The State Fiscal Service of Ukraine (“SFSU”) tried to tax a transfer of shares of a Ukrainian company carried out by two Cypriot companies. In 2014 a Ukrainian company, Pivdenny Girnycho-Zbahachuvalny Kombinat OJSC (“Pivdenny GZK”), bought shares of an associated company, Metallotekhnika LLC, from two Cypriot sellers (Case Nr. 804/3794/18). The price of the shares was set at $1.4 billion.
The current double tax treaty (“DTT”) between Ukraine and Cyprus does not prescribe any special tax regimes for transfer of shares, including sale of shares of companies whose assets are mainly represented by real estate located in Ukraine.
On December 11, 2015, Ukraine and Cyprus signed a protocol which could amend the current DTT and which prescribed Ukraine to tax capital gains from sale of shares if more than 50 percent of their value derived from immovable property situated in Ukraine.
However, the protocol has not been ratified by Ukraine, and its ratification has been postponed indefinitely. The possibility to withhold tax on such capital gains from foreign companies is also not provided for by current domestic Ukrainian legislation.
However, this case concerned not the indirect sale of immovable property in Ukraine, but rather withdrawal of capital, because Metallotehnika LLC did not own any real estate or other significant assets at that time (further, in 2018 the company was liquidated). The SFSU should have considered this transaction in accordance with its economic substance—that is, to recognize it as a withdrawal of capital and to tax it as dividends. Unfortunately, there is no such mechanism prescribed in current Ukrainian legislation.
In this regard the SFSU tried to recognize dependent agent permanent establishments (“DAPEs”) of the Cypriot sellers in Ukraine, since the SFSU found also that the Cypriot companies did not have any substance in Cyprus, their actual business activity was limited to ownership of corporate rights, including their purchase and sale, and several Ukrainian individuals were performing all substantial actions in Ukraine on their behalf.
The taxpayer has won this dispute for now, but the DAPE approach applied by the SFSU is a huge step for Ukraine, as there have been no previous attempts to recognize individuals or legal entities as DAPEs of foreign companies in Ukraine. Previously, there were only disputes in which the representative offices were recognized as permanent establishments ("PEs") because their activities were not limited to supporting ones.
This case is crucially important for the development of Ukrainian judicial practice as, from January 1, 2018, all transactions (including money transfers) between foreign companies and their PEs in Ukraine may be subject to Ukrainian transfer pricing rules (given the amount of such transactions exceeds 10 million Ukrainian hryvnia ($368,000) for the appropriate calendar year starting from 2018).
Despite the fact that the Ukrainian transfer pricing rules came into force in September 2013, they did not apply to PEs of foreign companies in Ukraine and the issues of profit distribution between foreign companies and their PEs until 2018.
In the period between 2014 and 2018 the SFSU considered that transfer pricing rules shall be applicable to transactions between residential Ukrainian companies and PEs of foreign companies in Ukraine; despite the fact that PEs are equal to resident companies for income tax purposes, and tax evasion could then be possible by unfair attribution of profit to PEs.
Before 2018, most PEs of foreign companies in Ukraine calculated the attributed profit under a simplified approach envisaged by the domestic Ukrainian legislation. In contrast to the approach recommended by the Organization for Economic Co-operation and Development ("OECD"), the Ukrainian simplified approach prescribes determining attributable profits to PEs as the difference between income and expenses of a PE, determined by applying a coefficient of 0.7 to the amount of income.
This approach essentially differed from that recommended by the OECD.
The issue of applying transfer pricing rules to PEs is a new phenomenon in itself for Ukrainian taxpayers. But in view of this litigation, there is an additional risk that the SFSU will also begin to recognize several individuals or Ukrainian companies as DAPEs of foreign companies if there are reasons for this. In our practice, we often meet situations in which there is such risk.
Thus, Ukrainian taxpayers and foreign companies that actually carry out their business activities in the territory of Ukraine through local individuals or legal entities may be recommended to prepare for such developments by additional analysis of their contractual and factual relationships, to eliminate the risks of identification as DAPEs.
Alina Bakulina is Partner and Head of Transfer Pricing Group with EBS, Ukraine.
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