Taxation of Permanent Establishments in Ukraine: Unresolved Issues

Taxation of Permanent Establishments in Ukraine: Unresolved Issues Author(s): Vitalii Trachuk, Khrystyna Franchuk Source: Kyiv-Mohyla Law and Politics Journal 4 (2018): 159–174 Published by: National University of Kyiv-Mohyla Academy http://kmlpj.ukma.edu.ua/ Taxation of Permanent Establishments in Ukraine: Unresolved Issues Vitalii Trachuk National University of Kyiv-Mohyla Academy, Faculty of Law; Baker McKenzie Kyiv Khrystyna Franchuk National University of Kyiv-Mohyla Academy, Faculty of Law; Baker McKenzie Kyiv Abstract This article deals with selected issues of taxation of permanent establishments in Ukraine that lack appropriate judicial and scholarly attention. It particularly focuses on the attribution of profits to permanent establishments according to OECD standards and Ukrainian law, taxation of dependent agent permanent establishments, and the State’s taxing rights with respect to the permanent establishment’s financing by its head office. The authors conclude that to improve the quality of permanent establishments’ taxation in Ukraine, appropriate procedures should be clearly prescribed in the law and due regard be given to the already developed international standards that might be, in fact, directly applicable. Key Words: permanent establishment, taxation, attribution of profits, Authorized OECD Approach, tax convention. Introduction For decades, Ukrainian tax legislation has contained a provision prescribing the taxation of permanent establishments (PE). Being a party to a range of double taxation treaties after the collapse of the Soviet Union, Ukraine was forced to implement the concept of PE as most developed countries had for about a century.1 Since then, Ukrainian authorities have registered numerous representative offices of foreign enterprises as PEs and taxed them with Corporate Income Tax (CIT) accordingly. Yet, many PE tax issues have arisen that the tax authorities or the Ukrainian courts have not adequately considered. The definition of a PE under the Tax Code of Ukraine (2010) (the Tax Code) is reasonably up-to-date if the 2017 OECD Model Tax Convention implementing the BEPS 1 Peter Harris and David Oliver, International Commercial Tax (New York: Cambridge University Press, 2010), 136. 160 Kyiv-Mohyla Law and Politics Journal 4 (2018) Action 7 is disregarded.2 Relying on the OECD and UN Models,3 the definition incorporates the canonical concepts of a “fixed place of business,” a “dependent agent,” and even a “services PE,” though the latter is a rather controversial concept from a tax policy perspective.4 Indeed, in defining “dependent agent,” the Tax Code, which covers even the negotiation of contracts, moved in a progressive direction because that definition arguably could be used to effectively combat aggressive schemes aimed at avoiding PE status through commissionaire arrangements and similar strategies.5 Likewise, Ukraine’s courts have properly developed the Tax Code’s definition of PE, allowing it to serve as an effective means to legitimately tax a portion of the profits derived by multinational enterprises arising from Ukraine, including those originating in Ukraine.6 This article’s purpose, however, is not to praise the accomplishments of the Ukraine’s legislature, tax authorities, or courts. Nor is it aimed at explaining or commenting on the issues that commonly arise in PE tax disputes, such as the application of specific activity exemptions. Instead, this article is intended to shed light on those issues that either have been completely ignored by the legislature or that suffer from a disproportionate lack of attention relative to the common issues. Therefore, this article focuses on the following: (1) the rules on the attribution of profits to PEs in Ukraine; (2) the application of the dependent agent PE concept; and (3) the taxation of PE financing by its head office. Attribution of Profits to a PE The issue of the attribution of profits to PEs arguably is the most controversial issue in international taxation. This issue is so complex that the OECD Member States 2 Model Tax Convention on Income and on Capital: Condensed Version 2017 (OECD Library, 2017), accessed December 14, 2018, http://dx.doi.org/10.1787/mtc_cond-2017-en; Preventing the Artificial Avoidance of Permanent Establishment Status, Action 7–2015 Final Report (OECD Library, 2015), accessed December 14, 2018, http://dx.doi.org/10.1787/9789264241220-en. 3 Model Tax Convention on Income and on Capital: Condensed Version 2005 (OECD Library, 2005), accessed December 14, 2018, http://dx.doi.org/10.1787/mtc_cond-2005-en, Article 5; United Nations Model Double Taxation Convention between Developed and Developing Countries (The United Nations Financing for Development, 2001), accessed December 14, 2018, http://www. un.org/ga/search/view_doc.asp?symbol=ST/ESA/PAD/SER. E/21&Lang=E, Article 5. 