Tax Aspects of Land Transactions

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Svetlana Bilyk, Senior Tax Manager
Valery Ilchenko, Senior Tax Consultant
PricewaterhouseCoopers

High projected returns on investments in the Ukrainian land market make it extremely attractive for investors. However, actual returns on investments may turn out to be substantially less than projected due to inaccurate analyses of tax implications.

Benjamin Franklin once said, "In this world nothing is certain but death and taxes". At the same time, despite of the inevitability of tax payments, practice has repeatedly demonstrated that those who do not know the law pay taxes for those who know it very well.

In view of this, the principal objective of this article is not just to guide you through the general tax issues arising upon land transactions, but also to consider the tax planning strategies that could allow you to achieve significant tax savings.

Brief overview of taxes applicable to land transactions

Under Ukrainian legislation, the following taxes may apply to land transactions:

• Corporate profit tax: capital gain realised by a Ukrainian resident on a sale of land or shares in a company holding land is taxed at 25%.
• Withholding tax: capital gain realised by a non-resident on a sale of land or shares in a company holding land is subject to withholding tax at 15%. Effective double tax treaties (DTT) may provide tax relief for capital gains on sales of shares in a company holding land, but not the land itself.
• Value added tax: land is generally exempt from VAT except when the value of the land is included in the value of the real estate object (in the latter case, VAT at 20% rate applies).
• Stamp duty or notary fees: minimum 1% of the value of land specified in the sale-purchase agreement.

Based on an analysis of specific cases, we will consider the tax consequences of various structuring options available to both residents and non-residents.

Sale of land as an asset

а) Tax consequences of sale for a resident

Capital gains (selling price less acquisition costs) realised by a Ukrainian resident entity on a sale of land will be subject to corporate profit tax at 25%.

b) Tax consequences of sale for a non-resident

Capital gains (or potentially all income, if there is no DTT in place) realised by a non-resident on a sale of land will be subject to withholding tax at 15%. The DTTs promulgated by Ukraine do not allow this tax to be reduced. However, the proper tax structuring of a sale transaction could avoid payment of this tax.

It should be noted that Ukrainian tax legislation does not contain a mechanism to collect withholding tax, if the buyer of land is a non-resident entity that has no registered presence in Ukraine. At the same time, payment of withholding tax due may be required by a Ukrainian bank, provided the settlements for land between two non-residents are made through Ukrainian bank accounts.

In some cases, settlements for investment objects (e.g., land) between two non-residents can be made through accounts in foreign banks. However, we stress that this is possible only in a limited amount of cases.

c) Attractiveness of an asset deal for a buyer

An asset deal is generally an attractive route for a buyer of land to follow. This is because the buyer will not inherit any contingent liabilities existing in the Ukrainian asset holding company.

Furthermore, if a Ukrainian company finances the deal by way of interest bearing borrowings, interest on such borrowings should be tax deductible, provided the land is to be used in the business activities of the company. Should the value of land be significant, a tax deduction of these interest expenses would result in substantial tax savings, as long as the debt financing is properly structured.

It is generally recommended for a non-resident to acquire land through a special purpose vehicle rather than directly. This is justified by the ability to structure future exit from a Ukrainian project in a tax efficient manner and certain considerations of a regulatory character (e.g., legal restrictions on non-residents preventing them from holding certain categories of land, difficulties with obtaining construction permits and other documentation etc.).

One of the key factors underlying the tax efficiency of the holding structure is the choice of an appropriate jurisdiction to locate the company that will hold shares in the Ukrainian company. In practice, Cyprus is the jurisdiction most frequently used for this purpose, but there are other efficient alternatives. Careful consideration of all options has become especially crucial in light of the renegotiation of the existing Ukraine-Cyprus DTT.

d) Stamp duty

The transfer of land attracts a stamp duty (notary fees) at the rate of not less than 1% of the contract value. The law does not specify which party is liable for the payment of the stamp duty. Generally this is subject to negotiations between the contracting parties.

e) Practical aspects

Asset deals are not common in Ukraine, mainly due to the negative tax implications arising for the seller.

Sale of shares/corporate rights in a land company

a) Tax consequences for a resident

Capital gains arising on a sale of shares/corporate rights by a Ukrainian resident are computed in accordance with the so-called ‘’pooling method’’. Under this method, income and expenses from transactions with shares/corporate rights are recognized in the respective pool. If the aggregate income from shares/corporate rights exceeds the aggregate expenses incurred on the acquisition of the shares, the excess is treated as ordinary income subject to 25% corporate profit tax. A negative result is not tax deductible, but carried forward to offset future income from trading in shares.

