Ukraine: Implementation Of BEPS Action Plan In Ukraine

ABSTRACT

The article provides for concise yet instructive overview of the Ukraine's participation in the BEPS agenda. It examines the fulfillment of Ukraine's commitment to implement the anti-BEPS initiatives, as well as observes the way in which it was made. The article also provides for brief comments on potential effect the introduced changes might have on the existing tax practices exercised by Ukrainian enterprises and international businesses using Ukrainian jurisdiction.

INTRODUCTION

In 2013, Organization for Economic Cooperation and Development, jointly with G20 initiated Base Erosion and Profit Shifting (BEPS) Project aimed at tackling tax planning strategies that exploit loopholes and mismatches in international tax legislation to shift profits to low or no-tax jurisdictions with no genuine economic activity.¹

The BEPS Project comprises 15 Actions, each dealing with particular abusive instruments used to avoid tax and equips governments with tools to counteract the aggressive tax planning schemes put in place by taxpayers and their advisors to avoid tax which put a strain on international fairness and competitiveness and deprive states of their fair share of tax revenues.

Almost 6 years have passed since the final BEPS reports were published and all the interested countries were encouraged to modify their both domestic tax legislation and tax treaties to factor the results of OECD and G20 work. Ukraine declared its commitment to follow the BEPS agenda and implement the proposed changes.²

The article provides for brief overview of Ukraine's path towards implementation of BEPS package to align its legislation with world's best practices.

CONTROLLED FOREIGN COMPANIES

BEPS Action 3 introduces a powerful mechanism that tackles tax avoidance arrangements that artificially shift profits to low-tax jurisdictions through the use of subsidiaries established therein, known as controlled foreign companies (CFC) rules.

CFC rules allow governments to tax undistributed profits of non-resident entities in the hands of resident beneficiaries. Such measures are aimed at preventing 'concealment' of profits (primarily passive-type) of international groups in jurisdictions that levy little or no tax on such profits.

Ukrainian CFC rules apply to Ukrainian resident shareholders, both incorporated entities and individuals, holding 50% of corporate interest (jointly 50% for individuals) in certain qualified non-resident entities (which apart from corporate bodies also include partnerships, trusts and funds), requiring the former to report and assess Ukrainian corporate income tax on profits earned by their subsidiaries.

The Ukrainian CFC rules are aimed at mobile passive-type income which is easily shifted to escape taxation in Ukraine. At the same time, the Ukrainian legislation provides for the 'safe clause' for in nature passive income which in certain cases could be regarded as active which consequently excludes such income from the scope of Ukrainian CFC rules application. That said, it could be reasonably argued that such provisions introduce a loophole which reserves possibilities for abusive techniques aimed at artificial avoiding of CFC rules application.

Ukrainian CFC rules do not apply if total annual income of all CFCs under the control of a Ukrainian resident does not exceed EUR 2 mln.

Initially scheduled to become effective on 1 January 2020, operation of Ukrainian CFC rules was postponed to 1 January 2022.

Although tax planning arrangements with the use of Ukrainian holding companies are quite uncommon, CFC rules will drastically effect tax position of Ukrainian nationals, beneficiaries of companies established in low-tax jurisdictions.

REVISED PERMANENT ESTABLISHMENT (PE) DEFINITION

Tax planning techniques employed to artificially avoid a permanent establishment status are dealt with in BEPS Action 7 which proposes changes to a permanent establishment definition to encompass activities of taxpayers that benefit from various exceptions to avoid taxable presence in a source state.

More specifically, new changes provide for special 'substance-over-form' anti-abuse rule that curtail practices whereby international businesses intentionally fragment their activities in a source state in a way that each such activity in isolation can qualify as preparatory and auxiliary ('anti-fragmentation rules'). In addition, the new rules also address the situations where taxpayers artificially split long-term contracts to make each of them not exceed 12-month period to circumvent the exception applicable to the construction site works ('anti-splitting-up' rules).

The PE definition was further extended to include the so-called 'dependent agent' PE. Under this rule, an agent acting in a source state, that habitually concludes contracts in the name of a non-resident or negotiates the terms of such contracts that are subsequently accepted by a non-resident without significant alterations, shall be deemed as constituting a PE of such a non-resident in the source state.

The definition of permanent establishment contained in the Ukrainian tax legislation was always in line with OECD standards, and has been accordingly amended to factor the BEPS agenda.³

All the proposed changes were incorporated by Ukraine to its tax law and are effective as of May 2020. New rules set a lower PE threshold for a non-resident that could previously conduct business activity in Ukraine without creating a taxable presence, with all relevant tax implications.

