Back to 1982: It’s the height of the cold war, and the Soviet Union is desperately cultivating allies. The communist heartland signs a generous double taxation avoidance treaty with Cyprus– regulating which of the two countries has the right to levy taxes on subjects operating on both territories.
The landmark treaty gives left-leaning Cyprus most taxation rights upon companies operating in both countries.
The Soviet aim? To provide economic support to a rare European ally, similar to that enjoyed by Finland, and also to develop the Mediterranean island as a conduit for importing goods to the U.S.S.R.
Fast forward to 1992: The Soviet Union is gone, but the treaty lives on for each of the successor states, including Ukraine. Meanwhile, Cyprus has become an offshore tax haven with a corporate tax rate of 4.25 percent – a sweet deal.
With the Soviet republics embarked on a no-holds-barred path towards crony capitalism, the double tax avoidance treaty and low taxes are matches made in heaven for the asset-stripping post-Soviet nouveau riche. Capital flight from Ukraine takes off on a huge scale.
Fast forward further to July 2008: With a major economic crisis hiding just round the corner, Ukraine’s parliament votes on abrogating a treaty that critics claim has seen billions of dollars leave the country for the pockets of the rich over the previous seventeen years. The motion is backed by the government of Yulia Tymoshenko, but fails by only three votes.
Ironically, it was Ukraine’s Communist Party that failed to deliver the three votes needed. Petro Symonenko, leader of a Ukrainian Communist Party which like most domestic political groupings is, reputably, backed by big business tycoons, struggled to explain his party’s behavior. Defensive, he said the party did not want to damage relations with a country that, as of February 2008, had a Communist Party President, Dimitris Christofias. Skeptics suspect motives closer to party coffers.
If the treaty had indeed been abrogated in July 2008, and the $5.5 billion in Ukrainian financial flows to Cyprus in 2009 subject to Ukraine’s standard 15 percent withholding tax, Ukraine’s state coffers would be around $1 billion richer today: roughly equivalent to the budget sequester recently imposed on Ukraine by the International Monetary Fund in order for the government to borrow more money.
Only since 2007 have information exchange agreements with Cyprus allowed an accurate assessment of Ukrainian funds leaked to Cyprus year after year – $5.5 billion to $6 billion. But one thing is certain: Few countries have a bigger tax haven problem than Ukraine – and few countries have a bigger fiscal problem.
According to Ukraine’s state statistics committee, direct Ukrainian investment in Cyprus over the last three years accounted for an incredible 92 percent of all outward-going foreign investment by Ukrainian companies. Experts assess the tax revenues lost each year due to the Cyprus double tax treaty at 1-2 percent of gross domestic product (GDP).
Suspension of a far less generous Russia-Cyprus treaty in 2007 immediately boosted Russian tax revenue by 0.6 percent, according to World Bank figures.
Now the international financial institutions Ukraine relies on for funding are demanding that the country ends the Cyprus exemption. “Ukraine should close tax loopholes connected with the U.S.S.R.-Cyprus double taxation treaty,” said Martin Raiser, head of the World Bank mission to Ukraine, who drew up a 100-day plan to rescue Ukraine’s state finances. But with Ukraine’s parliament stuffed with businessmen – most of whom actively benefit from the treaty, including the current government’s main financial backers – implementing changes will not be easy.
A unique treaty
“The Cyprus-U.S.S.R. tax treaty, as it still applies in the case of Ukraine, is the most favorable double tax avoidance treaty concluded and in force,” said Sophie Stylianou, senior tax manager at Cyprus-based corporate law firm Eurofast Taxand.
“This is a magnificent treaty,” says Volodymyr Kotenko, head of tax and legal services in Ukraine for Ernst & Young. “It is unique. It exempts from tax virtually all income earned by Cyprus residents. And because there is no concept of beneficial owner, it may be equally used if the company registered in Cyprus is only an intermediary for a Ukrainian company or person.”
“The double tax treaty with Cyprus means that dividends, interest and royalties from Ukrainian companies to Cyprus residents are not taxed at all in Ukraine. These payments are only subject to tax in Cyprus. The Cyprus tax rate is zero on all of these items,” explains Hennadiy Voytsitskyi, head of law firm Baker McKenzie’s tax practice group in Kyiv.
“Moreover, while corporate profit tax in Cyprus is very low at only 10 percent, Cyprus itself has no withholding tax on financial flows to other countries, meaning Cypriot-registered companies can transfer money on to tax havens with even lower tax rates.”
“This all makes Cyprus a nice jurisdiction to siphon profits out of Ukraine,” says Voytsitskyi.
According to Volodymyr Didenko, partner for tax questions at leading Ukrainian law firm Magisters, the treaty allows Ukrainian business to achieve 20-30 percent tax savings. “This is not tax evasion, this is completely legal tax avoidance,” Didenko emphasized.
