Posted by Constantine M on August 29, 2004 at 06:55:04:
by Gennadiy E. Voitsitskiy
The aim of this article is to give a general overview of the structure of international taxation in Ukraine. For the purpose of such an overview, the tax practices of such leading world economies as the United Stated, the United Kingdom, Japan, The Netherlands, Germany, Canada and France are taken as the point of reference. Part 1 of this article reviews issues related to the assertion of the taxing jurisdiction on the basis of residence. Part 2 considers the structure of source-based taxation. Finally, Part 3 reviews some selected additional international issues.
1. Residence taxation
Basis for assertion of personal
Under applicable Ukrainian legislation, the determination of residence rests on the combination of objective and facts-and-circumstances tests, supplemented with a mechanical test based on the number of days present in Ukraine. For the purposes of personal income tax residence is not connected with residence in terms of immigration status.
An individual is resident for tax purposes if such an individual has his/her (i) place of residence in Ukraine, or (ii) permanent home in Ukraine, if such individual also has a place of residence in a foreign country. In the event of a permanent home being available to him/her also in a foreign country, such an individual would be deemed a Ukrainian tax resident if he/she has (iii) closer personal or economic relations with Ukraine (center of vital interests). If a country with which such an individual has closer personal or economic relations cannot be determined or such an individual does not have a permanent home available to him/her in any country, he/she would be deemed a tax resident of Ukraine if (iv) physically present in Ukraine for not less than 183 days (including days of entry and departure) in the relevant calendar year. If the residence cannot be determined on the terms described above, such an individual would be regarded as a tax resident of Ukraine if he/she is (v) a citizen of Ukraine. The aforementioned notwithstanding, an individual may (vi) elect to be considered as having a permanent home in Ukraine. Under such circumstances, an individual would acquire tax residency in Ukraine even if such an individual fails to satisfy any and all of the tests described above.
Of the two basic approaches, which are used in the tax world to establish a personal jurisdictional connection of corporations, i.e.: (i) formal legal connection to the jurisdiction, e.g., place of registration, incorporation or registry in commercial/banking/trade register, and (ii) economic and/or commercial connection to the jurisdiction, e.g., place of central management and control, residence of shareholders or principal business location, Ukraine has adopted a formal test approach which focuses on registration under applicable Ukrainian legislation.
Change of status
— Change of status of individuals
The change of status of individuals has to be considered from the standpoint of the “receiving” country and the “departing” country. Ukraine, as a “departing” country, does not regard the termination of residence as a sale event, i.e., when an individual ceases to be a resident he/she is not deemed to have disposed of the property. The departing taxpayer is taxed on his/her worldwide income (subject to any tax relief available under an applicable tax treaty) received or accrued before departure and not yet taxed in Ukraine. Ukraine does not generally extend its tax jurisdiction to former residents. Ukraine, as a “receiving” country, has no special tax rules pertaining to the establishing of resident status.
The applicable Ukrainian company law does not recognize the concept of “continuation of legal personality”, under which a Ukrainian corporation would be formally “continued” into a foreign jurisdiction. To be (re)incorporated in a foreign jurisdiction, a singular Ukrainian corporation will have to be liquidated with the attendant consequences to the corporation and shareholders. The assets to be distributed to shareholders upon liquidation and contributed to the non-resident corporation would be treated, for the purpose of applicable Ukrainian tax legislation, as a regular outbound transaction.
Mechanism for relief
of double taxation
If residence-based and source-based taxation claims are asserted on the same item of income, such income bears the burden of double taxation. The established practice distinguishes three main approaches to eliminating double taxation. The residence country may eliminate double taxation through either (i) a credit mechanism, i.e., the residence country grants foreign tax credit for foreign taxes paid on such foreign-source income; (ii) an exemption mechanism, i.e., the residence country exempts income earned from foreign jurisdictions from domestic tax; it allows the source country’s taxation to be the final taxation of international investment; or (iii) deduction mechanism, i.e., foreign taxes paid on foreign-source income are treated as a regular cost of doing business and are allowed to be deducted from taxable income of a domestic corporation.
