Modern Solution for the Avoidance of Double Taxation: Fair Rules for International Businesses

On 23 July 2018 Ukraine signed the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (in Ukrainian “Багатостороння конвенція про виконання заходів, які стосуються угод про оподаткування, з метою протидії розмиванню бази оподаткування та виведенню прибутку з-під оподаткування”) (hereinafter – the “Multilateral Convention” or the “MLI”). The Ukrainian Parliament ratified the MLI with the Law No. 2692-VIII which entered into force on 2 April 2019.

The MLI is one of the outcomes of the OECD/G20 Project to tackle Base Erosion and Profit Shifting (the “BEPS Project”). As provided for in the Explanatory Statement to MLI by OECD the purpose of the MLI is to swiftly implement the tax treaty-related BEPS measures.

Why needed?

Many countries now believe the treaties for the avoidance of double taxation (Double Tax Treaties) fail to achieve optimum effect to ensure the fair rules for international businesses. For this reason, OECD and G20 countries adopted measures to prevent base erosion and profit shifting (the “BEPS Project”).
Some adjustments should be made to the existing double tax treaties to implement the developed measures. In view of a great deal of such treaties worldwide, the MLI has become a flexible and time-efficient tool for simultaneous adjustments into separate provisions of double tax treaties.

Now the international tax agreements can be adjusted by one dialog, one stroke of signature and one act of ratification for a certain country. To date, about 87 countries have jointed the MLI, including Ukraine. On its part, Ukraine undertook to implement baseline standards which are the minimum standard based on 4 Actions:

Action 5 “Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance;
Action 6 “Preventing the Granting of Treaty Benefits in Inappropriate Circumstances;”
Action 13 “Transfer Pricing Documentation and Country-by-Country Reporting;”
Action 14 “Making Dispute Resolution Machanisms More Effective”, as well as several optional provisions.

At this, as far as the foreign elements of Ukrainian business structures are concerned, it seems that the adoption of the Principal Purpose Test would have the most wide-reaching impact.

Principal Purpose Test

This anti-abuse rule is based on the Principal Purpose Test (“PPT”). According to the PPT the benefits under the respective double tax treaty should not be granted where the principal purpose of any transaction or arrangement, or of any related person, was to obtain those benefits.

In practice, the tax authorities would now have a right, whenever they feel it appropriate, to question the purpose of payments abroad (e.g.: interest or royalty charges paid for the benefit of foreign company-creditor by the Ukrainian company) and, as a result, application of reduced withholding tax rates provided for by respective double tax treaties.

So, the Ukrainian entity should be ready to prove the commercially justified purpose of certain transactions or foreign company incorporation to which a certain payment is made (for e.g., the business expansion abroad, approximation to sales market or raw material market, counterparties’ requirements etc.).

Fact to consider: A long-term corporate structure may go to pieces due to considerable tax burden on account of cooperation with foreign companies.

Mutual Agreement Procedure

This minimum standard concerns improving a dispute resolution procedure. If a taxpayer considers that the actions of one or both contracting jurisdictions result or will result in double taxation, that taxpayer may present the case to the competent authority of the jurisdiction of his residence or nationality. At this, the limitation period is 3 years. However, if the competent authority finds it difficult to resolve a dispute at his own discretion, the case may be resolved by mutual agreement with the competent authority of the other contracting state, with a view to the avoidance of taxation.

Optional Provisions

Ukraine has chosen to apply a number of optional provisions under the MLI to tax treaties:
  •  Capital gains from the alienation of shares or interests of entities deriving their value are taxed in the state where such immovable property is located. This provision is applicable if, at any time during the 365 days preceding the alienation, these shares or interests derived more than 50 per cent of their value, directly or indirectly, from immovable property located in the other contracting country.
  •  Prevention of artificial avoidance of permanent establishment status:
    • definition of agency permanent establishment has been updated to include persons habitually playing principal role leading to the conclusion of contracts. At this, a person cannot be considered as an independent agent if it acts almost exclusively on behalf of one enterprise to which it closely related;
    • a fixed place of business will not constitute a permanent establishment only in cases when it is maintained solely for the purpose of preparatory or auxiliary activity.
The MLI will enter into force for Ukraine on the first day of the month following the expiration of a period of three calendar months beginning on the date of the deposit of its instrument of ratification which has not happened yet.

Ukraine included 76 jurisdictions in its MLI Position, however the MLI provisions will only be applicable to those treaties, the respective jurisdictions of which included Ukraine into their MLI Positions, and both countries made a notification with respect to the same provisions.

Even though the MLI operates to modify double tax treaties between two or more parties to the MLI, it will not function in the same way as an amending protocol, which would directly amend the text of tax treaties; instead, it will be applied alongside existing tax treaties, modifying their application in order to implement the BEPS measures. Therefore, special attention should be given when applying any bilateral double tax treaties in order to make sure that the provisions of MLI, if applied to particular treaty, are taken into account.

Issues to be considered right now

Even though the MLI will enter into force for Ukraine, according to some estimates, not earlier than the beginning of next year, its impact on your doing business should be analyzed right here and right now. To evaluate the extent to which you may be affected by the MLI adjustments, the following steps are recommended:
  1. In case tax benefits in the form of reduced rates are used it is necessary to assess whether those benefits are provided for by the double tax treaties covered by the MLI.
  2. These benefits should be evaluated in the light of PPT; at this, the tax reasons should be critically “weighted”.
  3. In case of existence of fixed place of business in another jurisdiction affected by the MLI or cross-border agency agreements the risks of permanent establishment should be considered.
When the possible risks have been determined, a strategy for mitigation of such risks, including the list of arguments in case of disputes with the tax authorities, should be prepared. Our tax experts will be ready to assist you with the above.

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