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Validity of Tax Gross-Up Clauses Questioned
In its Letter No 14086/5/22-5016 of 18 November 2009, the State Tax Administration of Ukraine ("STA") for the first time, in its response to request of the National Bank of Ukraine, pronounced its position on the validity of tax gross-up clauses widely employed in cross-border loan (financing) agreements involving Ukrainian borrowers. Taxand Ukraine reviews the clauses and highlights the risks to non-residents.
Under a standard gross-up clause, interest and other amounts payable by a Ukrainian borrower shall be increased (grossed-up) by the amount of withholding tax or other deductions made from the total payable to the non-resident lender. Effectively, the non-resident lender shall receive interest and other amounts payable net of any Ukrainian withholding taxes or other deductions.
The issue here is that Article 18.2 of the Law of Ukraine "On Taxation of Profits of Enterprises" ("CIT Law") prohibits contractual tax clauses, pursuant to which resident entities undertake to "pay" corporate income tax on income for non-residents. Although under gross-up clauses resident borrowers do not legally "pay" Ukrainian withholding tax for non-resident lenders, resident borrowers effectively incur the burden of such tax.
In the opinion of the STA, gross-up clauses are prohibited under Article 18.2 of the CIT Law and, as a result, are null and void.
It is hard to predict at this moment how this position of the STA may potentially affect cross-border financing agreements with resident borrowers paying grossed-up interest to non-resident lenders and, in particular, rights of non-resident lenders to receive grossed-up interest.
Non-resident lenders should carefully consider risks of the following negative consequences:
- Based on the letter from the STA, the National Bank of Ukraine ("NBU") may prohibit domestic banks to service transfers of additional grossed-up interest amounts to non-resident lenders. This may result in defaults of resident borrowers. The NBU has already instructed domestic banks to take into consideration the position of the STA on this issue (Letter of the NBU No 13-210/8254-23814 of December 22, 2009).
- Even without explicit instructions from the NBU, domestic banks may take a conservative approach and may refuse servicing transfers of additional grossed-up interest amounts by resident borrowers to non-resident lenders.
- Resident borrowers may use this position of the STA (as might be supplemented by position of the NBU) as an excuse for not paying increased (grossed-up) interest to non-resident lenders.
- Finally, it is possible that payment of grossed-up amounts under void gross-up clauses may be treated as unauthorised transfer of foreign currency by resident borrowers subject to a penalty in the amount of an unauthorised transfer.
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