Practice of European Court of Human Rights in Tax Disputes

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This is not a rare occasion nowadays that the practice of the European Court of Human Rights is used by local courts to resolve certain disputes. For the present, this practice is recognized as an independent source of law and is mandatory for the application by the courts (para 1 of s. 17 of the Law of Ukraine "On the Enforcement of the Judgments and the Application of the Practice of the European Court of Human Rights").

There are no exceptions in respect of tax disputes, where the courts more and more often begin to employ the practice of the European Court of Human Rights.

The analysis of the practice of the European Court of Human Rights in tax disputes shows that the most frequently it concerns Art. 1 of the Protocol 1 to the Convention for the Protection of Human Rights and Fundamental Freedoms.

This article enshrines the right to peaceful enjoyment of possessions. Especially, it reads that every natural or legal person is entitled to the peaceful enjoyment of his possessions. No one ought to be deprived of his possessions except in the public interest and subject to the conditions provided for by law and by the general principles of international law.

In the context of tax disputes imposing the duty to pay tax/depriving the right to receive a tax benefit (input VAT or VAT refund) is viewed as a deprivation of property. Accordingly, it should be exercised “subject to the conditions provided for by law and by the general principles of international law”.

The best known for Ukraine seems to be the practice of the European Court of Human Rights as regards the application of art. 1 of Protocol 1 on such matters as (1) the entitlement of a taxpayer to VAT input/VAT refund arising from the transactions with non-bona fide (from a tax perspective) suppliers and (2) the "quality" (predictability, precision) of tax laws.

Problem suppliers

To date, one can make note of three main judgments of the European Court of Human Rights on this issue. These comprise the judgments in Intersplav v Ukraine (2007, application No 803/02), "Bulves" AD v Bulgaria (2009, application No 3991/03), and Business Support Centre v Bulgaria (2010, application No 6689/03).

In these cases the local tax authorities denied the VAT payers’ right to input VAT /VAT refund in view of the abuses aimed at obtaining illegal VAT refund committed by their suppliers.

Checking the denial of the taxpayer’s right to input VAT/VAT refund against the requirements of Art. 1 of the Protocol 1, the European Court of Human Rights resorted to the principle of proportionality. This principle appears to be part of the rule of law principle and demands a "fair balance" to be struck between the public interest on one side and the protection of the rights of individuals subjected to the state intervention on the other side.

On the facts of the case, the European Court of Human Rights found that the "fair balance" requirement is not met when the taxpayer is deprived of his entitlement to input VAT/VAT refund in the absence of (1) evidence indicating his direct involvement in VAT abusive practices (2) evidence that he had knowledge or the means to obtain the knowledge of the fraud in relation to the VAT system committed by his suppliers.

Consequently, the court revealed a violation of Art. 1 of Protocol 1 guarantying the right to peaceful enjoyment of possessions.

"Quality" of tax law

As noted above, in accordance with Art. 1 of Protocol 1 no one ought to be deprived of his possessions except subject to the conditions provided for by law.

In the understanding of the European Court of Human Rights a law is not recognized as such, if it does not gratify the requirement of "quality of law". Quality of the law alludes to its precision and clarity.

In other words, if an obligation to discharge a tax is imposed by the law that does not satisfy the condition of "quality of law", the payment of such a tax is contrary to Art. 1 of Protocol 1.

In the cases of Shchokin v Ukraine (2010, applications No 23759/03 and No 37943/06) and  Serkov v Ukraine (2011, application No 39766/05) the European Court of Human Rights observed the violation of Art. 1 of Protocol No 1 because of the noncompliance with the requirement of "quality" of tax laws.

In the case of Shchokin v Ukraine the European Court of Human Rights treated as being of “low-quality” the law laying down the rate of personal income tax applied to the income earned outside the principle place of employment. At the time when the respective transactions were taxed the Decree of the Cabinet of Ministers of Ukraine “On Citizens' Income Tax” set forth a flat 20% rate, while the Presidential Decree “On Increasing the Amount of Tax-Free Monthly Income and Rates of Progressive Taxation of Citizens' Income” stipulated a progressive rate.

Citing the principle of conflict of interest* incorporated into the tax laws of Ukraine, the court held that the more favorable for the taxpayer approach should have been employed, that is the flat rather than progressive rate of individual income tax should have been applied.