The applicable Ukrainian legislation allows credit for foreign taxes paid on income obtained from a foreign source.
Issues in the structure
of a foreign tax credit system
— Creditable taxes
Ukraine allows foreign tax credit for income taxes paid on foreign-source income. Ukraine does not provide for the definition/description of creditable foreign income taxes, but rather specifically lists taxes that are NOT creditable against Ukrainian income tax liability. The following foreign taxes are not allowed to be credited: (i) tax on capital (property) and on the accretion of capital; (ii) stamp taxes; (iii) turnover (sales) taxes, (iv) other indirect taxes irrespective of whether they come under the category of income taxes, and (v) amounts of taxes paid on passive income (dividends, interest, insurance or royalties).
— Limits on the credit
Almost all developed tax jurisdictions limit the extent to which foreign tax paid on foreign-source income can displace domestic tax liability. Usually, creditable foreign income tax may not exceed the amount of domestic tax, which would have been levied on the relevant foreign source income.
The applicable Ukrainian corporate profits tax legislation limits the amount of creditable foreign taxes paid on foreign-source income by “an amount of tax that is due in Ukraine” in the relevant tax reporting period. Thus, it would be fair to suggest that the applicable legislation allow “averaging” between high-taxed and low-taxed foreign income and allow credit in full provided that the domestic tax is not exceeded. However, from the reading of the statutory language it is not entirely clear whether the creditable amount is limited by the amount of the domestic tax liability, which is computed on the worldwide basis, or, alternatively, by the domestic tax liability, which is due with respect to such foreign source income. A literal interpretation of the applicable legislation suggests that neither carry-forward nor carry-back is allowed for excess foreign tax credits.
The applicable Ukrainian personal income tax legislation forbids dual citizenship. In this respect an individual, who, in violation of such a prohibition, in addition to Ukrainian citizenship possesses the citizenship of another country, under applicable personal income tax legislation is denied foreign tax credit for foreign taxes paid on foreign source income.
2. Source Taxation
— Issues in the structure of net
basis taxation of business income
Ukraine extends its tax jurisdiction primarily on the basis of residence taxation. In addition, Ukraine claims its jurisdiction over income, which arises in Ukraine whether in the form of (i) business-type income, or (ii) investment-type income. With respect to business-type income, Ukraine claims tax over net income (computed with the allowance of deduction and depreciation allowances), whereas under the investment-type income, Ukraine claims tax over gross income, which is collected through the mechanism of a withholding tax. Applicable tax treaties on the avoidance of double taxation often modify Ukrainian domestic rules pertaining to the taxation of business-type and investment-type income. Presently, Ukraine has a network of around fifty treaties, most of which are based on the Model OECD Treaty.
— Threshold of activity
Income from business operations is taxed in Ukraine on a net basis when such operations reach a certain level. Ukraine taxes a foreign taxpayer if and when such a foreign taxpayer has a “permanent establishment” in Ukraine. The concept of the permanent establishment, as used in applicable Ukrainian legislation, is very similar to the concept used in tax treaties, and encompasses a fixed place of business and dependent agents. Importantly, certain categories of income are taxed in Ukraine on a net basis even in the absence of the permanent establishment, namely income from trade operations with securities and corporate rights.
— Attribution of business income
for net basis taxation
Having achieved the applicable threshold for taxation, the next question is what items of income are sufficiently associated with such a permanent establishment to be subject to net basis taxation. In the tax world, income is attributed to the permanent establishment either according to the (i) “direct” method, which attempts to allocate a particular item of gross income to the permanent establishment2, or (ii) “indirect” method, under which the net income of the foreign corporation is allocated to its various geographical locations. The allocation may be made on the basis of turnover, assets, payroll or other similar factors. The “direct” method further distinguishes between several approaches, on the extreme ends of whose continuum are (i.i) “actual economic connection” approach, and (i.ii) the “force of attraction” approach. As the name suggests, the first-mentioned approach focuses on the actual economic connection between a particular item of income and the permanent establishment. Under the “force of attraction” approach, all domestic source income is attributed to the permanent establishment, irrespective of whether the relevant item of income is in fact economically connected with the activity of such a permanent establishment. This approach requires an elaborated set of source rules, for the difference between domestic and foreign source becomes decisive as to whether an item of income is taxable to the permanent establishment on the net basis.
