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Increased Tax Rates for Ukrainian Businesses Related to Russia

Increased Tax Rates for Ukrainian Businesses Related to Russia

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Ukrainian Parliament currently considers bill No 7232 that increases tax rates for Ukrainian businesses related to Russia (the “Measure”). The aim of the bill is to discourage corporations from Russian business activities. If successful, it should decrease Russian fiscal revenue, which will leave Russia with less funds available for warfare. There is, obviously, a huge social request and support for such measures. However, actual effect of the bill is far not that definitive.

A brief overview of the scope of the Measure

Under the bill, the Measure will apply to Ukrainian businesses designated as “affiliated with Russia”. The bill operates a specific definition of “affiliation”. The company is deemed affiliated with Russia if it meets any of following criteria:

  • As at 23 February 2022, the resident of Russia was a direct or indirect owner or the ultimate beneficial owner of the company;
  • The company derives income from Russia or owns the company that receives such income or conducts transactions that may result in receipt of such income;
  • The company is a part of a multinational enterprise and any company of such an enterprise:
    • Derives income from Russian sources or conducts transactions that may result in receipt of such income, including by having a permanent establishment in Russia;
    • Has financial liabilities towards Russian residents;
    • Russian residents have financial liabilities towards such companies; or
    • Supports Russia economically, including by carrying business through a permanent establishment in Russia or by supply of goods and services to Russia without consideration.

The transactions which were actually carried out but were not documented would also be taken in consideration for purposes of the “affiliation” test.  

Ukrainian legal entities and permanent establishments of non-resident entities in Ukraine must file a special “affiliation declaration” and disclose any of the affiliation criteria. Misreporting on the affiliation declaration may result in an unscheduled tax audit. 

Businesses deemed affiliated with Russia will be subject to increase in tax rates for certain taxes. The following tax rates will be subject to increase by 1,5 times:

  • corporate income tax (increased to 27% instead of standard 18% for resident entities);
  • rent tax (royalty for use of subsoil, radiofrequency, etc.);
  • environmental tax; and
  • property tax.

Civil society have already exerted significant pressure on corporations that are not ready to leave and abandon Russian market. These companies experienced decrease in demand, negative publicity, bad performance of shares on stock exchanges and other effects. Still, quite a number of large corporations continue to conduct business in Russia. In such circumstances, the idea to create additional tax reason to abandon Russia seems very appealing at the first glance. However, further scrutiny of the Measure leaves us with more questions both on technical side of the bill and its chances to succeed. 

Withholding tax and treaty position

In Ukraine, withholding tax is a form to collect corporate income tax from non-residents. General withholding tax rate is 15%. However, lower rates apply if provided for by the applicable double taxation treaty.

Withholding tax is assessed, reported, withheld and paid by Ukrainian residents or permanent establishments. However, the relevant tax is not due from them but is merely administratively collected from foreign entities. It is unclear, therefore, whether the Measure should result in increase of the withholding tax due from affiliated companies. If so, it may affect non-affiliated payees since the tax burden is placed on them. Also, technically it would be more correct to assert that the Measure should not apply to such tax payments as the taxpayer (non-resident company) is not an affiliated entity. This issue may be further clarified during review of the bill in the Parliament.

In case the Measure applies to withholding tax, it will fall into the scope of treaty protection available to eligible non-residents. If the non-resident company is the tax resident of a state with effective double tax treaty with Ukraine, such tax treaty will prevent Ukraine from collecting withholding tax exceeding the maximum rate provided for by the treaty. Most of Ukrainian treaties establish tax rates for passive income that are lower than statutory 15% withholding tax rate. Therefore, increase of the tax rate to 22.5% by the Measure would not be effective because of the applicable treaty protection.

Non-discrimination rules and the Measure

Another interesting question is whether the Measure is in line with non-discrimination obligations of Ukraine in effective double taxation conventions. Such provision prohibits: 

  • To impose on permanent establishments of residents of treaty state taxation which is more burdensome than applicable to tax on domestic enterprise of the host state carrying out similar activity; and
  • To impose on subsidiaries of residents of treaty state taxation which is more burdensome than applicable to tax on enterprise carrying out similar activity whether owned by a person of the host state or the third state.

The Measure discriminates permanent establishment of Russian residents and Ukrainian entities with Russian capital. Therefore, Ukraine would need to cancel its double tax treaty with Russia in order to apply the Measure.

