New Tax Code of Ukraine, and Risks for Corporate Structures. November 2011

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1 Beneficial Ownership, New Tax Code of Ukraine, and Risks for Corporate Structures November 2011

2 Contents 1. Beneficial Ownership Concept History 2. Ukraine: Beneficial Ownership Concept before the Tax Code 3. Recent Trends and New Approach by OECD 4. New Tax Code of Ukraine and Beneficial Ownership 5. Draft New DTT between Ukraine and Cyprus 6. What To Do Best Practices PJSC "Deloitte & Touche USC"

3 Beneficial Ownership Concept - History The first line of defence against treaty shopping Used in Arts. 10, 11 & 12 Not defined in most treaties PJSC "Deloitte & Touche USC"

4 Beneficial Ownership Concept - History OECD : 1986: 2 reports: Double taxation conventions and the use of base companies Double taxation conventions and the use of conduit companies OECD Commentary: amended in 2003: Commentary on Art. 1: Improper use of the Convention Commentaries on Arts. 10, 11 & 12: Expansion of comments on beneficial owner test PJSC "Deloitte & Touche USC"

5 Beneficial Ownership Concept - History Report adopted by OECD Council November 1986 Report identifies two types of conduit companies 1. Direct conduits Beneficial owner 100% Third State (State of beneficiary) Conduit company Payer of dividends, interest, royalties, etc. Dividends, interest, royalties, etc. State A (State of conduit) State B (State of source) PJSC "Deloitte & Touche USC"

6 Beneficial Ownership Concept - History 2. Stepping stone conduits Beneficial owner Third State (State of beneficiary) Secondary conduit company ( sink ) State D (State of secondary conduit company) Conduit company Interest, commissions, service fees and similar expenses Dividends, interest, royalties, etc. Payer of dividends, interest, royalties, etc. State A (State of conduit) State B (State of source) PJSC "Deloitte & Touche USC"

7 Beneficial Ownership Concept - History OECD model: - Art. 10(2): the beneficial owner - Art. 11(2): the beneficial owner - Art. 12(1): beneficially owned Question: Who is the beneficial owner? PJSC "Deloitte & Touche USC"

8 Beneficial Ownership Concept - History Under English law, the term, beneficial owner, would exclude a legal owner who is trustee for another OECD Commentary: The term beneficial ownership is not used in a narrow technical sense PJSC "Deloitte & Touche USC"

9 Beneficial Ownership Concept - History Art. 3(2): As regards the application of the Convention at any time by a Contracting State, any term not defined therein shall, unless the context otherwise requires, have the meaning that it has at that time under the law of the State for the purposes of the taxes to which the Convention applies, any meaning under the applicable tax laws of that State prevailing over a meaning given to the term under other laws of that State. What is the context for the purposes of Art. 3(2)? Would the context include the OECD Commentary? Is it permissible to consult the OECD Commentary to determine the meaning of beneficial owner? PJSC "Deloitte & Touche USC"

10 Beneficial Ownership Concept - History Vienna Convention on the Law of Treaties: Article 31 : General rule of interpretation 1. A treaty shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose. 2.The context for the purpose of the interpretation of a treaty shall comprise, in addition to the text, including its preamble and annexes: a. any agreement relating to the treaty which was made between all the parties in connexion with the conclusion of the treaty; b. any instrument which was made by one or more parties in connexion with the conclusion of the treaty and accepted by the other parties as an instrument related to the treaty. Note: Bolding added PJSC "Deloitte & Touche USC"

11 Beneficial Ownership Concept - History 3. There shall be taken into account, together with the context: a. subsequent agreement between the parties regarding the interpretation of the treaty or the application of its provisions; b. any subsequent practice in the application of the treaty which establishes the agreement of the parties regarding its interpretation; c. any relevant rules of international law applicable in the relations between the parties. 4. A special meaning shall be given to a term if it is established that the parties so intended. Article 32 : Supplementary means of interpretation Recourse may be had to supplementary means of interpretation, including the preparatory work of the treaty and the circumstances of its conclusion, in order to confirm the meaning resulting from the application of article 31, or to determine the meaning when the interpretation according to article 31: a. leaves the meaning ambiguous or obscure; or b. leads to a result which is manifestly absurd or unreasonable. Note : Bolding added PJSC "Deloitte & Touche USC"

12 Beneficial Ownership Concept - History First disqualifying condition Second disqualifying condition OECD Commentary 12.1 Where an item of income is received by a resident of a Contracting State acting in the capacity of agent or nominee it would be inconsistent with the object and purpose of the Convention for the State of source to grant relief or exemption merely on account of the status of the immediate recipient of the income as a resident of the other Contracting State. The immediate recipient of the income in this situation qualifies as a resident but no potential double taxation arises as a consequence of that status since the recipient is not treated as the owner of the income for tax purposes in the State of residence. It would be equally inconsistent with the object and purpose of the Convention for the State of source to grant relief or exemption where a resident of a Contracting State, otherwise than through an agency or nominee relationship, simply acts as a conduit for another person who in fact receives the benefit of the income concerned. For these reasons, the report from the Committee on Fiscal Affairs entitled Double Taxation Conventions and the Use of Conduit Companies concludes that a conduit company cannot normally be regarded as the beneficial owner if, though the formal owner, it has, as a practical matter, very narrow powers which render it, in relation to the income concerned, a mere fiduciary or administrator acting on account of the interested parties Subject to other conditions imposed by the Article, the limitation of tax in the State of source remains available when an intermediary, such as an agent or nominee located in a Contracting State or in a third State, is interposed between the beneficiary and the payer but the beneficial owner is a resident of the other Contracting State : OECD Commentary (paragraphs 12 to 12.2 to the Commentary on Art. 10) [substantially identical comments are contained in the Commentaries on Art. 11 and Art. 12] PJSC "Deloitte & Touche USC"

