Will the Denunciation of Cyprus Treaty Save Ukraine from Default?

One of the key measures in addressing tax avoidance by large corporations in Ukraine that the government announced is denunciation of double tax treaty with Cyprus. Is it a populist idea with limited substance? Or will it really help Ukraine to generate much needed tax revenue?

The key claims of the government in support of the measure are the following. First, a Cypriot company may sell any assets, shares and other property in Ukraine without paying any tax either in Ukraine or Cyprus. Second, Cyprus double tax treaty is unusually favourable. In particular, tax rates are lower than rates in other double tax treaties (the “DTT”) and in other states of EU. Third, Cyprus DTT results in losses to Ukraine in the amount of UAH 6 billion per year, and the treaty revocation will allow channelling these amounts to Ukrainian budget.

It is true that Cyprus is the largest source of foreign direct investment for Ukraine. Cyprus’s 31% of all FDI into Ukraine is a clear sign that investments are channelled through the country rather than originate in it. The reasons obviously include tax advantages Cyprus offers (though they are not as high as many believe, because certain types of income exempt from income tax are subject to special defense contribution, which is rather high). Equally importantly, though, are flexibility of Cyprus legislation (particularly corporate), generally based on English law preferred for commercial transactions worldwide , cheap services related to having a company, and certain reluctance of Cyprus authorities to share sensitive information with post-Soviet states.

Some of the savings achieved through using Cyprus, particularly due to harmful tax practices, Ukrainian government would rightfully want to tax in Ukraine. It is true that the governmental measure may help generate revenue for the state in the short run. But this is not sustainable. Moreover, Ukraine may end up losing tax revenue, as outlined below. The key misconceptions about operation of DTTs that, it may seem, the proposal on denunciation of the treaty is based on are addressed below:

1. Ukraine may not denounce the treaty with immediate effect without violation of the law. The Cyprus treaty may only be terminated with the effect starting 2019 which will not help Ukraine now (please see article 27 of the treaty, and note that Ukraine is a party to Vienna Convention on the Law of Treaties of 1969, which prohibits unilateral termination of the treaties);
2. As opposed to previous tax treaty with Cyprus from soviet times, which was indeed disastrous for Ukraine, new treaty is based on OECD model and uses standard tax rates, as provided below.
3. The rates in Cyprus DTT are similar to, and sometimes lower, than the rates in other DTTs:
   • The rate for dividends, for example, is 5% if the shareholding is at least 20% or if the investment was at least EUR 100,000 (same rate and 20% threshold as in the DTTs with Switzerland, Netherlands, UK, Germany and a number of other countries), and in other cases the standard Ukrainian 15% applies. In contrast, DTTs with many other countries provide for 10%, and the Dutch treaty sets full exemption for investments of at least USD 300,000;
   • Interest is taxed at 2%, as opposed to full exemption for interest paid to Swiss (applies to commercial credit and loans granted by financial institutions) and UK lenders (no qualification), and the same 2% applied in many other countries (e.g. the Netherlands, Germany, where the low rate is limited to commercial credit and loans of financial institutions);
   • Reduced rate for certain types of royalties paid to Cyprus is 5%, as opposed to 0% in case of Swiss, Dutch, German (applies to certain types of royalties) and UK (applies to all royalties);
4. No tax on sale by foreign resident with no local presence of assets, save for real estate, shares and other securities, is a feature of international trade and taxation and not result of Cyprus DTT. Ukrainian tax code in particular exempts such income (for example, sale of cars, equipment, commodities) from income taxation in Ukraine, and so do all DTTs based on OECD model convention;
5. Sale of real estate by Cypriot owners is taxable in Ukraine under the treaty, just as under other DTTs;
6. DTTs generally exempt from taxation sale of shares, save to the extent where majority of the assets of the local business is real estate. This is indeed where Cyprus DTT and some other DTTs to which Ukraine is a party differ (e.g. Swiss, Dutch, UK, German and Russian DTTs). However, it does not matter because even if the Ukraine had the right to tax such capital gains, absent effective transfer pricing rules the business would have easily avoided the tax – the shares may be sold for nominal value first, or instead of selling shares of Ukrainian company the owner should sell, fully tax free, its Cyprus holding owning Ukrainian subsidiary;
7. Most tax revenues from denouncement of the treaty Ukraine would come not from taxing sale proceeds, but taxing interest and royalties at standard 15% rate instead of 2% for interest and 5% or 10% for royalties, as currently provided by the treaty (and, potentially, if one decides to pay dividends, also from payment of dividends). However, by 2019 business would have sufficient time to re-locate to another jurisdiction, and thus savings would be marginal;
8. Ukraine will lose in tax revenues, to the extent business moves from Cyprus to another jurisdiction with more beneficial treaties, for example the right to pay zero tax on interest (e.g. Switzerland or the United Kingdom) or royalties (e.g. the Netherlands, the United Kingdom, Germany, Switzerland) instead of the current 2% and 5%, respectively.

Despite the above, the Cyprus treaty denunciation has understandable appeal. Cyprus regime is preferential, and significant tax and other savings are achieved through this. Thus, some may believe it is unfair to forgive large business hiding profits away from Ukraine.

However, the principal policy consideration should be not to achieve justice (everybody should bear the same tax burden) by taking tax savings from people we do not like (such as oligarchs). Instead, any suggested measure should be programmatic – namely, generating more tax revenue for Ukraine, while minimizing overall tax burden of business – the more business keeps, the more it invests or spends, preferably in Ukraine, both of which is good for the economy.

The suggested measure does not seem to pass the test. To tackle tax avoidance, which is of crucial importance for Ukraine, one may consider standard solutions, such as transfer pricing, controlled foreign companies rules, thin capitalization rules, rules on treatment of inter-group financing, general anti-avoidance measures, limitation on tax benefits and other anti-treaty abuse measures, not all of which is properly implemented in Ukraine. Initiatives in some of these areas are a more important part of the tax reform package proposed by the government.

As for the Cyprus treaty denunciation, it is best used as a threat, to motivate Cyprus to proper exchange of information – an area in which Cyprus is notoriously lacking – and signing with Ukraine of information exchange agreement.