You're reading: Experts: New Ukraine-Cyprus deal still leaves lots of loopholes for tax evasion

A new Ukraine-Cyprus tax treaty that President Viktor Yanaukovych signed on Nov. 8 with his Cypriot counterpart seems set to put an end to the era of untaxed capital flows between the countries, and the tax evasion and unethical practices that took place. But experts forecast no major change for Cyprus’s role in Ukraine’s economy, leaving some of the biggest problems unresolved.

Ukraine’s economic relations with Cyprus since independence were based on a Soviet-era treaty that took taxes out of the equation, making it a top destination for businesses seeking to repatriate capital in the post-Soviet republic. As a result, the small island nation – with a population of roughly one million people – became Ukraine’s biggest foreign investor, ahead of Germany and the United States.

This treaty opened the floodgates for massive tax evasion, transfer pricing and even money laundering schemes, which operated under minimal scrutiny and with the tacit backing of officials who often benefited from the arrangement.

This continues to cost Ukraine billions of dollars in lost revenue, with some experts putting the figure as high as $3 billion, or almost 10 percent of the government’s annual budget. Ukraine’s former World Bank country director Martin Raiser was a vocal critic of this arrangement, pointing to the case of Russia, where the elimination of the double-taxation agreement raised revenues by  nearly $7.5 billion.

According to estimates by Kyiv-based think tank Razumkov Center, when the treaty enters into force it could bolster the budget by some $100 million. When exactly this will happen depends on how quickly parliament ratifies the deal, with early 2013 as the most likely time frame. That would mean the treaty could come into force on Jan. 1, 2014.

While the final version of the treaty has not been disclosed, a leaked version shows that despite higher taxes, the treaty leaves considerable room for companies to optimize their books.

First comes a change to dividend taxation. Companies with investments of at least 100,000 euros ($127,000) or 20 percent of share capital will pay 5 percent, while others will face a high rate of 15 percent. Businesses will be pleased to learn, however, that profits from the sales of shares in Ukrainian companies will continue to be untaxed by Ukraine’s authorities.

Royalties are also set to go up, to 5 percent for copyrights on scientific work, patents, trademarks, company secrets and process or information concerning industrial or commericial experience.

While a considerable increase, this nonetheless leaves the door open to a widely used transfer pricing scheme, whereby Ukrainian subsidiaries purchase overpriced consulting services, for example, a Cyprus-based holding will still be able to move capital out of the country – bypassing capital movement restrictions at a minimal cost – to a lower tax jurisdiction.

Interest rates will have the lowest impact at 2 percent. “The 2 percent withholding tax under the new convention may be set off against the Cypriot domestic 10 percent tax. Thus, rather than a loss this is a temporary cash flow deficit, which is not tragic at all,” said Svitlana Musienko, head of tax at the Kyiv office of global law firm DLA Piper.

Moreover, interest payments present a similar opportunity to royalties to move capital out, experts note. Parent companies can thus charge subsidiaries high rates, effectively transferring profits within a holding structure.

Meanwhile, the problem of poor transparency and tax information exchange between the two countries, which critics say facilitated fraudulent behavior, seems to have been curiously transformed rather than solved.

At present Ukrainian authorities requesting tax information will have to: identify the person or entity under investigation; specify the nature and form in which they need the information; explain the purpose of the information; produce a statement that the request is in conformity with the law, and state that the requesting country has exhausted all means except those that create excessive difficulties.

According to Vladimir Kotenko, head of tax at Big Four auditor E&Y’s Ukraine office, this raises a number of questions about interpretation and how such documentation should be produced, leaving Cypriot officials a wide scope to deny unwanted tax queries.

Another problem concerns the issue of beneficial ownership, which entitles an individual or entity to benefit from the treaty’s conditions. In the leaked version the criteria to benefit from this condition are not specified, which experts believe will make the question dependent on an official’s discretion.

“If applied by the authorities, this might indeed create additional troubles for taxpayers,” Kotenko said.

Companies should pay particular attention to this issue. Indeed, the economic slowdown and budget deficit has led to more aggressive revenue-collecting policies as state officials step up their game.

“Ukrainian tax authorities are becoming more familiar with these international tax principles and are starting to use these concepts when challenging companies that have claimed treaty benefits,” said Ron Barden, head of tax at Big Four auditor PwC’s Ukraine office.

Other havens

At present, it seems unlikely Ukrainian businesses will leave Cyprus for other havens en masse, exports note.

“While the zero withholding tax rates under the current USSR-Cyprus Treaty were unique, and a major reason why over 60 percent of investment into Ukraine was routed through Cyprus, there are other advantages, and these will continue to apply,” argued Barden.

These include a “relatively low corporate tax rate; no tax on dividends being paid from Cyprus; a strong, English-based legal system; a sound infrastructure and banking system within the EU; and a cost efficient corporate maintenance program,” he added.

Whether or not companies will move ultimately depends on their individual reasons for going offshore. The Netherlands have very attractive rates for the repatriation of profits, low requirements for holding companies, significant exemptions for patents and research costs and a very warm investment climate, said Mykola Stetsenko, managing partner at Avellum law firm.

Austria is a little more expensive, but also offers interesting expemptions and a solid business climate, he added. This makes both countries attractive locations for locating holding companies.

However, businesses should beware of the jurisdictions’ high maintainance costs, Stetsenko warned.

Meanwhile, questions of tax information, beneficial ownership and real presence will also continue to favor Cyprus. “Dutch tax authorities are more demanding regarding the issues of substance, ‘real presence,’ in the countries to which dividends are paid out of Holland,” said DLA Piper’s Musienko, contrasting this situation to the laxer Cypriot approach.

“Cyprus has other advantages concerning corporate issues and structuring of transactions, which are familiar both to businesses and lawyers,” she added. “The bottom line is that it is too early to say goodbye to Cyprus. It still can be of service.”

Kyiv Post editor Jakub Parusinski can be reached at [email protected]