Tax in Ukraine: 12 Questions to Ask

During the times of an economic downturn almost all businesses experience reduction in their profitability, and some businesses find themselves in a loss making position. In these circumstances, when an additional assessment for corporate income tax comes in from a tax inspector, senior management of a business raises a very logical question: “Does it make any sense, and what drives this assessment?” The answer is obvious. Not only business, but Government also suffer from the financial crisis. Ukraine, as a country, has social responsibilities to its citizens and, rightly or wrongly, the best way for the Government to fulfil them during the downturn period is to make the tax administration much more aggressive than it was in the past. As a result, we have already evidenced the Ukrainian State Tax Administration’ interpretations of the tax laws becoming more aggressive. Tax inspectors are now focused on finding extra budgetary revenues (through tax assessments) as much as you are focused on cutting the costs including tax costs. This may sound logical to some extent, but on the other hand, the economic crisis should not serve as an excuse for the authorities to broaden their interpretation of Ukrainian tax laws just to get extra budgetary inflows. We believe that this consideration is crucial for the businesses that go through the period of current economic downturn.

Despite the recent regulation regarding prohibition of non-scheduled tax audits, obviously it is advisable for businesses to ensure that they are fully compliant with the existing tax regulations during these difficult times. But it also makes an economic sense for businesses to use all the options allowed by the domestic tax legislation to manage their tax burden, and not to overpay their corporate income tax. Even for those businesses that in the past were conservative and preferred overpaying tax rather than having a tax dispute, the time has come.

Tax Issues for Senior Management

From our experience in Ukrainian market during the downturn times, tax issues listed below become even more important for businesses and require urgent attention from senior management:

“12 CORPORATE INCOME TAX QUESTIONS FOR ANY BUSINESS TO ANSWER”

• How do I report on the tax costs to the shareholders?
• What is my effective Corporate Income Tax rate in Ukraine? Does this correspond to the tax rate in my management accounts?
• Do I have the personnel of the right quality/experience and relevant corporate procedures in place to control my effective tax rate? If not, do I use professional tax consultants?
• Do I use all available (legal) domestic and international tax planning opportunities to reduce my effective tax rate?
• In particular, what is the level of my non-deductible costs? Can this be further managed?
• Do I have appropriate software to support the calculation of my effective tax rate? Is it accurate and does it reflect my needs?
• In tax disputes, do I take aggressive / prudent / conservative position? Can this be revised?
• What is my defence strategy for a potential transfer pricing assessment?
• If I have losses, do I recognize them in full and utilize them in time, or do I simply follow instructions from my tax inspector?
• Do I take advantage of the bad debt’ tax deduction available in Ukraine?
• Do I pay specific attention to the utilization of foreign exchange losses? Do I understand that while it was not important in the past, when the Ukrainian Hryvnia was stable, it becomes more important nowadays, while the tax laws are not clear?
• Do I take advantage of the accelerated depreciation / indexation of fixed assets for the tax depreciation purposes in Ukraine?

At the times of the business downturn in Ukraine, many of these issues become alarming. We discuss some of them in detail.

Transfer Pricing

Ukraine is suffering from significant changes in market prices these days. Moreover, in crisis times it is always an option to sell goods with a rebate in order to cut storage costs and improve the cash flow. When deciding on discount, Ukrainian transfer pricing rules should be considered.

According to the Corporate Income Tax Act of Ukraine of 28 December 1994, No. 334/94-VR (hereinafter - CIT Law), taxable income is calculated based on the contractual price, but cannot be lower than usual prices for goods (services). As a general rule, contract price is considered the usual price. This usual price is considered to be the fair market price if it cannot be proven otherwise. To determine the fair market price, it is necessary to compare the contractual price with the price for identical or similar goods/services in agreements concluded at the same time under similar conditions.

Thus, to demonstrate that the discount provided does not constitute taxable income the seller should be ready to prove that the price after the discount is usual for such type of discounted sales in the market. While the burden of proof that the contractual price does not satisfy the usual price requirement rests with the tax authorities, from the practical standpoint it is recommended to keep all transfer pricing documentation.

In practice, there are only a few court decisions on transfer pricing that are in favour of the tax authorities. Currently, Ukrainian tax authorities do not possess a specific methodology, databases or procedures to verify or determine fair market prices.

Significant risks should exist only if a taxpayer has internal comparables (i.e., similar goods sold to both related and unrelated parties at different prices), or if the products being sold have a clearly determinable market price (e.g., commodities traded at exchanges), and the taxpayer's prices vary significantly from the market price. Also, risk exists when selling prices of goods and services are lower than the purchasing prices or cost values and the tax authorities has evidences that the company's activity is primarily aimed at receiving of tax, not business, benefit.

Tax Loss Management

The filing of 2008 annual CIT returns has shown that many taxpayers had incurred significant amounts of tax losses as a result of the economic downturn. The expected results of 2009 filing are even worse.

At the beginning of May 2009 the taxpayers were already affected by the governmental attempt to prohibit 2008 losses carry forward for the 1st quarter 2009. Although the respective regulation did not come into force and currently there are no restrictions on utilising tax losses, there is still a risk that such limitations may be introduced in future.