The double tax treaty is, in fact, only half the story, explained Svitlana Musienko, head of DLA Piper’s tax practice in Kyiv. The other half are the tax avoidance schemes companies employ to maximize their benefit from the treaty, which are reflected in corporate structure.
Ukrainian holdings maximize revenue channeled through Cyprus and minimize profits taxable in Ukraine. To do so they employ two mechanisms that enjoy worldwide notoriety for tax avoidance effects: transfer pricing and thin capitalization.
Transfer pricing means that subsidiaries belonging to one international holding skew the prices they charge each other so that company profit is realized where tax is least – invariably a tax haven. Offshore shareholders use thin capitalization schemes to provide funding to their onshore companies in the form of loans instead of equity. The onshore company’s debt can thus exceed its actual capitalization many times over, hence the term.
The point is that the company then pays interest to shareholders on these outsize loans, instead of declaring profits. Interest is tax deductible for the company in Ukraine and exempt from tax for the offshore shareholder under the terms of the Cyprus double taxation treaty.
The Organization for Economic Cooperation and Development (OECD) states have now declared war on both thin capitalization and transfer pricing, although there are huge difficulties in enforcing such clampdowns, especially regarding transfer pricing.
But in Ukraine, things are a whole lot easier. Both practices are completely legal.
Ukraine has no legislation against transfer pricing, and the Cyprus double tax treaty allows for thin capitalization, according to Pablo Saavedra, tax expert at the World Bank.
According to Musienko, head of DLA Piper’s tax practice in Kyiv, Ukrainian companies use Cypriot intermediaries in three main ways: firstly as a holding vehicle, to conduct upstream distribution on profits from Ukraine to Cyprus, and then further on to a final shareholder in a tax haven such as British Virgin Islands. Secondly, as a finance company used to shift taxable profits from Ukraine to Cyprus through thin capitalization schemes. Thirdly, as an intellectual property company, shifting taxable profits from Ukraine to Cyprus by way of paying royalty for instance for use of some trademark owned by a Cypriot company.
In addition, “most of the ownership vehicles for Ukrainian companies that tapped foreign capital markets for equity are registered off-shore,” said Volodymyr Nesterenko of BG Capital.
Thus, with the exception of state-owned companies, use of Cyprus-based intermediaries is more or less obligatory for Ukrainian big business. But pressure is mounting on Ukraine’s cash-strapped government to broaden its tax base and end tax loopholes. The shadow economy is currently estimated at around 50 percent, most of which is down to underreporting of earnings and of income.
Closing down the scheme
Something has to give, and the most likely candidate is the double tax treaty.
Ukraine and Cyprus already hammered out a replacement treaty in 2008. The new draft treaty incorporates far tougher terms, including a 10 percent withholding tax on interest and royalties, and 5 percent on dividends, according to Magisters’ Didenko. However, the Cyprus parliament refused to accept the treaty, due to its anticipated impact on the country’s economy, dependent on the tax avoidance industry.
Ukrainian big business is also far from happy. “The 10 percent tax rate is unacceptable for business,” said Didenko. “Companies will not pay it.”
Cypriot finance minister Charilaos Stavrakis visited Kyiv at the end of June to continue negotiations on the issue, and indicated the Ukrainian side may have softened its position. “Ukrainians are very tough negotiators, but I’m still smiling,” he said at a meeting with tax experts, according to Ernst & Young’s Kotenko.
The Cypriot finance ministry refused comment on the provisions of the new treaty.
With Ukraine unlikely to abrogate the treaty unilaterally, “a horrible thing to do”, according to Kotenko, it still needs Cyprus to agree to a new version. The shadow cast on Cyprus by the mounting uncertainty is itself a stimulus for Cyprus to negotiate. “Our standard practice is to warn clients about the possibility of change,” said Kotenko.
There is also a new competitor to Cyprus in the eyes of Ukrainian business.
“Investors are now increasingly looking at alternative jurisdictions to structure their Ukrainian operations, such as the Netherlands, which now appears to be preferable in the long-term perspective,” said Serhiy Melnik of Salans law firm in Kyiv.
While Netherlands has a good double tax treaty with Ukraine, its domestic tax rates are substantially higher than Cyprus and it also collects withholding tax on funds moved out of the country.
The first signs of a shift in Ukrainian loyalties from Cyprus to Holland are already apparent. Experts point to recent changes in corporate structure of System Capital Management (SCM), the multi-sector industrial group owned by Ukraine’s richest man and high-profile government backer, Rinat Akhmetov.
Until 2009, SCM’s Ukraine subsidiaries were owned by Cyprus holding company, SCM Ltd, and the company’s website still displays them as such. However, in December 2009, as part of a corporate structure overhaul, SCM eliminated its Cyprus intermediary from the power sector holding DTEK, in favor of a Netherlands-registered holding company DTEK B.V.
SCM’s massive Metinvest holding, one of Europe’s largest steelmakers, is also owned by Dutch-registered Metinvest B.V. SCM investor relations manager Jock Mendoza-Wilson said the reason for the moves was “enhanced transparency.”