Date of publication: 13 April 2021
Nina Bets, Head of Tax Practice
Oleksandr Rudenko, Attorney at Law
Source: Forbes.ua, Image by jacqueline macou from Pixabay
The international fight against offshore companies reached its final stage. It is time to stop using the classic business structuring schemes
Until recently, the business structuring through Cyprus, the Netherlands, Great Britain, BVI, Isle of Man and Jersey was a quite fashionable trend. These countries have the low corporate tax rates and the possibility of applying preferential taxation regimes provided for by the conventions on the avoidance of double taxation.
The additional benefits include, inter alia:
- confidentiality and absence of public registers of beneficial owners;
- ability to use the nominee services;
- dispute resolution in international arbitration;
- European face of business, when a foreign company acts as the founder of Ukrainian business.
The business worked under the following scheme. A non-resident company provided an interest-bearing loan to the related Ukrainian company. In a while, it got the principal amount (without taxation) back from the funds earned by the Ukrainian company, and the interest amount – with the application of a preferential tax rate on repatriation in accordance with the agreement on the avoidance of double taxation.
This rate is 2% for Cyprus, 0% for the UK, and 2% for the Netherlands. Next, at the level of Cyprus, the United Kingdom or the Netherlands, there remained a minimum interest income margin subject to the corporate tax at the rate applicable in the relevant jurisdiction. The remaining income was transferred in favor of companies registered in offshores, where it was completely exempt from taxation.
This scheme is called intercompany loans. The foreign companies involved therein carried out limited economic activities in the country of registration, often received income in the form of interest on loans from the related parties, and had no real office or employees there. The companies and their bank accounts were managed primarily from Ukraine. I.e., the purpose of their operation was to optimize the tax burden.
What has changed?
Ukraine has ratified the Protocols Amending the Agreements on the Avoidance of Double Taxation. The interest repatriation tax rates have been increased to 5% for Cyprus, UK and the Netherlands. In addition, after 23 May 2020, an important requirement for the application of a reduced tax rate on repatriation is not only the confirmation that the recipient of interest income is the beneficial owner of such income (i.e., has the right to receive it and has no obligation to transfer it to the third parties), but also the principal purpose test.
The optimization of taxation has become more difficult and the guarantee of confidentiality almost impossible due to the circumstances as follows:
- MLI. In 2018, Ukraine and most countries of the world signed the MLI Convention, which stipulated that conventions on the avoidance of double taxation shall not be applied where the main purpose of their application is to obtain benefits in the form of tax exemptions and reduced tax rates.
- ATAD. EU countries have implemented the provisions of ATAD1 and ATAD2 of the EU Directives aimed at establishing the rules for countering tax evasion. These directives introduce the rules for interest expenses limitation and taxation rules for the CFCs.
- FATF recommendations defining the concept of shell companies and forbidding the banks to work with such companies.
A shell company is defined as any legal entity or trust in respect of which there is a reasonable ground to believe that it was created to participate in money laundering and tax evasion schemes, suppression of traces of corruption and other crimes.
From now on, the banks apply the risk-based approach to conduct an in-depth analysis of companies having the signs of a shell company. They check the financial statements, confirmed by an independent external audit, documents on the actual movement of goods, the provision of services, the performance of work, the payment of corporate tax, the personnel hiring, the availability of production space or office. It is believed that banks that do not carry out a detailed due diligence of their clients contribute to crime and shall be sanctioned with millions of dollars in fines.
- Introduction of registers of beneficial owners.
In certain jurisdictions, such registries are public, making confidentiality completely impossible. In others, the access to information contained therein can only be obtained by the law enforcement agencies upon request.
- Introduction of requirements for the economic presence.
In 2018-2019, in response to the complaints of the European Commission, most low-tax jurisdictions (BVI, Cayman Islands, Guernsey, Jersey, Maine, Mauritius, Belize, UAE) have finally introduced the requirements for economic presence, the failure to comply with which results in prohibition to operate in the said jurisdictions:
- company shall be managed from the territory of the relevant jurisdiction;
- there shall be an adequate number of qualified personnel;
- company shall have an adequate physical presence;
- adequate level of operating expenses;
- company’s main activity is carried out in the territory of the relevant jurisdiction;
- for companies engaged in development in the field of intellectual property, it is additionally required that the equipment used for research and development is located in the territory of the relevant jurisdiction.