There are some options available to manage this risk. The most common one is not to deduct the certain expenses in the current reporting period with their further utilization in the future. However, this method is not very transparent and requires regular management. Also the three year limitation shall be considered.

Another option to maintain tax losses is to recognize additional income in the current reporting period with deduction of relevant expenses in the future. These may be achieved, for example, by means of (1) obtaining returnable financial aid, (2) or by selling IP rights to the related party, (3) or by decrease of depreciation rates (will be analysed further). When implementing such instruments respective tax risks shall be considered.

Another important issue to consider when managing tax losses is the lack of availability of group reporting in Ukraine. This results in additional tax costs at the group level.

In practice the most known approach to deal with this issue is inter-group transfer pricing. However, this approach is lacking transparency and may be challenged by the tax authorities as the Ukrainian transfer pricing rules are discriminative. While the seller should recognise taxable income based on the contractual or market prices, whichever is higher, the purchaser is allowed to deduct expenses based on the contractual or market prices, whichever is lower. Thus, proper group structuring of profit and loss making operations is recommended.

Bad Debts

The majority of Ukrainian entities will face a significant increase in bad debts during the crisis. Legislation provides several instruments which allow a tax deduction for bad debts.

Under the general rule of the CIT Law bad debts are tax deductible provided the taxpayer has taken proper actions but failed to collect these debts from a debtor.

It is arguable what debt collection actions should be recognised as sufficient for the creditor to claim deductions. The tax authorities expressed an opinion that taxpayers are entitled to a deduction for a bad debt only when the state collection agency (after court proceedings) informed the taxpayer on discontinuing debt collection due to debtor’s insufficient assets. Due to the shortcomings in current court and collection systems, such debt collection process may take several years. However, there are grounds to be less conservative in determining the sufficiency of collection activities.

Definitely, effective deduction of bad debts could be achieved only in cooperation between tax and legal functions of the company.

The CIT Law also provides for accelerated deduction of doubtful debts by a creditor prior to the moment the debt is recognised as unrecoverable and subject for deduction as a bad debt. However, such debt may be written-off for tax purposes only after the court proceedings have been initiated by the creditor. If the creditor subsequently recovers an amount that has been deducted as a doubtful debt (and in some other cases) the amount recovered is reported as the taxable income. The procedure for such accelerated deduction is ambiguous and unclear, and, thus, each and every case should be considered carefully.

Foreign Exchange Losses

In 2008 Ukrainian Hryvnia was affected by significant changes in its exchange rate to USD. The current economic situation in Ukraine also gives grounds to expect future exchange rate fluctuations. Respective foreign exchange gains and losses may have tax consequences that the taxpayer should be aware of.

Firstly, there are grounds in legislation that in case of post-payment for imported goods foreign exchange losses on trade payables may be deducted for tax purposes. The law does not allow a taxpayer to recognise foreign exchange gains/losses on unrealised trade payables. However, in the reporting period of settlement of trade payables the taxpayer has to adjust deductible expenses by foreign exchange gains/losses based on balance value of foreign currency actually spent. At the same, time respective adjustment of the value of goods remaining in inventory must be considered (Article 5.9 of the CIT Law).

There are some other ways to make foreign exchange losses more clearly deductible. For example, the company may “convert” trade payables into an interest-bearing loan, or to settle trade payables by means of issuing a note payable. However, these options are not always easy to implement in practice.

Another issue we would like to draw your attention to is the rule that the difference between the balance value of foreign currency remaining at the bank account and the value of such currency calculated at the official exchange rate at the end of the reporting period will constitute tax gains/losses. Thus, it is recommended not to hold foreign currency at the bank accounts at the end of tax reporting period if there is expectation on Hryvnia exchange rate increase.

Depreciation

There are two main purposes of managing tax depreciation when dealing with crisis – to decrease taxable income and to utilise / manage losses.

According to the CIT Law, if the inflation index exceeds 10% in a calendar year, taxpayers may adjust the book value of their assets for tax purposes by the amount of the surplus. For example in 2009 the taxpayer could increase the tax book value of its fixed assets at 31 December 2008 / 1 January 2009 by 12.3% (the 2008 inflation index was 22.3%).

Such indexation will result in increasing depreciation charges and allowances for deduction of expenses related to repairs of fixed assets in future years. Also, in case of future sale of fixed assets the tax basis will be lower.

The law does not require that such indexation take place by a certain date and so taxpayers still could consider this option for 2009.

Another option to increase depreciation charges is provided by the Law On amendments to some of the Ukrainian Laws regarding the minimization of impact of financial crisis on the development of domestic industry of 18 December 2008, No. 694-VI. According to the law, accelerated 25% rate depreciation is applicable for the group 3 of fixed assets of the industrial enterprises.

However, the application of this rule may be problematic in practice because of unclear definition of “industrial enterprises” and charge basis (i.e., 25% per year or per quarter). First clarifications from the tax authorities are very conservative and we would expect future development of the practice.

If the company is in a loss making position there is no benefit in applying maximum tax depreciation rates, but only risk of losing tax losses and reducing future potential inflation adjustment. The CIT Law allows such taxpayers to claim depreciation at rates lower than those set by law.

For 2009 such an election should have been submitted together with the tax return for the 1st quarter of the tax year (i.e. by 12 May 2009).