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Distributed Profit Tax: How Should it Work?


Galyna Melnyk , lawyer at Ilyashev & Partners Law Firm

Source: Censor

The idea to introduce a distributed profit tax was set forth in the Law of Ukraine of December 21, 2016. Nevertheless, as of December 2017 this document has not yet been submitted to the Parliament as a legislative initiative as required by the aforementioned Law.

Under the Law on Amendments to the Tax Code of Ukraine Concerning the Improvement of the Investment Climate in Ukraine the Cabinet of Ministers of Ukraine was instructed to develop and submit – before July 1, 2017 – to the Verkhovna Rada of Ukraine a draft law on the introduction of a distributed profit tax.

Indeed, the relevant draft law was developed, published on the website of the Ministry of Finance of Ukraine, and in October this year was approved by the Cabinet of Ministers.

The introduction of this tax has provoked a heated discussion. The President promised the business to introduce a distributed profit tax as early as 2018.

However, the Ministry of Finance (the law drafter) has noted that although this tax as a whole should stimulate the businesses to reinvest the earned profits into production and development, in the first year of operation this tax will result in the state budget losses amounting to UAH 26 billion, and local budgets’ losses of UAH 5.4 billion.

In addition, the Ministry of Finance has made public a certificate of compliance of the draft law on the distributed profit tax with Ukraine’s commitments on European integration, which contains criticizing judgments as related to such an innovation.

The aforementioned certificate states that the distributed profit tax will be inconsistent with the Strategy to Counteract the Erosion of Tax Bases (BEPS Plan), chosen by Ukraine.

It is also mentioned therein that the distributed profit tax does not comply with the OECD Model Tax Convention, which is based on a classical model of profit taxation (currently in force in Ukraine and in most countries of the world).

So, what is the distributed profit tax?

Contrary to the classical model of income tax, under which the difference arising between the income and expenses shall be taxed, the distributed profit tax is applied to certain outgoing payments only (to the profit distributed as dividends and equivalent transactions).

Therefore, the classical expense side loses its importance, since the expenses are not taken into account when determining the tax base.

At the same time, when calculating the tax burden the profit distribution transactions are of special interest; the draft law proposes to levy a tax thereon at rates of 5%, 15% and 20% (depending on the type of transaction).

It is proposed to impose a 5% tax rate on the payments of interests, commissions, fines and other similar payments on loans received from related non-residents.

The 15% tax rate is proposed to be imposed, in particular, on profit distribution in the form of dividends; and in case of sale of shares, resignation from membership or liquidation of the company – on amount exceeding the member’s/shareholder’s costs to purchase the share (capital gain).

In addition, in case of payments/refunds of money from joint activities and trust management such tax will be imposed on the amount exceeding the amount that was transferred for joint activities/into trust management.

The draft law proposes to apply the 20% tax rate to all other transactions equivalent to the profit distribution. In particular, such transactions shall include:

• payment of interests and commissions on loans from non-residents registered in low-tax jurisdictions;
• payment of interests and commissions on loans from related non-residents, if the amount of debt is 3.5 times higher than the borrower’s equity;
• payment of financial assistance to a non-payer of the distributed profit tax (for example, to an individual, who is a single tax payer);
• free of charge transfer of property (goods/works/services) to a non-payer;
• inappropriate expenditures of the non-profit organizations;
• purchase of goods/works/sertvices from the related persons who use a simplified taxation system;
• investments abroad;
• payments to non-resident principals under intermediary contracts;
• payment of royalties;
• payments under controlled transactions incompatible with the arm’s length principle.

It is noteworthy that in most cases the distributed profit tax is imposed on the above mentioned transactions only if payments are made to the non-payer of the distributed profit tax.

That is, while money circulates among the payers of the distributed profit tax, it shall not be taxed.

At the same time, it restrains the possibility of withdrawing funds from the business with significant savings on taxes, in particular, in the form of loans to individuals and expenditure transactions with the payers of single tax and related non-residents.

The above described mechanism of taxation of the distributed profit introduces a fundamentally different approach to replenish the budget as compared to the one we have now.

The new model of business taxation is based on a deferred positive effect for the treasury: the lightening of a tax burden should stimulate the economy, leading to increase in the budget revenues in future.

Despite the Government’s good intentions, quite logical are businesses’ fears that in the event of introducing a distributed profit tax, the State will nevertheless adopt active measures to compensate for the budget deficit that is expected in the beginning.

And this means that it is quite reasonable to expect a reduction in the expenditure side of the budget (which, among other things, will negatively affect the quality of the administrative services provided by the State to businesses), increase in the rates of other taxes and fees, and tightening of additional charges based on the results of tax inspections.

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