Definition of business purpose according to Law 466-IX

Ukrainian Tax Code has contained the definition of the reasonable economic purpose (business aim) of transactions since its adoption back in 2010. Yet, this definition was unclear, and the ways of its practical application were limited.

Law 466-IX, which came into force in May 2020, introduced comprehensive changes into the Tax Code of Ukraine, including implementation of BEPS three-tier reporting standard. Alongside these important changes, the rules on business purpose were amended as well.

According to the definition, “reasonable economic purpose (business aim)” is the purpose that may occur on condition that a taxpayer aims at reaching certain economic goal in the result of business activity. Law 466-IX supplemented this definition with the explanation on what such economic goal may be and what transactions should be deemed as not having “reasonable economic purpose”. An economic goal (effect) particularly but without limitation should mean increase (saving) of the taxpayer’s assets and/or of their value in future.

At the same time, for taxation purposes, a transaction with non-resident is considered not have a reasonable economic purpose if:

• its principal aim or one of them is non-payment (underpayment) of taxes and/or decrease of the profit tax base;
• in comparable circumstances an entity would not be prepared to sell (purchase) such goods, works or services, intangible assets, or other items to (from) an unrelated party.

The Law 466-IX also specified how the business purpose test may impact the tax position.

Thus, new adjustment of the profit tax base was introduced into Article 140.5 of the Ukrainian Tax Code. According to it, the taxpayer shall increase the amount of taxable profit by the amount of expenses, incurred in transactions with non-residents if such transactions lack business purpose. The burden of proof in this case is levied on the tax office.

In other words, in the version of Law 466-IX, the test was applicable to any purchases from non-residents. And if the tax office challenges the reasonable economic purpose, such expenses may be disregarded when calculating the profit tax base.

Amendments by Law 1117-IX

However, such rules were amended by the Law 1117-IX, which came in force on 1 January 2021. According to these amendments, the test is applicable only to transactions with non-residents subject to transfer pricing (TP) control, transactions on payment of royalty, and transactions with non-residents that fall under the list of “low tax” states (territories) or the list of organizational forms of non-residents (covering fiscally transparent entities), adopted by the Cabinet of Ministers of Ukraine.

The Law also introduced the changes to the way of application of the test in Ukraine. Thus, in terms of TP control, the analysis of the business purpose was extended and now also implies analysis of the alternative options available to the parties acting with commercial rationality if they were not related. In addition to non-recognition of a transaction for taxation purposes, the tax authorities received the right to substitute the conditions of the transaction between related parties with an alternative transaction they deem commercially rational given the facts of the case.

New business purpose test rules for transactions with non-residents that fall under the list of “low tax” states (territories) or the list of organizational forms of non-residents (covering fiscally transparent entities) will be in force from 1 January 2022.

According to the current rules transactions with such non-residents are subject to special 30% adjustment. This adjustment means that the profit tax base should be increased by 30% of the value of the goods (services) purchased from or supplied to such non-residents unless taxpayers proves that the relations are at arm’s length (although such transactions are not subject to standard TP rules).

From 2022 the Ukrainian tax authority will receive the right to also control the business purpose of such transactions. And in case the tax authority finds that a transaction lacks reasonable economic purpose, the profit tax base would be increased by the entire value of the goods (services) thus purchased or supplied. In other words, absence of the business purpose would effectively mean 100% adjustment on transactions with such listed non-residents.

It is advisable not to ignore these new rules and get properly prepared as the tax implications may be material.

If you would like to know more about the new business purpose test in Ukraine, please visit the homepage of WTS Tax Legal Consulting, LLC, the exclusive representative of WTS Global in Ukraine.

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Transfer pricing rules before 2018

Transfer pricing (TP) rules were implemented into Ukrainian tax law from 2013. However, before 2018, permanent establishments (PEs) were a blind spot for TP control.

According to the Tax Code of Ukraine, non-residents that conduct business activity in Ukraine via a PE pay corporate profit tax. However, TP rules that were in force before 2018 did not provide any special rules for PEs. It was unclear whether PEs in Ukraine are subject to TP reporting requirements alongside regular corporate profit tax reporting, and what transactions of PEs in Ukraine may be recognised as being subject to TP control.

It was clear, however, that the Ukrainian TP rules lacked any legal basis to control dealings between PEs and non-residents establishing such PEs. This was due to the definition of controlled transactions for TP purposes, which did not provide grounds to extend the control to dealings between parts of the same legal entity.