The above-mentioned accounting rules for transactions with shares/corporate rights allow minimise the tax liability of a Ukrainian resident. The resident achieves tax savings by using the proceeds arising on the sale to acquire shares/corporate rights in other affiliated entities during the same reporting quarter. To ensure the intended tax efficiency, the seller of these shares/corporate rights should be either a non-resident company, incorporated in a jurisdiction with a favourable tax regime (e.g., Cyprus), or a Ukrainian investment fund that is exempt from tax under Ukrainian domestic legislation. Alternatively, the Ukrainian resident can acquire the shares/corporate rights from another Ukrainian resident that has sufficient unutilised losses from transactions with shares/corporate rights. Transfer pricing regulations need to be carefully considered.

We stress that the acquisition of shares/corporate rights should not be undertaken at the primary market (i.e. primary issuance of shares), as this may have negative tax consequences.

b) Tax consequences for a non-resident

Under Ukrainian domestic legislation, capital gains on sale of shares in Ukrainian companies are subject to 15% withholding tax in Ukraine unless exemption from tax is available under a relevant tax treaty.

The list of Ukrainian DTTs that exempt sales of shares in Ukrainian companies holding real estate includes treaties with Cyprus, the Netherlands (exemption only for land used in industrial, commercial, agricultural activity), Slovakia, Turkey and some other jurisdictions.

Therefore, the sale of shares in a Ukrainian company holding land can be exempt from tax in Ukraine, provided the non-resident is a tax resident of a jurisdiction with a favourable DTT.

In practice, Cyprus is most commonly used for structuring investments in the Ukrainian real estate market, including land. This is due to the combination of a unique DTT with Ukraine (does not allow Ukraine to impose tax on profits received by Cypriot residents in the form of interest, dividends or capital gains from sale of shares in Ukrainian companies) and a favourable tax regime in Cyprus. In particular, under Cypriot domestic legislation, income from transactions with securities (e.g., shares in Ukrainian companies) is generally exempt from corporate income tax. Hence, the sale by a Cypriot resident of shares/corporate rights in a Ukrainian company will not be taxed in both Ukraine and Cyprus!

The Ukrainian government intends to replace the existing DTT with Cyprus with a less favourable one. The latest available draft of this new DTT allows Ukraine to impose withholding tax on sales of shares in companies that derive their principal value from real estate (land) located in Ukraine. If the new DTT with Cyprus becomes effective, additional structuring will be required to ensure tax free exit from Ukrainian projects.

c) Attractiveness of share deal for a buyer

The acquisition of a company holding a land plot implies the inheritance of all contingent liabilities of this company by the buyer. Thus, a due diligence of the target company is required to reveal any potential exposures prior to concluding the deal with the seller. Also, due diligence allows the buyer to adequately assess the target and require the seller to mitigate the revealed risks. Possibly, the buyer will also succeed in convincing the seller to decrease the deal price.

Debt financing of the acquisition of a Ukrainian company holding land is more beneficial than equity financing. At the same time, additional structuring may be required to ensure that interest expenses result in maximum reduction of tax liabilities.

In theory, a share deal is less preferable for the buyer if compared with an asset deal. Nevertheless, purchasing a company may be an acceptable form of the deal for the buyer, provided the deal is structured in a tax efficient manner and the target is properly assessed.

d) Stamp duty

The sale of shares/corporate rights is not subject to a stamp duty.

e) Practice of utilization

Generally, sellers are more willing to undertake share deals rather than asset deals. This is justified by the possibility to avoid taxes on income arising from the sale. Given that the land market is predominantly a seller’s market, the share deal is the most widely used option.

Conclusions

Having analysed various options for structuring land transactions, we conclude that there are a number of tax planning methods that minimise tax costs when undertaking land transactions in Ukraine.

However, in order to take advantage of these methods, careful analysis of the individual facts and circumstances of each particular case is required. In practice, it often happens that the application of traditional tax planning methods is difficult or even impossible due to insufficient analysis of tax and legal issues at the initial stages of investment projects. In such cases, a complicated and sometimes expensive pre-sale restructuring is generally required.

In this respect, we strongly recommend that you carefully consider tax consequences of investment projects at the initial stages in order to reap the rewards later!