Protecting trade secrets during tax audits

Recently, the tax authorities have been paying more and more attention to auditing contractors of taxpayers (with a view to identify null transactions or other facts required to challenge the taxpayers’ right to input VAT or deductible expenses). If your enterprise makes money in that it buys goods and resells them at a higher price to other business entities, the conduction of such audits could be devastating for your business.

There are some situations in practice where such audits can result in the disclosure of the information on the suppliers of the taxpayer and the prices at which it buys goods from them to the customers (buyers) of the taxpayer. On the receipt of this information, it no longer makes sense for the customers (buyers) of the taxpayer to deal with the taxpayer and they may begin to purchase goods directly from the suppliers of the taxpayer. As a result, the taxpayer’s revenues can sharply decrease. In particular, this situation may occur when the tax authorities carry out a documentary audit of a customer (buyer) of the taxpayer and reflect in the audit report the movement of goods from the suppliers of the taxpayer to this customer (buyer).

To avoid a similar situation, it seems reasonable to take advantage of the legislation protecting trade secrets from disclosure by the tax authorities. The Tax Code unambiguously stipulates the right of a taxpayer for nondisclosure of trade secrets by the state controlling bodies (p17.1.3).

The following actions may be suggested to protect the interests of the taxpayer:

- Setting out in the internal documents of the taxpayer the list of information constituting trade secrets as well as the mechanism covering the protection of such information - the right of a taxpayer to trade secrets does not occur by itself and requires that certain  formalities are complied;

- A written notice to the tax authorities that the information on the suppliers of the taxpayer and the prices of goods at which they are sold to the taxpayer makes up the trade secrets of the taxpayer (with confirming internal  documents enclosed);

- Compliance during the documentary on-site tax audits with the requirement of the Tax Code to hand over documents containing trade secrets (such as contracts with the suppliers) to the tax authorities based on an acceptance certificate only (p 85.3); the acceptance certificate must clearly indicate that these documents contain the trade secrets of the taxpayer;

-  A written warning to the tax authorities that in the case of the disclosure of the trade secrets, including information on the suppliers of the taxpayers and the prices at which the goods are purchased from them, the taxpayer will have to (a) appeal to the prosecution office to hold the tax officials concerned criminally liable for breaching its trade secrets  (2) apply to the administrative court for the recovery of damages caused by the disclosure of trade secrets committed by the tax authorities.

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.