Making Connections
By Vladimir Kotenko
Ernst & Young LLC
Ukraine continues to
integrate into the globalized
world. The
drivers of that integration are too
many to count, but they definitely
include increased interest on the
part of foreign businessmen to
explore this economic terra incognita.
Ambitious investment plans
in Ukraine by internationals are only part of the story as aggressive
Ukrainian entrepreneurs are entering international capital
markets and making this integration a two-way street.
Such interaction gives rise to a number of issues, with taxation
being one of them. Specific tax issues are likely to be very
different for foreigners entering Ukraine than for Ukrainians
“going West”. Still, at some level all these entrepreneurs face
similar challenges. Learning the requirements of foreign tax law,
tailoring a business model to those requirements, introducing
tax driven changes in a home country can be named for starters.
These can be equally relevant for a multinational company
establishing a presence in Ukraine as it might be for Ukrainian
businesses attempting to access foreign capital markets or set up
tax efficient international sales or supply chains. Both are about
establishing common frames of reference, reconciling traditional
views and practices with foreign laws and practices and, above
all, mastering the art of adaptability.
Lost in Translation
Adapting is quite a challenge in Ukraine. Ukrainian tax legislation
is outdated (and one should not be misled by numerous
and frequent changes to tax laws, as they seem to be merely cosmetic).
The regulations do not address a variety of common business
situations in the modern market and it is no surprise then
that the tax treatment of many regular transactions is unclear.
The absence of precise rules impedes rather than promotes
tax planning. Although the legal system recognises the principle,
“What is not explicitly prohibited by law is allowed,” in practice
it is often ignored by the authorities. The “conflict of interest”
rule requiring the authorities to adopt a taxpayer-friendly decision
if the tax law is ambiguous is not really helpful either, as it is
fairly difficult to enforce.
Form over Substance Mindset
It is also important to note that the form-over-substance approach
still dominates the minds of both the local tax authorities
and local businessmen. On the one hand, this broadens the horizons
for tax planning and structuring, particularly where planning
involves foreign jurisdictions. Indeed, local businessmen
designing a tax planning structure can count on having it accepted
by the local authorities just by making sure that the relevant
documents look all right (no matter how fishy the structure may
be, with enough bows, ribbons, and stamps many problems can
be avoided). On the other hand, the form over substance mindset
blurs the line between tax structuring and tax evasion.
Period of Changes
Ukraine is still living through a period of change. Laws and
regulations (often fundamental ones) are being changed or are
expected to be changed. Lawmakers in Ukraine are experiencing
“teething problems” and this makes forecasting and projecting
legislative developments a real challenge.
Reconciling foreign practice with Ukrainian reality is a popular
pass time for both Ukrainians going abroad and foreigners
coming to Kiev and leverage, group structuring, and mutating tax
rules all illustrate the difficulties faced by those entrepreneurs.
Introducing Leverage into a Ukrainian Company
A foreign investor financing an acquisition of a company in
Ukraine with debt typically attempts to push down the cost of
financing to the acquired company (which usually is an operational
entity). Usually, the objective is to deduct interest costs in
Ukraine from the taxable profit. Requests from foreign investors
asking for advice on how to implement such a structure in
Ukraine are numerous.
Legally, there are a number of options to push down the debt
to the Ukrainian entity, for example, through assigning debt,
through a merger (upstream, downstream), or through a combination
of these transactions.
The feasibility of “debt push down” from a legal perspective
does not necessarily mean, however, that the company “acquiring”
the debt would be able to deduct the respective interest
expense.
Tax law does not set any specific rules for taxation of “debt
push down” structures. In other words, there are no explicit
restrictions on interest deductibility for such cases. However,
according to the law, interest is deductible only if it meets the
“business purpose” test.
Based on interpretation of relevant laws as well as available
tax opinions and court rulings the “business purpose” test may
be passed if:
• Loan interest is paid/accrued in relation to the borrower’s activity
which is regular, permanent, and significant for the borrower.