The similar findings were made by the European Court of Human Rights in the case of Serkov v Ukraine. In this case the court detected the lack of "quality of law" in the conflicting provisions of the Law of Ukraine "On Value Added Tax" and the Presidential Decree “On the Simplified System of Taxation, Accounting and Reporting for Small Businesses" in relation to levying VAT on importing goods to the customs territory of Ukraine carried out by unified taxpayers-individuals.

In lieu of conclusion

To finish on a good note, it is necessary to point out that it is not very difficult to find the examples of the application of the aforesaid practice of the European Court of Human Rights in the Unified State Register of Court Decisions of Ukraine with regard to the most topical tax cases. The most important thing seems to be that in many instances such an application is made in the interests of taxpayers.

The judgments in Intersplav v Ukraine and "Bulves" AD v Bulgaria are being applied in disputes concerning the input VAT/VAT refund arising from the transactions with non-bona fide VAT payers.

The judgment in Shchokin v Ukraine is being employed in disputes relating to carrying forward the tax losses (losses sustained in 2010 and the preceding tax periods).

* - Para 4.4.1 of the then effective Law of Ukraine “On the Procedure for Payment of Taxpayers' Liabilities to Budgets and State Purpose Funds”.

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.

Mortal Kombat Secrets or Registration of Correction Calculations to VAT Invoices

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At the meeting with the representatives of the State Tax Service of Ukraine (held on 1 February 2012 at the EBA office) the tax officers shared the technical secrets of the registration of certain correction calculations in the Unified Register of VAT Invoices.

The «recipe» is so intricate that reminded me the secrets and codes to Mortal Kombat, the most remembered fighting computer game I used to play in my childhood. Those secrets involved the complicated combinations of joystick buttons that activated the new hidden possibilities of the game.

Almost the same you are supposed to do while registering the correction calculation to the VAT invoices issued in 2011 and not registered with the Unified Register of VAT Invoices. This, for example, is concerned with the VAT invoices that were not subject to the registration in 2011 due to their insufficient amounts of VAT, but became registerable as from 1 January 2012 when more severe requirements as to the registration of VAT invoices came in force.

Initially, you register the VAT invoice and obtain the message that “the VAT invoice registration failed”. Then you neglect this message and proceed with the registration of the correction calculation, which ought to be sent for the registration within the same operation day.

The system compares the particulars of the VAT invoice and the correction calculation and finally register them in the Unified Register of the VAT Invoices.

Court Duty for Challenging Tax Assessments Rises

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The court duty for challenging tax assessments has risen. The most interesting thing is that this increase has occurred with no interference from the side of the legislature. It is just the result of the clarification of the Highest administrative court of Ukraine.

In its letter No 165/11/13-12 of 18 January 2012 the Highest Administrative Court of Ukraine spelled out that the claims related to appealing tax assessments are those of property nature. Thus, they qualify for the rate of court duty laid down for property claims and do not qualify for its rate established for non-property claims.

The rate for property claims, which is now applicable to the claims related to tax assessments, is 1% of the amount of the claim but not more than 2 minimum wage rates (UAH2,146 for 2012) and not less than 0,1 minimum wage rate (UAH107.30 for 2012). The rate for non-property claims that was formerly applicable to the clams under consideration is 0.03 minimum wage rate (UAH32.19 for 2012).

Principally, this scenario might have been foreseen at the time when the Court Duty Act (1 November 2011) took effect. The point is that the Court Duty Act changed the criteria based on which the court duty rates were applied to administrative claims. Before the Court Duty Act came in force (pursuant to the Closing and Transition Provisions of the Administrative Proceeding Code of Ukraine) the 1% court duty rate had concerned only claims aimed at the collection of funds, which had apparently precluded it from being applied to the claims in relation to tax assessments. Since the effective date of the Court Duty Act the rate in question has become applicable to any property claim.

In the light of this, it was not extremely difficult for the Highest Administrative Court of Ukraine to reason that the claims on the cancellation of tax assessments fall within the scope of property claims.

Fate Still Favors Developer-Venture Investor Tandem

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One of the most popular means of tax planning in the construction industry appears to be the use of investment funds (hereinafter – the "IF"). The scheme is quite simple and relies on corporate income tax exemptions enjoyed by the IFs.

