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- Galyna Melnyk
Tax Advisor, Deputy Director, PETERKA & PARTNERS
Engaging Ukrainian IT Specialists: Cross-Border Tax Aspects and Risks in Long-Term Perspective
Over the years, Ukraine has gained popularity as a source of IT specialists. The reasons for this are not only the exceptional skills of Ukrainian IT professionals, but also a range of other factors, among which the tax aspect is an important one. Ukraine has attracted foreign IT companies with its unique tax regime used by individuals, which allows reducing the cost of the final IT product created with their involvement.
In this article we will focus on important cross-border taxation aspects related to the engagement of Ukrainian individuals in the IT sector, paying specific attention to the tax aspects of their physical relocation to other countries due to the Russian aggression against Ukraine.
Typical Models Used in IT Sector
All the models that we will be discussing below are based on the key tax preference available in Ukraine, that being the simplified system of taxation. To benefit from it, Ukrainian individuals engaged in the IT sector register as private entrepreneurs and apply to be taxed with a single tax of 5% from their income. Besides this tax, only a small, fixed quarterly amount for the unified social contribution is due from them.
The availability of the above tax regime has made Ukrainian IT specialists very attractive counterparties for Ukrainian IT companies. Should the companies engage these IT specialists as their employees, they would have to bear a significant payroll tax burden (around 40%) and deal with all of the employment-related formalities. Also, the said beneficial tax regime has provided a significant cost reduction for those IT specialists who have chosen to work directly for foreign IT companies and receive remuneration from abroad.
As follows from the above, the most common models for engaging IT specialists in Ukraine are:
- Model with a legal presence in Ukraine:
A Ukrainian company (either a subsidiary of a foreign group or locally-owned) subcontracts Ukrainian individuals registered as private entrepreneurs using the simplified system of taxation. The basis of cooperation is a civil-law contract on software development, testing, etc. The Ukrainian company further supplies IT-products to foreign companies of the group (if Ukraine is used solely as a cost-centre) or both to affiliated companies and non-related customers worldwide.
- Model without a legal presence in Ukraine:
This model differs from the first only in that the foreign IT-company subcontracts Ukrainian individual entrepreneurs directly, without establishing any legal presence in Ukraine.
In view of the Russian invasion of Ukraine, the above two typical models were slightly altered due to the migration of individuals. Now many IT specialists continue working from outside Ukraine, while still preserving their legal status as private entrepreneurs using the simplified system of taxation.
Below we will analyse the cross-border tax risks typical for the above two set-ups and will also comment on the important double-taxation considerations relevant for those individuals who have relocated abroad due to the war.
1. Tax Risks Relevant for the Model with Legal Presence in Ukraine
The most typical tax risks in this case are:
- potential re-qualification of Ukrainian individual sub-contractors into employees of a Ukrainian company, engaging them with the respective additional assessments of payroll taxes at the hands of the Ukrainian company, and
- the Ukrainian tax authorities questioning the actual profit margin of those Ukrainian companies which cooperate only with foreign companies of their groups.
For the purposes of this article, we will comment only on the second risk – profit margin adjustment. Although quite high, the first risk has no international tax aspect to it and therefore falls outside the scope of this article.
The risk of the profit margin being questioned by the Ukrainian tax authorities can materialize if the Ukrainian company sells IT products to its foreign affiliated company at a price not being at arms-length (typically, closer to the cost). In this case, the tax authorities may apply the following tools to tax the real portion of profit actually attributable to Ukraine:
- transfer pricing adjustments, or
- permanent establishment recognition with attribution of the relevant portion of the profit to Ukraine.
Transfer pricing adjustments
As to transfer pricing adjustments, formally, there are certain thresholds to be met for Ukrainian transfer pricing rules to apply to a Ukrainian company. Those being, simultaneously: (i) revenue of the company (indirect taxes excluding) shall exceed UAH 150 million per annum, and (ii) transactions with an affiliated non-resident shall exceed UAH 10 million per annum, indirect taxes excluded.
Nevertheless, considering the recent tendencies in Ukrainian transfer pricing, Ukrainian tax authorities may apply a broader approach and identify the above thresholds based on the arms-length principle. In other words, low turnover figures with a foreign affiliated company may be re-assessed based on the actual market value of the products supplied. As a result, the above thresholds may be deemed as exceeded, with respective taxation of the accrued excess amount in Ukraine, also with potential re-qualification of this excess as dividends.
The overall recommendation aimed at combating the above tax risk would be to always use arms-length prices in relations with affiliated persons and to be ready to prove such prices by underlying benchmarking studies carried out from the Ukrainian perspective.
Permanent establishment recognition
Permanent establishment is a tool used by the state to exercise its taxation rights. The idea behind it is that if any commercial activity is carried out within a certain state, all attributable profits shall be taxable in that state. Accordingly, the Tax Code of Ukraine and numerous bilateral conventions on the avoidance of double taxation define permanent establishment rather broadly as a fixed place of business within which the business activity of the enterprise is carried out fully or partly in a certain state. Profits attributable to the permanent establishment are taxed in the state of its location. Such broad definition gives wide discretion to tax authorities applying the concept.
This is quite a typical set-up when a Ukrainian company creates a product in Ukraine solely for one foreign client (affiliated foreign company), which, in its turn re-sells it with a profit margin to its clients actually using Ukraine as a cost-centre. Accordingly, the Ukrainian-origin product will actually generate profits outside of Ukrainian taxation rights.
To combat this, the Ukrainian tax authorities may qualify a Ukrainian company as a permanent establishment of its foreign affiliate with the purposes of attributing a relevant portion of the profit to it and taxing it in Ukraine.
