In today’s reality, the fight against offshore companies and capital outflows to low-tax jurisdictions remains a pressing issue for the whole world.
Back in 2013, the Organization for Economic Cooperation and Development (OECD), with the active support of the G20 countries, developed the BEPS Project. Its main task was to combat the erosion of the tax base and artificial withdrawal of corporate profits from high-tax countries to low- or zero-tax countries.
For Ukraine, the BEPS Plan is protection against tax base erosion and income outflow to other countries. In addition, on February 28, 2019, the Verkhovna Rada of Ukraine approved the Law of Ukraine No. 2692-VIII “On Ratification of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting” developed by the Ministry of Finance of Ukraine (hereinafter referred to as the “MLI Convention”), effective as of April 2, 2019. For Ukraine, the MLI Convention entered into force on December 1, 2019.
Much has already been written about the changes to the tax conventions related to the introduction of MLI. To put it in a nutshell, taxpayers who close transactions with non-residents subject to bilateral agreements to avoid double taxation should pay attention to the main innovation of the MLI Convention – the so-called Principal Purpose Test (or PPT) chosen by most countries, including Ukraine. Its primary aim is to prevent an illegal application of benefits under tax agreements.
Thus, according to the definitions of the PPT Rules (specified in the OECD BEPS Action 6 Report and Article 29 “Right to Benefit” of the Model Tax Convention in clause 9), the following is stated:
“Notwithstanding other provisions of such Convention, a benefit under this Convention shall not be granted in respect of an item of income or capital, if it is reasonably concluded, given all the relevant facts and circumstances, that obtaining that benefit was one of the main purposes of any transaction that directly or indirectly resulted in that benefit unless it is established that providing that benefit in those circumstances corresponded to the object and purpose of the relevant provisions of this Convention”.
In other words, the principal purpose test means that benefits (for example, application of a reduced tax rate to non-resident income) under a tax agreement will not be granted in relation to profit or capital if there is reason to believe that receiving such benefits was one of the principal purposes of the transaction.
Various facts and circumstances will be taken into account to analyze whether obtaining a tax benefit is the “principal purpose of the transaction”. In practice, we understand that the procedure of the principal purpose test can be similar to arguing about a business goal, but with one significant difference. Passing PPT is not enough to prove that the transaction was actually closed and led to a profit. The main argument to pass the PPT should be to establish the real reasons why a particular business model was chosen and why non-residents of a specific jurisdiction were involved in such model. There may be many examples of such arguments, such as the existing possibility to attract credit funds and other financial circumstances in a particular market, the experience and material and technical base of a non-resident, etc. At the same time, it is essential in this context to prove that the impact of such arguments prevailed over tax savings, and not just such a transaction was profitable.
It is pretty logical that the principal purpose test corresponds to the business goal concept, and the argumentation, even though not identical, may complement each other.
The Law “On BEPS” (Law of Ukraine No. 466-IX of January 16, 2020) stipulates that certain transactions involving non-residents are to have a reasonable economic purpose – a business goal.
The business goal is a “longtime friend” for Ukrainian legislation and most Ukrainian taxpayers. Thus, regulatory authorities often used the concept of a “business goal” to prove a lacking connection with an economic activity or the “unreality” of transactions. However, until recently, there were no clear rules and regulations regarding the procedure for its application in the Tax Code of Ukraine (hereinafter referred to as the “Tax Code of Ukraine”).
Starting from May 23, 2020, as the relevant provisions of the Law No. 466 became effective, the definition of a reasonable economic purpose (business goal) has been significantly expanded, and references to the business goal have appeared in Articles 39 and 140 of the Tax Code of Ukraine. The notion of business goal became linked to transfer pricing and income tax. Thus, clause 14.1.231, Article 14, the Tax Code of Ukraine reads:
A reasonable economic purpose (a business goal) is a reason that can only be available if the taxpayer intends to obtain an economic effect as a result of economic activity.
The economic effect, among other things, but not exclusively, provides for an increment (preservation) of the taxpayer’s assets and/or their value, as well as the formation of conditions for such increment (preservation) in the future.
