Ukraine rethinking dividend distribution tax, rationalizing simplified taxes, and adopting beps measures, june 2017

1. I N T E R N A T I O N A L M O N E T A R Y F U N D F I S C A L A F F A I R S D E P A R T M E N T IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff. OFFICIAL USE ONLY Ukraine Rethinking Dividend Distribution Tax, Rationalizing Simplified Taxes, and Adopting BEPS Measures Roberto Schatan, Martin Grote, and Michael Kobetsky Technical Assistance Report | May 2017

2. F I S C A L A F F A I R S D E P A R T M E N T CONFIDENTIAL Ukraine Rethinking Dividend Distribution Tax, Rationalizing Simplified Taxes, and Adopting BEPS Measures Roberto Schatan, Martin Grote, and Michael Kobetsky Technical Assistance Report June 2017 IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

3. The contents of this report constitute technical advice provided by the staff of the International Monetary Fund (IMF) to the authorities of Ukraine in response to their request for technical assistance. This report (in whole or in part) or summaries thereof may be disclosed by the IMF to IMF Executive Directors and members of their staff, as well as to other agencies or instrumentalities of the TA recipient, and upon their request, to World Bank staff and other technical assistance providers and donors with legitimate interest, unless the TA recipient specifically objects to such disclosure (see Operational Guidelines for the Dissemination of Technical Assistance Information— http://www.imf.org/external/np/pp/eng/2013/061013.pdf). Disclosure of this report (in whole or in part) or summaries thereof to parties outside the IMF other than agencies or instrumentalities of the TA recipient, World Bank staff, other technical assistance providers and donors with legitimate interest shall require the explicit consent of the TA recipient and the IMF’s Fiscal Affairs Department. IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

4. 3 CONTENTS ABBREVIATIONS AND ACRONYMS _____________________________________________________________ 3 PREFACE __________________________________________________________________________________________ 5 EXECUTIVE SUMMARY___________________________________________________________________________ 6 I. DIVIDEND DISTRIBUTION-BASED CORPORATE TAX (DDBCT)______________________________ 9 A. Emerging Support for a DDBCT _________________________________________________________________9 B. Current CPT Revenue Performance ______________________________________________________________9 C. Why a Classical CIT Model?____________________________________________________________________ 12 D. Proposals for a Dividend Distribution Tax _____________________________________________________ 14 E. Arguments in Favor of a DDBCT _______________________________________________________________ 18 F. Arguments Against the DDBCT ________________________________________________________________ 20 G. Counter Avoidance Methods __________________________________________________________________ 23 H. Concluding Assessment of the DDBCT and Proposed Measures for Building Fiscal Buffers___ 28 II. THE SIMPLIFIED TAX SYSTEM—OPTIONS FOR RATIONALIZATION ______________________ 29 A. Current Simplified Tax System_________________________________________________________________ 29 B. Identified Shortcomings of the STS____________________________________________________________ 35 C. Global Experiences with Micro and Small Business Taxation __________________________________ 36 D. Adopting a More Practical Approach__________________________________________________________ 37 III. IMPLEMENTING BASE EROSION AND PROFIT SHIFTING MEASURES IN UKRAINE _____ 43 A. BEPS Context __________________________________________________________________________________ 43 B. Inclusive Framework ___________________________________________________________________________ 44 C. BEPS Minimum Standards _____________________________________________________________________ 45 D. Multilateral Instrument (Action 15)____________________________________________________________ 51 E. Additional BEPS Measures: Short-Run _________________________________________________________ 52 F. Additional BEPS Measures: Medium-Term_____________________________________________________ 54 IV. TRANSFER PRICING _________________________________________________________________________ 57 A. Regulatory progress and ongoing TP risks ____________________________________________________ 57 B. TP for Domestic Transactions__________________________________________________________________ 60 C. Exemptions ____________________________________________________________________________________ 61 D. Transfer Pricing on Commodities______________________________________________________________ 64 E. Pricing Grains __________________________________________________________________________________ 73 BOXES 1. Issues and Options for Taxing Micro, Small and Medium-sized Businesses (SMEs)____________ 38 2. Simplified LOB _________________________________________________________________________________ 47 3. FAD Recommendations on Transfer Pricing (October 2014)___________________________________ 59 4. Regulating Commodity TP In Developing Countries___________________________________________ 68 IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

5. 4 FIGURES 1. Ukraine: General Government Tax Revenue Mix (percent GDP), 2000–16 _____________________ 11 2. Ukraine and Comparators: General Government Revenue Mix (percent GDP), 2015 __________ 11 3. VAT C-Efficiency: Ukraine and Comparators, 2015_____________________________________________ 11 4. CIT Productivity: Ukraine and Comparators, 2015 _____________________________________________ 11 5. Tax Revenue as Percent of GDP, Ukraine vs. Comparator Average ____________________________ 12 6. Ukraine: FDI, 2005–15__________________________________________________________________________ 14 7. CIT Collections Ukraine vs. Estonia, 1990–2014________________________________________________ 20 8. Ukraine: Number of Employees vs. Single Taxpayers, 2002–16 ________________________________ 34 9. Ukraine Unit Export Prices and Exchange Quotations for Selected Grains_____________________ 74 10. Wheat Spot Prices: Black Sea and MATIF_____________________________________________________ 75 11. Corn Spot Prices: Black Sea and Chicago Board of Trade_____________________________________ 75 TABLES 1. Ukraine: General Government Revenue (percent GDP), 2000–16 ______________________________ 10 2. Statutory VAT and CIT Rates (percent), Ukraine and Comparators, 2016 ______________________ 12 3. Objective and Determinants of FDI Location __________________________________________________ 14 4. Ukraine: Financial and Tax Statistics for Sample of Companies, 2014/15 ______________________ 22 5. Ukraine: Single Taxpayers vs. Employees and Paid Tax, 2014 __________________________________ 31 6. Ukraine: Business Income—Tax Treatment of Taxpayers in the Simplified (Unified) and General Tax Systems ______________________________________________________________________________ 32 7. Ukraine: Single Taxpayers, their Income, and Taxes Paid, 2002–16 ____________________________ 34 8. Ukraine: Relative Importance of STS Groups 1-3, 2010–15 ____________________________________ 35 9. Stylized Distribution of Tax Rates according to Profit Margin _________________________________ 41 10. FDI Into Ukraine, 2012, 2016 _________________________________________________________________ 58 11. Ukraine Export Value Composition (USD Millions), 2008–16 _________________________________ 65 12. Net Income Over Total Costs and Expenses, Grain Merchant Wholesalers, Ukraine and the Rest of the World ________________________________________________________________________ 76 APPENDICES 1. Tax Revenue Comparisons ; Ukraine vs. Comparators _________________________________________ 79 2. Estonian Dividend Distribution Tax ____________________________________________________________ 80 3. Legal Text for Proposed Anti-Avoidance Provisions ___________________________________________ 83 4. Notes 1–9 to the Comparative Table on the Simplified Tax System ___________________________ 86 5. VAT Registration Thresholds, 2016 ____________________________________________________________ 91 IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

6. 5 APPENDIX TABLES A1. General Government Revenue by Source for Ukraine and Comparators (percent GDP), 2015______________________________________________________________________________________ 79 A2. CIT Productivity and VAT C-Efficiency for Ukraine and Comparators, 2015 __________________ 79 APPENDIX BOXES A3.1. Example of Imposition of Personal Income Tax upon Emigration __________________________ 83 A3.2. Example of Imposition of Corporate Income Tax upon Emigration _________________________ 83 A3.3. Anti-avoidance Rule in Cases of Employment through a Private Company ________________ 84 A3.4. Anti-avoidance Rule in Cases of Substantial Interest _______________________________________ 84 A3.5. Example of the Definition of the Term ‘Employment’ ______________________________________ 85 REFERENCES_____________________________________________________________________________________ 78 IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

7. 3 ABBREVIATIONS AND ACRONYMS AL Arm’s Length ALP Arm’s Length Principle APA Advance Pricing Agreement BEPS Base Erosion and Profit Shifting work program organized by the OECD CbC Country-by-Country CBOT Chicago Board of Trade CFC Controlled Foreign Corporation CFT Cash-flow Tax CIS Commonwealth of Independent States CPT Corporate Profit Tax or Corporate Income Tax CUP Comparable Uncontrolled Price DDBCT Dividend Distribution-Based Corporate Tax EBITDA Earnings before Interest, Tax, Depreciation and Amortization ECE Easter and Central European States EFF Extended Fund Facility FAD Fiscal Affairs Department of the IMF FDI Foreign Direct Investment GAAP Generally Accepted Accounting Principles GAAR General Anti-Avoidance Rule GDP Gross Domestic Product IMF International Monetary Fund IP Intellectual Property LLC Limited-Liability Company LOB Limitation of Benefits LTJ Low Tax Jurisdiction MAP Mutual Agreement Procedure MATIF Marche a Terme International de France MLI Multilateral Instrument MNE Multinational Enterprise MOF Ministry of Finance MSMW Minimum Statutory Monthly Wage MSW Minimum Subsistence Wage OECD Organization for Economic Cooperation and Development PE Permanent Establishment PIT Personal Income Tax PPT Principal Purpose Test R&D Research and Development SFS State Fiscal Service SPC Special Purpose Company SSC Social Security Contribution STS Simplified Tax System ST Single Tax IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

8. 4 TA Technical Assistance TNMM Transnational Net Margin Method TP Transfer Pricing UAH Ukrainian Hryvnia UTC Ukrainian Tax Code VAT Value-added Tax WHT Withholding Tax IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