The underlying idea is to "transport" the profit from a real estate developer paying corporate income tax on a general basis, to the IF commanding significant exemptions from this tax. Neither the income of the IFs from the operations with their assets nor the income accrued of the IFs’ assets is subject to corporate income tax in Ukraine (para 136.1.9 of the Tax Code of Ukraine).  In other words, the IFs can qualify as today’s Ukrainian tax-free havens.

The developer sells at an artificially low price (covering its costs and securing the minimum profitability) the real estate objects to the assets of the IF controlled by such a developer. In most cases this scheme is harnessed before the end of the construction and the interest in the unfinished real estate objects rather than finished real estate objects are transferred to the assets of the IF.

As a rule, the practice resorts to venture IFs. The assets of these IF are exposed to the less stringent requirements as compared to other types of IFs, which makes their usage within such schemes rather convenient.

After the purchase of the real estate objects (proprietary interests in them) from the developer the IF (the company managing its assets) sells them at a market price to the end customers and accumulates the profit. The latter, as noted above, is completely exempt from corporate income tax.

On top on that, the resulting profit may safely be taken away from the IF by dividends distributions to its investors (typically, companies affiliated with the developer). IFs are exempt from advance corporate tax payment accompanying dividends distributions (para 153.3.5. of the Tax Code of Ukraine).

Prior to the sale of the real estate objects (proprietary interests in them), the developer exercises their securitization – conversion into securities. The securitization serves at least two functions, inasmuch as:

1. Defers the moment at which the VAT becomes payable by the developer. The supply of securities is not subject to VAT (para 196.1.1 of the Tax Code of Ukraine). Consequently, the developer faces the VAT payable after the buy-back (redemption) of the securities from the end customers and the transfer of finished real estate objects into their ownership;
2. Is necessary for the observance of the legislation regulating IFs. This legislation does not provide a clear answer to the question whether the assets of IFs may comprise the proprietary interests in unfinished construction objects (in most cases these very items are sold within the scheme), but quite clearly indicates that the assets of IFs may embrace the various types of securities.

The securitization may be accomplished through the variety of different means. Of these, the allotment of special-purpose bonds (redeemable by transferring real estate objects into the ownership of their holders) appears to be the most transparent one. Among more confusing schemes there are those related to the allotment of options, usual bonds or even promissory notes, which are somehow tied to real estate objects.

After the completion of the construction the end customer obtains the title to the finished real estate object from the developer. This is achieved either by way of the buy-back or redemption of the securities acquired by the end customer from the IF (its asset management company).

In spite of its comparative simplicity and high tax efficiency, the scheme under consideration is not free from significant risks, the two most important of them are outlined below.

1. Transfer pricing. As mentioned above, in order to ensure the operation of the scheme the real estate objects (securities tied to them) ought to be sold to the assets of the IF at prices lower than the market-based prices. To put it differently, if the tax authorities are able to apply transfer pricing rules, the developer will be compelled to recognize the income based on a market price as well as to pay a fine and default interest. Even if the tax authorities fail to prove that the developer and the IF (its asset management company) are related parties, there still seems to be the legal grounds for the application of transfer prices. For example, having regard to the considerable tax benefits granted to IFs practically exempting IFs (their asset management companies) from corporate income tax, the tax authorities may view IFs as non-payers of this tax and apply transfer prices (para 153.2.3 of the Tax Code of Ukraine).
2. Business purpose test. The practice of Ukrainian courts has been intensely soaking up the doctrine of business purpose over recent years. This doctrine even deserved to be placed on a statutory footing (para 14.1.231 of the Tax Code of Ukraine). According to the doctrine in order for a transaction to qualify as "valid" for tax purposes, it needs to bear a reasonable economic reason (business purpose) other than obtaining tax benefits. It can be assumed that where the tax authorities can demonstrate that the securities were transferred to the assets of the IF solely for the purpose of reducing the tax burden, the developer can run into a set of troubles. These may include additional corporate income tax liabilities, fine, default interest and depending on the amount of the tax underpaid even the criminal responsibility for the developer’s management.

Fate still favors developer-venture investor tandem. Despite the fact that the aforesaid schemes have been employed by almost every other developer for many years, the search into the Unified State Register of Court Decision showed no examples of the tax authorities’ reaction to such "optimization" solutions.