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Anti-Offshore Rules Affecting Cross-Border Taxation in Ukraine from 1 January 2020
It is common for Ukrainian businesses to shift profit created in Ukraine to another country, often with the purpose of achieving favorable tax treatment of this profit and reduce tax obligations by applying legal loopholes and misusing tax treaty provisions.
The Ukrainian Parliament has decided to adopt international standards that prevent misuse of tax law loopholes and secure the taxation of profits in Ukraine.
Below we provide a summary of recent Ukrainian tax law developments restricting base erosion and profit shifting to low-tax jurisdictions that businesses will have to consider when doing business across borders.
In 2019, the Ukrainian Parliament ratified (1) a number of protocols amending bilateral tax treaties with certain countries as well as (2) the Multilateral Convention to Implement Tax Treaty Related Matters to Prevent Base Erosion and Profit Shifting (the MLI). All these measures should limit abuse of bilateral tax treaties and the tax-tree transfer of Ukrainian source incomes to low-tax jurisdictions.
Amendments to Cyprus/Ukraine Tax Treaty
The Protocol amending the Convention between the Government of Ukraine and the Government of the Republic of Cyprus for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income envisaged the increase of withholding tax rates and taxation of capital gains in Ukraine.
Dividends payable from Ukraine are subject to a 5% tax rate if a Cypriot recipient of such dividends is a beneficial owner of the dividend and is a company (other than a partnership) which:
(1) Directly holds at least 20% of the capital of the company paying the dividends; AND
(2) has invested in the acquisition of the shares or other rights of the company the equivalent of at least EUR 100,000.
Otherwise, a 10% tax rate is applied.
The preferential 2% tax rate applicable to interest payments is raised to 5%.
New Rules of Capital Gains Taxation
The Amendments to the Cyprus/Ukraine Tax Treaty significantly alter taxation of the sale of Ukrainian companies via Cypriot holding companies.
Capital gains derived from the sale of shares or other corporate rights that derive (i) more than 50% or (ii) a large portion of their value directly or indirectly from immovable property located in Ukraine shall be taxed in Ukraine at a rate of 15%, unless the following exemptions are applicable:
– the shares are listed on an approved stock exchange;
– the gains are derived in the course of a corporate reorganization;
– the immovable property from which the shares derived their value is property in which the business is carried out;
– the shares are of a public company;
– the capital gains are similar to those of interests in real estate funds;
– the seller is listed on an approved stock exchange;
– the seller is a public company;
– the seller is a pension fund, a provident fund or a similar entity.
Accordingly, if a seller or a target meets at least one of the above criteria, capital gains shall only be taxed at the level of a Cypriot holding company.
At the same time, capital gains derived from alienation of any other property (including shares and other corporate rights in Ukrainian companies that do not derive their value, directly or indirectly, from immovable property) are subject to taxation in the seller’s state provided that such gains are taxable in the seller’s state.
Taking into consideration the fact that capital gains derived by Cypriot companies are exempt
from taxation in Cyprus, Ukrainian 15% withholding tax shall apply. Accordingly, if the sale of shares (corporate rights) in a Ukrainian company or other property located in Ukraine is carried out between a Cypriot seller and another
non-resident buyer, proceeds received from such a sale is subject to taxation in Ukraine.
Although capital gains of a Cypriot company shall be taxed in Ukraine, there is currently no mechanism for such withholding of tax in Ukraine. Therefore, until the relevant law is adopted and a withholding mechanism is introduced, such gains will continue to be taxable at the level of a Cypriot recipient and, accordingly, exempt.
Ukraine has already implemented the MLI and intends to automatically modify all existing bilateral tax treaties with countries that also ratified/will ratify the MLI and extended/will extend it to bilateral tax treaties with Ukraine.
Principal Purpose Test
One of the key amendments is the introduction of the PPT applicable to transactions with a foreign resident eligible for tax benefits under a relevant tax treaty.
In a nutshell, the PPT aims to deny tax treaty benefits in the event of treaty abuse and prove that obtaining the benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit.
This means the Ukrainian tax authorities will be able to examine the purpose of establishing a company abroad and the solid grounds for making payments to such a company, and may decide on whether the PPT is satisfied or it is evident that the respective arrangement was put in place exclusively for the purposes of tax minimization.