However, the specific aspects of each jurisdiction should be taken into account. Certain jurisdictions even provide for the punishment in the form of fines, imprisonment and/or liquidation of the company for violating the rules established by the law. Such requirements make the cost of maintaining such companies higher or even unprofitable.
- Introduction of CRS (Common Reporting Standard) for automatic exchange of financial information.
Proceeding from the terms of the standard, the banks and other financial institutions collect information on the activities on individual accounts of non-resident individuals, corporate accounts of non-resident companies and provide it to the tax authorities of their country. Next, they automatically send such information to the country of tax residence of the owner of such an account. This means the complete abolition of banking secrecy.
- Introduction of the controlled foreign companies rules.
The residents (individuals and legal entities) who own companies in other jurisdictions are required to submit an annual report on such companies, and pay taxes on retained earnings. This rule makes the use of non-resident companies solely for the purpose of tax optimization almost impossible.
Ukraine has not yet joined the CRS for automatic exchange of financial information. However, it has already introduced the controlled foreign companies rules which are to take effect in 2022.
All individuals exercising effective control over foreign legal entities are required to submit, together with a declaration on property and income, a CFC report by 1 May 2023. And pay tax liabilities by 1 August 2023.
The Tax Code does not exempt from the obligation to file the CFC report. However, the CFC income can be exempted from taxation in Ukraine if there is an agreement on the avoidance of double taxation or on the exchange of tax information between Ukraine and the relevant foreign jurisdiction and any of the following conditions is met:
- the controlled foreign company pays income tax at an effective rate of at least 13%, or
- the share of passive income of a controlled foreign company does not exceed 50% of the total income received from all sources.
Regardless of the fulfillment of the above conditions, the profits of the controlled foreign company are not subject to taxation in the territory of Ukraine if any of the following conditions is met:
- the total aggregate income of all controlled foreign companies of one controlling person from all sources does not exceed the equivalent of EUR 2 million at the end of the reporting period;
- the controlled foreign company is a public company whose shares (participation interests) are traded on a stock exchange.
Given the rules, the companies registered in jurisdictions where the effective tax rate is at least 13% must from now on be used in the international business structure. Or companies with 50% of active income, i.e., the income received from the provision of services and the supply of goods.
Estonia and Montenegro
If you are considering business relocation, we recommend paying attention to two unobvious, at first glance, jurisdictions.
In Estonia, the corporate tax rate is 20%, payable only when you decide to distribute the dividends. Therefore, this European state is the most attractive for doing business. Estonia is the so-called white jurisdiction of the EU and is not included in the list of states the transactions with counterparties from which are considered to be controlled for the purpose of transfer pricing.
It is convenient to use an Estonian company for trade operations. In particular, for the supply of goods from/to EU countries. There is no foreign exchange control, no restrictions on the equity to share capital ratio. The company can get an unlimited loan from its participant. The agreement on avoidance of double taxation, signed by Ukraine and Estonia back in 1996, allows the use of preferential tax rates for repatriation.
Any individual or legal entity, including a non-resident, can be the founder of an Estonian company. A member of the board (director) can obtain a residence permit in Estonia for a period of 2 years with the right of extension thereof. And most importantly, there are no mandatory requirements for economic presence in Estonia, and European banks do not refuse working with the companies registered in this jurisdiction.
Montenegro is not yet the EU member but is a candidate for the EU membership, expected to join in 2025. The corporate tax rate is 9%, which is the lowest in Europe.
Montenegro has not joined the CRS for automatic exchange of financial information, i.e., its banks are not required to report on the non-residents’ accounts to the tax authorities. Since 2001, the agreement on the avoidance of double taxation between Ukraine and Montenegro has also been in place.
Montenegro offers citizenship by investment. To obtain a Montenegrin passport for yourself and your family members, you need to invest EUR 250 000 in real estate and donate EUR 100 000 as a contribution to budget. The knowledge of the language and residence in the territory of the state are not required. The program ends at the end of 2021.