When you are setting up a Ukrainian operation with 100% foreign ownership, you will need to hire local staff, at the very least an accountant and a director. In Ukraine, hiring local staff boils down to two options: you can either hire an employee as a full-time employee (registering his/her labor book, payIng social insurance taxes, facing problems with termination of socially protected personnel and those conscripted to the army, etc,) or as a private entrepreneur (an independent contractor without labor-related problems). Naturally, most prospective employers prefer the latter option, but it comes with certain risks.

As an example, if a company hires several independent contractors without full-time employees on the company payroll, the Ukrainian authorities may suspect that the company is attempting to avoid salary-related taxes due under Ukrainian law and the company may face unexpected examinations by the labor and tax inspections.

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In the past, such risk was insignificant because of minimal sanctions. Times have however changed. Now, more than in the past, the Ukrainian fiscal and labor authorities are trying to flush out hidden labor relations and to eliminate the shadow economy with the aim of bringing transparency into the Ukrainian labor market and finding new sources to finance the state budget.

Obviously, paying independent contractors under civil agreements minimizes taxation in comparison to labor agreements. However, the state labor and tax authorities may attempt to “re-qualify” relations with private entrepreneurs as labor relations upon their respective inspections.

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For example, state authorities may examine IT companies’ contractors/employees and independent IT specialists to determine whether actual labor relations exist (i.e., provided vacation time, sick leaves, additional benefits, etc.).

While the state labor inspection inspects labor safety and labor relations within the scope of their authority, the state tax authorities inspect to ensure that the proper labor-related taxes (which are significantly higher than taxes under civil/commercial contracts) are duly withheld and sent to the state budget in a timely manner.

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Thus, there is a constant risk that these controlling bodies will attempt to re-qualify commercial relations into labor relations with private entrepreneurs and will assess penalties for violation of both labor and tax regulations.

The tax authorities often argue that civil/commercial relations are fictitious (i.e., for the purpose of tax avoidance) and they attempt to establish labor relations in order to subject companies to significantly higher salary-related taxes, including personal income tax and social insurance contributions.

The grounds for unscheduled tax inspections are found in the Tax Code of Ukraine, which provides that such inspections may be conducted in case of the receipt of information on payroll tax evasion, including the failure to conclude labor agreements with hired staff when required by law.

Unfortunately, the penalties for breach of Ukrainian labor legislation are more significant today for employers when independent contractors are retroactively recognized as actual employees. Pursuant to the Labor Code, an individual or entity can be fined for permitting an individual to work without the execution of a labor agreement, payment of official salary, and payment of salary-related taxes. This fine is ten times the effective minimum monthly salary at the time of violation for each individual worker whose rights were violated (currently Hr 6,500 x 10).

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The controlling authorities now have far more incentive to conduct unplanned examinations of employer/employee status versus customer/private entrepreneur relations. That is why proper documentation of labor relations between a Ukrainian company and its employees and sub-contractors is vital.

In considering labor disputes, Ukrainian courts firstly establish the key differences between consulting (sub-contractor) and labor agreements.  In brief, a labor agreement does not envision the final result of an employee’s work; instead, it is a continual relationship on the terms and conditions set forth in the labor agreement. Thus, after performing any specific task, labor relations do not terminate, and the employee is expected to continue performance throughout the duration of his or her agreement.

Similar to a labor agreement, a consulting agreement can be concluded on a long-term basis, but the results of the private entrepreneur’s work must be documented, transferred to the customer/client and paid depending on the actual volume of work performed by the service provider.

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There is no fixed amount of remuneration each day/month/year, since the private entrepreneur only receives remuneration for time and labor actually spent during each specific order/task.  Moreover, if the private entrepreneur’s services are no longer required, the agreement with him/her can be easily terminated and there are no benefits, such as severance pay, social security, pension payments, etc.

Another key difference between labor and sub-contractual relations is the payment process. Under a labor agreement the salary is paid regularly, as a rule, twice per month (monthly advance and second half of monthly salary). Under a consulting arrangement, remuneration is paid for works/services actually rendered, the results of which are transferred to the customer, for example, upon completion or in agreed upon stages (milestones).

Therefore, if a consulting agreement provides for a regular, strict payment schedule and mentions such payments as “salary” (especially at a fixed rate per month), then there is a high probability that such agreement will be recognized as a labor agreement.

Based on the above, relations between a customer and a private entrepreneur should bear as little features as possible of labor relations (for example, no vacations, sick or maternity leaves, benefits such as phones and cars, bonuses, medical and other allowances, etc.).  All required documents related to service/consulting agreements must be meticulously drafted and kept (such as written tasks/orders from the customer in the form of annexes to the said agreements, signed transfer-acceptance acts, lease agreements concerning leasing of workspace).  Importantly, you should verify that all Ukrainian private entrepreneurs are registered as subjects of entrepreneurial activity and organize their own accounting.  You should also verify the tax amounts of employees vs. independent contractors.

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Ultimately, it is the tax authorities who will analyze and decide whether penalties should be applied.  And that’s the biggest risk of them all.

It is still too common for Ukrainian companies to minimize taxes by documenting full-time employees as private entrepreneurs. The trend in companies is to lock down only their key “players” by concluding full-time employment agreements with them.  This way, companies can avoid the loss of key employees to competitors.  That is why there is a rule: the more successful the business, the more frequently the tax authorities inspect such business.

 

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This is the first of a regular series of Legal Insights from a cooperation agreement between Kyiv Post and Frishberg & Partners 2022.

 

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