Taxation of Capital Gains from Immovable Property
The majority of tax treaties to which Ukraine is a party envisage that gains derived by a resident of a contracting state from the alienation of shares in an entity that derived more than 50% of its value from immovable property situated in the other contracting state may be taxed in that other contracting state. At present this rule applies if the relevant value threshold is met at any time during 365 days preceding the alienation.
Extended Permanent Establishment Status
Permanent establishments are often used to avoid taxes. The main issue of the current PE definition are the exemptions under which certain economic presence is not deemed a permanent establishment and, therefore, not taxable in Ukraine.
The MLI introduces changes to tackle common tax avoidance strategies used to prevent the existence of a PE, including through agency or commissionaire arrangements, establishing related distributors, splitting-up of contracts, limiting specific activity exemptions and fragmentation rules.
The PPT and other provisions of the MLI are already applicable in respect of the bilateral tax treaties executed by Ukraine with the UK, Canada and Cyprus, and prevent the use of tax treaties to achieve a double non-taxation effect or the creation of indirect benefits for residents of third countries.
Cyprus has ratified the MLI, which comes into force on 1 May 2020, and automatically amends the tax treaty between Ukraine and Cyprus.
Starting from 1 January 2021, a Ukrainian-resident company that is distributing dividends, royalties, interest, lease payments and other incomes from Ukraine to a Cypriot tax-resident company must prove that the benefits obtained under the Cyprus/Ukraine Tax Treaty were not the only purpose (or one of the principal purposes) for the Cypriot company to receive such incomes if it wants to be able to continue to apply relevant reductions or relief of the withholding tax in Ukraine.
In order to be able to prove the above, the Ukrainian distributing company will need to provide evidence that the Cypriot company has sufficient substance (office, staff, on-going business expenses, etc.) to carry on certain activities/operations (e.g., management, marketing, sales etc.) or has a business purpose for being set up in Cyprus (e.g., logistics benefits, import/export facilitation, a market entrance, optimization of procurement procedures or sales, etc.).
Accordingly, ratification of the MLI by Cyprus will significantly affect all companies that are structured via Cyprus and/or distribute incomes to Cypriot companies and will restrict obtaining benefits under the Ukraine/Cyprus Tax Treaty, unless the activity/operation of Cyprus companies are restructured to address Principal Purpose Test requirements.
Anti-BEPS Law No.1210
Draft Law No.1210 On Amendments to the Tax Code of Ukraine on Improvement of Tax Administration, Elimination of Technical and Logical Inconsistencies in Tax Legislation has been adopted by the Ukrainian Parliament, and if it is signed into law by the president it will implement the following amendments which will affect cross-border transactions of the Ukrainian business community:
– Introduction of controlled foreign companies (CFC) rules in Ukraine, which will lead to taxation of undistributed profit of CFCs at the level of the Ukraine resident (both individuals and legal entities) that controls such CFCs;
– Introduction of a “business purpose test” in transactions with non-residents for the purposes of corporate income tax and transfer pricing;
– Implementation of three-tiered TP reporting in accordance with the OECD BEPS Action Plan: In addition to local filing, multinational groups would be required to prepare a master file if an annual consolidated income of a group exceeds EUR 50 million and a country-by-country report if an annual consolidated income of a group exceeds EUR 750 million;
– Some payments to non-residents of Ukraine, after being adjusted to arm’s length prices, could be equated to the distribution of a constructive dividend and, therefore, subject to 15% withholding tax and 18% advance corporate income tax.
– The concept of a beneficial owner is narrowed and a look-through approach will be allowed for the purposes of application of tax treaty benefits;
– The domestic definition of a PE would be amended to align it with the updated definition under the OECD Model Income Tax Treaty, and a new administrative procedure would be introduced to examine non-residents that carry on business operations in Ukraine while avoiding proper tax registration;
– The mutual agreement procedure for resolution of cross-border tax disputes under tax treaties would be implemented in domestic legislation.
Although the president can veto Anti-BEPS Law No.1210, the principal amendments will (subject to certain adjustment in line with the Ukrainian president’s right of veto) be adopted at short notice during parliamentary proceedings. Therefore, multinational corporations and Ukrainian companies will, to some extent, have to adapt their business structures according to new tax regulations, which will reduce their profit levels.