On 16 January 2020 Ukrainian Parliament adopted draft Law No. 1210 (the "Law"), putting an end to many years of debate over which direction the Ukrainian tax reform shall take. The choice was made in favor of the BEPS plan and increasing tax transparency.
The Law has already been submitted for the President's signature. If signed, it will substantially change the existing rules for Ukrainian companies and individuals, as well as for foreign investors. The Law will come into force on the day following its official publication. However, the most crucial changes will be coming into force in several stages, the final of which should be 1 January 2021.
Below we address the new tax rules in respect of controlled foreign companies ("CFC"), which we believe to be one of the most interesting developments for Ukrainian taxpayers.
What are the CFC rules?
The CFC rules serve a useful tool allowing the countries to tax the profits of foreign companies (including partnerships and trusts) controlled by their residents. The CFC rules first appeared in the USA in the second half of the XX century. More than 40 countries have similar laws today.
Why do we need the CFC rules?
Consider these rules on the example of Andrew. Andrew permanently resides and works in Ukraine. It means that it is in Ukraine, where he has to pay all his income taxes (including those on income received abroad).
Andrew owns some real estate in Monaco and stock in foreign corporations. These assets generate approximately EUR 2 million in profits annually. Although Andrew owns these assets, he decided to formally convey them to his company in the British Virgin Islands (BVI). The company has zero staff and resources, and Andrew, as before, has full de facto control over all the assets. At the same time, from the Ukrainian tax perspective it is not Andrew who earns the income, but his BVI company. That is why Ukraine does not tax those incomes until they are distributed to Andrew. This BVI entity serves as a nominal owner, artificially buffering Andrew from his foreign profits.
Such "artificial" structuring allows Andrew to make profits without paying taxes in Ukraine until the formal distribution of funds in his favor (e.g., dividends). Practically-wise, such distribution may be postponed indefinitely or occur after Andrew becomes a tax resident in another country with low or zero tax. This would allow him to avoid Ukrainian taxation entirely. Simultaneously, Andrew and his company also do not pay taxes in the BVI since no applicable tax exist there.
It is precisely the kind of tax structuring that the CFC rules are targeting by allowing to "neglect" a separate tax status of a foreign company and viewing its profits as being earned directly by the "controller" (i.e., Andrew). So, as a result, the EUR 2 million profits of the foreign company are automatically considered to be Andrew's taxable income in Ukraine (regardless of whether they were distributed to Andrew).
What is CFC?
To understand how the CFC rules operate, one must first determine what may be considered a CFC. For the Ukrainian tax purposes, it is either a foreign legal entity (a company) or an entity without legal personality (e.g., a trust or partnership). To be treated as CFC these have to be "under control" of a Ukrainian resident (either an individual or a company).
The "control" test is satisfied if a Ukrainian resident:
a) independently holds more than 50% of shares in a CFC; OR
b) holds more than 25% (10% after 2023) of shares in a CFC, provided that together with other Ukrainian residents she owns at least 50% of such shares (irrespective of whether these residents are related or not); OR
c) solely or jointly with other related Ukrainian residents effectively controls a CFC.
The rules allowing to identify control over a foreign entity are very broad and catch-all. For instance, if a foreign bank has a record of a Ukrainian resident being an ultimate beneficial owner of the company, this will be a sufficient evidence of control for Ukrainian tax purposes.
In general, if control de facto exists (even if it is formally absent or hidden), it will be very difficult to avoid the CFC rules.
Is it possible to avoid/reduce the taxation of CFC's profits?
Yes, that is possible. The CFC's profits are expected to be released from the Ukrainian tax if at least one of the following conditions is met:
a) Ukraine has a double tax treaty with CFC's country AND either one of the following criteria is satisfied:
- CFC actually pays corporate tax at an effective rate of 13% or higher, or
- the share of CFC's passive income (dividends, interest, royalties, income from securities trading, etc.) does not exceed 50%;
b) the total combined income of all CFCs controlled by a Ukrainian resident does not exceed EUR 2 million a year;
c) CFC is a publicly-traded company listed on a recognized stock exchange;
d) CFC is a charitable organization.
Important. CFC rules are primarily aimed at taxing passive incomes. Profits of companies engaged in active trade or business should not be taxed in Ukraine provided that such companies are registered in countries that have a double tax treaty with Ukraine.
However, even if the profits of CFC are exempted from Ukrainian tax under the above rules, the Ukrainian resident is still required to report such CFC and its profits to the tax authorities.
It is also expected that individuals will be temporarily able to dissolve their CFCs tax-free.
How the CFC's profits will be taxed in Ukraine?
The CFC's profits will be included in the tax return of Ukrainian residents and taxed at a rate of 19.5% for individuals and 18% for companies. The tax rate applicable to individuals may be reduced to 10.5% if CFC's profits are distributed as dividends.
The income from a CFC is to be recognized in proportion to the share of control. Returning back to our example, if Andrew's share in the BVI company is 60%, he shall include only 60% of EUR 2 million into his taxable income (i.e., EUR 1.2 million).
In case a CFC pays corporate tax abroad, it is expected that the amount of the foreign tax should be eligible for credit against the Ukrainian tax. So, if Andrew's company were registered in Cyprus and paid 12.5% corporate tax there, Andrew would have to pay in Ukraine only the difference between the Ukrainian and Cypriot taxes.
When will it all come into force?
CFC rules are expected to come into force on 1 January 2021. Currently there is some uncertainty concerning the first fiscal year being subject to reporting under the CFC rules.
How will the tax authorities get information on CFCs?
Ukraine is expected to join the automatic exchange of tax information under the Common Reporting Standard some time soon. It will allow Ukraine to automatically obtain information on the bank accounts of foreign entities controlled by Ukrainian residents. At present, more than 100 countries have joined this automatic exchange framework. The list includes some popular directions among Ukrainians (such as the BVI, the United Arab Emirates, Malta, Cyprus). Moreover, the Law requires Ukrainian banks and financial institutions to report all information they have about foreign entities of Ukrainian residents to the tax authorities.
It is unlikely that Andrew will be able to keep in secret the profit of his company for a long time.
Don't the CFC rules contradict the tax treaties?
Taxpayers in different countries attempted to challenge the application of the CFC rules relying on some provisions of tax treaties, but they were not successful in general. The international community does not find the CFC rules as contradictory to the tax treaties.