Revised Personal Income Tax: Implications for Tax Planning. The New Personal Income Taxation Act Still Leaves Room for Tax Planning 

February, 2004 - Mukola V. Orlov

On 1 January 2004 Ukraine woke up to the new personal income tax. A development of the previous individual income taxation, this tax is, if anything more sophisticated. Its novelties will have a lasting impact on many of the tax planning strategies involving individuals. Without attempting a comprehensive analysis of the new tax, this article offers an outline of some of its major implications for tax planning. A. Attack on tax avoidance Apparently, one of the main aims of the Personal Income Taxation Act of Ukraine of 22 May 2003 (the Act)1, which introduced the new tax, is combating rampant tax avoidance, which was a reaction to the inadequacies of the previous income tax system. The Act does not contain a general anti-avoidance rule; instead, several of its provisions attempt to target the most widely used tax avoidance structures. Employee vs. contractor The tactic of contracting individuals rather than employing them has been widespread. If an individual contractor qualified for the single tax, this structure allowed both the employer and the individual to avoid paying considerable payroll taxes. Indeed, contracting became so popular that many companies now try to contract almost anyone who works for them, including directors and secretaries. Paragraph 2 of Section 1.8 of the Act was drafted expressly to discourage such practices. It provides that any individual contracted for more than one month should be treated as an employee of the contracting person for tax purposes. Whatever the practical application of this provision, it sends a clear message that the tax authorities are inclined to scrutinize the extensive use of the services of individual contractors. Employee benefits Another tax avoidance technique, which came under attack in the Act, is employee benefit structures. It has been a common practice of Ukrainian companies to pay part of employee salaries through different forms of benefits in an attempt to avoid payroll taxes. Employees of such companies received discounts on goods and services which were bought, free meals, financial assistance, valuable gifts etc. The Act effectively closed some of the loopholes by bringing more clarity into the taxation of employee benefits. At present, taxation of such benefits is subject to detailed rules, in particular, targeting free services, meals and goods, compensation of expenses, financial assistance and discounts on goods or services (Section 4.2.9). The Act also limited the amount of financial assistance and insurance premiums paid by an employing company which is exempted from taxation (Sections 9.7.3 and 4.2.4(â)), as well as the exempted amount of tuition fees paid by an employing company for its employee (Section 4.3.20). It should be noted separately that there is no longer exemption for payments, which are used at source to purchase shares or make dividend payments (with the minor exception provided for dividends which are paid in the form of shares or other corporate rights (Section 4.3.17)). Thus, any purchase of shares by employees (e.g. organized by the company within an employee benefit plan) would not relieve the respective sums from being liable to income tax. At the same time, the Act exempts from taxation compensation of certain medical expenses by an employing company, as well as certain benefits received by an individual from charities and trade unions. B. Broadening the tax base The introduction of the flat 13 % tax rate was balanced by broadening the tax base. This was achieved by abandoning many exemptions granted under the previous income tax system. The most notorious additions to taxable income include gifts, bank deposits and inheritance. Taxation of gifts The Act envisages that any gifts received by an individual are taxable. The applicable tax rates range from 5 to 26 %. Certain exemptions (zero tax rates) are provided only for gifts exchanged between spouses, with the exception of securities, equity rights, title to the property of an enterprise as a going concern and intellectual property rights. (The same rules apply to the taxation of inheritance.) It should come as consolation to the taxpayers that the rules on the taxation of gifts and inheritance come into effect on 1 January 2005. Consequently, we are simply bound to witness a surge of gift-making this year. Among other giftmakers, this rule should be considered by the companies, which conduct promotional campaigns involving distribution of gifts to loyal or lucky consumers. Trips abroad for fans of coffee or chocolates will no longer be tax-free soon and for in-kind gifts it is the generous company that will have to foot the bill. Furthermore, certain gift programs would be subject to special tax treatment. Thus, any winnings in lotteries or other public draws are now taxed at the double tax rate (i.e. at 26 % till 2007 and at 30 % thereafter). The bad news is that these rules came into effect this year. Taxation of deposits The Act provides that any interest paid on bank deposits is taxable at 5 % but postpones the taxation of interest until 2005. It should be noted, however, that the tax authorities are not only trying to start taxing interest payments in 2004, but even apply the 13 % tax rate to them this year. Although the outcome of this conflict between the word of law and its interpretation is difficult to predict, the odds are that this time the tax authorities will have to back down in the face of a strong banking lobby. C. Income from real estate Separate rules are introduced for the taxation of individual income from real estate, which comes into effect on 1 January 2005 (Article 11). The Act differentiates between real estate acquired prior to the Act coming into effect and after that date. The tax rates of 1 or 5 % should be applicable to the income received from the sale of real estate acquired prior to 1 January 2004. The profit from the sale of real estate (i.e. the difference between the purchase price and the sale price) acquired after that date is taxed at 13 %. The sum of tax liabilities also depends on the type of real estate sold and the number of times an individual sells real estate during a calendar year. Interestingly, the Act also introduced new rules on the rental of real estate by non-resident owners. From this year, non-resident companies or individuals can rent out real estate only through representative offices or resident companies. Although many experts argue that the regulation of legal entities is beyond the scope of the Act, it remains to be seen whether the tax authorities will share this view. D. Taxation of non-residents The Act pays special attention to the taxation of non-resident individuals. It attempts to tax any income received by non-residents “working” in Ukraine, in particular non-residents rendering professional services in Ukraine, non-resident CEOs of Ukrainian companies, and generally any non-residents working in Ukraine, even if employed by foreign companies. Any income paid to such non-residents by foreign companies should be transferred to their bank accounts opened in Ukraine.


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