Ukrainian Business Will Continue Using Offshores as the Only Means to Survive

To tackle tax avoidance, the state should focus not only on tax specific measures, but also on reduction of other incentives for businesses for work from offshore.

Many in Ukraine believe that implementation of the governmental tax initiatives of the late hits the poor and middle class the strongest. The rich will not share in losses. Instead, they will continue benefiting from tax schemes and use of offshores – the option not available to a common citizen or a small business.

The government counters by listing measures aimed at reaching the wealthy. For example, a major blow to the offshores should be duty to disclose beneficial owners effective as of 25 October 2014, proposed denunciation of double tax treaty with Cyprus initiated by the government[1], and improved transfer pricing rules.

To be able to evaluate the governmental proposals and, if needed, suggest more efficient approach to tackle tax avoidance, one should understand the incentives for the business to work in Ukraine through foreign companies and not directly. True, the principal motive would be tax minimization, which is universal for business of any origin. There might also be commercial considerations – modern business can hardly limit itself to one jurisdiction if it wants to grow. Still, there are other reasons, distinctively Ukrainian, which prompts you, as the owner of the business, to use foreign jurisdictions. Even if there is no commercial need. Even if it results in paying taxes comparable to Ukrainian.

These reasons include inflexible and often poorly drafted legislation (e.g. corporate, exchange controls, contractual), no reliable and just court system, difficulties with enforcing court and arbitral awards, and constant changes of the legislation. A result –without foreign structures you are unable to do basic things your business needs in order to operate and develop. Things that you as the owner, if acting fully locally, are not able to do, include the following:

1. You cannot attract foreign equity financing via IPO abroad. Ukrainian company without foreign holding may not do IPO outside of Ukraine (see page 4 of the PWC’s overview for jurisdictions of issuers of Ukrainian businesses, all of which are foreign).
2. You cannot attract cheap debt financing.  Ukrainian company may not issue bonds abroad. Borrowing from foreign institutions requires NBU registration, compliance with requirements as to the structure of payments, specific provisions in the agreement etc. It is practically impossible, or at least very expensive, for a foreign lender to enforce guarantees by Ukrainian companies. All of this scares away foreign lenders and increases price of debt and risk of default for Ukrainian borrowers.
3. You cannot finance your subsidiary via interest bearing loan, as for doing so you must be a financial institution. Granting suretyship, even though done in practice, creates similar risks.
4. You cannot convert your debt into equity, even though your creditor, understanding prospective of the business, may be willing to become a shareholder instead of creditor.
5. You cannot attract strategic investor for less than controlling share, because you may not govern your arrangement with the partners the way you seem fit. Shareholders’ agreements, in which the parties may give minority shareholders veto rights, change quorum requirements, grant each shareholder a representation on the board of directors, agree how to sell business, would not be enforceable in Ukraine. Instead, shareholders of Ukrainian companies have to comply with the corporate governance rules set by Ukrainian legislation, even if unfit for their purposes (see in particular part 6 of Higher Commercial Court recommendations, also note that all large M&A deals are governed by foreign law, usually English as the most flexible).
6. You cannot buy a business from a foreign owner, unless you trace all past owners. The Ukrainian bank will not accept for procession  your payment for shares in Ukrainian business, unless you can trace, using bank and other documents, history of how the foreign seller, and all previous foreign owners, purchased their shares. This is indeed possible if previous owners are related. If it is done between independent parties, the right documents are usually not available.
7. You cannot trade as you seem fit, as Ukrainian law limits your options. The term of the advance payment to a foreign seller may not exceed 90 (180) days (i.e. it makes impossible trade with China without intermediary). You cannot grant commercial credit to your trade partners, because for each item you sell the payment must reach Ukraine within the term set by the law. There are other initiatives of the central bank in this area.
8. You cannot hedge your currency risks. Mandatory conversion of foreign currency proceeds, and inability to purchase currency in advance, before your payment is due, increases currency risks and related losses.
9. You cannot use profits from Ukrainian business to purchase things abroad. For this, even if your profits are legal and fully taxed in Ukraine, you would need license from central bank, which may or may not be granted.
10. You cannot protect your rights in court. Even if you get a court decision, you cannot promptly enforce it.
11. You cannot get tax ruling confirming tax implications of your transaction. You can apply for explanations on tax issues. But generally, you cannot describe your situation, and receive a ruling explaining how you will be taxed, which will be binding both for you and the state.
12. You cannot plan. Because the laws change constantly, and a major tax payable in January may be introduced on 25 December of the preceding year, you cannot plan your activities, and count on financial results you calculate in advance.

Thus, to the extent you can afford it, you plan around these limitations by creating corporate structures abroad, and doing everything you cannot do in Ukraine in another jurisdiction, which may or may not be a classical offshore.

Whether it is done purely for tax avoidance reasons, or for more legitimate reasons, Ukraine loses. First, due to reduction of tax base on which Ukraine imposes tax. Second, transfer of functions to foreign jurisdiction shifts value creation from Ukraine to foreign country. The money which Ukrainians, Ukrainian companies and Ukrainian state could earn is thus earned by foreign players. Third, structures lacking substance and done purely for tax and other non-commercial reasons lead to losses to business and economy, which could be at least partially avoided if it were not for inefficient legislation.

Thus, to tackle tax avoidance, the state should focus not only on tax specific measures, but also on reduction of other incentives for businesses for work from offshore. So far, this seems not be addressed by the governmental proposals.

[1] Cyprus companies are the largest investors in Ukraine. Their FDI (foreign direct investment) share exceeds 30% of total FDI in Ukraine as of 2014.