Analytics

The most effective system of tax collection in the world is the Estonian system.  Estonians spend about to  0.4 euros (budget expenditures on tax and customs authorities) to collect 100 euros of tax. In Ukraine, according to conservative estimates, this number  is two or three times higher. Such efficiency is achieved by Estonians due to maximum number of e-services and compliance with the principle that if the effort does not justify the effect, such an effort shall not be done. Electronic services are built on the principle of a single window, if some data has been provided to the state one time , the same data shall not be provided for the second time  due to automatic interaction between the state authorities and databases. Such principles shall be the foundation of the tax reform in Ukraine.

Electronic cabinet

Based on these principles, changes to the Tax Code in the part of electronic cabinet of the taxpayer were developed. Such changes contemplate transfer of databases from the State Fiscal Service of Ukraine to the Ministry of Finance as well as the possibility for the taxpayer to take ALL actions related to administration of taxes, which can be implemented in electronic form via e-cabinet. It stands to reason that the proposed changes are accepted by the Ministry of Finance, and since last year have been supported by the Verkhovna Rada Committee on Tax and Customs Policy (draft law 3357).

Electronic services and e-document management (refusal from paper documents) save the European economy up to 2% of GDP. This huge amount of expenditures is worth “investing” into such services by the state. For instance, the total profit tax in Ukraine now provides about the same 2% of GDP.

In this aspect passing of the draft law on electronic trust services and complete shift to e-document management by the state authorities and business is of great importance for the tax sphere, since it increases administrative efficiency and significantly reduces expenses, which itself becomes a compensator to reduce the tax burden on taxpayers

Corporate Profit Tax – conditions for reforming

Corporate Profit Tax (‘CPT’) in Ukraine is no longer a budget-forming tax, being quite harmful for normal business activity. CPT is actually a tool for direct capital withdrawal from the owner, determining the tax base as a “profit”. And if the owner does not have any profit, it does not mean the absence of the tax. Moreover, the procedure for calculating the tax base as the financial result + tax adjustments + excessive demands to primary documents + adjustment for “sham transactions” does not guarantee the predictability of the final amount of tax to be paid by the taxpayer. At the same time, the current model of CPT makes it possible, with real profits, not to pay the tax or pay it at a rate of 0 to 5 percent.

Complicated rules of tax base calculation, ensuring maximum discretion for the tax authorities in the regulations adopted by them, on the one hand, and existence (availability) of legal mechanisms for tax optimization, on the other hand, result in maximum CPT load on diligent taxpayers, and make CPT neutral for others. Practical consequences of such situation are reflected in the following figures:

There are 269 thousand of CPT taxpayers in Ukraine, while only 1086 taxpayers with the turnover more than UAH 20 million (USD 800 thousand) provide more than 90% of budget revenue from the CPT. Analysis of this taxpayers’ category shows that it consists, as a rule, of companies with foreign investments and state enterprises. These are the taxpayers with approximately constant model of behavior – they pay taxes and distribute dividends, regardless of the complications or simplifications in the regime of taxation with CPT.

At the same time, 8 thousand of CPT payers with the turnover more than UAH 20 million (USD 800 thousand) are loss-making companies. The amount of accumulated by these CPT payers losses reached UAH 1 trillion 68 billion (at the end of the 1^st quarter of 2016)! In the normal conditions, losses may indicate that economy is in crisis. But in Ukraine there is a catch. Based on the dynamics of the first quarter of 2016, we can assume that the discussed loss-making companies will pay abroad about UAH 48 billion of passive income during the year. In general the expected amount of passive income to be paid out of Ukraine during 2016 by all categories of the taxpayers is at the level of UAH 75 billion (USD 3 billion).

Proceeding from memorandum of GLOBAL FINANCIAL INTEGRITY the annual outflow from Ukraine is USD 11.7 billion. While USD 3 billion is the payment of passive income (as discussed above), it can be assumed that up to USD 8 billion are extracted through underpricing of exported goods or importation of overpriced services and goods. These are the transactions that are potentially subject to the rules of Transfer Pricing (‘TP’).

With this background, for 1086 profitable taxpayers as a result of the tax adjustment of financial result under the current rules of CPT (without TP), the tax base was increased by an average of 35%! (a potential source for modernization). Seizure of 75% of profit after taxation of the state-owned enterprises is worth mentioning as well. This is the policy of consumption!

To struggle against CPT evasion, Ukrainian government is actively elaborating legislation on controlled foreign corporations (‘CFC’), on brining the rule of taxation with CPT in line with the OECD/ G20 Base Erosion and Profit Shifting (BEPS) Package, on zero declaration and indirect methods of taxation for individuals.

Will such complex new rules work? Considering the history with TP management as well as absence of information exchange between Ukraine and other countries, this is unlikely to happen. But the main point – the basic reasons for capital outflow

still remain, the lack of changes in the economic and monetary policy of the state remains as well, and the lack of protection guarantees for property rights. However, the new complicated rules will require consulting for those who always pay taxes, and structuring for those who minimizes them.

Exit Capital Tax

With this background, for the purposes of dealing with CPT issues, two approaches might be acceptable. Complete abolition of tax and its replacement by a modified property tax with a focus on land value tax or introduction of the entirely different philosophy of profit taxation. Combination of these two approaches is also possible. In this regard, it is worth mentioning that the land tax now works only in Kyiv, the tax collection of which is about 20% of the total land tax in Ukraine. Because of land tax exemptions, local budget loses billions of hryvnias, getting billion-financing from the state budget, which constantly has a “hole”. That very “hole” that does not reduce the unified social tax (UST). Property tax is complicated for taxpayers’ psychology, especially for the post-Soviet space.In this connection, quick steps towards increase of revenues from the land tax are not likely to be taken.

