Ukraine: Transactions between foreign head office and PE become controlled

From January 1, 2018, transfer pricing rules apply to transactions between non-residents and their permanent establishments in Ukraine. The main points which permanent establishments of nonresidents should take into account to mitigate tax risks are summarized below. 

1. For transfer pricing purposes, only transactions between a non-resident and its permanent establishment qualify as controlled transactions. Transactions between a non-resident and representative office (branch) which is not a permanent establishment are not considered controlled transactions. However, if the tax authorities prove that non-resident's representative office shall be considered as a permanent representation, which happens in practice, transactions between the  non-resident and such permanent establishment, including transactions in the past periods, will be subject to transfer pricing rules. This can result, inter alia, in the payment of fines in case of failure to submit reports on controlled transactions and transfer pricing documentation, not to mention the risk of assessment of corporate tax liabilities.

2. Transactions between a non-resident and its permanent establishment qualify as controlled transactions, if the total value of transactions in the reporting (calendar) year exceeds UAH 10 million (approximately USD 357,000 at an exchange rate of UAH 28 for USD 1).

Although the Tax Code of Ukraine does not provide the list of operations between a non-resident and a permanent establishment which are considered as controlled transactions, one may assume that the amount of financing received from head office will be taken into account when determining the total value of transactions between a non-resident and its permanent establishment.

3. The extension of transfer pricing rules to the operations between a non-resident and its permanent establishment will concern primarily the permanent establishments which are financed exclusively or mainly by the head office. These are, first of all, permanent establishments which act as sales representatives in Ukraine, and permanent establishments involved in construction or assembly projects, in which payments for the performed work is made directly to non-resident's bank account outside of Ukraine.

Permanent establishments which are not financed by head offices and which receive income directly from independent purchasers of goods, works and services should not be subject to transfer pricing rules, since the remittance of after-tax proceeds to the head office no longer affects the taxable profit of permanent establishment or of non-resident and, therefore, cannot be considered as controlled transaction for transfer pricing purposes.

4. The Tax Code of Ukraine does not provide special rules for transfer pricing analysis of transactions between a non-resident and its permanent establishment. Hence, the analysis of such operations should be based on the general rules applicable to transactions between associated legal entities, but taking into account that permanent establishment is not a separate legal entity and it is considered as a distinct taxpayer for tax purposes only. This means, in particular, that the analysis of the functions and risks of the parties should be made on the basis of factual circumstances (as no contracts between a nonresident and its permanent establishment are executed) and the nature of relations between the non-resident and its permanent establishment.

For example, the relations between a non-resident acting as a general contractor in construction project on the territory of Ukraine and its permanent establishment can be considered as subcontract relations where the permanent establishment acts as a subcontractor in relation to the head office. A permanent establishment whose personnel is engaged in promoting sales of non-resident's products in Ukraine (establishing and maintaining contacts with customers, negotiation of conditions and / or execution of contracts, accepting and processing orders, complaints, etc.) can be considered as rendering marketing services, commercial agency and other services to a non-resident.

5. Depending on the functions, which a permanent establishment performs in Ukraine, the appropriate transfer pricing method shall be applied. The application of the cost plus method or transactional net margin method will be justified for most permanent establishments of non-residents operating in Ukraine. This can be explained, in particular, by legislative foreign exchange restrictions which significantly narrow the directions of payments of a permanent establishment in foreign currency and, consequently, the functions of the permanent establishment, and by economic purposes for which non-residents create permanent establishments in Ukraine (act as sales representative, perform works and services for resident customers, conduct supporting activities). When applying these methods, the most appropriate profit level indicators would be the gross margin on cost of sales (for the cost plus method) and net cost plus margin or Berry ratio (for the net profit method).

6. The extension of transfer pricing rules to the operations between a non-resident and its permanent establishment obliges the permanent establishment to submit by October 1 of the current year report on controlled transactions carried out in the reporting year and to prepare transfer pricing documentation for controlled transactions and submit documentation to fiscal authority during 30 calendar days from receipt of request. The scope of transfer pricing reporting may increase, if the Parliament of Ukraine adopts a law amending tax legislation of Ukraine for the implementation of 8 steps (3, 4, 6, 7, 8-10, and 13) of the OECD Action Plan on Base Erosion and Profit Shifting (BEPS).