9. 5 PREFACE In response to a request from the Minister of Finance, Mr. Oleksandr Danylyuk, a technical assistance mission from the International Monetary Fund’s (IMF) Fiscal Affairs Department (FAD) visited Kiev from March 13–27, 2017 to review selected tax issues and advise on specific tax reform proposals. The mission comprised Messrs. Roberto Schatan (mission head), Martin Grote (both from FAD) and Mr. Michael Kobetsky (external expert). The mission presented the aide memoire and explained its recommendations to the Minister. During its visit, the mission met with Mr. Eugeni Kapinus, Deputy Minister of Finance and Yana Bugrimova, Advisor to Finance Minister. It also had several rounds of productive discussions with Mr. Yevhen Kozlov, Advisor to the Minister in the Reform Support Team, and staff of the Ministry, including Ms. Elena Markiereva, Head of Corporate Income Tax, and Ms. Liudmyla Palamar, Deputy Head of International Taxation Division. Also, the mission met with Mr. Nickolay Mishin, Director of Transfer Pricing, State Fiscal Service, and staff from both the Ministry and the Service. The mission also met with Ms. Olena Makeieva, Advisor to the Minister of Finance. It also held discussions with Ms. Nina Yuzhanina, Chair of Rada's Tax and Customs Policy Committee, and with several representatives of civil society organizations that closely follow taxation issues in Ukraine, including the Centre for Economic Strategy and the Center for Social and Economic Research. From the private sector, the mission met with representatives from the European Business Association, the American Chamber of Commerce, Cargill, EY, PwC, and grain traders. The mission also met separately with the representatives of the Technical Assistance Office of the U.S. Treasury, with Mr. William Tompson, Head of the Euroasia Division of Global relations at the OECD and with a team of consultants of the German Advisory Group Ukraine, including Mr. Thomas Otten and Mr. David Saha. The team acknowledges the excellent support that it received from Mr. Jerome Vacher (IMF Resident Representative) and Mr. Ihor Shpak (senior economist, IMF Kiev office). The mission also recognizes the excellent research assistance provided by Messrs. Victor Mylonas and John R. Damstra from IMF headquarters. Finally, the mission would also like to express its sincere appreciation to Mr. Victor Verhun and Mss. Liza Snegireva and Oksana Burakovska for their outstanding interpretation and collaboration. IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

10. 6 EXECUTIVE SUMMARY Tax policy is beginning to stabilize in Ukraine—tax revenues are raised at sufficient levels to finance macro-fiscal targets and the latest changes to the tax system have been relatively modest compared with the multiple structural reforms adopted in the first half of this decade. However, there is room for improvement, building on the tax edifice that has been developed gradually over the years. The mission was asked to comment on some pending tax policy issues improving the simplified tax system (STS) so that it strictly serves its purpose; adopting G20/Organization for Economic Cooperation and Development (OECD) standards on Base Erosion and Profit Shifting (BEPS) with the view to protecting the tax base from international tax planning; and rationalizing transfer pricing regulations to make them more operational. None of these aspects of the tax system are technically easy and finding wide consensus for solving them has been difficult too. This report proposes options for changes in these areas within the bounds of practicality. More challenging are the remaining strong pressures in Ukraine for fundamentally changing the course of tax policy. The mission met with different stakeholders and found that there is still appetite for sweeping changes, namely, to replace the current Corporate Profit Tax (CPT) with a dividend distribution-based corporate tax (DDBCT) system, representing a radical departure from the current model. Some go beyond this and propose experimenting with a corporate asset tax; others would even like to see a rate reduction of the personal income tax. The mission devoted a good part of its attention to the discussion about adopting a DDBCT. The current Ukrainian income tax system taxes profits as they accrue annually (the CPT) and, additionally, withholds an amount when dividends are distributed to shareholders. The proposed system, in lieu of the CPT, would tax profits when distributed and would eliminate the withholding to shareholders. Intuitively, the new system appears to be very simple as it would eliminate (for tax purposes) the need to track revenues and deductible expenses. As dividends are distributed at the discretion of shareholders and since this event would trigger the tax, shareholders would have a strong incentive to defer profit distribution or to find ways to disguise these through overpayments of other transactions, thereby avoiding the tax altogether. . To stop this practice, the new regime, as proposed, would also tax ‘deemed’ dividend distributions at a higher rate—betraying its goal of simplifying the tax system. Current revenues from the CPT are 2.3 percent of GDP and they are placed at risk with the DPT through deferral alone. Only two countries presently have this system, Estonia and Georgia—the second very recently. Estonia’s experience is indicative: CIT revenue collapsed from an average of 2 percent of GDP in 1995–99 to 0.7 percent of GDP in 2001 (after the introduction of the reform). It took 14 years to reverse the initial impact. Dividend distributions in Ukraine have been very low; not even 0.5 percent of profits in 2014 for foreign owned companies not even 0.5 percent of profits, but currency controls make this an unreliable predictor of what could occur under normal IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

11. 7 circumstances. A prudent estimation is that introducing the DDBCT would severely affect tax revenues, and its supporters have not proposed a well thought plan for how to compensate for it. The initiative, for all practical purposes, amounts to a double tax cut, one for eliminating the current withholding tax on shareholders and another for permitting indefinite deferral of the corporate tax. In the mission’s assessment, this would be a breach of Ukraine’s commitment under the IMF Extended Fund Facility (EFF) program. Since the Ministry of Finance (MoF) has the legal obligation to draft a bill introducing the DDBCT, the mission suggests that the bill itself include a conditionality that the new tax would not go into effect unless tax revenues (from other sources) have increased to absorb the potential impact of the DDBCT, that is, approximately two percent of GDP. The alleged advantages of the DPT are quite questionable: there will be no gains in simplicity if transfer pricing rules should be strictly imposed to a very large universe of transactions; also, there is no hint of an imminent corporate liquidity crunch to justify an interest free public financing program amounting 2 percent of GDP, annually. On the other hand, coupling a DPT with a corporate asset tax would defeat the purpose of promoting private investment. Ultimately, it is not clear what current shortcomings would this new system resolve; in a way, it is a solution in search of a problem. The ultimate argument for supporting the DDBCT is that it offers a way for extracting taxpayers from the arbitrariness of the tax authority. However, the CPT has already been simplified substantially and remaining enforcement problems can fundamentally be resolved at an administrative level. There is a limit to how much policy changes can do in this respect; further radical changes are not justified on this account and they threaten to re-introduce instability and unpredictability into the system. Thus, the mission cannot support adopting the DDBCT. There are measures that can be adopted to improve the overall tax system, however. The STS is important because it involves many people and it marks one of the relevant frontiers with informality. The system should honor its name, encourage businesses to grow, and should not serve as a refuge for high income taxpayers to avoid tax. Unfortunately, the current system falls short in all these areas. Legal entities should not benefit from the STS’s privileges, nor should VAT payers, the position of self-contractors should be strictly defined so that employees cannot be retained as independent service providers. Once taxpayers have migrated to the general system they should not be allowed to go back to the STS. Taxing transnational companies is also a challenge. It is now recognized that the international tax architecture has weaknesses that need to be addressed so that those companies do not exploit them to minimize their tax obligations. OECD and G20 countries have committed to adopt several measures, both in domestic laws and through amending treaty networks, to counter international tax avoidance. Ukraine joined the Inclusive Framework sponsored by the OECD and thus committed herself to adopt the minimum standards. Very succinctly, these are: (1) to eliminate harmful tax practices; (2) require information from Multinational Enterprises (MNEs) IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

12. 8 headquartered in Ukraine to provide information country-by-country about their revenues, profits and taxes through country-by-country; (3) introduce anti-treaty-shopping provisions; and (4) improve Mutual Agreement Procedures (MAPs) among competent authorities, so that double taxation disputes may be resolved within a reasonable time frame. The option to include obligatory arbitration is available as a mechanism to achieve this. The implementation plan developed by the MoF contemplates adopting only the minimum standards for now and defer adoption of all other BEPS measures for the medium-term. The mission agrees with adopting the minimum standards and although they are well understood by the MoF, there are a few optional features (e.g., anti-treaty shopping measures) that the mission considered more in detail and advises which could be of greater benefit for Ukraine. For example, at least for the time being, the mission believes that adopting binding arbitration procedures should be deferred. More experience with MAPs should be developed first. This advice is relevant for drafting the articles which will not be reserved by Ukraine when signing the Multilateral Instrument (MLI – BEPS Action 15). More importantly, the adoption of the minimum standards will require devoting resources and the MoF is critically understaffed in this area. The rest of the BEPS measures require prioritization. Measures to protect the tax base, and which are relatively simple to apply, should get attention first. Limiting interest deductions, a common instrument to shift profits abroad (BEPS Action 4); strengthening the concept of permanent establishment (PE) of foreign resident companies operating in Ukraine (BEPS Action 7), could be first in line after the minimum standards are adopted. Other measures, such as a well-defined controlled foreign corporation (CFC) regulatory framework (BEPS Action 3); or a defensive mechanism against hybrid instruments that lead to double non-taxation (BEPS Action 2), will require technical assistance (TA) well beyond the scope of this mission. More generally, Ukraine needs to review its treaty network, which will require more than renegotiating low withholding tax rates. Finally, transfer pricing (TP) regulations and enforcement in Ukraine have improved over the years. However, the general regime could be refined. The mission makes some recommendations to this effect. For example, it is recommended that the arm’s length principle be applied to domestic controlled transactions, but reverting in this case the burden of proof onto the tax authority. The more complex issue in TP is the special regime applying to commodities. To prevent aggressive tax planning by commodity exporters, it is mandated by law that prices must be set per quoted prices on specific international exchanges. There has been considerable push- back from the private sector in this regard. The mission recommends some flexibility through additional administrative regulation which would admit an average of quotes from private brokers trading commodities in the Ukrainian market to be considered as being equivalent to commodity exchange data. This preserves the essence of the system, but making it more practical. IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