• Loan interest is incurred in relation to income-generating
activity.
• The loan is used for its stated purpose.
The issue is, therefore, twofold: (1) whether the local law
allows in principle tax deductibility of interest incurred in connection
with acquisition of a company, and, if so, (2) how passing on the debt (and interest) to an operational company would
impact tax deductibility.
There are technical arguments supporting the tax deductibility
of interest on a loan used to acquire a company. However, the
tax authorities normally ignore those arguments and object to the
tax deductibility of investment-related interest costs (such opinions
have been expressed in a number of private rulings). This
uncertainty often makes taxpayers cautious or simply reluc tant to
implement sophisticated structures like the one discussed above.
The above is a telling example of how the obsolescence of
laws may limit business activity. This should be kept in mind
when planning for today’s Ukraine.
Structuring the Group: Substance Matters
The other example is more relevant for Ukrainian business
groups introducing foreign elements into the group structure
(e.g., holding company, group financing vehicle, IP holding/licensing
entity) to enter foreign markets.
Often the existing corporate, trading, IP, etc. structures of
the Ukrainian business groups do not meet Western standards.
The downsides of these structures can be many:
• lack of transparency of the group, no single/traceable owner(s);
• inefficient investment and profit extraction tools;
• inadequate legal protection of the group’s assets, etc.
To enter a foreign market, one may set up the right structure.
However, underestimating the need for the substance may be detrimental
for the set up’s sustainability. It may result in disputes
with the tax authorities over tax residence, Double Tax Treaty and
EU Directives application, the validity of issued tax rulings, etc.
Actually, the tax deficiencies may ruin the commercial project.
Importantly, such deficiencies are normally noticed by experienced
foreign buyers, investors, and by the authorities.
Detailed substance requirements and relevant tests differ from
country to country. The authorities may look at various things:
where the important decisions are taken, where the management
and the core business personnel reside, even at where the business
correspondence is stored. However, it is not frivolous to say that
in nearly all countries the authorities would expect the chosen
structure to adequately reflect the business reality (i.e., the form
should not disguise the substance). Complying with this requirement
may be particularly challenging for Ukrainian businessmen.
The form over substance mindset, counting on the lack of sophistication
of local taxmen and extrapolating that perception on the
foreign revenue authorities, make it a challenge.
Foreign investors should bear this in mind when approaching
Ukrainian projects.
Since the early Nineties, Cyprus has become the largest foreign
investor in Ukraine. The majority of Ukrainian tax planning structures
involve Cyprus. Cyprus owes this not so much to its excellent
climate, but rather to an extremely favorable Double Taxation
Treaty with the former USSR which is still honored by Ukraine.
However, since 2006 the Ukrainian government has been
talking about renegotiating a new treaty with Cyprus.
The version of the treaty proposed by the acting Ukrainian
government is far less favorable. It introduces a 5% withholding
tax in Ukraine on dividends and 10% on interest and royalties
(none of which exist in the current treaty).
Cyprus is reported to be reluctant to hold negotiations. The
2006 attempt to renounce the existing treaty and force Cyprus
into negotiations did not, it seems, bear fruit. Since then, there
is no telling if and when the new treaty will actually come into
force. It could come into effect in 2008 at the earliest (and even
with some retroactive effect).
Investors dealing with Ukraine through Cyprus-based structures
are learning to live on a volcano.
Many of them decided to take the risk. After all, even if Cyprus
accepts the new treaty proposed by Ukraine, it is still likely
to remain quite a favorable jurisdiction given its comparatively
low tax burden and EU membership.
Meanwhile, investors prudently explore “life beyond Cyprus”
by seeking to design back-up structures. Building a model
adaptable to the changes in the Ukrainian environment is a challenge.
One needs to monitor the market regularly.
Actually, it is always advisable to build an “adaptable” model
for Ukrainian operations, no matter which jurisdiction one plans to
invest from. Also, given the permanent “teething problems” of local
lawmakers, regular monitoring of prospective legislation is a must.
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