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).

Top-5 innovations of Tax Code of Ukraine (for year 2011)

Below, I give 5 the most important, in my opinion, innovations of the Tax Code of Ukraine in terms of their influence on Ukrainian businesses:

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1. Accrual method. Since the second quarter of 2011 the corporate income tax payers have had to forget about the good old method of "first event". The Tax Code of Ukraine replaced it with the accrual method. According to this method, income is recognized at the date of the transfer of the title to the goods or at the date of signing the acceptance certificate in respect of the supply of works (services). Expenses are recorded by a taxpayer in the period when it recognizes the income from the sale of the relevant goods (works, services).

2. Automatic VAT refund. Automatic VAT refund seems to be the pleasant surprise of the Tax Code of Ukraine. "Automatism” lies in that the VAT refund is provided without a documentary tax audit (based on a cameral tax audit only) and within a shorter time frame. Despite the active opposition of the tax authorities, some taxpayers did manage to obtain VAT refund on “automatic basis" in 2011.

3. Criminal case without issuing a tax assessment. In the event of a tax-crime the tax assessment is not issued to the taxpayer until the trial of the criminal case ends. This change deprived the taxpayers of one of the most efficient ways to fight against groundlessly instituted tax-crime cases. Before the Tax Code of Ukraine took effect it had been possible to abolish the tax assessment through administrative court and then based on the decision of the administrative court to have the resolution on the institution of the criminal case canceled through the general court.

4. The concept of beneficial ownership. The introduction of the concept of beneficial ownership into the Tax Code of Ukraine substantially increased the tax risks of Ukrainian holdings encompassing non-resident companies and as a result caused quite a stir among tax advisers. This concept is mainly applied to detect the possibility to use the tax advantage granted by a double tax treaty (a full exemption from or a reduced rate of withholding tax). According to the concept the enjoyment of the benefits of double tax treaties is only possible where the payment of income is made to a non-resident being a beneficial (actual) owner of income, rather than an intermediary, agent or nominee.

5. Restricted deductibility of expenses related to goods (works, services) received from non-residents and unified tax payers. The Tax Code of Ukraine brought the inconvenient for business restrictions related the deductibility of consulting, marketing, advertising and engineering services purchased from non-residents as well as the complete non-deductibility of the goods (works, services) acquired from individuals-unified tax payers, safe for IT services. While the non-deductibility of the goods (works, services) purchased from unified tax payers has been repealed since 1 January 2012, the restrictions pertaining to non-residents remain in force.

Lastly, in 2011 the market was really shocked by the non-deductibility of the previous taxperiods losses incurred prior to 1 January 2011. Nevertheless, the instant “achievement” should be ascribed not to the Tax Code of Ukraine, but to the tax luminaries of the State Tax Service of Ukraine who found "the time and inspiration" for this overly "advanced" interpretation of the Tax Code of Ukraine.

Accrual method in corporate income taxation

By  Dmytro Savchuk

Below, please see the article by my colleague Dmytro Savchuk touching upon accrual method in corporate income taxation. 

 

One of the most anticipated changes brought by Title III of the Tax Code of Ukraine is a new method of determining income and deductible expenses.

Income and deductible expenses will be determined not under the "first event" rule enshrined in the Law of Ukraine "On Corporate Income Tax" (hereinafter - the “CIT Law”), but based on the accrual method. Under this method the income from the sale of goods is determined on the date of the transition of the title to such goods to the buyer, and the income from services rendered and works performed is determined on the date of the execution of the report or another similar document confirming the rendering of the services or the performance of the works. Deductible expenses making up the cost of goods (works, services) are recognized in the reporting period in which the income from the sale of such goods (works and services) was determined. 

Given that the said procedure for recognizing income and deductible expenses coincides with the methodology defined by financial reporting standards, the transition from the “first event” rule to the accrual method may draw closer tax accounting and business accounting to each other. Differences that may arise between tax accounting and business accounting as a result of the application of the accrual method are said to be so-called tax differences. They result from the economically reasonable restrictions imposed by the state in respect of corporate income taxation. In addition, the convergence of tax accounting and business accounting may simplify the preparation of a corporate income tax return. 

At the same time, against the background of the growth in receivables owed for the goods delivered, the transition to the accrual method in determining income may adversely affect the liquidity of some businesses.For example, the CIT Law stated that in case of the sale of goods (works, services) for state budget funds the income was recognized on the date of the receipt of the money or other consideration (the cash method). The Tax Code of Ukraine does not provide for an alternative to the accrual method.

The suppliers of budgetary organizations will also determine income based on the accrual method. Since our budgetary organizations do not have the habit of timely disbursing their obligations, such taxpayers will have to pay tax on profits, which even does not exist yet.

In general, the determination of income and deductible expenses according to the accrual method is a very expected and favorable innovation in the tax legislation. Nonetheless, despite all the advantages of this method, some taxpayers would rather favor the cash method (income and deductible expenses are determined on the date when the respective funds are received/paid). For instance, the Tax Code of the Russian Federation enables certain taxpayers to opt, on their own, for the cash method.

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.

Tax issue of the Legal Monitor Newspaper

My colleagues have prepared a new issue of the Legal Monitor devoted to tax issues. The emphasis is placed on regulatory novelties brought by the Tax Code of Ukraine. As for me, it is worth considering the article by Dmytro Savchuk “Long-Anticipated Harmonization” covering the harmonization of tax reporting and accounting, including the introduction of the accrual method instead of the “first event rule” for the purpose of corporate income taxation and the possible impact of these novelties on doing business in Ukraine.

The rubric “Interesting Details” is also worth attention, where you can find the information about the special relations between the world famous people such as the Beetles Rock Band and painter Salvador Dali with tax authorities.

The issue is free to download in PDF format in English and Ukrainian.