13. 9 I. DIVIDEND DISTRIBUTION-BASED CORPORATE TAX (DDBCT) A. Emerging Support for a DDBCT 1. Several political groupings, NGOs, and some members in the Rada have supported the introduction of a dividend distribution-based corporate tax (DDBCT). This would replace the classical CPT1 model that taxes corporate profits both in the hands of the company as net earnings accrue and of its shareholders when dividends are distributed. This model provides that, in the case where profits are not distributed, significant tax deferral benefits accrue to taxpayers at their discretion. Following the Estonian model (but in contrast with the Georgian system), the DDBCT proposal would eliminate the accompanying dividend withholding tax on domestic distributions and profit repatriations to non-residents. 2. The lobbyists for the DDBCT emphasize the following positive aspects of the DDBCT—(1) it enables the build-up of cash reserves for reinvestment which is particularly attractive for companies that cannot access credit lines; (2) since the assessment of taxable income is no longer needed and the tax is only triggered when a dividend is declared, interaction with the State Fiscal Service (SFS) is limited to the events of dividend distributions; (3) since the tax is raised on flows into and out of the stock of distributable reserves, reliance on financial statements with cross-reference to data from financial institutions would facilitate enforcement and compliance; and (4) given the proffered minimization of contact with the SFS, remaining governance weaknesses in the revenue administration-taxpayer relationship will be reduced. 3. This TA Report will summarize the arguments for and against the DDBCT versus the classical CPT system. The arguments in favor will be balanced with the drawbacks of the system—highlighting first and foremost the revenue risk stemming from the taxpayer’s choice to defer the distribution of profits out of the company. A major part of this chapter will analyze likely avoidance risks for the DDBCT and suggest counter measures. B. Current CPT Revenue Performance 4. The current CPT effectively generated revenues equal to an average 3.9 percent of GDP from 2001 to 2016 (Table 1). IMF Staff reviewing Ukraine’s fiscal performance for purposes of the Art. IV consultations and the 3rd Review under the EFF commented positively that budget execution continues to be strong, complying with commitments under the program targets. For example, the estimated 2016 budget deficit is 2.3 percent of GDP, in lieu of a target of 3.7 percent of GDP. This was achieved through stronger collection of taxes and non-taxes. 1 In the Ukraine the corporate income tax (CIT) is labeled as the corporate profit tax (CPT). IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

14. 10 Table 1. Ukraine: General Government Revenue (percent GDP), 2000–16 5. Ukraine’s revenue mix over time indicates a gradual decline in CPT collections for the period 2001–16 (as percent of GDP). Over the same period, personal income tax collections (PIT) increased by 1 percentage point and the VAT revenue importance (as percent of GDP) added another 5.6 percentage points (Figures 1 and 2 and Table 1 in Appendix 1). Ukraine’s collection efficiency in respect of CPT and VAT is below the regional average for CIT, but almost on par with the average VAT C-efficiency for the comparator countries, evidencing the benefits of recent VAT administration reforms (Figures 3 and 4). 6. It is a concern for the future successful execution of the EFF program that there may be major tax cuts. After the tax reforms of late 2015, statutory tax rates in Ukraine are no longer high by international standards—Ukraine’s CPT rate is higher than for countries in East Europe but compare favorably with EU-28’s 22.8 percent (Table 2).2 Evidence points at a solid revenue performance in the Ukraine versus the regional comparator group, as expressed in percent of GDP (Figure 5). Ukraine’s fiscal stability could be at risk on the revenue front with a change in the corporate tax system that is not equally efficient. 2 According to the World Bank Paying Taxes (PWC) benchmark Ukraine’s CIT rate and compliance period are comparable with the rest of Europe and improving. Ukraine has aligned its financial and tax accounting requirements so that CIT compliance no longer exerts a high compliance burden on transparent businesses. Revenue Instruments 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Total Revenue(A + B + C+ D+ E) 32.3 32.4 34.7 36.6 35.8 40.4 41.6 40.2 42.4 40.8 43.4 42.9 44.7 43.3 40.3 42.1 38.1 A. Taxes (a+ b+ c + d) 20.2 19.3 20.8 21.8 20.1 24.1 25.3 24.1 25.3 23.9 26.0 26.0 25.9 24.4 23.8 25.8 28.0 a. Taxes onincome, profits, andcapital gains NoData 8.1 8.6 9.6 8.2 8.9 8.7 9.2 9.5 8.2 8.5 8.9 8.8 8.7 7.3 7.0 8.1 Payableby individuals NoData 4.2 4.6 4.9 3.7 3.8 4.0 4.6 4.6 4.7 4.7 4.6 4.8 4.9 4.7 5.1 5.7 Payableby corporations andotherenterprises NoData 3.9 4.0 4.8 4.5 5.1 4.6 4.6 4.8 3.5 3.7 4.2 4.0 3.8 2.5 2.0 2.3 b. Taxes ongoods andservices NoData 8.9 10.0 9.0 8.8 12.1 13.8 12.3 13.3 13.3 13.3 13.5 13.5 12.0 12.7 13.2 14.5 c. Taxes oninternational tradeandtransactions NoData 0.9 1.0 1.4 1.4 1.5 1.3 1.3 1.2 0.7 0.8 0.9 0.9 0.9 0.8 2.0 0.9 d. Taxes Not ElsewhereClassified NoData 1.4 1.2 1.8 1.6 1.6 1.5 1.2 1.2 1.7 3.4 2.8 2.7 2.8 3.0 3.6 4.6 B. Grants 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 C. Social contributions 6.9 7.6 8.5 9.6 10.1 10.8 11.0 11.0 10.9 11.7 11.7 12.4 13.1 13.2 11.6 9.6 5.6 D. OtherRevenue 5.2 5.4 5.4 5.2 5.6 5.5 5.4 5.1 6.2 5.2 5.7 4.5 5.7 5.7 4.9 6.6 4.5 E. Residual* 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Source:WEO;GDPDataSource:WEO Note:Markedfields representWEOestimates."NoData"fields representmissingvalues. *Residualis duetotaxrevenues notelsewhereclassifiedbyWEO. IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

15. 11 Figure 1. Ukraine: General Government Tax Revenue Mix (percent GDP), 2000–16 Figure 2. Ukraine and Comparators: General Government Revenue Mix (percent GDP), 2015 Figure 3. VAT C-Efficiency: Ukraine and Comparators, 20153 Figure 4. CIT Productivity: Ukraine and Comparators, 20154 3 VAT C-Efficiency is defined as VAT Revenue / (Total Final Consumption net of VAT Revenue * VAT Rate). 4 CIT Productivity is defined as (CIT Revenue as percent of GDP) / (CIT Rate). 0.0 5.0 10.0 15.0 20.0 25.0 30.0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 TaxRevenueComponents(%GDP) GeneralGovernmentTaxRevenueMix(%GDP),Ukraine,2000-2016 PIT CIT Goods Trade Unclassified 0.0 10.0 20.0 30.0 40.0 50.0 60.0 RevenueComponents(%GDP) Country General GovernmentRevenueMix (% GDP), Ukraineand Comparators, 2015 PIT CIT General Goods and Services International Trade Unclassified Taxes Social Contributions Grants Other Revenue 0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00 VAT C-Efficiency for Ukraine and Comparators, Latest Year of Actual Data Available 0.00 0.05 0.10 0.15 0.20 0.25 0.30 Ukraine Albania Armenia Belarus BosniaandHerzegovina Bulgaria Croatia CzechRepublic Estonia Georgia Hungary Kosovo Latvia Lithuania Macedonia,FYR Moldova Montenegro,Rep.of Poland Romania Serbia SlovakRepublic Slovenia CIT Productivity for Ukraine and Comparators, Latest Year of Actual Data Available IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

16. 12 Table 2. Statutory VAT and CIT Rates (percent), Ukraine and Comparators, 2016 Figure 5. Tax Revenue as Percent of GDP, Ukraine vs. Comparator Average C. Why a Classical CIT Model? 7. A CIT is imposed on adjusted accounting profits of corporations as specified in a country’s tax code. It is calculated by deducting costs, including interest payments, from gross receipts or turnover. A CIT has been justified in most countries by the special privileges the corporation receives such as the legally protected limited liability. It is also justified for preventing income sheltering by high-tax-rate individuals. Importantly, the imposition of a CIT could contribute to progressivity in taxation if its economic incidence mainly falls on capital. 8. The CIT is levied on “net” or “taxable income.” Some countries impose a further tax on retained earnings after CIT with the view to forcing undistributed profits out of the company to shareholders on which a further tax could be imposed by way of a dividend withholding tax (WHT)—either withheld at source by the distributing company or taxed in the hands of shareholders. There is also the consideration of dealing more effectively with personal holding companies, which is typically owned by a small number of individuals engaged in investment activities. Depending on the tax system employed, such companies or their shareholders may be subject to additional or heavier tax burdens to discourage the use of these company structures for tax avoidance purposes. 9. Other countries subject retained earnings to a higher or lower rate of CIT than distributed profits. This is the so-called split-rate system under which different rates of CIT are levied on retained and distributed profits. Where the rate on distributed profits is lower than that of retained earnings or profits, this system operates as a partial integration system in relieving Current Standard Rate Nonstandard Rates Ukraine 20.00 0; 7 18.00 Albania 20.00 0; 10 15.00 Armenia 20.00 0.0 20.00 Belarus 20.00 0; 20 18.00 Bosnia and Herzegovina 17.00 0.0 10.00 Bulgaria 20.00 0;9 10.00 Croatia 25.00 5; 13 20.00 Czech Republic 21.00 15; 10 19.00 Estonia 20.00 0; 9 20.00 Georgia 18.00 0.0 15.00 Hungary 27.00 0; 5; 18 19.00 Kosovo 18.00 0; 8 10.00 Latvia 21.00 0;12 15.00 Lithuania 21.00 0; 5; 9 15.00 Macedonia, FYR 18.00 0; 5 10.00 Moldova 20.00 0; 8 12.00 Montenegro, Rep. of 19.00 0; 7 9.00 Poland 23.00 0; 5; 8 19.00 Romania 20.00 0; 5; 9 16.00 Serbia 20.00 0; 10 15.00 Slovak Republic 20.00 0; 10 22.00 Slovenia 22.00 0; 9.5 17.00 Avg, excl. Ukraine 20.48 15.52 Avg, incl. Ukraine 20.45 15.64 EU - 28 Average, 2015 1/ 21.50 22.80 1/ EU, 2015 latest available year for CIT rates, 2014 for VAT rates. Country VAT/GST Rate CIT Rate Source: IBFD and EU DG: Taxation and Customs Union 0.0 5.0 10.0 15.0 20.0 25.0 30.0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 TaxRevenue(%GDP) Year Tax Revenue % GDP, Ukraineand Comparator Average Ukraine Avg, excl. Ukraine IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

