In Re (#01-02 January-February 2019)

Attribution of Profits to Permanent Establishments: is Ukraine Adopting the Authorized OECD Approach?

Yuriy Tsvetkov, Vitali Trachuk

Ukrainian tax legislation has never been sufficiently clear as to how exactly, for Corporate Income Tax purposes, a foreign enterprise should attribute income and expenses to its permanent establishment (PE) in Ukraine. This lack of legal guidance potentially sets at variance taxpayers and the government. On the one hand, taxpayers are not in a position to reasonably determine a portion of profits attributable based on the current imprecise rules. As a result, taxpayers are effectively incapable of effective tax compliance, thereby facing inherent tax risk associated with operating via a PE in Ukraine. On the other hand, the government is unable to conduct effective tax audits of PEs due to vague legislation, losing tax revenues when PEs are not quite sincere in attributing certain profits to their business activities in Ukraine.

Taking a first step towards countering tax avoidance through PEs, about a year ago the Ukrainian Parliament subjected transactions between the PE and its head office to transfer pricing rules. Yet, this measure per se did not resolve the issue.

The second major step towards installing correct regulatory framework for PE taxation should be the adoption of a completely new profits attribution mechanism in line with the principle of arm's length ("as if it were a distinct and separate enterprise).

How PEs are presently taxed

The majority of transactions between a foreign entity and its PE in Ukraine take the form of a so-called financing. More specifically, the PE business model presupposes that a Ukrainian PE operates without a considerable profit margin, whereas the head office covers PE's operational costs with regular financial contributions. Such contributions are generally treated as income by the Ukrainian tax office.

When a PE operates under the general model of taxation attributable profits are determined according to general accounting rules at the PE level its taxable base created through financing is effectively reduced by relevant expenses incurred by the PE. Provided the PE operates under the 0.7 model, the tax base is equal to 30% of financing received from the head office. It follows that, since financing is basically aimed at covering costs incurred by the PE, the latter is, in fact, taxed as if it had a 30% mark-up on the services provided to head office. This percentage of mark-up is artificial and, depending on circumstances, may be too high for some taxpayers and, at the same time, too low for others.

As a result, in the case of a general model, PEs pay little or no CIT in Ukraine, which dictates the increasing scrutiny of PEs by the tax office. As for the 0.7 model, CIT is actually paid by PEs, but the model is neither effective for countering abusive taxpayers nor fair from the taxpayers point of view.

Few Ukrainian PEs obtain profits directly from their activities in Ukraine. In their case, however, the financing from head office is not usually considerable and, usually, does not significantly affect the taxable base. For such PEs, the CIT base is currently determined more or less fairly.

Transfer pricing (TP) rules for PE financing

On 7 December 2017, the Ukrainian Parliament introduced a new provision in the transfer pricing rules of the Tax Code of Ukraine (Tax Code), classifying transactions between a non-resident and its permanent establishment in Ukraine as controlled transactions for transfer pricing purposes.

This amendment effectively means that should the transfer pricing thresholds be reached, taxpayers have to treat PE financing as remuneration for services rendered by the PE to its head office and determine such financing at arm's length, accordingly. This approach is generally in line with international rules on taxation of PEs.

Considering the complexity of accurately ascertaining the exact role of the PE in the overall enterprise, it appears rather difficult to determine an appropriate transfer pricing method in that respect. It may be argued that, under such circumstances Ukrainian taxpayers might opt out of applying the transactional net margin method (TNMM) which is so popular in Ukraine. In fact, it appears to be quite difficult to find comparable cases in a PEs context.

In any event, following the amended TP rules, Ukrainian PEs will have to file the transfer pricing report describing the instances of PE financing for the 2018 reporting year. Accordingly, it is likely that many taxpayers, especially those operating under the general model, will have to adjust their CIT payables.

Authorized OECD Approach

The Ministry of Finance of Ukraine recently published a Draft Law On Implementation of the BEPS Actions in Ukraine (the BEPS Draft Law).1 One of the most significant changes to be introduced delves into the taxation of PEs.

To this end, the BEPS Draft Law suggests substituting the existing models of PE taxation with a new model, which presupposes taxation of a PE "as if it were a distinct and separate enterprise effectively applying the arm's length principle with specific reference to the transfer pricing rules.

It worth noting that this approach is not unique or innovative. In fact, it is in the streamline of the globally recognized model of attribution of profits to PEs, as endorsed by the OECD in its 2010 Report on the Attribution of Profits to Permanent Establishments. This model is also known as the Authorized OECD Approach.

However, the proposed wording of the Tax Code does not appear to be specific enough. The Authorized OECD Approach provides for a sophisticated mechanism of profit attribution, involving:

functional and factual analysis;

recognition of dealings between the PE and the enterprise in its entirety; and

determination of the profits of the hypothesised separate and independent enterprise (i.e. the PE) based on comparability analysis under the transfer pricing rules.

Yet, the new proposed PE taxation rules fail to address the functional and factual analysis stage, as well as the issues of recognition of dealings within a single enterprise. In the absence of such rules, there is a high risk of conflicts in tax approaches between the enterprises and the tax office. Moreover, Ukraine might develop practices which do not conform to OECD standards. There is a hope that the new subordinate legislation to be developed in furtherance of the discussed draft law will shed some light on the governments view on profit attribution to PEs. Otherwise, the taxpayers get in hardship, having no clear play rules when it comes to attributing profits under the Authorized OECD Approach.

Taxpayers who have contemplated establishing a PE in Ukraine or are contemplating this, should be fully aware of the coming changes and assess them against their current internal tax approach. Their existing business models may be at risk and, should the draft law be passed, may require revision of their corporate and commercial structures in order to cope with the new reality.


Developing a revenue-efficient approach to taxation of PEs, despite this form of doing business being rather rare in Ukraine, appears to be one of the priorities of the current government. We believe that aligning Ukrainian PE taxation rules with international standards is a positive step towards legal certainty and the investment attractiveness of Ukraine. Improvements in this respect are long overdue and adopting clear and precise rules of PE taxation is a hot-button for Ukraine.

At the same time, current Ukrainian transfer pricing rules which the government relies upon in the draft law sponsored by the Ministry of Finance provide rather poor guidance on determining arms length remuneration of a PE for the services rendered to the enterprise. Furthermore, a proposed initiative to adopt the Authorized OECD Approach might not be successful if no additional guidance is provided both to taxpayers and the tax office.

In any event, when this article was written, the BEPS Draft Law was not even registered in the Ukrainian Parliament and may be re-considered even at the initiative level. Apart from the legislative basis, enforcement and court practices will have to be developed in respect of attribution of profits to PEs. Nonetheless, the ambition and attempt to establish a proper legal framework for taxing PEs in Ukraine is quite a positive sign, for this should establish the plain field for both the foreign businesses and the tax office.

Vitalii Trachuk
is an associate at the Kyiv Office of Baker McKenzie

Yuriy Tsvetkov
is a counsel at the Kyiv Office of Baker McKenzie

1 See
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