This ambiguity meant that PEs of non-residents mostly ignored TP control in Ukraine, even though, under the rules existing before 2018, some PE transactions might have been recognised as being subject to TP control: for instance, if a PE had dealings with a foreign related party of the non-resident that established the PE.

Introduction of TP reporting for PEs in Ukraine

Starting from 2018, Ukrainian TP rules were supplemented with the new type of controlled transactions, namely, transactions between a non-resident and its PE in Ukraine. The Ukrainian Tax Code prescribes a special value threshold for recognising such transactions as controlled, namely UAH 10 million (roughly EUR 305,000), without applying the turnover-based threshold which is provided for enterprises.

Thus, 2018 became the first TP reporting period for PEs in Ukraine.

However, there was still some ambiguity due to the lack of proper guidance from the Ukrainian authorities on how PEs in Ukraine should conduct the analysis in practice and comply with the reporting requirements. Moreover, it was unclear how the results of such TP analysis may be applied to the corporate profit tax base calculation.

The Tax Code of Ukraine (sub-para.141.4.7) provided for the following options to calculate profits that non-residents derive through their Ukrainian PEs:

• The profit is calculated according to the general rules of the Tax Code, assuming that the PE is deemed a taxpayer separate from the non-resident and operates independently.
• If a non-resident operates both in and outside of Ukraine and does not determine profit derived from Ukraine, a separate balance sheet for its Ukraine-related activity should be prepared. This balance sheet should be approved by the tax authority at the location of the PE.
• If it is impossible to reliably calculate the profit sourced in Ukraine, then the profit is calculated as Ukraine-sourced income of the PE less costs, calculated by applying a 0.7 coefficient to such income. In other words, the profit is effectively calculated as 30% of the income received by the PE without needing to allocate and prove costs related to the PE activity.

PEs filed special reports to declare their profit tax liabilities using one of the mentioned methods. Many PEs opted for the approach calculating profit as 30% of income due to its simplicity.

After extending TP control to dealings between non-residents and their PEs in Ukraine, the above rules were supplemented with the reference that the profit under all such methods should be calculated with due regard to Ukrainian TP rules. It was not clear though how such rules should have been applied for the cases when the profit is calculated as 30% of income.

Recent changes to calculation of profit

The rules of profit calculation by PEs in Ukraine were changed once again by Law #466-IX, which came into force in May 2020. From this date onwards, the special rules of profit calculation by PEs, including the calculation method applying the 0.7 coefficient, were deleted from the Tax Code.

Instead, the new rules stipulate that the profit should be calculated following the arm’s length principle. Such profit should be in line with the profits of independent entities carrying out the same or similar activity as if such PE operated separately from the non-resident. The amount of any profit should be calculated according to Article 39 of the Tax Code setting forth Ukrainian TP rules.

Two-step analysis recommended

Yet this change has not made the situation clearer. Ukrainian TP rules are primarily designed for application by enterprises and do not contain any special rules which may be followed by PEs to determine their profits. Also, there is no official clarification from the authorities so far.

We understand that the only reliable way would be to follow the OECD-authorised approach to allocate profits to PEs. It implies that the two-step analysis should be carried out:

• firstly, hypothetical dealings between the non-resident and its PE should be identified, and
• secondly, such dealings should be priced by applying TP methodology.

Ukrainian taxpayers are required to file corporate profit tax returns quarterly (with some special exceptions). Therefore, it is likely that the forward-looking TP analysis should be implemented, otherwise, in many cases PEs in Ukraine would lack the information necessary to draft the return.

Yet these are just preliminary thoughts on the matter. Hopefully, taxpayers will receive proper clarification from the authorities very soon.

Clarification still required

Such clarification is desperately required due to the lack of appropriate transition rules in Law #466-IX. This change occurred in the middle of the year and a lot of PEs have already reported their profits for the first quarter applying the previous mechanisms. So, the question arises of how to file the reports after the changes. Thus far, the tax authorities have just recommended filing the ordinary profit tax return instead of the report on profit of the PE. However, the tax authorities have not shared their vision on how the data from previously filed reports should be transferred to such regular profit tax returns. This is especially important in the cases when the profit was calculated as 30% of income.

Hopefully, the authorities will very soon produce clear guidance that can be followed. Otherwise, the only option for PEs in Ukraine would be to use the results of the TP analysis for previous years and adapt these for the current profit tax reporting. If a PE has not conducted any such analysis, it is highly recommended to do so urgently.

If you would like to know more about the latest TP-rules for PEs in Ukraine, please visit the homepage of WTS Tax Legal Consulting, LLC, the exclusive representative of WTS Global in Ukraine.

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