17. 13 double taxation. Other jurisdictions impose lower tax rates on retained earnings, with the view to encourage re-investment Classical CIT system and the neutrality principle of taxation 10. Given the international taxation context and the need to design effective anti- avoidance legislation, today’s company tax systems and their reforms are becoming more complex and challenging. It results in high operating costs of a tax system—which is an important indicator of its cost-effectiveness.5 Every tax reform should therefore have as one of its objectives a reduction in complexity of the tax system. It should, inter alia, include steps towards simplification of filing, paying and complying with taxes; it should streamline the tax structure; lower the statutory tax rates when afforded by withdrawing costly tax expenditures; and by cutting the number of deductible items. However, such reforms pose a trade-off if they are accompanied by a material risk to revenues, as presented by the DDBCT proposal. 11. A recent OECD study6 confirmed in a tax-by-tax assessment that CIT had a comparatively more negative impact on growth. It ranked taxes in terms of being least distortive to economic growth, starting with recurrent property taxes, property transaction taxes, net wealth taxes, inheritance taxes; consumption taxes (VAT and excises on tobacco and alcohol), environmentally-related taxes, labor taxes (PIT and social security contributions) and ending with CIT and personal capital income taxes. From that perspective, the conversion of the classical CIT into the DDBCT may correspond with these empirical findings. Yet, most jurisdictions continue with the imposition of the classical CIT. However, Ukraine’s combined tax rate of 22 percent (18 percent CPT plus the WHT on net dividends; 5 percent for residents and 15 percent for non- resident companies, unless a lower treaty rate prevails) is comparable to global and regional practices.7 But tax competitiveness is not the only growth-stimulating measure available. Taxes’ impact on investment and growth 12. One possible justification for the migration from a classical CIT model to the DDBCT is to allow domestic companies to finance from own reserves expansion of their companies and to attract foreign direct investment (FDI). There is an expectation that domestic investors would retain earnings, use saved resources for productive reinvestment and economic growth with the view to broadening the tax base. There is a concern about declining 5 The larger amount of tax revenues per unit of operating cost are collected, the more effective is the system.. 6 Bradbury, D. and Brys, B. presented their findings to the OECD Committee on Fiscal Affairs, Paris; see also Brys, B. et al., 2016. 7 See Table 2. IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

18. 14 FDI flows into the Ukraine, dropping from 5 percent of GDP in 2006 to 3.1 percent of GDP in 2015 (Figure 6). Table 3. Objective and Determinants of FDI Location Figure 6. Ukraine: FDI, 2005–15 13. Even so, empirical evidence suggests that taxation is not the main factor in business investment decisions. According to a World Bank survey of firms investing internationally, national taxes rank number 11 among the top 20 important factors in determining their location decisions (Table 3). Accessing markets, political stability, corruption, labor markets and other operational costs are more important than taxes for location decisions by firms. Tax measures are poor substitutes for these key determinants of investment. In such cases, the first-best solution would be to address these underlying problems directly. Moreover, the most important tax considerations for business investment decisions are not necessarily the relative tax burdens of competing economies. It may be more relevant whether the tax system is stable, predictable, less discretionary and transparent. Frequent policy changes create uncertainty for investors and may dissuade potential investors from investing. To summarize, Ukraine overall level of income taxation is not a concern for investors given comparative international tax levels. D. Proposals for a Dividend Distribution Tax 14. Policymakers interviewed by the mission stated generally that draft tax law amendments follow closely the Estonian Dividend Distribution based Corporate Tax (see Appendix 2 for a brief description of the Estonian model). In discussing the DDBCT with the Ministry, the mission concluded that a type of cash flow tax is envisaged for Ukraine’s corporate sector, including financial institutions, without imposing any other tax (i.e., final dividend WHT) on dividend repatriations. Some uncertainty remains about the design of the DDBCT but herewith a description of key design elements of the DDBCT. Taxpayer 15. The DDBCT applies only to legal persons and PEs established by non-residents. It does not apply to legal persons and individual entrepreneurs that currently utilize the Simplified 1 Improved market access 1 Access to customers 2 Reduced operating costs 2 Stable social and political environment 3 Other factors 3 Ease of doing business 4 Source of raw materials 4 Reliability and quality of infrastructure and utilities 5 Consolidated operations 5 Ability to hire technical professionals 6 Develop new product lines 6 Ability to hire management staff 7 Improved productivity 7 Level of corruption 8 Develop new technologies 8 Cost of labor 9 Improved labor force access 9 Crime and safety 10 Reduce risk 10 Ability to hire skilled laborers 11 National taxes 12 Cost of utilities 13 Roads 14 Access to raw materials 15 Availability and quality of university and technical training 16 Available land with all services in place 17 Local taxes 18 Access to suppliers 19 Labor relations and unionization 20 Air service Most Important Determinants of Location Objecives of Firms Investing Overseas 1/ Source: MIGA, Foreign Direct Investment Survey, World Bank/Miga, January 2002. 1/ Ranked by order of importance. 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 InboundFDI(Flow),%GDP Year Inbound FDI (Flow), Ukraine and ComparatorAverage Ukraine Avg, excl. Ukraine Linear (Ukraine) IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

19. 15 Tax System (STS). This ensures that companies may see no longer a benefit in income splitting, starting the downward migration from the general CIT regime to benefit from the STS’s low- effective rates. It also does not apply to the Not-for-Profit sector (listed by the SFS on the Register of Nonprofit Institutions and Organizations),8 so-called budget entities, central government institutions, and diplomatic or foreign government entities. Tax base and deemed dividend distributions 16. The tax base constitutes distributed dividends to residents and non-residents in cash or in kind. It also includes transfers of funds by PEs to their parent companies with the proviso that these are only clearly defined profit or deemed profit distributions, excluding payments for goods and services between related parties. 17. Deemed dividend distributions include: (1) Payments for expenses not-related to carrying on a business (outflows out of the business entity) will attract the DDBCT; (2) Any gift or donation or free-of-charge supply of goods and services; (3) Non-repayable financial aid such as a loan; (4) Certain payments to non-residents registered in offshore low-tax jurisdictions;9 (5) All payments to taxpayers operating under the STS; (6) Payments to related parties (both residents and non-residents) if condition of the transaction is not at the arm’s length standard; (7) Payments of interests to related non-residents above a stated threshold for prevention of thin capitalization and payments of royalties to non-DDBCT trigger a higher tax rate in certain circumstances;10 (8) Capital contribution to the equity of non-residents or repurchase of shares of non-residents; (9) Amounts of assets transferred to shareholders during the liquidation of the taxpayer greater than the statutory fund or the original capital contribution; (10) Bad debts if the taxpayer did not actively pursue collection of these with provided evidence to back this up (e.g., 8 According to Art. 133 of the UTC, it includes civil associations, political parties, arts and culture, charitable and religious organizations, unions, employer organizations, housing construction cooperatives, homeowner associations, professional unions, agricultural purchase cooperatives. 9 Ukraine publishes periodically, authorized by the Cabinet of Ministers, a list of low tax jurisdictions where (1) the CIT rate is five percentage points or more, lower than the rate in Ukraine; and (2) that do not have a treaty or other agreement with Ukraine that provides for a guaranteed exchange of information. The 16 Sep 2015 Official List of Low-Tax Jurisdiction consists of 65 countries. 10 The deductibility of royalties paid to a non-resident is limited to the taxpayer’s royalty income plus 4 percent of the taxpayer’s turnover in the previous tax year (article 140.5.5 of the UTC). Newly established companies may not deduct such costs during the first year of operations. Royalties are fully non-deductible if paid to a resident in a listed offshore jurisdiction; the non-resident is not the beneficial owner of such payments (unless the beneficial owner authorizes the actual recipient to collect the royalty payments); the royalties are not subject to tax in the recipient’s state; and the royalties are related to the intellectual property originally developed in Ukraine. Also, not deductible are royalties that are paid to a resident company that is: (i) tax exempt; (ii) subject to a different tax regime (except for individuals); or (iii) taxable at the reduced rate. The above-mentioned limitations on the deductibility of royalties do not apply if the taxpayer provides the tax authorities with transfer pricing documentation confirming that the royalties are established at arm’s length. (continued...) IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

20. 16 were courts approached to enforce a collection action); and generally (11) any transfers to foreign jurisdictions to purchase and operate foreign businesses, acquiring proprietary interests and securities of foreign issuers, purchasing title to real property located outside Ukraine, or any intangible asset. 11 Tax rate 18. The current 18 percent CPT rate is proposed to be converted into a 15 percent standard DDBCT rate on dividend distributions. A 20 percent DDBCT rate applies to deemed dividends or interest payments to related parties or surcharges on the usual price in terms of transfer pricing arrangements and similar indirect distributions. Hence, the likely avoidance component is “condoned permanently” through the payment of a higher tax rate—almost granting a permanent amnesty for tax avoidance schemes. By reducing the CPT rate from 18 to 15 percent alone constitutes a revenue loss. In contrast, the Estonian and Georgian DDBCT model strictly maintained the standard CPT rate for the dividend distribution corporate tax. Also, unlike the Georgian regime, according to the Ukrainian proposal payments attracting the 15 percent DDBCT will not be subject to any further WHT, following strictly the Estonian tax model. Payment of tax and reporting requirements 19. The DDBCT is payable on a quarterly basis vis-à-vis the monthly payment cycle in Georgia and Estonia. Commonly, the tax is payable when the actual dividend distribution occurs. For other payments (not yet defined) taxpayers have 10 days following the deadline for submission of tax returns. The tax is paid at the cost of the taxpayer who is making the dividend distribution because the tax base of the DDBCT is a net amount. It needs to be grossed up: e.g., in the case of a non-deductible expense/dividend of a 100 the expense amount needs to be divided by 0.85 (100/0.85 = 117.65). The DDBCT rate of 15 percent is applied on that (117.65 * 15 percent = 17.65). What is left (117.65 – 17.65 = 100), is distributed as a dividend or say the non-deductible expense. If the system would tax the dividend with the 15 percent CPT rate, it would be akin to a dividend WHT. 11 The DDBCPT may raise a few tax treaty issues. Essentially, foreign investors who pay the profit distribution tax in the Ukraine may have problems having this tax credited in their own country. Ukraine would want to make sure that the treaties which provide for that credit do not cease to do it due to the change in the tax. According to the draft DDBCPT Ukraine will abandon the dividend withholding tax (WHT), so credit for this tax will become irrelevant. Ukraine has 61 treaties, plus 6 from Soviet times that are also considered as binding. In terms of a few treaties the current treatment of providing credits: (1) Ukraine–U.S. treaty: a credit is given according to domestic provision of each country, where the U.S. allows for indirect credit; (2) Ukraine–U.K. treaty: the United Kingdom gives credit for the taxes on underlying profit share if the UK entity controls at least 10 percent of voting power in the Ukrainian entity; (3) Ukraine–Estonia: Estonia gives credit for underlying profit share, if the Estonian entity controls at least 10 percent of the Ukrainian entity. The Ukraine gives credit according to its domestic provisions. The relevant articles are 22, 23, 24, depending on the treaty, normally titled Elimination of Double Taxation. The 10 percent is to eliminate credit for portfolio investments. IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