For taxation purposes, a transaction involving a non-resident is considered to have no reasonable economic purpose (business goal) if:
- the main purpose or one of the main purposes of the transaction is non-payment (incomplete payment) of the amount of taxes and/or reduction of the taxpayer’s taxable profit;
- under comparable conditions, a person would not be ready to purchase (sell) such goods, works (services), intangible assets or other items of business transactions other than goods from unrelated persons.
From January 1, 2021, according to the new amendments (Law of Ukraine No. 1117-IX of December 17, 2020), the rules regarding business goals apply only to: – controlled transactions; and from January 1, 2022 – to uncontrolled transactions with residents of so-called “low-tax” jurisdictions and non-residents who do not pay corporate tax (according to the resolutions of the Cabinet of Ministers of Ukraine No. 1045 of December 27, 2017 and No. 480 of July 4, 2017, respectively), as well as uncontrolled transactions for calculating royalties in favour of non-residents (regardless of whether the non-resident recipient is low-tax).
Next, we will consider an example of determining the existing business goal for transactions that, from the perspective of Ukrainian realities, involves most risk, namely, unprofitable commodity operations.
It is important to note that the absence of an economic effect does not indicate the absence of a business goal in transactions since the intention to obtain an economic effect is a prerequisite for having a business goal. However, in the absence of an economic effect, the taxpayer should justify objective reasons that influenced this effect.
Thus, an enterprise may incur losses caused by both unfavourable economic conditions and expenses arisen out of entering a new market or producing new products. Based on this, emerging losses in a certain period may be justified by the cost of implementing a business strategy chosen by the enterprise (for example, setting low prices to increase its market presence). However, the policy of reduced prices may only be accepted for a limited period to generate profit in the future. However, if the expected positive result from the chosen business strategy is not achieved within a period that would be acceptable for a comparable independent enterprise, then the compliance of the business strategy with the arm’s length principle may be questionable.
Therefore, for unprofitable transactions, it is essential to analyze the correct choice of a business strategy, reasons for unprofitability, general trends in the relevant market (prepare an analysis of the dynamics of price changes, demand), etc.
As is evident from the foregoing, determining the presence or absence of a business goal contains a subjective assessment factor, which is the basis for disputes between regulatory authorities and taxpayers.
Finally, although the current norms of the Tax Code of Ukraine provide that the duty to prove the absence of a business goal in a business transaction is assigned to the regulatory authority, it is not difficult to assume that in most cases, payers themselves will have to justify an available business goal in certain transactions with non-residents.
It should be noted that the taxpayer should keep in mind the concept of confirming the reality of transactions, but at the present stage, ordinary documents such as agreements, acts, invoices, payment documents, etc. are sufficient only to confirm the reality of the transaction when reflected in tax accounting, but as an evidence base for confirming the existing business goal, this may no longer be enough. Therefore, it is necessary to think about the reasoned justification of the economic feasibility of carrying out all types of business transactions, which is not an easy process and requires a comprehensive approach.
In order to justify the existence of a business goal, it is necessary to provide documents confirming the reality of the transaction (agreement, acceptance and transfer act, act of services rendered, payment documents, pricing policy, marketing policy) in the first place, as well as to prepare arguments and evidence of the economic feasibility of such transactions (correspondence with counterparties; management reports on transactions feasibility; tender documentation, business plans; calculations of the marketing department; reviews-analysis of markets; calculations confirming the growth of company’s overall indicators, increase in profitability indicators; analysis of possible losses of individual transactions and measures to reduce them; justification of risks and negative factors affecting the expected economic effect; documents confirming starting a new direction of the company’s work, etc.).
In our opinion, today it is advisable to take into account the signs of a business goal in its activities to form evidence of its presence, if possible, even before or within closing an economic transaction, to conduct an inventory of transactions with non-residents, analyze business structures and assess an economic effect of transactions closed. Therefore, one may claim that a responsible but not too formal approach to conducting procedures to prove a business goal may significantly simplify the procedure of the Principal Purpose Test (PPT). However, it will most certainly not replace it entirely.
Ivan Kysil TP consultant
Roman Baranivskyi TP consultant