You're reading: New tax law puts squeeze on optimization schemes

Business are confused how to interpret and apply the new tax code.

Uncertainty and ambiguity are rife among businesses in Ukraine after the new tax code was adopted at the end of last year. Lawyers, accountants, auditors and tax consultants are overloaded with clients’ requests how to understand and apply certain provisions of the new legislation.

One of the main provisions raising questions is relations between businesses and private entrepreneurs who provide services to them and pay taxes under the simplified system of taxation.

It’s a scheme that allows companies to avoid declaring de facto staff as employees, in turn freeing them of the obligation to pay hefty payroll taxes which often exceed 30 percent of salaries paid to staff.

Long used as a tax optimization scheme by employers, registering de facto employees as private entrepreneurs has deeply hurt revenues going to the pension fund.

With the new tax code, authorities have tried to eliminate it. But from a legal standpoint, it remains unclear whether the scheme can still be used.

But this is by far not the only problem area businesses are facing in connection with the new tax code. “All the disadvantages that the tax code contains are becoming visible now and are driving accountants and specialists who deal with taxes mad,” said Oleksandr Minin, senior partner at law firm KM Partners.

“At the same time, the state tax administration is taking a very tough position that is very unfavorable for taxpayers.”

Most chapters of the recently adopted tax code came into force at the beginning of 2011. Some other rules envisioned in the new tax law will take effect several months later this year.

The first two months of 2011 showed that businesses still have many questions that have no clear solutions – neither by lawyers nor by tax authorities.

Among them are procedures related to the refunding of value-added tax, payment of dividends and royalties and calculation of profit tax, the rate of which will be gradually reduced from the current 25 percent to 23 percent in 2011 and 16 percent in 2014.

“We have a lot of work at hand,” said Hennadiy Voytsitskyi, partner and head of the tax practice at the Ukrainian office of Baker & McKenzie, an international law firm.

Voytsitskyi said that since the beginning of the financial crisis in 2008 a large part of their work was devoted to their clients’ court disputes with tax authorities. Now, however, clients are more busy seeking consultations regarding the new tax code and how it will affect them.

Back in the shadows

Use of the private entrepreneur scheme, which has for many years allowed de facto full-time employees at companies to pay a “simplified” tax of Hr 200 per month, is one of the biggest headaches.

“Many sectors of our economy have been very dependent upon such schemes,” said Voytsitskyi. “This is one of the factors why a significant part of the Ukrainian economy remains beyond official statistics – in the shadows.”

Estimates published in Ukrainian media suggest that about three million employees across the country abused the system. Firms could deduct the costs of goods and services purchased from these private entrepreneurs from their tax bills.

But from April 1 this year, they won’t be able to do so anymore, making it less favorable to work with many small traders who have no other way to earn income. Voytsitskyi from Backer & McKenzie offers four solutions in this situation.

In the short term, companies – especially unprofitable ones – could continue working with private entrepreneurs, not declaring their losses. In the long term, this solution is not suitable as every company is interested in being profitable sooner or later.

A second scenario proposed by the lawyer is to work with private entrepreneurs who pay not Hr 200 under the privileged tax option, but the usual 15-17 percent individual profit tax. In this case the employee may agree partially or completely to cover additional tax expenses of the individuals.

However, this will only happen with qualified professionals who are in demand on the market. More often the tax burden will be carried by the individuals.

The third possibility is for individuals to open a private service company, which according to the new tax code will receive a five-year tax holiday.

The fourth solution for the company is to hire those private entrepreneurs as full-time employers and to pay the hefty payroll taxes.

“Regarding tax planning, the best option is the simplest one,” Voytsitskyi said, referring to the fourth option. “The simplest solution is to switch to labor relations where everything is regulated. But it is a big is whether this advice corresponds with business models and business opportunities of the clients.”

The answer, says Olexander Minin from KM Partners, is that many businesses are not prepared to shoulder the burden of heavy payroll taxes and prefer to operate in the shadows.

“In most cases companies are not ready to register these people as staff employees and pay all social taxes,” he said. “As often happens, individuals will be left to survive on their own. Shadow payments and salaries in envelopes will increase at that point. Others will lose their jobs.”

Crackdown planned

Why did protests by smaller businesses erupt last year? The new taxation legislation essentially decreases the burden on big businesses, cutting profit taxes, for example. It increases the burden on small- and medium-sized businesses.

There are signs that government is preparing to crackdown on tax optimization schemes used by small and medium-sized businesses.

But no specific action is seen by government to also target big companies that have long funneled much of their profits into offshore tax havens, such as those owned by the nation’s all-powerful oligarchs.

According to Iryna Akimova, deputy head of presidential administration, the government has been preparing a draft law on a simplified system of taxation that may limit application of a single tax.

Besides this, the new tax code already contains a rule that if relations between an employer and an individual are recognized as a full-time job, they will have to pay full payroll taxes.

“The rule is not clear but it gives room for tax officials to abuse their powers,” said Ivan Yurchenko, senior attorney at Vasil Kisil & Partners. Amendments to the civil code adopted recently contain a definition of reasonable business object.

It says that if the transaction, or in this case an agreement between company and individual, does not have a reasonable business object but is aimed at minimizing taxes, then it will be recognized invalid with all legal consequences.

“New rules and amendments are not clear enough but give a sign that the tax authorities will operate more actively regarding tax optimization schemes using this new arsenal of tools,” Yurchenko said.

Kyiv Post staff writer Oksana Faryna can be reached at [email protected]