The recommendation here is very much the same as for the previous transfer pricing risk. The Ukrainian company shall not operate solely as a cost-centre with some minimal margin needed to cover its costs. It shall invoice the affiliated foreign company as an independent contractor using arms-length prices. For that, a benchmarking study should be made.
It should be noted that currently, the risk of the above re-qualification is not very high. However, considering recent world-wide tendencies in regards to combating profit shifting, and also considering recent changes to Ukrainian tax laws aimed at being in line with those tendencies, the said risk becomes more and more relevant each day and should not be disregarded.
2. Tax Risks Relevant for the Model Without a Legal Presence in Ukraine
The key tax risks in this case stem from the potential recognition of a foreign IT company’s permanent establishment in Ukraine. This would be the case if tax authorities were able to prove that such company has a fixed place of business in Ukraine. Recently adopted amendments to the Tax Code of Ukraine introduced even more strict anti-tax-avoidance rules concerning cases of doing business in Ukraine without registering a legal presence in the country. Among others, such amendments are aimed at revealing and taxing hidden permanent establishments.
In view of the said amendments and also with regard to OECD commentaries to the Model Tax Convention (also applied by Ukrainian tax authorities and courts), the following circumstances can lead to the recognition of permanent establishment in Ukraine:
- Ukrainian individuals working not as independent contractors of a foreign IT company, but rather as employees or dependent agents (e.g., not bearing any commercial risks, being subject to comprehensive control and detailed instructions of this company, using resources provided by it (such as premises, equipment), reference in the service contract to an exact position, monthly salary, health package, payroll schedule, probation period, mandatory number of hours per week/day, paid time-off, etc.);
- Ukrainian individuals having their own corporate e-mail box on a foreign IT company’s domain;
- Ukrainian individuals being authorized to act on behalf of a foreign IT company or negotiate legal deeds to be further executed by it;
- Ukrainian individuals working exclusively for the said foreign company and/or its affiliated companies (e.g., this may be evidenced with non-compete clauses included into services contracts)
- Existence of premises in Ukraine legally or de-facto linked to the foreign IT company (like an office in Ukraine to which all the Ukrainian IT specialists come on a regular basis to perform work for this particular company or its affiliates, especially if such office is leased in the name of this company or its affiliated person);
- Ukrainian individuals actually creating/contributing to the creation of an IT product, the selling of which is the main business activity of the foreign IT company (this point seems to be one of the main risk factors, along with having a fixed place of business in Ukraine).
The failure to register a permanent establishment qualifies as tax evasion in Ukraine. In this case, the tax authorities will compose a special act stating the amount of income and profit attributed to a foreign IT company’s business activity in Ukraine and the amount of underpaid Ukrainian corporate profit tax (the rate is 18%). Moreover, there is a chance that in this case the tax authorities may also re-qualify payments to Ukrainian individuals as salary with the following additional assessment of payroll taxes.
From a short-term perspective, the above risk is rather low due to the following factors:
- There is no officially approved methodology for attributing income to a non-resident’s permanent establishment in Ukraine;
- It seems quite problematic in practice for the Ukrainian tax authorities to audit effectively the activity of a foreign group for the purposes of identifying its income attributable to Ukraine;
- We are not aware of any practical cases of such income attribution and additional tax assessments related to salary, nor are we aware of any cases of reclassification of contractual relations into employment relations when a potential employer has no legal presence in Ukraine.
However, in the long-run, the most compliant and safe option, from a tax perspective, is to switch from engaging individual entrepreneurs directly by a foreign company to establishing a legal presence (subsidiary in Ukraine) with further employment of the required labour force or using the tax benefits of a newly-introduced tax incentive for the IT industry called “Diia City”. The latter allows engaging staff with a tax burden only slightly higher than that enjoyed in the current set-ups.
3. Cross-Border Tax Aspects for Relocated IT Specialists
The fact that a Ukrainian individual is physically residing outside Ukraine and is rendering services from there does not preclude him/her from enjoying the benefits of the simplified tax system. At the same time, this fact does not release the individual from the obligation to pay the respective mandatory payments in Ukraine and file the respective reporting.
Importantly, neither of the mentioned mandatory payments payable by the individual in Ukraine are covered by the bilateral double taxation treaties entered into between Ukraine and other countries in which such individual may now stay. Usually, such treaties provide for an exhaustive list of Ukrainian taxes covered by them, those being corporate profit tax and personal income tax only. Single tax and the unified social contribution are not mentioned.
This means that should any taxes apply to an individual’s income under the tax laws of the country to which he/she fled from the war, they cannot be credited against the single tax and unified social contribution in Ukraine. The mentioned two mandatory payments shall be paid by the individual in Ukraine anyway, regardless of the provisions of the treaty, as long as he/she preserves his/her current status as a private entrepreneur using the simplified system of taxation in Ukraine.
Moreover, according to paragraph 14.1.213 of the Tax Code of Ukraine, the fact that the individual is registered as a private entrepreneur in Ukraine automatically means that he/she qualifies as a tax resident of Ukraine. Notably, this criterion is a specific Ukrainian one, not mentioned in the treaties.
This means that should the individual qualify, from a foreign tax perspective, also as a foreign tax resident, there is a potential for double taxation in the country of his/her residence and in Ukraine. This may also have an adverse tax effect on other types of the individual’s income not directly linked to his/her professional IT activity (such as inheritance, alimony, etc.).
From the long-term perspective, the most tax compliant and safe option is to engage Ukrainian IT specialists via a Ukrainian subsidiary of the group, which would further sell IT products at arms-length prices. IT specialists can be either employed by this company or engaged on special terms envisaged by the Diia City regime.
The article was prepared as of August 2022.