21. 17 20. As can be seen from the example below, corporate income is taxed from a reverse perspective. The example is gleaned from Estonian legislative guidelines as to how the distribution tax operates—it is understood that the Ukrainian approach is identical. Under the Estonian system, however, corporate distribution tax is imposed on “non-deductible” expenses (paid fringe benefits, gifts, donations, entertainment expenses, non-business related expenses). The distribution tax payable is equal to 20 percent of the gross amount, i.e., [0.2 × ((5) + (6) + (7) + (8) + (9))]. Herewith a simplified example of a DDBCT calculation (for tax year 2016): (1) gross income 700,000 (2) royalties paid (100,000) (3) interest paid (100,000) (4) other business related expenses (100,000) (5) fringe benefits paid (net amount) (30,000) (6) gifts, donations, entertainment expenses (net amount) (25,000) (7) non-business related expenses (net amount) (30,000) (8) dividends paid (net amount) (310,000) (9) distribution tax payable [20/80 × ((5) + (6) + (7) + (8))] = (98,750) 21. The draft legislation is mindful that the DDBCT could be avoided by incurring loan arrangements between related parties. Thus, by concluding a related party loan arrangement in lieu of dividend declarations, profits could be distributed via artificially inflated interest payments. The draft legislation keeps the existing earnings-stripping rule, triggered first by a debt-to-equity (thin cap) safe harbor of 3.5:1 and second, the amount of accrued interests is more than 30 percent of EBITDA of the current year. Thus, only the excess interests paid to related resident and non-residents are subject to a deemed dividend tax. 22. The following payments are taxable deemed dividends under the DDBCT: (1) A royalty paid to a related non-resident is subject to the DDBCT at a 20 percent rate as to the amount that exceeds 4 percent of previous year’s revenue; (2) Repayable financial aid or a loan given is subject to the DDBCT if it is not refunded within 3 months. However, if a taxpayer attracts the DDBCT according to this rule, the arising tax obligation can be reversed at the time of repayment of the loan. Note that overpayment of tax can be utilized against next period’s tax liabilities—a cash refund is not an option; (3) This rule is not applicable to banks or other financial institutions. So, financial institutions attract this tax too; and (4) A taxpayer can reduce its tax liabilities by the distributed profit tax paid by its subsidiaries, subject that such taxpayer holds as a least 10 percent of the shares of such subsidiary.12 23. Other general provisions that may be included in the final draft: (1) Donations by companies to the not-for-profit sector in the form of non-repayable financial aid and the free supply of goods or services will not attract the DDBCT if the donation does not exceed 0.5 percent of the donor’s total turnover; (2) Purchases of goods and services from residents 12 This rule appears to be a tax expenditure, rewarding dominant shareholders concentrating wealth in a few big corporate structures. What is the intention with this draft provision? (continued...) IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

22. 18 using the Simplified Tax System (STS) will not attract the DDBCT if the annual purchase amount does not exceed 5 percent of the purchaser’s total turnover.13 24. In terms of transition rules not much clarity exists at this stage. The draft law as explained to the mission provides for a reduction of DDBCT liabilities on dividend distributions if previously CPT was paid on those profits from which the dividend was distributed. The question of tracing and its associated administrative complications are not addressed—but which can be problematic if it stretches back for decades or will the three-year statute of limitation kick in? E. Arguments in Favor of a DDBCT When is a cash flow tax beneficial? 25. According to the 2015 EU Commission study there is an interest in cash flow taxes for the following reasons: It addresses the tax wedge between debt and equity financing and its simplicity supposedly improves compliance and alleviates administrative burdens. Also, it encourages the retention of profits for reinvestment. To be beneficial, pure cash flow taxes must have the following elements: (1) provide for immediate expensing; (2) equal treatment of debt and equity; (3) be based on cash-in-cash-out without accrual accounting; and (4) support administrative simplicity. 26. The following arguments in favor of CFTs, especially as to the DDBCT, are probably overstated: (1) the DDBCT does away with complex accounting-rules based measurement of taxable profit. Yet, standardized accounting rules must be followed to determine net earnings from which the dividends are declared. This still requires effective anti-avoidance measures like those employed by a revenue administration for purposes of the classical CPT; (2) it only partially addresses neutrality between debt and equity;14 (3) the DDBCT is levied on net cash flow relating to in- and outflows; and (4) the S-based DDBCT measures the economic success of a company by considering shareholder contributions and dividend distributions. Less need for loan capital 27. Based on the Estonian experience, all things being equal, and without reference to non-economic risks one could expect increasing reinvestments. Estonia experienced also a 13 The reason for this rule, apparently, is not to shut out completely small enterprises; companies will benefit from the new regime even if 5 percent of their purchases are with the small companies; still, by having payments above that threshold treated as deemed dividends may impede the economic growth of the STS sector and it would be quite difficult to monitor this from an administrative perspective. The STS is discussed in chapter II. 14 Under a DDCBT there is formally no tax advantage whether financing investing trough equity of debt; however, weak enforcement may create an incentive to distribute deemed dividends trough interest payments. IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

23. 19 reduction in the overall share of loan capital or the need for debt financing. There are thus reasonable expectations that the DDBCT would improve the access to credit. Less valuation disputes 28. As there is no tax on retained earnings and the distribution tax is applied only to profit distributions (including hidden profit distributions), valuation of assets has no significance for tax purposes. In the standard CPT the valuation of rights, e.g., intellectual property rights or capital gains, are complex and very prescriptive with the view to minimizing on tax avoidance opportunities. Expensive litigation is commonly the consequence. In contrast, as the DDBCT is a S-based cash-flow tax, allegedly opportunities for valuation disputes will be less, reducing overall administrative costs. No need for tax depreciation rules 29. Currently, the Ukrainian CPT permits accelerated depreciation. Moreover, taxpayers may carry forward their losses indefinitely. This potentially translates for an investor into a de facto multi-year tax holiday whereby CPT tax liabilities are deferred if the deduction for depreciation generates a tax loss for more than one year. Consequently, investors in the Ukraine already benefit from generous tax depreciation rules on fixed assets: it is unclear how much additional investment will be generated by the DDBCT; firms may simply park funds in cash. 30. The DDBCT model is not interested in retained earnings on which the CPT would have been levied. Because the company no longer pays tax on this basis there is also no longer a gross income line from which to deduct the depreciation. Deductions disappear altogether with the concept of taxable income. But for regular accounting purposes the corporate taxpayers would, of course, still calculate the economic depreciation according to an acceptable accounting rule, which will affect reportable net earnings. Loss carry forward provisions disappear 31. In case of the Estonian model, since there is no tax on net revenue or earnings, losses have no significance for tax purposes either. However, since losses reduce the net earnings position from which taxable distributions are made, the SFS should still track these in their effort of monitoring the correctness of the net earnings calculation. Capital gains 32. Capital gains derived by companies remain exempt from tax until profit distribution occurs. This would obviate the need for complex capital gain rollover relief measures as companies may dispose of assets for purposes of growing real investments. IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

24. 20 F. Arguments Against the DDBCT Transitional or permanent decline in revenues 33. A marked decline in CIT collections, as foreseen, will put continued fiscal consolidation at risk which is needed to ensure debt sustainability amidst strong spending pressures. Moreover, the DDBCT has other challenges which, given international experience with such tax, will be especially pronounced in the areas of domestic transfer pricing in order to enforce payment of tax on deemed dividends. This will test any capacity- challenged tax administration and leaves tax leakage as the big unknown. 34. Estimation of likely revenue losses is therefore difficult as few other countries have taken this tax reform route. The possible decline in CPT collections should be Ukraine’s biggest concern. The revenue importance of CPT since 2001 to 2016 was an average 3.9 percent of GDP. Based on the Estonian experience post the 2000-introduction of a DDBCT, CPT revenue collapsed from an average of 2 percent of GDP in 1995–99 to 0.7 percent of GDP in 2001 (after the introduction of the reform). It took 14 years to reverse the initial impact. Figure 7 illustrates the revenue loss of Estonia’s switch to a DDBCT. Thus, revenue losses associated with switching to a DDBCT are worrisome as companies’ reserves may be retained and not distributed. Revenue risk amplified by uncertain dividend-payout ratio 35. Profits may stay in reserves until companies figure out how to stream them out via untaxed channels. For example, over-invoicing of intermediate inputs provided by special purpose vehicles created for this tax minimization effort). These would be made in lieu of dividends, leading to permanent revenue losses (Estonia, 2009 Article IV Report). The importance of historically stable dividend payout ratios 36. Traded companies in established markets tend to adhere to stable dividend distributions.15 Companies are as a rule reluctant to cut dividends, since it can drive the stock price down and reflect poorly on the abilities of their respective management. Thus, a relatively high payout ratio in Ukraine would make a sharp decline of DDBCT collections less likely. 15 The dividend payout ratio is defined as the portion of dividends distributed over a company’s profit or net earnings. Figure 7. CIT Collections Estonia, 1990–2014 IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

