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. 

Photo from http://galleryhip.com

Corporate Income Tax: Reloaded

Co-authored by Anton Babak 

Within the scope of the Tax Reform of 2015 the Corporate Income Chapter of the Tax Code of Ukraine has been completely recast. What follows is a brief description of new corporate income tax (“CIT”) rules mainly being in force as from 1 January 2015.

General Changes

-  CIT is no more levied on profits determined under special tax accounting rules. It is now levied on pre-tax profits calculated in accordance with book accounting standards, but subject to certain adjustments (tax differences);

- Tax differences are not mandatory for small enterprises (with annual income up to UAH 20 million). They may opt for not to apply the tax differences. In this case CIT is chargeable on the amount of “raw” book profits;

- Tax authorities has obtained the right to audit book accounts of taxpayers (either under the Ukrainian GAAP or the IFRS). This does not come as a surprise as at present book profits do make up the basis of the tax assessment;

- Approach to the expenditures that are not associated with the conduct of the taxpayer's business has dramatically changed. As for now, these expenditures are generally allowable;

- 4% limitation on the deductibility of consulting, marketing, advertising and engineering services bought from non-residents do not apply anymore;

- Borrowers under inter-companies interest free loans are no more chargeable to CIT on the deemed interest accrued on such loans and in certain cases on the principal of such loans;

Tax Differences

- Depreciation and amortization: special depreciation and amortization rules provided by the Tax Code of Ukraine apply. They do not differ in any material respect from those being in effect formerly;

- Transfer pricing rules: pre-tax book profits can be increased taking account of differences between arm’s length and contractual prices;

- Thin-capitalization rules: certain interest expenses incurred in respect of related non-residents are now disallowed. The restriction normally applies to taxpayers whose debt-to-equity ratio exceeds 3.5 (for banks and financial organizations - 10);

- Purchases from residents of blacklisted jurisdictions and non-profit organizations: a deductibility restriction is now set at 70% of the amount of the actual expense. The restriction can be overridden where the taxpayer is able to justify under transfer pricing rules the arm’s length character of the underlying transactions;

- Royalty: deductibility restrictions essentially remain the same as before (e.g. a full non-deductibility of royalties paid out to residents of blacklisted jurisdictions and a 4% restriction on the deductibility of royalties paid out to other non-residents). The novelty is that the above restrictions can now be circumvented where the taxpayer is able to justify under transfer pricing rules the arm’s length character of the underlying transactions;

- Transactions in securities: special tax accounting rules disabling the utilization of securities-related losses remain in force.

Administration Novelties

- New rules concerning advance CIT on dividends operates. Advance CIT is nowadays payable not on the full amount of the dividend distribution, but only on the excess of this amount over the taxed profits of the corresponding tax period;

- New rules with regard to filing tax returns and paying monthly advance payments have been laid down (will be effective from 2016). The new deadline for filing annual tax returns will be 1 June of the year following the tax year. The threshold for those required to pay monthly advance payments of CIT will increase to UAH 20 million of the annual income (as against current UAH 10 million). A twelve-month period for the calculation of monthly advance payments will be determined from June of the current tax year through May of the next tax year (as against the present March-February period).

* - Photo from http://www.chud.com

Blocked VAT-Accounts Finally Get Started

Co-authored by Andrii Kuleba 

 (Junior Associate of 

Lavrynovych & Partners Law Firm)

Ukraine has finally implemented the system of blocked VAT-accounts to combat VAT-fraud. Ukrainian system of blocked VAT-accounts is innovative and does not have any equivalents in the world. It is based on a prepayment principle. A supplier in first place remits VAT to his blocked VAT account, and only after that the purchaser can enjoy his resultant input VAT deduction.

There is a special formula to calculate the limit on issuance of VAT invoices. Under this formula the maximum amount for which a supplier is permitted to issue a VAT invoice is determined taking account of his input VAT. Should the supplier intends to issue a VAT invoice for the amount exceeding one calculated according to the formula, he first needs to deposit additional funds to his blocked VAT-account.

The system of blocked VAT-accounts also entails the fully electronic administration of VAT:

- VAT invoices and VAT returns are issued/filed in electronic format only;

- All VAT invoices are subject to registration in the electronic register maintained by the state fiscal authorities. Only based on VAT invoices registered with the above register a purchaser can claim his input VAT deduction.

Blocked VAT-accounts have been in test-mode operation since 1 February 2015. The test-mode operation means that VAT is administered electronically and VAT liabilities are settled towards the state revenues through blocked VAT-accounts. However, over this transitory period of time the limit on issuance of VAT invoices (calculated under the special formula) does not apply. Thus, suppliers are not supposed to finance their blocked VAT-accounts before making taxable supplies in certain cases.

Since 1 July 2015 the system of blocked VAT-accounts will become fully-operational, which first and foremost mean the application of the limit on the issuance of VAT invoices.

It is also worthwhile to mention that the current system of blocked VAT-accounts has been seriously modified in response to the severe criticism of business society in respect of its adverse effect on VAT taxable persons.

First, there is now the real possibility for taxable persons to return the overpayments of tax accumulated in their blocked VAT-accounts.

Second, taxable persons are now given the opportunity to increase the limit on issuance of VAT invoices (calculated under the special formula) by the surplus of their input tax of previous tax periods.

Third, in order to minimize distractions of working capital, the limit on issuance of VAT invoices (calculated under the special formula) will automatically increase by the average monthly amount of VAT liabilities remitted to the state revenues by the taxable persons over the last 12 months.

 

VAT-Revolution: Modification

It is more than a month has passed since the publication of the article on the new system of VAT administration. Over this period of time, some important points have shown up. 

