Court practice as to the moment of deductibility of royalties for the profit tax purposes
We have the pleasure and feel it appropriate to draw your attention to the recent developments of court practice in respect of the moment of deductibility of amounts of royalties, accrued and paid by a profit-tax payer.
In the decision of the Supreme Court of Ukraine dated January 14, 2009 in case # 09/13 which has recently become publically available the Court stipulated literally the following position:
“…taking into consideration subparagraphs 5.4.1, 5.4.2 of paragraph 5.4 of Article 5 of the Law of Ukraine “On Corporate Profit Tax” dated December 28, 1994 #334/94-BP the collegium of judges of the administrative chamber of the Supreme Court of Ukraine have concluded that only royalties, already paid by a taxpayer, may be included into deductible expenses”.
According to the said position of the court notwithstanding the provisions of Article 11 of the CPT Law allowing deduction of expenses under the so-called “first event rule” (i.e. upon the moment of accrual or payment or only upon accrual in case of transactions with non-residents) the amount of royalties is allowed for deduction only in tax period during which this amount is paid. It shall be noted that Ukrainian State Tax Administration (“STA”) has started maintaining such approach since 2008 (see e.g. letter of STA # 4516/7/15-0217 dated March 11, 2008). Yet, in its earlier letters STA insisted that amount of royalties shall be deductible upon the receipt of services (see e.g. letter of STA # 693/6/15-0316 dated January 27, 2006). Specialists of KM Partners have warned about this risk of disputes with tax authorities in respect of the moment of deductibility of royalties already during the conference “Actual issues as to royalties: taxation and other”, which took place last year.
Taking into consideration that the approach of the Supreme Court of Ukraine as to the moment of deductibility of royalties only upon payment lacks proper legal grounds and that such conclusion is really artificial and out of context of the case as such we cannot exclude that this conclusion has been “lobbied” by the STA.
Considering the current situation we have to conclude that deduction of royalties upon the moment of accrual (i.e. receipt of service) without payment triggers material risks of dispute with Ukrainian tax authorities. In case the dispute is referred to court it is most likely that court will support approach of the tax authorities. Therefore, to be on the safe side in further tax periods it is advisable to deduct royalties upon payment or, in relations with non-residents, after royalties are both accrued and paid.
As regards past periods the issue whether it is necessary to correct tax accounting in this respect may arise. The answer to this question depends on many circumstances e.g. whether tax audit has already started, whether the amount of deduction at risk is significant or whether the taxpayer has recorded tax loss etc. Therefore, one may hardly provide any general advice suitable for all cases. Yet, while making decision whether to apply to self-correction it is advisable to consider the following conditions.
Firstly, we do not suggest correcting tax accounting of the tax periods already audited by tax authorities. The law stipulates definite grounds for repeated tax audits and it is not easy for tax authorities to use this opportunity. Thus, in case tax authorities try to carry out repeated tax audit with regard to deductibility of royalties then it is advisable to check what is used as the basis for such audit. Such tax audit may be disallowed by taxpayer unless the requirements of the legislation are met. In addition, we suggest not providing the officials of tax authorities with the documents regarding royalties during repeated tax audits dedicated to other issues.
Secondly, if during the year amounts of royalties were deducted upon accrual but the actual payment occurred till the end of respective year tax authorities have no legal grounds to assess tax liabilities in respect of such royalties (this conclusion is based on the fact that deductible expenses through the year are determined under progressive total method). Moreover, the Supreme Court of Ukraine in one of its decisions has noted that penalties shall not be applied to taxpayers without assessment of tax liabilities as such. Thus application of penalties by tax authorities without assessment of tax liabilities may be cancelled by court. Therefore, cases, when the amount of royalties was accrued and deducted in one year but paid in the other year, remain at risk. In addition, there are risks for the cases when tax audit covers tax periods during which royalties were accrued and deducted but not the period when they were paid even if royalties are paid till the end of that year.
Thirdly, we cannot exclude that the said approach of the Supreme Court of Ukraine will be changed later. This statement is based on the fact that approach of the court in each particular case is based on the arguments presented by the parties in the dispute. Hence, if in the other case the parties base the position on other arguments the court may change its position. The example of such situation is the court cases, participated by JSC “Obolon”, about priority rights of shareholders in respect of purchasing of shares. Another example is the situation regarding the use of Incoterms for the purposes of applying VAT at the zero rate. Thus, in the court case # 1/5/119 dated November 12, 2002 the Supreme Court of Ukraine supported approach of tax authorities which was then actively advocated by tax authorities as in the discussed case. However, in the other case the position of taxpayer was better grounded and the Supreme Court of Ukraine adopted the decision dated March 20, 2007 in which the opposite (i.e. favorable for taxpayer) approach was confirmed.
Lobbing of the respective amendments to the Corporate Profit Tax Law is one of possible ways of solving the discussed issue. If such measure is interesting for you please inform us in order to join the efforts of interested parties.
We trust that the above comments may be useful for you. Please do not hesitate to contact us in case of any questions to the above or if any additional information might be required.
The above commentary presents the general statement for information purposes only and as such may not be practically used in specific cases without professional advice.
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