As for effect of the other double tax treaties, the position is not straightforward. It is recognised that the non-discrimination provision in the tax conventions is not per se the most favoured treatment clause. The Measure applies equally to companies with capital from any state (apart from Russia) and is dependent on the business such company or another part of its international group carries out. It gives proper grounds to argue that the Measure is non-discriminatory towards entities with non-Russian capital. 

Exemption

The bill proposes that the Measure will not apply if the relevant company is involved in an activity of social, humanitarian, or economic significance for Ukraine. This may include supply of goods and services which are not produced in Ukraine (the list of qualifying goods and services to be approved by the Government).

There are no specific requirements or thresholds to apply the exemption. Certain companies may use it as a loophole for the abuse of the proposed rules. They may supply insignificant amounts of qualifying goods or services to avoid application of the Measure.

Wartime losses

The war dramatically influenced the revenues of all Ukrainian businesses, either related to Russia or not. It is highly unlikely that any of them will have taxable profits in 2022 (or even in years to come).

Apart from that, business affiliated with Russia face extreme dropdown in customer demand and sales levels. One of multinational food retail stores experienced 50% drop in sales after the corporation announced it is not leaving Russia. 

In such circumstances, economic effect of the Measure with respect to corporate income tax is highly questionable. There are reasonable doubts as to whether any businesses will report profits subject to tax. Especially businesses deemed affiliated with Russia. It seems the Measure is not likely to have actual impact with respect to income tax position.

Impact of the Measure on other taxes

Other taxes to be hiked by the Measure are not directly linked to the bottom line in companies’ P&L statement. But what if we have a closer look on the Measure in that respect.

Environmental tax is far not the cornerstone of Ukrainian fiscal system. Its overall impact on businesses is not crucial. Although some of the industries may face higher amounts of environmental tax payable, it is seldom a market-maker on the tax arena. We would not expect its increase by 1.5 times to have drastic impact on tax collections.

Property tax apply to certain types of real estate and has higher impact in land-based business. In particular, impact of property tax is significant in farming and development businesses. Companies in these industries may be heavily affected. For other types of business property tax is not a major expense.

Rent tax (royalty for use of subsoil and other resources) is much more interesting area. Rent tax is not directly linked to profit. For some types of resources, it is linked to income or value of the extracted minerals (i.e., ore, oil, natural gas, etc.). For this industry the effect of the Measure may be considerable as well.

The most significant effect of the Measure, however, is likely to be for companies subject to rent tax for radiofrequency use. It is a major tax cost for mobile operators. If any of them is deemed as a Russian affiliated company, its tax bill will have a dramatic impact on the company’s financial position.

The first suspect here is one of leading Ukrainian operators “Kyivstar”. “Kyivstar” is among the top 20 biggest Ukrainian taxpayers. Application of the Measure to the rent for radiofrequency will most likely push them up to the top 10 or top 5 Ukrainian taxpayers. This will constitute a significant economic effect for the Ukrainian state budget (and for the business) unless such mobile operator qualifies for the exemption.

Is it an indulgence?

One of the major threats of the Measure, in our opinion, is not tax related. As we mentioned, corporations that did not break their ties with Russia are subject to huge international pressure both from customers and investors. Such pressure is a significant factor in their consideration whether to abandon Russian market. Until recently, Russia was a lucrative place to do business (it is not likely to be so after economic effect of all recent sanctions is fully unraveled). Negative impact of dealing with Russia on the corporation’s bottom-line or share price should have been very material to push management to exit Russia.

It is extremely unlikely that the Mesaure will result in such material effect on large multinational enterprises. Ukrainian business is seldom big enough to general sufficient tax increase as a result of the Measure. On the other hand, payment of increased tax in Ukraine may be used by companies to justify their continued involvement in dealings with Russia or to partially remedy the negative effect on the public opinion. Corporations may try to showcase compliance with the Measure as a sufficient and only hurdle required by Ukrainian government to continue doing business and paying taxes to Russia. This will contradict and even undermine the object and the purpose of the Measure as it is.

Therefore, concerns with ultimate economic effect of the Measure and its possible “indulgence” outcome, in our view, significantly outweigh fiscal gains which may reasonably be expected. We call all civilized world to continue ban and boycott of Russia-related business and provide further support to Ukraine.

Slava Ukraini!

By Vadim Medvedev, Partner, and Viktoriia Shvydchenko, Associate, Avellum