Transfer Pricing Analysis: How to consider the impact of the year of 2022 on Ukrainian businesses?

The year of Russia’s full-scale invasion of Ukraine has become a time of immense difficulties and unprecedented challenges for businesses operating in Ukraine, both for subsidiaries of foreign groups and companies with Ukrainian capital.

Companies have incurred significant operational losses as a result of Russian aggression. However, as it turned out, this does not mean that a company will be exempt from paying income tax.

So what should companies do to avoid additional tax accruals under the current legislation?

Losses incurred by businesses due to the war. Theory.

The sale of goods or services between companies within the same group registered in different countries is a standard business practice. The purpose of such transactions is not to optimize taxes, but to achieve certain operational and strategic objectives.

For example, a Ukrainian subsidiary buys household appliances from its manufacturing plant in Germany and resells them in Ukraine. Or vice versa, a Ukrainian plant sells its products to a company within its own group in Europe. Having its own distributor in the country allows the group to increase sales in this market, as local companies have the established connections, logistics network, and sales channels.

Under the transfer pricing (TP) rules implemented in more than 70 countries, Ukrainian companies have to substantiate that the terms of the related party transactions are at arm’s length.

For example, a subsidiary has to justify that its import price for a product is not too high, and a manufacturing plant has to prove that its export price is not too low. Simply put, that they are not underestimate their profits.

Determination of arm’s length prices is based on a complex procedure provided for by the tax legislation (Article 39 of the Tax Code of Ukraine). In most cases, it involves the profitability analysis.

A Ukrainian distributor needs to prove that its profit margin is comparable to that of similar distributors in Ukraine. If this is not the case, in particular, if the margin is below the market range or even negative, it may result in additional income tax charges at a rate of 18%.

In addition, the amounts of such adjustment will be considered so-called dividends equivalent payments and may be additionally subject to withholding tax at a rate of up to 15%.

Let’s imagine that during the war a Ukrainian distributor or factory incurred expenses that it has never had before. For example, the company’s warehouse with goods was destroyed during the shelling, or the company provided additional assistance to employees, or moved its production facilities and staff to safer regions. As a result, the company reported a negative profit margin in 2022.

How to justify war-related losses. Practice.

The TCU allows for the existence of external factors and economic conditions (Article 39.2.2.2 of the TCU) that affect the companies’ operations and therefore allows them to reflect such factors in the company’s profitability analysis.

War is a significant external factor. How to consider its impact? Can a business adjust its profitability? Ukrainian tax legislation does not provide a clear answer as there is no applicable provision for such impact on the financial results of companies.

Below are some possible approaches to adjusting profitability for external factors:

• Excluding from the calculation of profitability the company’s financial results for the period when it was operating under limited conditions.

During 2022, business operations in Ukraine were suspended due to hostilities, as many assets of companies were ‘trapped’ in the occupied territories or in high-risk areas along with supply chains disruptions, all of which has caused disruption in operations.

In some cases, operations were hampered by shortage of staff, while some companies were unable to make cross-border payments due to currency regulations, which sometimes made it impossible to import goods.

As a result, Ukrainian companies did not receive the expected profit, while operating expenses remained unchanged or decreased insignificantly.

It is necessary to determine the amount of expenses and income for the period when the business did not operate or operated to a limited extent and consider whether it is appropriate to exclude it from the calculation of financial results.

It is not about adjusting the company’s financial statements, but about adjusting the financial results solely for the purpose of determining the tax base.

• Analysing gross margin rather than operating profit margin.

When analysing a company’s profitability, it is common to consider operating profit margin, which takes into account operating expenses. For the purposes of the analysis for 2022, it is advisable to change this approach and analyse gross margin (gross profit to revenue ratio).

This indicator was less affected by the war. Unlike operating profit margin, it does not depend on the operating expenses of a business.

• Identifying the ‘extraordinary’ expenses that a company incurred during the war and excluding them from the calculation.

We have already mentioned extraordinary expenses in detail above, including the loss of assets due to shelling and additional costs associated with changes in the logistics routes and providing financial support to employees. This can also include the costs of disposing of products that were not sold within a specified period of time.

Such ‘extraordinary’ expenses may be considered to be excluded from the calculation of operating profit; however, only for the purposes of transfer pricing analysis.

These are the key examples of approaches to accounting for the impact of war on business. There are other options. Although the issue of adjusting profitability is essentially a tax issue, during the TP analysis you should involve not only the finance department but also other departments, from logistics and sales to HR.

Response of tax authorities

The State Tax Service has not provided any explanations or expressed its position on how to account for the impact of the war on Ukrainian business. During informal discussions, some opinions were expressed that such an impact should be taken into account, but the Ukrainian tax authorities did not specify how it should be done.

We do not rule out that the tax authorities may challenge any of the above adjustments made by the business, ignore them, and impose additional tax charges.

Tax authorities can apply additional tax charges only after 1 October of the current year. However, we are currently observing that tax authorities are sending numerous inquiries to taxpayers regarding their transactions with non-residents in 2022, asking to explain whether these transactions were carried out at arm’s length, and if not, they will be required to accrue additional tax liabilities

If a company does not take certain steps, in particular those outlined above, regarding taking into account the impact of the war on its operations, it will most likely have to self-accrue additional tax liabilities in case of losses.

If a Ukrainian business does make adjustments for the impact of the war, the tax authorities will first have to challenge such adjustments and then make their decision on accrual of additional tax liabilities.

The article is co-authored with Oleg Servetnyk, Transfer Pricing Senior Consultant at Deloitte Ukraine.

Source: Forbes