25. 21 Companies in view of the reputational risk would not necessarily stop dividend payments entirely to economize on their tax obligations. 37. International empirical work on the determinants and dynamics of companies’ dividend policies since 1956 seem to indicate that publicly traded companies tend to have a payout ratio of 40 to 60 percent.16 It is relatively stable over time, unless there is a dramatic decline in net earnings, say caused by events such as the 2008/9 global financial crisis. Hence, even if the tax regime for dividends or corporate profits would change, companies and their management may still seek to protect their reputation by maintaining dividend payouts in line with past practice. It is for that reason that management never pay out most of the generated net profit but keep back a healthy margin of working capital to be able to maintain the same dividend levels. The existence of such stable dividend policy could mitigate some of the revenue risks stemming from the proposed CPT model change in the Ukraine. Comparable dividend payout behavior in Eastern Europe is not easy to access17—for the big Russian oil and gas firms, payout ratios have improved since 2006 from a very low base of 5 percent and by 2013 ratios had climbed into the mid-teens. 38. Predicting the DDBCT’s revenue potential is exceedingly difficult as it largely depends on the differentiated dividend distribution behavior (past and present) of local vs. international companies. Equally, it is difficult to project when companies will retain reserves for reinvestments. Ukrainian company-level data on dividend distributions was not available to the mission. The Orbis Company Database18 contains a sample of 232 Ukrainian companies of which only 27 paid dividends in 2014/15 with a low dividend payout ratio of 0.32 (Table 4). This coincided with a period of extreme Hryvnia volatility, whereby the depreciation was managed by prohibiting currency outflows, stopping profit repatriations almost entirely. These currency restrictions continue with only some relaxation until today. Even though the sample represents only 8 percent of all taxpaying companies, a DDBCT with such low dividend payout behavior would severely erode tax collections. The DDBCT may be a poor investment incentive 39. The Estonian authorities admit that the effects and the perception of the dividend distribution tax have not been universally positive. The Praxis research paper,19 analyzing the 16 Lintner, J, Harvard University, 1956; Ben Naceur, S. and others2006; Amidu, M and J. Abor. 2006. 17 Croft, (2015). 18 Orbis, (2017). 19 http://www.praxis.ee/fileadmin/tarmo/Projektid/Innovatsiooni_poliitika/Tulum/Tulumaks_l6ppraport.pdf, Praxis, “Effect of non-taxation of undistributed profits on investment and development.” IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

26. 22 effects of the Estonian system, finds that changing the system caused an initial confusion among foreign investors and, in certain cases, may have contributed to a decision not to invest. Table 4. Ukraine: Financial and Tax Statistics for Sample of Companies, 2014/15 40. Some key weaknesses in the Estonian distributed profit tax are—(1) the government’s singular focus on favoring tax treatment of retained earnings for reinvestment even though there are other financing mechanisms; (2) it is not obvious why investment financed by retained earnings should be treated more favorably than investment financed by new equity or debt finance; (3) incentives to retain earnings discriminate against new and expanding businesses, relative to established and more static businesses; and (4) it remains unclear that favoring retained earnings is attractive to potential foreign investors, as they may want to repatriate earnings to the home country without a (relative) tax penalty. 41. A number of other disadvantages are associated with the DDBCT: (1) transition arrangements are problematic on the issue of how to treat old investments that benefited from standard depreciation allowances with a significant stock of unredeemed losses; (2) the lock-in effect of dividends may have negative externalities such as sub-optimal use of retained capital;20 and (3) it may contribute to excess leveraging by companies as the regime provides a preferential tax treatment of debt (debt service charges are not taxed, unlike dividends). With these elements, the Estonian tax model provides an implicit subsidy to corporate entities and sole proprietors. This may have added to increased foreign borrowings and overall macroeconomic vulnerability. The 2015 EU Final Report on cash-flow taxation emphasizes that, even though the Estonian dividend distribution tax is the simplest of all the CFTs, avoidance risks are still material and predominantly happen through profit distribution via fringe benefits and 20 The Estonian experience indicates a jump in the acquisition of luxurious company cars and upmarket real estate for alleged business purposes. (continued...) Sector Number of Observations Number of Companies with Dividend Payout Turnover Sales EBITDA Profit/Loss Before Taxation Tax Dividends CIT Base CIT Payment CFT Base CFT Payment Dividend Payout Ratio in % Banks 4 - 20,774,083 10,099,359 80,411 309,411 42 - 80,031 14,406 80,411 14,474 Chemicals, rubber, plastics, non-metallic products 26 3 664,100,000 642,700,000 101,800,000 59,781,042 12,268,263 536,110 74,300,000 13,400,000 52,700,000 9,488,331 0.90 Construction 11 - 89,947,636 28,766,509 46,094,999 43,335,713 120,576 - 43,300,000 7,796,562 45,900,000 8,253,908 - Food, beverages, tobacco 24 - 961,300,000 945,500,000 183,000,000 124,700,000 24,764,110 - 120,000,000 21,700,000 115,000,000 20,700,000 - Gas, Water, Electricity 21 7 2,607,000,000 2,559,000,000 270,800,000 116,700,000 23,729,053 615,146 149,000,000 26,900,000 61,100,000 11,000,000 0.53 Machinery, equipment, furniture, recycling 30 7 1,501,000,000 1,034,000,000 352,300,000 221,300,000 55,133,867 698 281,000,000 50,600,000 285,000,000 51,300,000 0.00 Metals & metal products 15 5 6,866,000,000 5,957,000,000 1,405,000,000 536,400,000 108,300,000 3,456,011 532,000,000 95,800,000 1,080,000,000 194,000,000 0.64 Other services 27 2 33,918,189 27,412,788 6,545,280 11,061,569 623,720 1,458 4,886,540 879,577 5,600,328 1,008,059 0.01 Post & telecommunications 1 - 321,463 275,865 65,510 35,133 9,576 - 35,133 6,324 25,113 4,520 - Primary sector 32 3 3,313,000,000 3,049,000,000 758,800,000 331,400,000 122,100,000 3,234 370,000,000 66,600,000 488,000,000 87,800,000 0.00 Textiles, wearing apparel, leather 9 - 22,179,054 21,068,548 3,904,561 3,247,846 639,401 - 3,235,860 582,455 3,320,861 597,755 - Transport 15 - 6,783,028 5,166,499 1,048,543 656,325 128,982 - 568,392 102,311 981,978 176,756 - Wholesale & retail trade 13 - 279,000,000 273,000,000 18,604,750 2,575,567 1,194,510 - 2,695,058 485,110 15,700,000 2,831,777 - Wood, cork, paper 4 - 77,073,321 75,815,663 16,729,377 12,357,683 2,532,214 - 12,000,000 2,167,093 12,800,000 2,302,146 - Total 232 27 16,442,396,774 14,628,805,232 3,164,773,432 1,463,860,290 351,544,313 4,612,657 1,593,101,014 287,033,837 2,166,208,692 389,477,727 0.32 Source: Orbis Database IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

27. 23 loans to related parties. Nevertheless, their threat can be mitigated by the design of effective anti-avoidance and safe harbor rules.21 G. Anti-Avoidance Methods 42. The next sections analyze the tax avoidance opportunities of the DDBCT. Tax minimization efforts by taxpayers is expected to continue under the new regime through three basic channels: (1) Retained earnings will be distributed not by dividend but through over-invoicing of intermediary inputs (technical/management services) specifically managed from special purpose vehicles created by related parties; (2) Company structures can multiply the level of debt at the level of individual group entities via intra-group financing and financial instruments that can be used to make payments which are economically equivalent to dividends but have a different legal form; and (3) The DDBCT can be avoided by delaying dividend distributions for extended periods. Next to the tax deferral benefit, taxpayers would on disposal of company shares (with appreciated value due to retained earnings) be liable for realized capital gains but it may be particularly difficult to trace if there is an indirect transfer of ownership in third countries. 43. The biggest risk to collections stems from taxpayers’ ability to defer profit distributions as evidenced by the Estonian experience. Both the CPT and DDBCT taxation models will require comprehensive and effective anti-avoidance rules for the following risk areas: (1) companies distributing profits via over- or under-invoicing of management and technical fees provided by related parties (transfer pricing); (2) distributing profits via inflated interest payments and the need for introducing earnings stripping rules; (3) deferring profit distributions for extended periods until disposal of shares in a company which requires effective capital gains taxation rules for the indirect transfers of ownership; and (4) sole proprietors accessing the DDBCT benefits by switching employment into personal service provider companies. Overstating cost deductions between related parties (transfer pricing) 44. A popular tax-planning vehicle in a standard CPT model is to overstate deductions as this reduces taxable income. This is evidenced, for example, through loans between related parties to bump up interest deductions. In terms of the DDBCT, tax is only imposed on distributed profits. Hence, differences between deductions for accounting purposes and for tax purposes are irrelevant. The revenue administration, in terms of the DDBCT model, is no longer required to value deductions for tax purposes, including employee remunerations, directors’ fees, interest, royalty payments for intellectual property. For DDBCT purposes it seems that it is not 21 European Commission, 2015: 11. Also, the Georgian DPBCT will apply to non-business expenses, goods and services rendered free of charge, as well as representation expenses above a certain threshold. To make the intended tax regime stick, appropriate anti-avoidance measures are necessary as proposed in other sections of the TA Report. IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

28. 24 important to determine whether expenses are deductible but to ascertain whether a dividend (real or deemed) is distributed and to monitor non-business related expenses. 45. Avoiding the DDBCT can also be done through over-invoicing. To make it work, the transactions are arranged between related parties to pay inflated considerations for say management services, technical services, financial services or any other intermediary input costs. This way no profits are distributed but higher income accrues to the related service provider, who may be resident or non-resident. This is hard for the tax administration to police effectively, enabling a syphoning-off accounting profits to offshore entities. 46. It is therefore not a foregone conclusion that the revenue administration will experience an easing of administrative burdens to enforce the DPBCT. In the mission’s view, and flagged as a concern in Estonian publications,22 a risk remains that the DDBCT model can still encourage over-invoicing as a tax avoidance tool. In the case of Estonia, companies are only required to file a tax return when dividends are declared and hence, can operate for years outside proper risk-based audits of the revenue administration. One should note that tax avoidance/evasion risks increase if taxpayers are not periodically monitored. Ukrainian transfer pricing rules and the DDBCT 47. On January 1, 2015, Ukraine aligned its transfer pricing regulations with the OECD transfer pricing guidelines—rules applying only to controlled non-resident transactions. With the possible introduction of the DDBCT, domestic transfer pricing will become a risk to watch (see chapter IV). Legislation should be broadened since transfer pricing adjustments to transactions between the Ukrainian taxpayer and its direct or indirect shareholder may be reclassified as deemed dividend distributions. Generally, transfer pricing adjustments will qualify as distributions of profit, and thus be subject to the DDBCT. 48. According to one of the legal drafts, the scope of transfer pricing rules is envisaged to be restricted only to transactions with persons, resident in countries on the list of low- tax jurisdictions (65 in total). It completely ignores cross-border transactions among related parties. The absence of domestic transfer pricing rules will discriminate against multinational enterprises, providing domestic companies with an advantage as they will be able to use the avoidance methods discussed in this section to shift cash dividend tax-free among related parties. Also, it will enable taxpayers to shift shareholders’ personal expenses to businesses tax free without the authorities being able to attack this mischief. This is further facilitated by no longer being required to file audited financial statements or CPT tax returns on an annual basis. Hence, these schemes cannot be audited by the SFS. 22 http://www.praxis.ee/fileadmin/tarmo/Projektid/Innovatsiooni_poliitika/Tulum/Tulumaks_l6ppraport.pdf, the study, “Effect of non-taxation of undistributed profits on investment and development.” was financed by the EU and Government of Estonia. IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

