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.

Beneficial Owner: Hunt for Phoenix

Co-authored by Vadym Avdieiev

 At one of international taxation events we heard from a colleague from Avellum law firm, Mr. Vadim Medvedev, about the very interesting case of Phoenix Capital LLC* related to the application of the concept of beneficial owner. We could not help, but examine the case in more details and share our findings with our dear readers.

So, what makes the case so special?

First of all, the case is memorable for featuring an unusual approach to a determination of beneficial owner. The case did not revolve around so familiar to us quotations of Article 103 of the Tax Code of Ukraine providing that agents cannot count as beneficial owners of an income.

The taxmen and courts went much further. They investigated into the ultimate beneficial owner of Ukrainian “Phoenix” that had paid the income to a Cyprus-based company named Okland Holdings Limited. They established that the ultimate beneficial owner of both of those companies had been the same person – a mysterious “PERSON_1” under the terminology of the Unified State Register of Court Rulings.

The evidence confirming the simultaneous ownership over those two companies was the information provided by Ukrainian bank “Pivdencombank” on the existence of  the indirect control of “PERSON_1” over Ukrainian “Phoenix” through a chain of non-resident companies. Moreover, surprisingly though, such “incriminating” evidence was also the letter of the Head of the Representative Office of Okland Holdings Limited referring to the same “PERSON_1” as the beneficial owner of this Cypriot company.

Unfortunately, we have been unsuccessful in finding information on how exactly the taxmen managed to obtain those “unique” pieces of evidence. Most likely, they were gathered during a criminal proceeding initiated against the management of Phoenix Capital LLC. The criminal proceeding is, as always, a “sealed book”. From a small fraction of information publicly available we have not managed to find answers to our questions.

If anyone of our readers is more familiar with the case of “Phoenix”, we would highly appreciate your comments regarding how the taxmen managed to “persuade” the bank and the representative of the Cyprus company to disclose such valuable information.

* There is a fair number of court judgments in the case rendered by courts of different instances. However, in our opinion, the details of the case are best covered in the Resolution of the District Administrative Court of Kyiv dated 4 March 2013 (http://www.reyestr.court.gov.ua/Review/29724246)

** The photo is from http://www.qygjxz.com 

Beneficial Owner: Ukrainian Approach

Introduction

It is well known that the application of tax reliefs and exemptions under double tax treaties is contingent on the concept of beneficial owner. In order to qualify for such a relief or an exemption, say, a reduced withholding tax rate on interest payment, the recipient of the interest payment must be its beneficial owner. Otherwise, the recipient will be liable to a full rate of source-country withholding tax.

Ukrainian tax law does contain the definition of beneficial owner. Under the Tax Code of Ukraine (para 103.3) a beneficial owner of interest and other income is defined as a person entitled to such income. It is also provided for in this para that a person that is even entitled to certain income cannot count as its beneficial owner where it acts merely as an agent, nominee or intermediary with regard to this income.

This article looks at how the concept of beneficial owner is understood and applied by Ukrainian judicial and tax authorities.

Formal approach

As the jurisprudence of Ukrainian courts shows, the courts and the tax authorities have so far been much concerned with the technical side of the definition of beneficial owner.

On the one hand, the tax authorities tried to challenge arrangements where a recipient of Ukrainian-sourced income was in a certain sense an agent or an intermediary. They were just trying to invoke the direct provision of the above para 103.3 of the Tax Code of Ukraine excluding agents and intermediaries from the scope of the definition of beneficial owner. This was by and large done in respect of sublicense arrangements. The tax authorities were attempting to equate foreign lessees sublicensing intellectual property rights to Ukrainian taxpayers to agents or intermediaries.

On the other hand, the courts, as usual, rejected the tax authorities’ claims on the following grounds:

1) Sublicense arrangements are intellectual property-related contracts under Ukrainian civil law. They do confirm the recipients’ entitlement to Ukrainian-sourced income, thereby rendering such recipients the beneficial owners of the income;

2) The reference made by the tax authorities to para 103.3 of the Tax Code of Ukraine is ill-founded, as the sublicense arrangements are not those governing the activity of an agent or an intermediary under Ukrainian civil law.