Quite a different model of distributed profit tax instead of corporate profit tax was proposed in the draft law 3357. Modified version based on the experience of Estonia, peculiarities of Ukrainian realities, received criticism and elementary completion of legal technique, received the name of the Exit Capital Tax.

The main idea (concept) of Exit Capital Tax is that only the amounts extracted from business shall be the subject to taxation. The decision of the owner, which results in capital extraction, leads to appearance of the object of taxation. Thus, for the owner everything is predictable due to the opportunity to see the real picture of the financial results of the company. In such circumstances, it is also possible to achieve financial recovery of enterprises due to the appearance of additional cash assets in the form of a deferred tax payment, which creates prerequisites for investment and capitalization of companies.

Effectiveness of tax administration is provided by simplicity of the tax model. For reference:  VAT and the excise duty became the world’s main source of filling the budget precisely because of its simplicity. Base (transaction price) * rate = tax. Simple enough for everyone: both taxpayers and controlling authorities. As a result, revenues from CPT from legal entities in Europe decreased from 5 to 2-3% of GDP. In Germany, 200 people administer VAT, which is almost 200 billion euros per year).

Simplicity of Exit Capital Tax model, which is constructed following the principle of administrating of indirect taxes, will result in effectiveness of its tax administration. The object is the transaction (as in indirect taxes), which results in capital outflow from business. The object appears in case of the owner’s decision to pay dividends in favor of the non-payer of tax as well as in case of hidden outflow of similar payments (royalties, interests in favor of non-residents, financial assistance to non-payers of tax, investments abroad). The object also appears in case of transactions that resulted in necessity to make surcharges under certain conditions (controlled transactions and transactions for which the usual prices are used).

In the proposed system all transactions between the payers of the Exit Capital Tax shall not be subject to taxation. Therefore, it makes no sense to monitor all transactions that are carried out between 269 thousand taxpayers. Conditionally, all payers of the Exit Capital Tax represent closed business – environment. While capital rotates in this business environment – it is neutral for tax and control, only capital outflow from this environment is controlled. This approach reduces the number of controlled transactions and allows smartly filtering the subjects of control and quickly covering the “hole” of capital outflow from the system.

Control over CPT:

Control over Exit Capital Tax:

If today, on the basis of “sudden” discovery of the “hole”, the tax authorities address to all those who carried out transactions with this “hole”, potentially that is 269 thousand taxpayers, in the offered system all these transactions become neutral as there is no notion of profit and expenses, as well as losses. The funds collected in the form of non-cash in a bank account of the “hole” should come out of the system in cash form or need to be sent abroad. The legislation would require application of the mechanism of struggle against such phenomena. It will allow to monitor the situation, and not to ascertain activity of the homeless six months later, who was funded by unidentified persons and billions of losses of the budget, which are collected from the same 1086 companies, which actually paid everything diligently.

Since there is no such notion as losses, all adjustments under TP rules become direct objects, resulting in the taxation of capital, leaving Ukraine. Interest and royalties under certain circumstances also become the direct object. Therefore, the basic schemes of capital outflow without taxation are shut down.

The proposed system of Exit Capital Tax is a self-regulating economic model, since if no dividends are distributed, investment increases the production, and as a result increases the turnover of goods and services with an increase in revenues from VAT and payroll taxes. Keeping money in a bank account in Ukraine is simple because it is not taxed, with the current level of inflation and currency risks, looks more like a theoretical risk. The effectiveness of this system is proved not only by the experience of Estonia, but also by a number of researches. Speaking proof is its implementation in Georgia.

In any system options of tax evasion still remain or can always be found. But the following principle shall be adhered to: “do what will result an economic effect, and set aside what is unimportant.” Quite similar to audit –the risk with little materiality is not checked. So let us stop caviling and complicating the lives of diligent taxpayers in an attempt to build a very complex system with no leaks, but with great opportunities for tax structuring with the purposes of optimization.

This tax system with simultaneous raising of the threshold of obligatory VAT registration to UAH 5 million creates conditions for switch to a common system of small businesses, which will submit tax return only if it distributes dividends or carries out a number of transactions that are equal to capital outflow, for instance, provides financial assistance to non-taxpayers.

PS:

The model of Exit Capital Tax has been elaborated without any lobbying or grants (as, indeed, e-cabinet). It is rather difficult to blame this model in defending anyone’s interests, but an attempt to truly create a healthy business environment in Ukraine. As a consequence, the model is rigidly criticized from all sides. The spent time and the quality of working out of the material give reason to believe that the draft law is ready for the adoption in the first reading with further elaboration for the second reading.

During discussion on the possibility of implementing this model, critics point out at the hole in the budget in the event of its implementation. How can any reform be implemented without that very “hole”, being the most stunning argument for all reforms. Objections that there will be no hole, since accrual on TP and taxation of passive profits become direct objects, meet the argument that the tax authorities do not administer TP properly. This is the argument of those who need to do this job! The land tax, which can also become an important compensator, is not perceived –this is the local budget, and so on.

The usual tactics to bring down the real reform repeats again –raising the question that existence of the model is impossible without elimination of simplified taxation. And this is done on purpose. After all, it means that the simplified taxation system, feeling the impact, can help whack a model that is not profitable to other players, and in fact, is very beneficial for simplified tax system taxpayers. But who will notice this? In this regard, it shall be stated that under the current dynamics of the capital outflow in the amount of USD 11 billion almost without taxation, dabbing with finger at unified tax looks like foolishness with the purposes that are remote from the truth.

The authors have done everything for the model to be adopted. Further is the question of political will to reform and business activity, which has to decide to live by a code of “BEPS”, in the fear of abolition of the unified tax or by the Exit Capital Tax.

Kind regards,

© WTS Consulting LLC, 2016

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