29. 25 Recommendation  Do not introduce the DDBCT without comprehensive domestic transfer pricing rules. Distributing profits via inflated interest payments 49. In the cross-border context, the difference in the tax treatment of the payer creates a tax-induced bias, towards debt financing. The distortion is compounded by tax planning techniques that may be employed to reduce or eliminate tax on interest income in the jurisdiction of the payee. Parent companies are typically able to claim relief for their interest expense while the return on equity holdings is taxed on a preferential basis, benefiting from a participation exemption, preferential tax rate or taxation only on distribution. On the other hand, subsidiary entities may be heavily debt financed, using excessive deductions on intragroup loans to shelter local profits from tax. 50. Base Erosion and Profit Shifting risks in this area may arise in three basic scenarios:  Groups placing higher levels of third party debt in high tax countries.  Groups using intragroup loans to generate interest deductions in excess of the group’s actual third party interest expense.  Groups using third party or intragroup financing to fund the generation of tax-exempt income. 51. To address the risks of excessive gearing, Action 4 of the BEPS Action Plan (OECD, 2013) describes best practices in the design of rules to prevent base erosion using interest expense (see Chapter III). The favored approach is to limit an entity’s net deductions for interest, and payments economically equivalent to interest, to a range between 10–30 percent of its earnings before interest, taxes, depreciation and amortization (EBITDA).23 This is sometimes referred to as an ‘earnings stripping’ approach. Ukraine currently has a thin capitalization rule which is much weaker and would not be sufficient to counter tax planning through excessive borrowing if the DDBCT was adopted. Recommendation  To address the DDBCT’s high avoidance risk through debt finance, introduce a tighter debt to equity ratio of say 1.5:1 plus an interest deduction cap of 30 percent, based on EBITDA. 23 The recommended approach is based on a fixed ratio rule which limits an entity’s net deductions for interest and payments economically equivalent to interest to a percentage of its EBITDA. As a minimum, this should apply to entities in multinational groups. To ensure that countries apply a fixed ratio that is low enough to tackle BEPS, the recommended approach includes a corridor of possible ratios of between 10 percent and 30 percent. IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

30. 26 Taxation of capital gains 52. Designing and enforcing a regime for taxing capital gains realized (by residents and non-residents) from domestic sources is important, since dividend payouts can be deferred—resulting in appreciating share values. Capital gains derived by resident companies and permanent establishments of nonresident companies are exempt from the DDBCT until they are distributed, since dividends would contain capital gains when distributed and would thus attract the tax rate of 15 percent. But the company may never declare a dividend and its shares should appreciate reflecting the retained earnings and an increase in capital gains on their realization. Under the current tax regime, any such capital gain would be subject to CPT. The DDBCT would do well in keeping the capital gains tax, otherwise the tax deferral could become an outright exemption as retained earnings could be cashed-out by investors free of tax. 53. There are however widespread strategies for legally avoiding a tax on capital gains imposed by a source country.24 They include the transfer of assets through offshore holding companies and the use of treaty shopping, which may be difficult to detect, but rules to address the taxation of capital gains derived by non-residents upon the disposal of assets within the country may be introduced. The asset itself is located in the source country and can be subjected to tax when transferred, for instance through withholding. Taxing such transfers is admittedly difficult to enforce, but this does not justify having the loophole either under the CPT or the DDBCT. In the case of the DDBCT the problem looms larger as retained earnings may not be subject to tax while undistributed. An indirect transfer of the asset can render them fully exempt. Share transfers 54. Usually, countries tax non-residents’ capital gain on the sale of domestic immovable property and the gain realized from the transfer of the shares in a company owning the domestic real estate. Accordingly, under article 13, paragraph 4 of the OECD Model Convention, the taxation of capital gains realized by a resident of one of the Contracting States from the alienation of shares deriving more than 50 percent of their value directly or indirectly from immovable property situated in the other Contracting State may be taxed in that other State. The DDBCT would not tax such capital gains (unless distributed as dividends) and would be hence avoided on the transfer of ownership of assets pregnant with undistributed profits. Emigration by an individual or legal entity 55. When persons emigrate, and cease to be resident under the domestic tax legislation of the country from which they depart, the value of certain migrated assets may include hidden capital gains. These are attributable to the period of residence, even if not yet realized at 24 Cui, 2015, United Nations. IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

31. 27 the time of migration. Taxpayers may defer (or avoid) taxation by realizing a capital gain on the disposal of the shares in a Ukrainian company after they have become resident of another State. Several countries tax such capital gains at the moment of emigration (the exit is the deemed realization event and the CGT on it is labeled as an exit tax). Boxes 1 and 2 in Appendix 3 provide elements to consider when designing the imposition of a tax on unrealized capital gains upon emigration. Employment through a Personal Services Company 56. In Ukraine, there is already a problem of employees (especially in the IT sector) reclassifying themselves as entrepreneurs, assuming legal person status and thereby economizing on PIT liabilities and Social Security Contributions (SSC). This trend is exacerbated by the concessionary nature of the STS regime which substitutes the CPT rate with a low rate turnover tax. Given that the DDBCT allows for unfettered discretion when to pay tax, there is an additional incentive to incorporate—but this time outside the STS framework. Hence, regulatory interventions will be needed to stop tax planning through a non-genuine transition from employee status to a personal service company. 57. In the following situations, however, the personal service provider (incorporated) still fulfils the functions of an employee: (1) the personal service provider-company or the sole proprietor, i.e., the former employee renders the services at the premises of the former employer; (2) the personal service provider-company or the sole proprietor performs all activities himself and does not or is not allowed to hire someone else to perform the activities; (3) the former employer still controls or supervises the manner in which the activities are performed; and (4) the major part of the personal service provider-company’s or the sole proprietor’s income consists of income earned through the activities performed for the same former employer. In such cases the relationship is often regarded as deemed employment. 58. If the former employee renders the services through a personal service provider- company, he/she will most likely own 100 percent of the shares in that company. The profits earned by the company can be distributed to the former employee-shareholder as dividend distributions. Such dividend distribution will attract the proposed 15 percent DDBCT. However, dividend distribution may be deferred, whereas if the former employee would have received a salary, the entire amount would have attracted PIT as it accrued. This arbitrage activity will be informed by the tax rate interaction of the PIT and the DDBCT rate. 59. Irrespective whether the DDBCT is introduced, an anti-avoidance rule against the tax avoidance scheme of reclassifying an employee relationship into a personal services company needs to be implemented in Ukraine. Such rules have been introduced in several countries, e.g., the Netherlands, South Africa and the United Kingdom (see Appendix 3, Box 3). The model article safeguards that individuals rendering services through a personal service provider-company or as sole proprietor or independent contractor are deemed to be employed by the principal. Consequently, the principal is obliged to withhold wage tax and SSCs from the IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

32. 28 fees paid to the personal service provider-company or sole proprietor. Also, according to the article in Box 4 (Appendix 3), individuals or shareholders who own a substantial interest25 in a company are deemed to earn an arm’s length salary from which wage tax and/or social security contributions must be withheld by the company. It is recommended that Ukraine introduces provisions as stipulated in these model articles in the UTC to deal with this major tax planning issue in the current STS but also the future DDBCT regime. It is further proposed that the article that includes the definitions that apply for the entire Tax Code is supplemented by a definition as to what constitutes ‘employment’; an example of which is given in Box 5 (Appendix 3). The DDBCT and the Simplified Tax System 60. Given that only legal persons will be taxed under the DDBCT, a concern is that sole proprietors could face a more disadvantageous tax system on earned business and professional income. In Ukraine, individual entrepreneurs and small companies have the option to pay under the STS. The STS is payable annually and it will represent a tax disadvantage, as compared to the DDBCT that can lead to protracted periods of zero-effective tax. On the other hand, since the DDBCT does not apply to legal persons operating in the STS, it could stop companies’ ongoing income splitting and migration into the STS, since it would no longer be an advantageous tax regime. Recommendation  Implement specific rules to avoid postponement of taxation by sole proprietors by incorporating their business activities into a legal entity, and thus postponing the DDBCT until profits are distributed. H. Concluding Assessment of the DDBCT and Proposed Measures for Building Fiscal Buffers 61. The mission in the sections above cautions against adopting the DDBCT, given the danger of significant revenue losses to the treasury. One of the reasons put forward by the originators for the DDBCT is that it would obviate the need for annual audits of financial statements of legal person but would only trigger a risk-based audit (facilitated by the SFS access to taxpayers’ bank records) when dividends or deemed dividends are distributed. This would reduce the interaction with the SFS; it creates the opportunity to work around the SFS capacity 25 Deeming provisions can also be applied to ensure that a reasonable portion of income received by such entities is treated as labor income. For example, in the Netherlands, directors’ fees are treated as ordinary employment income, and any employee who owns at least 5 percent of the shares in a company (a so-called substantial interest) is deemed to earn an annual salary of at least EUR 44,000, unless the taxpayer can prove that his actual salary is lower, or the authorities can provide that the salary is higher, on an arm’s length basis. IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