The judgment of the Highest Administrative Court of Ukraine (the “HACU”) dated 21 May 2013 in the so-called “Semki Case” is a classic example of such a formal approach to the understanding of the concept of beneficial owner.

For those who may be interested the full text judgment in this case is available at http://www.reyestr.court.gov.ua/Review/31368171 (in Ukrainian).

Economic-based approach

In May 2014 the HACU ruled on the Donbass Aero Case that completely changed the approach to the understanding of beneficial owner. The full text judgment in this is available at http://reyestr.court.gov.ua/Review/38106136 (in Ukrainian).

The case revolted around a sublease arrangement. A taxpayer which is a Ukrainian airline leased two aircrafts from two different foreign companies. The companies that provided the aircrafts into the lease of the Ukrainian airline were not legal owners of such aircrafts. They leased the aircrafts from other foreign companies and accordingly subleased them to the Ukrainian airline.

The airline did not deduct any withholding taxes from the lease payments made in favour of the foreign lessors by relying on relevant double tax treaties exempting such income from withholding taxation in Ukraine.

The tax authorities argued that the exempting provisions of the double tax treaties should not have been invoked by the airlines, as the foreign lessors could not qualify as the beneficial owners of the lease payments. The tax authorities pointed out to the sublease nature of the concerned arrangements making, to their way of thinking, the foreign lessors in question agents or intermediaries falling outside the scope of the beneficial ownership concept under para 103.3 of the Tax Code of Ukraine.

The court ruled in favour of the airline. It held that:

1) The term “beneficial owner” of income should not be construed in a narrow and technical sense. It should be understood in light of the object and purposes of double taxation treaties. In particular, as follows from international practice of the application of double taxation treaties, a beneficial owner is a person that does not only receive income, but also determine its further economic destiny;

2) The tax authorities failed to satisfy the court that the lessors were restricted in their ability to dispose of the leased payments received from the airline. That is, the tax authorities failed to substantiate that the lessors were unable to determine the further economic destiny of the Ukrainian-sourced income received.

Following the solution of the Donbass Aero Case on 31 October 2014 the State Fiscal Service of Ukraine (the “SFSU”) published its letter No 9033/7/99-99-10-02-02-17 on the application of the concept of beneficial owner.

In this letter, the SFSU guided itself by the judgment of the HACU in the Donbass Aero Case. It committed itself to a wide economic approach to the determination of beneficial owner set forth in the above judgment. In particular, pursuant to the SFSU’s letter the term “beneficial owner” should not be interpreted in a narrow technical meaning. To be considered a beneficial owner, a recipient of Ukrainian-sourced income must be a person who determines the subsequent economic destiny of the received income.

OECD Commentaries

It is noteworthy that the aforesaid wide economic approach to the understanding of beneficial owner appears to be in full accord with the 2014 OECD Commentaries to Model Tax Convention on Income and on Capital (the “Commentaries”).

The Commentaries, namely, state as follows:

1) The “beneficial owner” term is not used in a narrow technical sense and should be understood in its context in light of the object and purposes of double tax treaties;

2) No relief or exemption under a double tax treaty can be granted to a conduit company. A conduit company, though the formal owner, it has, as a practical matter, very narrow powers which render it, in relation to the income concerned, a mere fiduciary or administrator acting on account of the interested parties;

3) A direct recipient of the income is not considered the beneficial owner of this income if that recipient’s right to use and enjoy the income is constrained by a contractual or legal obligation to pass on the payment received to another person.

Conclusion

The shift from formal to economic-based approach in the understanding of beneficial owner is sure-fire step ahead for Ukrainian court jurisprudence and administrative practice. It aligns Ukraine with the countries of the developed world in this respect of the application of double tax treaties.

At the same time, the economic-based approach requires much greater efforts from the tax authorities. The mere interpretation of the Tax Code of Ukraine will no more work for them. They must resort to an international exchange of tax information and an economic analysis. Yes, it is time-consuming and difficult, but there is no other way out for the tax authorities should they really want to protect the Ukrainian tax base.

* Photo from http://cgrfsh.blogspot.com/