Article by Mykola Orlov

Both the EU enlargement and the Orange Revolution have provided additional boost to the recovering Ukrainian economy. Multinationals are now more than ever interested in expanding into Ukraine (the "China of Europe" as it is now called by many), while local companies vie to conquer as much of the domestic market as possible ahead of the newcomers. Ukraine is on the verge of an M&A boom, although there have already been quite a few such transactions over the past three years.

Every M&A arrangement involves analysis of a number of factors. One of the most important of these is taxation, particularly on the Ukrainian side. Many Ukrainian taxes are still far from being either predictable or stable. Some transactions, which are standard in the West, may have unexpected Ukrainian tax consequences. Special attention should be paid to the interpretation and application of Ukrainian tax laws by the Ukrainian tax authorities, which may be ill-grounded and unwarranted by these laws themselves. Failure to appreciate the importance of tax planning in Ukraine may well kill the deal or render it considerably less attractive.

Although practically every step in an M&A has tax consequences, the present discussion focuses only on one of them – M&A financing. Though often neglected as technical, this first stage may well set the tenor for the entire deal. Special attention is also paid to applicable currency regulation which, together with taxation, significantly affects the choice of finance structure.

Direct Acquisition

A foreign company may acquire a Ukrainian company or its assets directly. In such case, the financing arrangement behind it is beyond the scope of Ukrainian taxes, unless, of course, there is a Ukrainian donor (e.g. a bank) involved. Care should be taken, however, to choose the most efficient tax structure for repatriation of income from Ukraine in order to make any offshore financing arrangements viable.

It should be separately noted that tax treatment of representative offices of foreign companies in Ukraine makes them inefficient for use in acquisitions. (For example, any funds transferred to a representative office for such purpose will be treated as its taxable income by the Ukrainian tax authorities.)

Foreign investors should also mark the recent change in the policies of the National Bank of Ukraine (NBU) on financing foreign investments. As the chief currency regulator, it now requires that a foreign investor willing to acquire a Ukrainian company (or any shareholding in it) conduct the relevant settlements through its account in a Ukrainian bank. The NBU further mandates that foreign investors purchase securities issued by Ukrainian companies, including shares of stock, only with the national currency of Ukraine (Ukrainian hryvnias). For that, such investors will have to open a bank account in one of the Ukrainian banks, transfer hard currency to it, and have these funds converted into Ukrainian hryvnias. Although the legality of such requirements is doubtful and the respective decisions are scrutinized by Ukrainian courts, it remains to be seen whether the NBU will be forced to change its mind.

Acquisition Through a Ukrainian Company

The situation is different when an M&A is structured through a Ukrainian company, e.g. a Ukrainian subsidiary of a foreign multinational. Any financing provided to such entity must be scrutinized in terms of application of the Ukrainian profits tax. (Such transactions are not subject to Ukrainian VAT.)

Generally, a Ukrainian company used for M&A purposes is financed in the following ways:

  1. through equity;
  2. through an interest bearing or non-interest bearing loan; or
  3. through a gift.

Equity

Any contributions to the authorized capital of a Ukrainian company are not subject to the Ukrainian profits tax. Care should be taken, however, to have them properly documented. There have been instances when the Ukrainian tax authorities have refused to treat incoming hard currency funds as such contribution if the receiving Ukrainian company has failed to register the increase of its authorized capital (to be reflected in the company’s charter) with the appropriate state registering body.

accounts. Required to enforce Ukrainian exchange controls, Ukrainian banks always check the source and purpose of incoming funds and are reluctant to credit them to a company’s account if the company fails to produce satisfactory documentary evidence.

Although the NBU regulation requiring that all monetary contributions be made in Ukrainian hryvnias is temporarily suspended, it still requires that foreign investors make them not directly from their foreign bank accounts but through special (investor) accounts with Ukrainian banks.

It should also be mentioned that any dividend payments are subject to the 15 percent Ukrainian profits tax to be withheld by the distributing Ukrainian company. The tax rate may be reduced under a double tax treaty (DTT) to 5 or even 0 percent, as is the case with the United Kingdom and Cyprus, respectively.

Ukraine attempts to tax any funds withdrawn from a Ukrainian subsidiary by its foreign parent, unless such Ukrainian company is liquidated.

Loans

Any term loans provided to a Ukrainian company are divided, for tax purposes, into "financial loans" and "repayable financial assistance." (Under Ukrainian tax law, a foreign company may provide both types of loans.)

To qualify as a financial loan, the funds must be provided on a repayable basis (i.e. for a fixed period of time) and the loan must be for-purpose (such purpose should not be too broadly defined) and interest bearing. Any term loans which do not bear interest and are not otherwise paid for are considered to be repayable financial assistance, which is treated differently from financial loans. Furthermore, agreements under which repayable financial assistance is provided may not specify the purpose for which it was provided. 

In the case of term loans provided by foreign (non-resident) lenders, the tax consequences for the two types differ significantly.

Financial Loan. The principal received under a financial loan arrangement is not included into the taxable income of the borrowing Ukrainian company. When repaid, it is not accounted for as tax-deductible expenses of the Ukrainian company. At the same time, interest payments may be accounted for as tax-deductible expenses of the Ukrainian company.

A Ukrainian company is required to withhold 15 percent of Ukrainian profits tax from the interest payments made to a foreign lender. However, more than 50 of Ukraine’s DTTs provide for lower tax rates on interest payments, e.g. 0 percent for loans provided by residents of the UK, to 2 percent for loans provided by banks and non-banking financial institutions resident in Germany, and 5 percent for loans provided by other residents of Germany.

It should be separately noted that Ukrainian tax law provides for a limitation on the amount of interest payments that can be included into the tax deductible expenses of a Ukrainian company if half or more of its shareholders are foreign (non-resident) entities. This ceiling applies to interest payments made to such foreign (non-resident) parent entities, or other entities related thereto, and is equal to the sum of:

  1. the amount of interest payments received by the Ukrainian company from its borrowers in the respective tax (accounting) period; and
  2. 50 percent of its taxable profit over such tax (accounting) period, excluding the interest payments mentioned in (a) above.

Repayable Financial Assistance. Funds provided as repayable financial assistance by a foreign lender, if not repaid within the calendar quarter in which they were received, are included into the taxable income of the borrowing Ukrainian company. Later, when repaid, such funds may be accounted for as tax-deductible expenses of the Ukrainian company.

Both interest bearing and non-interest bearing loans are subject to registration (approval) of the NBU. The main criterion for such approval is observance of the interest rate limitation. At the moment, the NBU has set the following ceilings:

  1. for fixed interest rates:

    2. 9.8 percent for loans of up to 1 year;

    10 percent for loans from 1 to 3 years; and

    11 percent for loans exceeding 3 years.

  2. for floating interest rates: 3 month US dollar LIBOR + 750 basis points.

Failure to register a loan will prevent the borrowing Ukrainian company from making either principal or interest payments to the foreign lender.

Gifts 

Any funds provided to a Ukrainian company for an indefinite period of time, i.e. the repayment date is not specified, are treated for tax purposes as non-repayable financial assistance. The Ukrainian company must include the full amount of such assistance into its taxable income. Furthermore, Ukrainian tax law does not allow for accounting as tax deductible any funds later repaid by the Ukrainian company to the lender under such arrangement.

Conclusion

Ukrainian law makes M&A financing a difficult task. Apart from pure tax planning, it requires an understanding of the technicalities of Ukrainian exchange controls and investment regulations. Failure to follow this maze of legal requirements may have long-term consequences. Despite overall improvement of the investment climate, the applicable Ukrainian law is still marred by fits of state intrusion and overregulation.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.