We are now witnessing a real quest for greater transparency both on a national and international level. The media is taking its fair share in this pursuit by regularly publishing or broadcasting success stories of the tax authorities which, alone or in collaboration with their foreign colleagues, have cracked down one of the ever-evolving schemes for tax evasion or prevented an attempt to expatriate funds in breach of tax legislation.

For an innocent observer, it would seem that the life-time of tax dodgers is coming to its end and off-shore tax havens are on the verge of extinction. For professionals, dealing with tax, it is evident that ever since the G20 summit held in April 2009, the issue of preventing tax evasion due to loopholes in national legislation and/or Treaties for Avoidance of Double Taxation (DTTs) has been high on the agenda of both politicians and businessmen. The level of scrutiny by national tax authorities is rising; cooperation between tax officials of different jurisdictions is improving.

The bilateral relations between Cyprus and Ukraine are not an exception to global trends. The island country has become a second home for many Ukrainian citizens who have chosen to invest here for private or business purposes. Since various new measures have been approved in the legislation of both Cyprus and Ukraine, a brief analysis of their effect on most-common tax structures involving those two countries may prove useful both for current and potential investors.

A good starting point would be to address the much-discussed concept of beneficial ownership. Although in use since the 1940s in DTT provisions related to interest, dividend and royalties, its practical application is still subject to heated debate among academics and tax practitioners. In order to provide useful guidelines both to tax authorities and tax payers, the OECD released a paper proposing changes to the Commentary on Articles 10, 11 and 12 of the Model Tax Convention. Although at present Ukraine is not a member of the OECD and the membership application of Cyprus is pending approval, we could expect that the guidelines of one of the most influential international economic organisations will undoubtedly affect the provisions of national tax legislation.

And while Cyprus largely relies on precedents in the interpretation and application on this important concept, Ukraine has chosen a different route. Among many other novelties, the new Ukrainian Tax Code came up with a legal definition of "beneficial owner" – a recipient of dividends, royalties, interest and any other income that is entitled to receive this income, at the same time expressly excluding agents, nominee holders (owners) and intermediaries. For professionals, this legally-binding definition leaves less room for flexibility when applied in practice. Fears of additional risks associated with transactions between Ukraine and Cyprus are the hottest topic of discussion between tax practitioners of both countries. The main question, around which the debates evolve, is how the new definition of "beneficial owner" will affect the application of benefits under the current Cyprus-Ukraine DTT.

Even a brief look at the provisions of the Treaty reveals that it does not contain any reference to beneficial ownership. This should come as no surprise taking into consideration the global tax environment back in the 1980s when the DTT was signed. In the absence of authoritative interpretations and administrative/court practice in the application of the provisions of the Ukrainian Tax Code, it remains to be seen how the tax structures involving Ukrainian and Cyprus residents will be affected in practice. It seems that the responsibility for proving who the beneficial owner of the income is will lie on the Ukrainian payer. If the latter is in doubt, it may choose to apply the general 15% withholding tax (WHT) rate, leaving to the Cypriot recipient to prove its "beneficial ownership" standing. If the Ukrainian payer opts for reduced DTT rates, it could face a dispute with local tax authorities and possibly penalties. As a result, the floodgates for international tax disputes will remain open until enough authoritative interpretations and/or practice are accumulated.

An interim "remedy" should be sought in the precedence of the DTT provisions over the contradicting domestic rules, at least up to the moment in the near future when the negotiations on the new DTT between the two countries are finalized. Since an interim solution is not a sustainable tax strategy, the businessmen in both countries should take active steps, including restructuring their investments, in order to make them tax-resistant to the forthcoming changes. Some useful practical steps in this respect would be to enhance the substance and economic visibility of corporate components of these structures as a way to prove their "true" tax residency, to avoid payments through "unnecessary" intermediaries and evidently low margins, to use "mixed" tax structures containing both investment/holding component and real business content, to duly prepare and keep any supporting documentation.

Another significant change introduced by the Ukrainian Tax Code is the restriction imposed on the right to deduct fees paid to non-residents for consulting, marketing and advertising services. The amount of such fees exceeding 4% of income from sales for the previous year will be disallowed for tax purposes. In addition, any payment for such services will be disallowed if the recipient is resident in any of the jurisdictions included in Resolution 143-p of the Cabinet of Ministers of Ukraine being applied for Tax Code purposes from 1 April 2011 (the list excludes Cyprus). Since Cypriot companies usually act as holding companies for Ukrainian subsidiaries, this restriction should be taken into account when the aim is to avoid the payment of dividends and the associated WHT, substituting it with payment for services allegedly being delivered by the mother-company to the subsidiary.