Ukraine’s experience in the net base taxation of permanent establishments is somewhat unique as the applicable legislation allows, in the order of preference, using either the “direct”, “indirect”, or so-called “coefficient” method. Generally, an item of income is attributed to the permanent establishment according to the “direct” method, whereby the permanent establishment is taxed only on the active income attributable to it and on passive income effectively connected with it. Under the “indirect” — a second best — method, the net income of the foreign corporation is allocated to its Ukrainian permanent establishment on the basis of a “separate balance sheet”. Finally, under the “coefficient” method, the net basis income of the permanent establishment is determined as the difference between its actual gross income and derived gross expenses, which, in turn, are computed by applying the coefficient 0.7 to the gross income (or, formulary, X minus 0.7X).
— Determination of deductions in the net basis taxation of business income
As with the attribution of business income, in determining deductions in net basis taxation the (i) “direct” and (ii) “indirect” methods of cost allocation also apply. The “direct” method focuses on the economic connection between the expense and domestic activity. Under the “indirect” method, expense is allocated on a factors-based formulary basis.
In Ukraine, the determining of deductions depends on which of the three methods, i.e., “direct”, “indirect”, or “coefficient”, applies in the attribution of income to the permanent establishment. The permanent establishment, assimilated under the direct method to an independent enterprise, takes deductions related to its Ukrainian activity, which, however, does not preclude expenses undertaken outside Ukraine. The deductions under the “indirect” method depend on the relevant factors, as agreed with the Ukrainian tax authorities. Finally, as discussed above, the “coefficient” method’s deductions are equal to 0.7 of gross income of the permanent establishment, irrespective of its actual expenses.
So-called “self-charged” expenses for payments and transfers made by the permanent establishment to its head office deserve separate mention. The relevant Ukrainian legislation does not give a clear-cut answer as to whether or not such expenses are deductible to the permanent establishment for the purposes of net basis taxation. However, it would be fair to suggest that only expenses which are actually paid or accrue to third parties, would support deductibility. As a permanent establishment is a dependent part of a foreign corporation, contractual arrangements between the permanent establishment and the head office are not accepted; whereas deductibility must be supported by the valid documentation.
Issues in the structure of gross
Ukraine imposes a 15 % gross-based withholding tax on a statutory catalogue of Ukrainian source income categories when paid by a Ukrainian resident or permanent establishment to a non-resident. The income subject to withholding is typically investment-type income that is deemed to have a domestic source. A withholding tax is also imposed on artistic, sporting and cultural activities. Importantly, Ukraine also imposes a withholding tax on business-type income derived from carrying out (i) joint activity (without forming a domestic legal entity), or (ii) long-term contracts, on the territory of Ukraine. Ukrainian source income is subject to withholding by the payer and the withheld amount functions as a final tax. The 15 % rate withholding may be reduced in accordance with an applicable double tax treaty concluded between Ukraine and the respective jurisdiction.
Branch profits tax
It is a generally established practice in the tax world that dividends, which are paid by a domestic corporation to its non-resident shareholders, are subject to a gross-based withholding tax. However, with regard to the remittance of profits from a permanent establishment activity, the approach of individual nations differs. Thus, some countries do not subject the remittance of such profits to any further source-based taxation. Yet another country, in order to eliminate the difference in treatment of alternative investment structures, imposes tax on the branch income of foreign corporations.
Ukraine does not have a formal branch tax. However, the aforementioned statutory catalogue of Ukrainian source income categories, which are subject to a 15 gross-based withholding tax, contains a “catch-all” clause, which refers to “other profits [derived] by a non-resident (a permanent establishment of such or another non-resident) from carrying out business activity on the territory of Ukraine”. Having regard that, as noted above, business-type income from carrying on (i) joint activity, or (ii) long-term contracts, on the territory of Ukraine, is explicitly subjected to the withholding tax, it would be fair to suggest that the remittance of profits from a permanent establishment activity is likely to be subject to withholding by virtue of the “catch-all” clause.