Within the Ukrainian context, newly introduced extended PE definition will prove particularly useful to catch commonplace practices exercised by Ukrainian businesses that use in their corporate structures non-resident companies established in low-tax jurisdictions (primarily, Cypriot-resident) with nominal directors. Such companies are effectively managed by Ukrainian individuals who habitually take active participation in such non-resident company's operational activity. Former permanent establishment definition seemed rather weak to counteract such abusive practices.

As of now, considerable number of tax treaties to which Ukraine is a party provide for extended PE definition. Having said that, the Ukrainian legislative definition of a permanent establishment providing could hardly be applicable to residents of states which did not respectively modified their tax treaties with Ukraine. That said, the absence of the relevant provisions in double tax treaties can be invoked as restricting application of extended Ukrainian PE definition to the residents of such states.

TRANSFER PRICING

Considerable efforts of OECD and G20 working group were dedicated to transfer pricing (TP) and resulted in adoption of Action 8-10 which introduces new approach towards transfer pricing setting and assessment, and Action Plan 13 that provides for new transfer pricing filing and reporting requirements.

New legislative changes were enacted in the tax law of Ukraine that align Ukrainian transfer pricing rules with the global trends.

In particular, the Ukrainian TP rules were strengthened with the substance-over-form principle, in accordance with which the actual conduct of the parties to a transaction is to be examined.⁴ In assessing whether the remuneration under the foreign economic contract is at arm's length, not just contractual provisions but assets used, functions performed, and risks assumed by each party to a transaction shall be taken into account.

Should the actual conduct of the parties differ from which is formalized in a contract, contractual distribution of functions and risks is to be disregarded.⁵

The issue of how the arm's length principle is to be implemented in transactions that involve exploitation of intangibles has been subject to particular attention. Considering the ease with which international businesses can speculate with highly mobile income generated by the use of intangible assets, an accurate assessment of each particular activities is needed to arrive at proper remuneration to be allocated to the parties involved.

In order to deal with such challenge, Development, Enhancement, Maintenance, Protection and Exploitation (DEMPE) concept was introduced, whereby each party to the group is to be remunerated based on the particular functions performed (along with the associated assets used and risks assumed) with respect to the intangible in question.⁶

Within the Ukrainian context, DEMPE analysis may prove particularly useful in attributing profits to permanent establishments of international businesses engaged in software development activities, as their structures often involve IT engineers located in Ukraine.

In terms of TP reporting, Ukraine adopted the three-tiered transfer pricing reporting under Action Plan 13. In addition to local file, the Ukrainian companies-members of international groups will also have to submit master file and country-by-country (CbC) report, once the relevant consolidated group revenues exceed the thresholds established at the proposed by OECD level of EUR 50 mln and EUR 750 for master file and CbC, respectively.⁷

The first reporting year for master file and CbC report will be 2021.

MULTILATERAL INSTRUMENT (MLI)

On February 2019, Ukraine ratified the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (MLI). MLI is an international treaty that provides for universal mechanism to automatically implement the treaty-related ani-abuse rules to the existing tax treaties already in place between the contracting states without the necessity to renegotiate the relevant provisions on bilateral basis.

In entering into the MLI, a contracting state negotiates its treaty position and opts for the MLI provisions that will affect the relevant tax treaties with respect to other contracting states. The majority of MLI rules are elective, however, there are two provisions that constitute the so-called 'minimum standard' which is subject to mandatory application. All double tax treaties intended to be modified by the MLI shall include the principal purpose test (PPT) and mutual agreement procedure (MAP).

The PPT deals with abusive treaty-shopping techniques and is aimed at preventing granting the benefits under the tax treaties (resulting in exception from taxation or reduced taxation) in situations where granting such benefits was not intended. The MAP, in its turn, addresses the situations where inappropriate taxation was to the detriment of the taxpayers, enabling them to initiate the relevant procedure to remedy such mistreatment.

Principal-purpose test (PPT)

Under the PPT, a contracting state may deny applications of benefits under the relevant tax treaties if, having considered all the relevant facts and circumstances, it could be reasonably established that one of the principal purposes of underlying arrangement or transaction was to obtain, either directly or indirectly, such treaty benefit.

That said, an international arrangement or transaction shall generally be regarded as not satisfying the principal purpose test if it would be reasonable to conclude that entering into such arrangement/ transaction cannot be substantiated by genuine economic purpose but is rather driven by tax considerations that are aimed at obtaining the treaty benefits that otherwise would not be available.

Along with the PPT introduced to the double-tax treaties through MLI mechanism, Ukraine has also incorporated it into domestic tax legislation as a specific anti-avoidance rule. Such domestic provision could potentially be invoked in curtailing treaty abuse cases with participation of entities-resident in countries which did not modified their tax treaties with Ukraine to include the PPT.