What is of significant importance for the functioning of the traditional tax structures involving Ukraine and Cyprus is the fact that the same restriction applies to payment of royalties. Cyprus has established itself as one of the most renowned jurisdictions for registering IP companies due to favorable provisions in the national legislation and the extensive network of DTTs, further enhanced by the possibility to export royalties from Cyprus tax-free under the EU Interest and Royalties Directive. In addition to the 4% restriction described above, any payment of royalties will be disallowed in a number of cases, of which only two might potentially have effect on Ukraine-Cyprus structures – when the Cyprus resident is not the beneficial (actual) recipient (owner) of the royalties and when the IP rights were initially registered by a Ukrainian resident and subsequently transferred to a Cyprus IP company.

Since we have reviewed the concept of beneficial ownership in detail hereinabove, we will make some notes on the second hypothesis only. A possible way to mitigate the tax risks related to royalty payments is to put in place such a structure, that would not require the IP product to be registered in Ukraine (e.g. entering into cost-sharing agreement between Cyprus and Ukrainian group members, envisaging the end-product to be owned by Cyprus/other non-Ukraine resident company and the right to use it to be licensed to the Ukrainian company). Another option would be for the Cyprus Company to register a permanent establishment in Ukraine, in which case the amount of royalties paid to the permanent establishment will not be restricted.

Due to beneficial provisions of national tax legislation, Cyprus has been largely used to base companies acting as "financing" for other group members either by way of debt or working capital. The efficient accumulation of income is possible due to various favourable provisions, including the absence of thin cap rules and debt-to-equity restrictions. A minimum interest margin/spread of 0.125% – 0.35% is accepted. Interest income derived by resident companies may be subject to special defence contribution. However, the interest derived from ordinary business activities, including interest closely connected with business activities, is not treated as interest but as business profit and is, therefore, subject to 10% corporate income tax. The concepts "interest derived from ordinary business activities" and "interest closely connected with business activities" are defined in Circular 2003/8, issued by the Commissioner of Income Tax. Accordingly, the former concept would include interest income of banking businesses, including all banking units, cooperatives and businesses having as a primary object the provision of loans, as well as interest income of financing businesses offering hire-purchase, leasing and other financing arrangements (trade debtors, insurance companies, companies that act as a vehicle for the purpose of financing group companies etc.) The accumulated interest income may be exported to its Ukrainian or any other non-resident creditors without any WHT due.

How would such a financing structure look from the viewpoint of Ukrainian tax authorities inspecting a resident company which has received a loan from its parent company resident in Cyprus? The answer seems to depend on the percentage of foreign participation. If the latter is 50% or more, the amount of the interest allowed for tax purposes would be limited to 50% of taxable profit (before interest), plus any interest income received by the Ukrainian debtor. As a way to mitigate this restriction, the law allows the remaining interest to be carried forward indefinitely. If the foreign participation is below 50%, no restrictions on the deductibility of the interest payments should be imposed. As a result, the answer to this situation seems to be simpler than for royalty payments - carefully balancing the amount of foreign participation and the share of interest income in the overall profit should ensure that there are no negative tax effects triggered by intra-group financing.

A number of significant changes have been made in the legislation of Cyprus since August 2011, among which are the increase in the Special Defence Contribution due on interest income - from 10% to 15% and that on dividend income from 15% to 20%. What most foreign investors, including Ukrainian ones fear, is the fact that the amendments noted above will affect their tax position in a negative way. It must be noted that these changes do not affect any non-residents, for which the above sources of income continue to be non-taxable at the level of Cyprus.

Tax and corporate structures vary substantially. From more traditional to more innovative, from more simple to more complex – all of them have (at least) one common feature – they are subject to change. Being closely related to and highly-dependent on constant amendments in legislation, the schemes aiming tax optimisation need regular revisiting, reviewing and rethinking from all possible angles. Timely and expert advice may provide invaluable help. The development of business strategies for the future is predetermined by objective trends in the economic environment mirrored by legislative measures. Instead of resisting the new trends, the companies should invest adequate time and resources in monitoring them and enhancing the collaboration with their local revenue authorities. By being more transparent and cooperative, businesses will be able to develop stronger connections with national legislators, to enhance the coordination with their advisors and, ultimately, to build stronger and more effective long-term tax strategies.  

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.