document issued by the foreign tax authorities on the results of the exchange of tax information.  A classic example of such a "fatal" case for taxmen, decided by the court of appeal, is available at this link: http://www.reyestr.court.gov.ua/Review/72641240.

As to transfer pricing

- There is already the first case concerning the essence of transfer pricing considered by the new Supreme Court (http://www.reyestr.court.gov.ua/Review/80418267).

- Honestly, there is nothing phenomenal in this case. In the past, there have been many similar cases when, before the introduction of the transfer pricing rules, the rules of the usual prices were applied.

- In this case both the taxpayer and the tax authorities (in the course of the tax inspection) used the "first method" (the method of comparable uncontrolled price) to the transactions on the exportation of grains. The new Supreme Court resolved the case in favor of the taxpayer by a reference to the fact that the tax authorities failed to prove  that the prices had been understated by the taxpayer. The new Supreme Court "blamed" the tax authorities for not taking into account all the conditions for the comparability of the concerned export transactions and referring to only one source of information (the official site of the Agrarian Exchange).

- Oddly enough, but  the new Supreme Court appeared to be a great fan of  British LLP and a huge hater of Swiss companies=). Under very controversial circumstances, it recognizes transactions with British LLPs (for periods before the amendments to the Tax Code of Ukraine was brought according to which the attribution of transaction with British LLPs to controllable  one is no more in doubt), uncontrollable (http://www.reyestr.court.gov.ua/Review/80418267      and http://www.reyestr.court.gov.ua/Review/8060725).

-  In the meanwhile, on approximately the same level of controversy attached to the issue as to whether to treat as controllable transactions with Swiss companies in 2015 (in September 2015 Switzerland was removed from the list of low tax jurisdictions), the new Supreme Court does not express similar “altruistic” sentiments (http://www.reyestr.court.gov.ua/Review/76906000).

- The new Supreme Court holds that transactions with Swiss companies carried out before September 2015 are subject to control. This is despite the fact that the taxpayer  managed to submit evidence that in the canton, at the place of the registration of its Swiss counterparty, the rate of corporation tax had not been in fact 5 percentage points lower than that of Ukrainian corporate income tax.

Recast Transfer Pricing Rules

In the scope of the tax reform of 2015 the transfer pricing (“TP”) rules incorporated in the Tax Code of Ukraine have been completely restated. The new TP rules have been in operation since 1 January 2015. However, taxpayers report in 2015 for the year of 2014 according to the old TP rules. The new TP reporting requirements will first apply in the year of 2016 when the taxpayers report for the year of 2015.

What follows is a brief account of the recast TP rules:

- The notion of “arm’s length principle” is now explicitly stated in the Tax Code of Ukraine. A transaction is considered to be in compliance with the arm’s length principle if its terms and conditions do not differ from those of comparable uncontrolled transactions carried out between independent parties.

- The new TP rules normally apply to the calculation of corporate income tax only. They do not generally apply for the purposes of the computation of VAT.*

- Domestic transactions (transactions between residents) are not normally viewed as controlled transactions anymore. Controlled transactions are only those involving non-residents.*

- The scope of controlled transactions involving non-residents has been significantly expanded. Nowadays, in addition to transactions with related non-residents and non-residents from low-tax jurisdictions, the following transactions with non-residents are caught:

1)    transactions of sale of goods through commission agents;

2)    transactions with residents in countries that do not make publicly available information on the ownership structure of their legal entities;

3)    transactions with residents in countries that do not have effective treaties with Ukraine enabling the exchange of tax information.

- Transactions involving artificially inserted intermediaries are now a separate type of controlled transactions. In order to determine whether an intermediary has been inserted artificially to lay the transaction outside the TP control, the functions, risks and assets of the intermediary are examined. Should those be insignificant, the intermediary will be most likely treated as artificially inserted one.

- The financial threshold for controlled transactions has been considerably remodelled. At present, it consists of two conditions that must be simultaneously met for a transaction to be considered as controlled. Those two conditions are as follows:

1)    Annual gross revenues of the taxpayer, taken along with those of all its related parties, in the current tax year exceed UAH 20 million; and

2)    Gross amount of all transactions conducted by the taxpayer/its related parties with any of their  counterparties in the current tax year exceeds either UAH 1 million or 3% of the  taxable income of the taxpayer.

- The new criteria of relationship have been introduced. First, taxpayers can be now recognised as related parties by means of debt-to-equity ratio (more than 10.0 times debt-to-equity ratio for banks, lease and financial companies, as well as more than 3.5 times debt-to-equity ratio for other taxpayers). Second, the state fiscal authorities can now claim “factual” relationship even where no one of the criteria of relationship set forth by the Tax Code of Ukraine is directly met. In this case, the state fiscal authorities should obtain a court order confirming “factual” relationship.

- The TP methods remain as earlier. Their description has been largely amended to fit in more closely with that of the OECD Transfer Pricing Guidelines.

- Taxpayers importing or exporting commodity exchange-traded products are supposed to apply comparable uncontrolled price method (method No 1) based on the price quotations of the commodity exchanges concerned. Such taxpayers may also apply other methods of TP, but subject to the full disclosure of their supply chains to the state fiscal authorities.

- There is no more division of informational sources to “official” and “non-official” ones. A taxpayer may use any informational source open to the general public.

- Further to a TP return, a new piece of TP reporting has emerged. This is a TP annex to a corporate income tax return that lists controlled transactions. The annex is mandatory and to be filed by all taxpayers having controlled transactions over the reporting year. As opposed to the annex, a TP return is not to be filed in all cases. It is to be filed only by those taxpayers whose amount of the controlled transactions with at least one of their counterparties exceeds UAH 5 million (excluding VAT).

Co-authored by Anton Babak

- The length of TP audit has been significantly prolonged. As for now, it may continue up to 30 months from its commencement.

- The maximum time for the issuance of TP-related tax assessments by the state fiscal authorities has been extended to 7 years.

- Penalties for TP-related violations have become much more severe. In particular, the failure to report a controlled transaction in a TP return can lead to a penalty of 5 % of the value of the non-reported transaction. The failure to provide TP documentation at the request of the state fiscal authorities can lead to a penalty of 3% of the value of the controlled transactions involved, but no more than 200  minimal statutory salaries (currently, UAH 243,600).

* - Due to the lack of clarity in the Tax Code of Ukraine, there is still the risk of the application of the TP rules in respect of VAT and domestic transactions in certain cases. This, in particular, may occur with reference to controlled transactions involving artificially inserted intermediaries. 

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