In light of the object and purpose of the double tax treaties (also embodied in the preamble wording), the latter cannot be construed as designed to facilitate tax avoidance and evasion. That said, it shall generally remain possible for a contracting state to limit availability of the relevant tax treaty benefits in certain abusive situation by applying its domestic legislation provisions.

OECD Commentaries on the Articles of the Model Tax Convention further confirm that application of domestic anti-abuse rules to prevent granting treaty benefits in inappropriate circumstances would not be conflict with the provisions of the double-tax treaties restricting the taxation rights of the relevant state, even if the relevant anti-treaty shopping provision is not included into the relevant double tax treaty.⁸

Considering the above, it could be reasonably claimed that introduction of the principal purpose test in international tax treaty network along with relevant domestic anti-abuse rule will put an end to cases of flagrant treaty abuse in cross-border transactions.

MAP

Just like principal-purpose test, provisions on mutual agreement procedure have also been introduced to the Ukrainian legislation to resolve tax disputes arising under the tax treaties.

Both residents and non-residents who deem that they have been subject to taxation not in accordance with the provisions of the relevant DTT can present the relevant case to the competent authorities of either contracting state to reach satisfactory solution.

Having said that, it has to be noted that resorts to the MAP are quite uncommon even around the world, which makes it particularly difficult to estimate how the relevant procedure will operate in Ukraine.

OTHER BEPS-RELATED PROVISIONS

Alienation of shares in real estate-rich companies. The previously existing rule that allowed the source state to tax capital gains from alienation of shares in immovable property-rich companies was strengthened by 365-day test whereby such profits become subject to taxation in Ukraine if the shares being disposed derived their value, directly or indirectly, from immovable property located in Ukraine at any date during the 365-day period prior to such alienation.⁹ The relevant mechanism has also been introduced that enables to collect the Ukrainian WHT due in cases of both direct and indirect alienation.¹⁰

Revised 'thin' capitalization rules. Specific anti-avoidance rule that limits the deductibility of base-eroding interest payments in favour of non-resident recipients in cases of substantial debt financing, which previously effected payments to related parties only, was amended and, as of 1 January 2021, is applicable to payments made in favour of all non-residents. Furthermore, the amount of interest expenses allowed as deductible is decreased from 50% to 30% of EBITDA.¹¹

Introduction of constructive dividends. As of 1 January 2021, certain payments made in favour of non-residents are treated as dividend-equivalent and are, consequently subject to 15% Ukrainian WHT.¹²

CONCLUSION

Introduction by Ukraine of the world's best practices in the field of fiscal affairs will enhance its international standing, provide for higher level of tax transparency and cooperation. Adherence to strict standards aimed at fair cross-border taxation has become inextricably connected with the country's prestige as resistance to join anti-BEPS initiatives could be reasonably perceived as facilitating tax avoidance and as signs of beggar-thy-neighbor policies.

At the national level it is expected that anti-BEPS measures will result in higher level of tax revenues collection. Most importantly, new rules will provide for greater equity and equality in economic competitiveness and will align the taxpayers' position, discouraging huge companies from entering into aggressive tax planning arrangements which result in considerable tax savings, thus posing less powerful enterprises that cannot afford such complex structures at a competitive disadvantage.

Footnotes

1. BEPS Actions - Developed in the context of the OECD/G20 BEPS Project, OECD website: https://www.oecd.org/tax/beps/beps-actions/

2. On January 1 Ukraine will join the BEPS Action Plan to tackle Tax Evasion (22 November 2016), News The Ministry of Finance of Ukraine: https://www.mof.gov.ua/en/news/-sichnia-ukraina-pryiednaietsia-do-planu--po-borotbi-z-unyknenniam-vid-opodatkuvannia

3. 3 Article 14.1.193 of the Tax Code of Ukraine (the 'TCU) (as it reads as of May 2020)

4.

5. Article 39.2.2.10 of the TCU (as it reads as of January 2019)

6. Article 39.2.2.9 of the TCU (as it reads as of January 2019)

7. Article 39.4.7 and Article 39.4.10 of the TCU

8. OECD Model Tax Convention on Income and on Capital: Commentary on Article 1 para 61 and 77 (2017), Models IBFD

9. Item 'e' of Article 141.4.1 of the TCU (with the relevant changes effective as of July 2020)

10. Art.141.4.2 of the TCU (with the relevant changes effective as of July 2020), whereby a non-resident that acquires shares in Ukrainian property-rich company from other non-resident shall register with the Ukrainian tax authorities prior to such acquisition, withhold the Ukrainian tax due and remit it to the state budget.

11. Article 140.1-140.3 of the TCU

12. Art.14.1.49 of the TCU. The relevant changes took effect on 1 January 2021.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.