13 Beneficial Ownership Concept - History Indofood case Leading Judgement: But the meaning to be given to the phrase beneficial owner is plainly not to be limited by [a technical and legal approach which focuses on the contractual arrangements]. Regard is to be had to the substance of the matter. In both commercial and practical terms [Indofood Mauritius] is, and [Indofood Netherlands] would be, bound to pay on to the Principal Paying Agent that which it receives from [Indofood Indonesia]. In practical terms it is impossible to conceive of any circumstances in which either [Indofood Mauritius] or [Indofood Netherlands] could derive any direct benefit from the interest payable by [Indofood Indonesia] except by funding its liability to the Principal Paying Agent or [Indofood Mauritius] respectively. Such an exception can hardly be described as the full privilege needed to qualify as the beneficial owner, rather the position of [Indofood Mauritius] and [Indofood Netherlands] equates to that of an administrator of the income PJSC "Deloitte & Touche USC"

14 Ukraine: Beneficial Ownership Before Tax Code No formal rules For banks NBU introduced the concept back in 2007 Applied in practice without legal grounds: fiscal approach Tax authorities referred to OECD approach Protocols to effective double taxation treaties PJSC "Deloitte & Touche USC"

15 Recent Trends and New Approach by OECD 29 April 2011 public discussion draft CLARIFICATION OF THE MEANING OF BENEFICIAL OWNER IN THE OECD MODEL TAX CONVENTION The concept of beneficial owner found in Articles 10, 11 and 12 of the OECD Model Tax Convention has given rise to different interpretations by courts and tax administrations NEW: Since the term beneficial owner was added to address potential difficulties arising from the use of the words paid to a resident in paragraph 1, it was intended to be interpreted in this context and not to refer to any technical meaning that it could have had under the domestic law of a specific country (in fact, when it was added to the paragraph, the term did not have a precise meaning in the law of many countries) This does not mean, however, that the domestic law meaning of beneficial owner is automatically irrelevant for the interpretation of that term in the context of the Article: that domestic law meaning is applicable to the extent that it is consistent with the general guidance included in this Commentary PJSC "Deloitte & Touche USC"

16 Recent Trends and New Approach by OECD Where an item of income is received by paid to a resident of a Contracting State In these various examples (agent, nominee, conduit company acting as a fiduciary or administrator), the recipient of the dividend is not the beneficial owner because that recipient does not have the full right to use and enjoy the dividend that it receives and this dividend is not its own; the powers of that recipient over that dividend are indeed constrained in that the recipient is obliged (because of a contractual, fiduciary or other duty) to pass the payment received to another person. The recipient of a dividend is the beneficial owner of that dividend where he has the full right to use and enjoy the dividend unconstrained by a contractual or legal obligation to pass the payment received to another person. Such an obligation will normally derive from relevant legal documents but may also be found to exist on the basis of facts and circumstances showing that, in substance, the recipient clearly does not have the full right to use and enjoy the dividend Similar approach to dividends, interest and royalties PJSC "Deloitte & Touche USC"

17 New Tax Code of Ukraine and Beneficial Ownership The Tax Code introduced the concept of a beneficial owner of Ukrainiansourced income For a non-resident to qualify as the beneficial (actual) owner (recipient) of Ukrainian-sourced income (dividends, interest, royalties, etc.), they should be entitled to receive the income in question A legal entity or individual who acts in the capacity of an agent or nominee / fiduciary, or who is recognized as an intermediary, may not be regarded as the beneficial owner of income, even if they are entitled to receive the income in question Ukraine specific issue: the beneficial owner rules affect not only taxation treaty benefits but tax deductibility of expenses for domestic taxpayers Lack of rulings / court practice PJSC "Deloitte & Touche USC"

18 New Tax Code of Ukraine and Beneficial Ownership Tax authorities: lack of consistent approach Letter 7505/7/ of 18 March 2011: to claim treaty benefit in respect of royalties one must be a register owner of the respective rights. Intermediaries do not qualify; but Letter 3917/5/ of 30 March 2011 says any proof of the right to income can be accepted, OECD and UN Model Treaty Commentaries can be taken into account PJSC "Deloitte & Touche USC"

19 Draft New DTT between Ukraine and Cyprus OECD Model-based Treaty Refers to a beneficial owner in respect of dividends, interest and royalties PJSC "Deloitte & Touche USC"

20 What To Do Best Practices Qualify as tax resident To claim treaty benefits, you need to have substance in the residence country What is the source of this requirement? No reference to substance in OECD / UN model treaties Two possible sources: 1. Domestic tax law or substance over form doctrine 2. Anti-avoidance rule is read into treaty, perhaps based on the Vienna Convention on the Law of Treaties PJSC "Deloitte & Touche USC"

21 What To Do Best Practices Substance (the basics) Local office Local knowledgeable directors Board meeting held in country Sufficient capitalization Local bank account Company accounting, secretarial and other compliance activities carried on in country PJSC "Deloitte & Touche USC"

22 What To Do Best Practices Substance (additional) Additional economic activities carried on or risks assumed More than a special purpose holding company Financial substance: The financial capacity to bear the relevant risks Managerial substance: Employees or directors who make the key decision about assets and risks: Assets: Whether to spend money (and how much) to acquire the asset, how much to spend to maintain the asset, how to best exploit or deploy the asset, etc. Risks: Whether to take on the risk, how to best manage the risk, etc. Operational substance: Employees or directors who are performing various functions e.g. procurement, finance, accounting, HR, etc. Place as many activities as possible in the company Financing/licensing structures: Avoid blatant back-to-back Increase size of rate spread Pay attention to payment dates Use equity / mixer structures PJSC "Deloitte & Touche USC"

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