Nearly two years before the adoption of the Law № 466 (known as a “small tax reform”) the Ukrainian tax authorities for the first time approbated analysis of a business transactions in terms of the legality of applying the reduced tax rate of WHT to the passive income paid from Ukraine, and by this actually started application of the principal purpose test (hereinafter - "test").

The essence of the test is that the benefits provided by the provisions of the Double Tax Treaty do not apply if there are grounds to conclude that the application of such benefits was the principal purpose of the transaction with a non-resident.

It means that if the tax authority does not agree with the economic reasonableness of the transaction with a non-resident and concludes that its principal purpose is to obtain the benefits under the DTT, the company may at least be charged of WHT at 15% rate and penalties. Further, the tax authority may raise the issue on transfer pricing and compliance with the «arm's-length principle» as well.

Therefore, in order to reduce the business risks, it is advisable to pay attention to several conclusions in the first tax disputes on the application of the test. Thus, the District Administrative Court of Kyiv in the Rulling dated 01.03.2021 analyzed the conclusions of the tax authority on the illegality of the application of the reduced WHT rate when paying interest on a loan from a non-resident counterparty. The court analyzed whether the principal purpose of this transaction was only to receive the benefits of the DTT with the United Kingdom. In the Act of the tax audit, the tax authority referred to paragraph 7 of Article 11 of the DTT with the United Kingdom.

While analyzing of the conclusions of the tax authority, the court used the «principal purpose test» and examined a number of the following issues:

  • Whether all/almost all amount of interest is transferred to the third parties after a short period of time after the receipt?
  • Does the creditor have documented and / or undocumented liabilities to the third parties that require the creditor to transfer interest in favor of the third parties?
  • Whether the business activity of the creditor is limited to obtaining the interest and its subsequent transfer in favor of third parties?
  • Does the creditor have an economic substance in the jurisdiction of residence?
  • Does the application of tax benefits meet the objectives of the applicable tax legislation?

The court concluded that the non-resident counterparty provided the loan within its own business activities and in connection with the economic and commercial needs of the taxpayer. Therefore, the conclusion of the tax authority that the transactions between the taxpayer and his counterparty are part of the of tax planning model and there were no evidences on artificial obtaining of tax benefits of the DTT with the United Kingdom.

The similar conclusions are also set out in the Rulling of the Poltava District Administrative Court dated 03.08.2020 in case № 440/2010/20, that was left in force by the Rulling of the Second Administrative Court of Appeal dated 10.02.2021.

Thus, in the case № 440/2010/20, the courts concluded, in particular, that the non-resident lender:

  • has the «full privilege to receive a profit directly»;
  • does not transfer income from loans to third parties, but makes payments from such income;
  • is a bona fide taxpayer, is not a fictitious company and was not created to benefit from the DTT but to benefit from the London and UK markets advantages;
  • carries out its activities with the use of qualified specialists and professionals;
  • bears a real commercial risk;
  • pays taxes in UK in a larger amount than those charged in the disputed tax notice-decision.

As a result, the courts have concluded that the tax authority's assumptions about making the loan to benefit from the DTT with the United Kingdom are unfounded.

Thus, the first court practice on the application of the principal purpose test indicates a deep analysis of the essence of disputed transactions, features of commercial activities of counterparties, economic substance of a nonresident in the country of registration, legal and factual ability to dispose of income. Therefore, businesses should be prepared to prove that the application of a reduced rate of WHT was not the main purpose of the transaction and justify the commercial reasons for its implementation.

If you want to know more about the specifics of the principal purpose test and aspects of protection against similar conclusions of the tax authority, we suggest to discuss how KPMG in Ukraine can help your company to minimize the risks of the possible charges.

Sergiy Popov, Partner, Head of Tax & Legal, Head of Healthcare & Pharmaceuticals KPMG in Ukraine

Iryna Khilyak, Senior Lawyer at KPMG Law Ukraine