You're reading: How to plug a $12 billion hole

On May 29, changes to the transfer pricing law, seen as a crucial regulatory act to prevent the shifting of capital abroad, came into effect. Vasil Kisil & Partners law firm estimates that state coffers lose out on $12 billion annually due to so-called offshore tax optimization schemes.

Initially, the law went into force on Sept. 1, but subsequently later was revised because companies were experiencing hardships in providing reports on their offshore transactions. At first, the deadline was set for May 1, but afterwards was shifted to Oct. 1.

The recent changes, however, introduced far smaller fines for non-compliance with transfer pricing rules, which makes the procedure less bribe-prone, experts say.

“That is an adequate step given the current situation in the country. The lack of certain secondary legislation on the matter coupled with the general turmoil of the past six months made it unwise to keep May 1 as the reporting deadline. The decision to have it shifted to Oct. 1 is a well-balanced one,” says Oleksandr Martynenko, senior partner at CMS Cameron McKenna.

However, most companies have already submitted their transfer pricing reports to avoid fines, says Denys Lysenko, Vasil Kisil’s partner.

The standard way of moving profits starts with registering a resident company in an offshore jurisdiction that has lower taxes. Then a Ukraine-based producer sells what it produces to that offshore entity at an extremely low price to avoid paying a substantial amount of taxes under Ukrainian tax legislation.

When any interested party wants to purchase those products, it buys it from the offshore entity which pays significantly lower taxes at a given jurisdiction. Goods that are actually sold may never leave Ukraine under this scheme.

Transfer pricing legislation is applied when there is a suspiciously low price for the sale of goods or services to foreign companies. In this case, average market prices are used to assess the transactions.

The tax havens of Cyprus and British Virgin Islands remain the most popular offshore jurisdictions for Ukrainian businesses.

Ukraine’s transfer pricing legislation is adequate, says CMS’s Martynenko. It covers deals whose aggregate annual value exceeds $5.1 million. If transaction take place with a foreign resident, transfer pricing laws are implied if the corporate income-tax rate in that country is lower than Ukraine’s by 5 or more percentage points, or 14 percent and less.

However, secondary legislation that applies to other existing laws is lacking, especially for the banking sector.

Meanwhile, Lysenko of Vasil Kisil & Partners thinks that Ukrainian transfer pricing rules are more complicated than those nations with a longer track record in this area, namely America, Britain and Germany.

The law leaves enough room for inventive entrepreneurs to engage in capital flight, adds Pavlo Demchuk, a Kyiv-based expert on transfer pricing.

Generally, the most important factors that lead Ukrainian businesses to favor offshore jurisdictions are not only lower taxes, but also the poor quality of Ukrainian corporate and commercial legislation. Inadequate court protection contributes to this, too, lawyers say.

However, it is realistic to give companies incentives to return to Ukrainian taxation.

“Further measures, including a potential tax amnesty for previous periods, could and are likely to be considered to boost Ukraine’s investment potential for primarily domestic players,” says Lysenko of Vasil Kisil & Partners.

Martynenko of CMS Cameron McKenna agrees: “Give them good laws coupled with solid protection and decent tax treatment and they will be back with their capital. By ‘good laws,’ I mean a common law system.”

Almost all offshore jurisdictions, apart from Andorra and Monaco, belong to the common law system, which is less dependent on government decisions. Money likes stability and predictability, says Martynenko.

Meanwhile, Boston Consulting Group estimates that globally some $9 trillion of capital has shifted to offshore jurisdictions, while it expects this figure to reach $11.2 trillion by the end of 2017.