4 Model Tax Convention 2017, Commentary on Article 5, 154–64, paras 132–69. 5 Tax Code of Ukraine of December 2, 2010, accessed July 1, 2018, http://zakon2.rada.gov.ua/laws/ show/2755–17, Article 14.1.193; Action 7–2015 Final Report, 15. 6 Decision of the Kyiv Appeal Administrative Court in Case No. 826/244/15 of June 12, 2018, accessed July 3, 2018, http://www.reyestr.court.gov.ua/Review/74728831; Ruling of the Supreme Court in Case No. 2А-16434/12/2670 of June 13, 2018, accessed July 3, 2018, http://www.reyestr. court.gov.ua/Review/74785269; Ruling of the Kyiv Appeal Administrative Court in Case No. 826/18313/16 of June 20, 2018, accessed July 3, 2018, http://www.reyestr.court.gov.ua/ Review/74879947. Vitalii Trachuk, Khrystyna Franchuk. Taxation of Permanent 161 Establishments in Ukraine: Unresolved Issues decided against proposing detailed rules on it in the Model Tax Convention and in the Commentaries to the Model Tax Convention when issuing special Reports and Guidelines on this matter.7 Nevertheless, 10 years ago they adopted the Authorized OECD Approach (the AOA) on the attribution of profits to PEs.8 What exactly is the AOA? To answer this question, this article first analyzes the basic principles underlying the concept of PE, starting with what a PE is. A PE, in short, is a legal instrument that allows a source State to tax business profits arising within its territory. In other words, under the standard rules of international taxation, a State may legitimately tax only those business profits of foreign enterprises that not merely arise within its territory but also satisfy a set of specific legal requirements, which in themselves form a concept of PE. These legal requirements represent a certain economic connection between an enterprise and the source State. This economic connection may be physical (“fixed place of business”) or influential (“dependent agent”). Once the economic connection is established and a PE is deemed to exist, the source State receives the right to tax the PE, but the specific taxation model remains to be determined. The right to tax an enterprise through its PE is not a right to tax any profits of this enterprise wherever and whatever their source. More notably, the source State does not even receive the right, as it is argued, to tax any business profits of an enterprise derived from its own territory. The source State receives the right to tax only those business profits that are attributable to the respective PE. The question of attribution is dealt, generally, with three models: (1) the “force of attraction” model; (2) the “relevant business activity” model; and (3) the last, but not the least important, the “functionally separate entity” model. The “force of attraction” model represents the most primitive view on the attribution of profits to PEs. That is, this model bypasses the attribution process as such, allowing the State to tax all profits of an enterprise with a PE that are derived from the source State, regardless of whether they are actually and economically connected with the PE. This model, however, does not correspond with the principles embodied in the OECD Model. In fact, it contradicts the precise wording of Article 7(1), which states that: “[t]he profits that are attributable to the permanent establishment… may be taxed in that other State.” 9 The “relevant business activity” (the RBAA) and the “functionally separate entity” (the FSEA) models are quite similar in that they attribute profits to a PE in contrast to 7 Report on the Attribution of Profits to Permanent Establishments of July 17, 2008, OECD, accessed July 1, 2018, https://www.oecd.org/tax/transfer-pricing/41031455. pdf; 2010 Report on the Attribution of Profits to Permanent Establishments of July 22, 2010, OECD, accessed July 1, 2018, http://www.oecd.org/tax/transfer-pricing/45689524.pdf; Additional Guidance on the Attribution of Profits to a Permanent Establishment under BEPS Action 7of March 22, 2018, OECD, accessed July 1, 2018, http://www.oecd.org/tax/transfer-pricing/additional-guidance-attribution-of- profits-to-permanent-establishments-BEPS-action-7. pdf. 8 Report on the Attribution of Profits. 9 Article 7(1), Model Tax Convention, 2005. 162 Kyiv-Mohyla Law and Politics Journal 4 (2018) the “force of attraction” model. But, otherwise, they are fundamentally different from each other. The RBAA is a widely used and discussed model of attribution. Although it does not derive from the explicit wording of Article 7, countries have successfully applied it; Australia, for example.10 Under the RBAA, the PE’s profits are determined by apportioning the overall profits of the enterprise from its business activities that

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