 

Firstly, there is a high likelihood of the new administration system being revoked. The revocation of the new system is provided for by the Coalition Agreement. Moreover, the bill No 1141 on the revocation of this system has been registered by the Verkhovna Rada (Ukrainian parliament).

Secondly, the blocked VAT-accounts will not be opened at the Clearing Сenter for Servicing Contracts in the Financial Markets. Pursuant to the effective resolution of the Cabinet of Ministers of Ukraine No 569 such accounts will be rather opened at the State Treasury of Ukraine.

Thirdly, on 4 December 2014, the State Fiscal Service of Ukraine published a methodological document "Basic Rules of the Electronic VAT Administration." The document provides clarification on many aspects of the operation of the new system of administration.

*- Photo from http://www.slovoidilo.ua

Blocked VAT-Accounts: Not That Effective

Over the time that has passed since the publication of my article on the new system of VAT administration, I have lost my illusions as to 100% efficiency of the new system. 

Blocked VAT-accounts are well able to resist VAT-fraud when it comes to transactions between taxable persons. However, they are virtually powerless against VAT-abuses when it comes to transaction between taxable and non-taxable persons. A sham company can supply goods/services to a non-taxable person and fail to declare its output VAT. A limit on the registration of VAT invoices in the unified electronic register will not help here. The sham company just will not issue a VAT invoice at all thereby avoiding depositing funds into its blocked VAT-account. The VAT "saved" in such a way the sham company will be able to transfer to an unconscientious trader by providing him with “all-loved” consulting services plus, of course, black cash in suitcases.

Let me illustrate this loophole of the new administration system by way of example.

Company A is willing to convert UAH 1 mln. into black cash and still enjoy fake input VAT.  Company A reaches out to Company B (a sham company). The parties enter into a contract for consulting services (Company A is the client, and Company B is the contractor) at the amount of UAH 1 mln., inclusive of UAH 166.66 thousand of VAT. Company A transfer UAH 1 mln. to Company B as an advance payment for the consulting services.

Company B does not hurry with the issuance of the VAT invoice to Company A for the amount of UAH 166.66 thousand. The point here is that for registering such a VAT invoice in the unified register, Company B would have to fund its blocked VAT-account for UAH 166.66 thousand. Instead, Company B seeks a possibility of issuing the VAT invoice to Company A without depositing any funds into its blocked VAT-account.

To this end, Company B buys for the same UAH 1 mln. computer equipment from Company C (a taxable person) and gets for itself a VAT invoice for the amount of UAH 166.66 thousand. The purchase is of true nature. Company B really gets the computer equipment.

Now, having the VAT invoice confirming its entitlement to UAH 166.66 thousand of input VAT, Company B issues a VAT invoice to Company A for the same amount with no funding of its blocked VAT-account.

At the final stage Company B sells the purchased computer equipment to Company D (non-taxable person) for UAH 1.1 mln., including UAH 183.33 thousand of VAT. Again, it is a true nature transaction. The computer equipment actually goes to Company D.

It seems as if there were no options for Company B, but to fund its blocked VAT-account for UAH 183.33 thousand necessary for the issuance of the VAT invoice to Company D. However, Company D resorts to “unexpected maneuver”. It does not issue the VAT invoice and does not record its resultant output VAT in the VAT return.

Company D is not a taxable person and by and large does not need the VAT invoice. Therefore, it will not complain to the State Fiscal Service of Ukraine about Company B failing to issue it with the VAT invoice. Furthermore, the law itself does not provide any enforcement mechanism that can be used to compel Company B to provide Company D with the VAT invoice. A provision setting out 15 days time limit for registering a VAT invoice in the unified register is not enshrined by any effective legal sanctions.

After receiving the funds from Company D Company B illegally converts them into black cash and transfer the obtained black cash to Company A, of course, less of the conversion fees charged.

By the way, the question arises as to the amount of black cash conversion fees. It appears that a 27-30% fee mentioned in my preceding article is rather an overstated amount. Arguing that the amount of the fee would soar that high, I was premised on the assumption that the new administration system would completely close the gap allowing sham companies to evade VAT.

As the aforesaid example shows I was wrong. The new system of administration still permits sham companies to evade VAT, but this will be much more difficult than it is today. Sham companies will incur additional operating expenses. To secure a "deal" they will have to at least carry out a real purchase of goods and find a non-taxable customer ready to buy such goods from them at prices close to market ones.

Given the additional operating expenses, sham companies will charge more for their services. How much will it be - it is difficult to say. However, it is clear that it will be something above the current 7-10%, but below 27-30% suggested in my previous article. Perhaps, it will be something around 12-15%.

What could the government do to block/restrict the VAT-evasion possibilities open to supplies involving non-taxable customers?

In my opinion, the government may consider assigning certain controlling responsibilities to banks or to non-taxable customers, in particular those of them being sole traders or legal entities.

Banks can be prohibited from processing payments made by non-taxable persons to taxable persons, until the taxable person (supplier) provides the bank with the confirmation of the registration of the corresponding VAT invoice in the unified register.

As for non-taxable persons, they could be obliged to complain to the tax authorities about their taxable suppliers failing to provide them with the confirmation of the registration of the VAT invoices in the unified register. This obligation would be appropriate to safeguard by means of a fine being equal to the amount of the VAT for which the VAT invoice should have been issued. The presence of such a significant fine would encourage the non-taxable persons to complain to the tax authorities about the taxable persons failing to issue the VAT invoices. The tax authorities would therefore be able to receive promptly the information about the abuse and would be able to respond to it accordingly.

*- Photo from http://villains.wikia.com