Limitation on base-eroding payments to non-residents
Tax treaties usually reduce or even eliminate the gross basis taxation of certain types of income. If the relevant type of income is, in addition, deductible for the purpose of net basis taxation, there is a clear incentive for a taxpayer to reduce — to the maximum extent possible — the net basis tax base by increasing deductible expenses. The main techniques employed in countering such base-eroding payments are (i) “thin capitalization” rules, and (ii) “earning stripping” restrictions. The “thin capitalization” rules restrict or even disallow the deduction of interest paid by domestic corporations to foreign shareholders when a debt-equity exceeds certain ratio(s). “Earning stripping” rules, in turn, limit the extent of the interest deduction when interest payment is deemed excessive in relation to domestic income
In Ukraine, no “thin capitalization” rules apply to non-residents.
However, “earning stripping” restrictions do apply. The restrictions are not limited to payments of interest to related parties; they apply to interest payments made by (i) a Ukrainian borrower, which is, directly or indirectly, at least 50 % foreign-owned, to (ii) a lender, which is, directly or indirectly, at least 50 % foreign-owned (i.e., whether resident or non-resident). If both conditions (i) and (ii) above are satisfied, an “excess” interest expense of a borrower, defined as interest in excess of 50 % of the borrower’s adjusted taxable income for the reporting period, will be not deducted currently but can be carried forward and deducted in later period(s), subject to the 50 % limitation in such period.
3. Additional international topics
Many countries apply, in both international and domestic tax matters, various anti-avoidance techniques, including the (i) substance-over-form and “step-transactions” principles, which enable the re-characterizing of tax motivated inter-related financial arrangements, (ii) anti-dividend stripping rules, (iii) the theories of abuse of law and abnormal management decision.
In Ukraine there are some precedents of courts applying the substance-over-form principle. However, this principle is not statutorily embodied in tax legislation.
However, the applicable tax statute embodies anti-avoidance rules, which limit to 85 % the deduction from the income tax base of payments for goods (works, services) made in favour of a seller, which is established in a low-tax jurisdiction, or to an account in a financial institution in such a jurisdiction.
Selected inter-company pricing issues
Dealings between related parties, i.e., controlled transactions, must be undertaken at arm’s length. A controlled transaction meets the arm’s length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances. Most countries follow, with regards to intercompany pricing, the general framework of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations.
In Ukraine, “comparable uncontrolled price” is the principal method for the purpose of arriving at the arm’s length price. The “resale price” and “cost-plus” methods are limited in their application to prices of natural monopolies. The applicable tax law does not recognize profit-based methodologies of the OECD Transfer Pricing Guidelines.
Selected treaty issues
Tax treaties of Ukraine are broadly based on the OECD Model Convention, despite the fact that Ukraine is not a member state of the Organization of Economic Cooperation and Development.
Under the Constitution of Ukraine, statutory law and (tax) treaties are of equal status. However, tax legislation recognizes the superiority of international tax rules over domestic tax rules. As a consequence, in the event of conflict between domestic legislation and treaty provisions, the latter prevail. Treaty obligation may not be overridden by the latter, inconsistent domestic legislation. Ukraine gives effect to treaties through acts of Parliament.
Some, but not all, of Ukraine’s tax treaties contain a limitation of benefit, or anti-treaty shopping, article, which focuses on economic connection between a “resident” corporation claiming treaty benefit and the foreign jurisdiction. There is major scope for treaty shopping related to the use of treaties by residents of non-treaty countries.
Almost all Ukraine’s tax treaties contain a non-discrimination article guaranteeing national treatment of domestic corporations owned by non-resident shareholders. The article’s formal coverage follows the general outline of the OECD Model Convention article. ¢
1 This article is written following the general structure of Hugh Ault’s Comparative Income Taxation: A Structural Analysis, The Hague: Kluwer Law International (1999), pp. 368-480
2 Other domestic thresholds for taxation may take the form of either “trade of business”, as in the United States and France, or “business activity”, as in Canada. However, most countries use a permanent establishment as a threshold for taxation, including, Germany, the Netherlands, Japan, Sweden etc.
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