33. 29 challenges; and reduces interfaces for collusive behavior. In lieu of fixing these shortcomings in the administration of the CPT’s, the mission believes that the introduction of an entirely new tax model based on dividend distributions is a seriously flawed strategy because:  Fixing the SFS’s capacity is unescapable and would have multiple spin-offs, since the SFS collects all taxes—replacing the CPT with a tax known for its low revenue potential simply avoids the problem;  It would require the renegotiation of tax treaties for treaty partners to recognize it as equivalent to an income tax and continue to provide existing credits. 62. Evidence presented on the Estonian introduction of a DDBCT highlights the serious long-term decline in CPT collections. Current revenues from the Ukrainian CPT are 2.3 percent of GDP which would be placed at risk by taxpayers’ discretion as to when to declare in future dividends—translating potentially into long deferral periods. Currently only two countries have adopted this system, Estonia and Georgia—the second only in 2017. Estonia experienced a CIT revenue collapse from an average of 2 percent of GDP in 1995–99 to 0.7 percent of GDP in 2001 and it took 14 years to reverse the initial impact. Besides risking the hitherto solid CPT collection performance the other purported benefits of the advocated cash flow tax are exaggerated, especially that tax avoidance would be easier to contain. 63. The mission therefore advises against the introduction of the DDBCT since it is unlikely that other revenue instruments with the revenue productivity of the CPT could be identified and introduced on short notice. The relatively strong performance of the CPT should be preserved as international business finds the tax functional and competitive. If the tax is enacted anyway, the mission advises the MoF to condition it as follows:  Insert into the tax amendment law a transitional clause that requires for the DDBCT to take effect that total tax revenues must be 2 percent of GDP higher than current level. II. THE SIMPLIFIED TAX SYSTEM—OPTIONS FOR RATIONALIZATION A. Current Simplified Tax System 64. Small businesses—or not so small if income splitting precedes it—may opt for a STS, in which case they become exempt from CPT and some other taxes. Legal and natural persons who have joined the STS regime are exempt from CPT, PIT, Land Tax, VAT except for those STS payers who voluntarily opted to pay the standard VAT. Taxpayers engaged in certain activities (e.g., financial or insurance activities, production and sales of excisable products) as well as non-residents cannot opt for a STS. Table 6, read together with Appendix 4 (providing a detailed description of allowed activities for the Groups in the STS) compares five simplified tax systems for different categories of taxpayers. IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

34. 30 65. The STS consists of multiple and fragmented small business tax systems. There are different thresholds that do not seem to have a logical relationship with the VAT registration threshold (for Group 2 and 3, see article 291.3 of the UTC). Collectively these regimes are referred to as the “Single Tax System”, the “Simplified Tax System” or “Unified Tax System”—indeed these terms are used interchangeably.26 As pointed out in the 2015 IMF TA Report27 this terminology is misleading because between, and sometimes within, each of these regimes or “Groups” the applicable tax rates and bases vary, depending on the circumstances specific to the regime in question. The remainder of this section focuses on Groups 1 through 3. Group 4 provides a tax regime for farmers under a flat rate of tax based on land area—which was the former Fixed Agricultural Tax (FAT), as discussed in previous reports.28 The instant analysis and proposed changes to the STS should be read together with the reform proposals made in the 2015 IMF TA Report as the system’s horizontal inequity still exist. 66. Group 1 is purely for self-employed individuals, whereas Group 2 may employ up to 10 employees. Individual entrepreneurs (Group 1 and 2) provide 40 different categories of consumer services (see Note 3, Appendix 4), which excludes professional services. Taxpayers under the STS are heavily concentrated in the trade and services (Table 5). Formally, professionals in the legal, engineering, accounting and medical services fields, that may only provide these services if duly certificated, do not qualify as taxpayers in Group 3. However, if the certified professionals would conduct an entrepreneurial activity they can utilize tax privileges of the Group 3 simplified regime. This appears to be an exploitable barrier. 26 Chapter 1 of Part XIV of the UTC, Articles 291 et seq. All references hereafter are to the UTC unless indicated otherwise. 27 Schatan, R., S. Caner, C. Waerzeggers and V. Thuronyi, 2015, Ukraine—Reducing Social Security Contributions and Improving the Corporate and Small Business Tax System, The 2015 FAD TA Report, hereafter. That Report’s arguments against the STS are still relevant and, hence, should be read together with the instant analysis and proposals for further rationalization as it would simultaneously address more effectively distributional fairness. 28 IMF, Restoring a Strategic Approach to Tax Reform, March 2105. IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

35. 31 Table 5. Ukraine: Single Taxpayers vs. Employees and Paid Tax, 2014 Economic Activity, Taxpayer Data for 2014 % Share of General Taxpayers % Share of Single Taxpayers VAT Personal Income Tax Extra Territorial organizations and institutions 28 17 0.00 11 0.00 340 340 Other, taxpayers that are in the process of migrating to another group 149 138 0.01 11 0.00 568,234,183 568,234,183 Household activities 69 46 0.00 23 0.00 310 310 Public management and defence; mandatory social insurance 31,961 31,771 3.16 190 0.02 175,215 122,934 52,281 Extraction industries and development of mines 2,980 2,704 0.27 276 0.03 1,314,579 954,890 359,689 Supply of energy, gas, conditioned air 2,729 2,433 0.24 296 0.03 146,531 128,766 17,765 Water supply, sewerage, waste management 6,857 5,064 0.50 1,793 0.16 2,764,996 1,777,754 987,242 Finance and insurance 16,042 11,170 1.11 4,872 0.44 1,094,903 559,272 535,631 Education 27,655 21,028 2.09 6,627 0.60 358,881 57,246 301,635 Arts, sports, leisure and recreation 18,785 11,674 1.16 7,111 0.65 2,683,595 629,615 2,053,980 Health care and social aid 33,201 18,495 1.84 14,706 1.34 1,658,947 91,486 1,569,461 Agriculture, forestry and fishery 79,595 56,416 5.61 23,179 2.11 26,551,786 14,220,308 12,331,478 Construction 64,351 40,691 4.05 23,660 2.16 29,550,403 23,118,150 6,432,254 Temporary lodging and catering 58,741 33,371 3.32 25,370 2.31 33,611,429 15,263,704 18,347,724 Administration and support services 68,911 43,229 4.30 25,682 2.34 27,323,701 17,916,141 9,407,559 Transport, storage, post and courier 110,869 51,572 5.13 59,297 5.41 167,484,065 127,533,140 39,950,925 Other services 153,160 93,329 9.29 59,831 5.46 15,433,332 6,238,315 9,195,017 Property transactions 96,719 33,932 3.38 62,787 5.72 86,680,950 34,358,383 52,322,568 IT services 89,492 26,620 2.65 62,872 5.73 19,714,742 12,241,236 7,473,506 Professional, scientific and technical services 118,607 54,796 5.45 63,811 5.82 52,108,712 18,565,004 33,543,708 Processing industry 127,527 59,588 5.93 67,939 6.19 153,802,009 115,486,938 38,315,071 Wholesale and retail trade; car and motorcycle repairs 993,379 406,983 40.49 586,396 53.47 640,242,056 414,201,975 226,040,082 Total 2,101,807 1,005,067 100.00 1,096,740 100.00 1,830,935,665 803,465,257 1,027,472,409 Source: Ukrainian authorities, Fund staff calculations. Number of Registered Individuals /Entrepreneurs Including Under General Tax System Under Single Tax Collections of (Mandatory) Taxes and Duties Individuals-enterpreneurs Including Total IR Doc Id: 435803 User: SCevik Download Date: 3/2/2018 - 12:10 PM Current Classification: FOR OFFICIAL USE ONLY To be handled in accordance with GAO 35. NOT to be released to Executive Directors and their staff.

36. Table 6. Ukraine: Business Income—Tax Treatment of Taxpayers in the Simplified (Unified) and General Tax Systems Group I Group II Group III General Regime Taxpayer Category Individual entrepreneur / sole trader Individual entrepreneur / sole trader Individual entrepreneur / sole trader Legal entity (unless its 25 percent and more share capital belongs to legal entities not registered as Unified Taxpayers) Individual entrepreneur / sole trader Legal entity Income criteria Income during a calendar year does not exceed UAH 300,000 (calculated on a cash basis) /Note 1 (#) Income during a calendar year does not exceed UAH 1.5 million (calculated on a cash basis) /Note 1 Income during a calendar year does not exceed UAH 5 million (calculated on a cash basis) - (UAH 20 million before 2016) /Note 1 No Managing the Threshold /Note 2 /Note 2 /Note 2 N/A Number of employees -criteria None Up to 10 Unlimited Unlimited Allowed /excluded activities /Note 3 /Note 3 Any non-excluded activity. /Note 3 Any activity, allowed by the legislation Restrictions with whom to trade and the right to issue tax invoices Can only perform: - retail sales on market places, or - sell goods and services to individual persons (public). /Note 4 Can only perform: - services to simplified tax regime payers (legal entities and entrepreneurs) or individual persons (public) - production/sale of goods; - restaurant activities. Invoice (as a primary document for tax purposes, containing information about seller, its tax ID, subject of purchase, price to be paid, etc.) is allowed. /Note 4 No restrictions on counterparties. Invoice (as a primary document for tax purposes) is allowed. /Note 4 No restrictions on counterparties. Have to be compliant with all tax filing and self- assessment requirements by inter alia issuing invoices (as primary documents for tax purposes). Reporting Annually Annually Quarterly Annually Quarterly (on cumulative basis / Annually (**) Tax base Value of statutory subsistence level amount for able-bodied persons (set by the law as of 1 January of the accounting (tax) year) – UAH 1,600 as of 1 January 2017 (*) Value of minimal statutory monthly salary (set by the law as of 1 January of the accounting (tax) year) – UAH 3,200 as of 1 January 2017 Income received in cash or in kind within the accounting (tax) period. /Note 1 Income (in cash and in kind) less expenses (related to the business activity, including amortisation of certain fixed assets). (***) Net profits before tax (NPBT) as per accounting records, either Ukrainian statutory or International Financial Reporting Standards (IFRS), and adjusted for ‘tax differences’ (****) 32 IRDocId:435803User:SCevik DownloadDate:3/2/2018-12:10PM CurrentClassification:FOROFFICIALUSEONLY TobehandledinaccordancewithGAO35. NOTtobereleasedtoExecutiveDirectorsandtheirstaff.

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Ukraine rethinking dividend distribution tax, rationalizing simplified taxes, and adopting beps measures, june 2017

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