Exports of Commodities and Analysis of Traders’ Profitability: What Tax Challenges Are Faced Here?

Well before the full-scale invasion, commodities were the largest items in Ukrainian exports. Agricultural produce and metallurgical goods made up more than half of total export in 2021. Furthermore, in 2022, this figure even increased, according to the State Statistics Service of Ukraine. Thus, those sectors are of key significance for the economy.

However, the past two years have introduced new challenges due to missile attacks, destroyed and damaged infrastructure facilities, the Ukrainian-Polish border blockades, occupied ports, and problems with electricity supply. And, in 2023, the Procedures on Determining the Compliance of the Terms and Conditions of Commodities Controlled Transactions with the Arm’s Length Principle adopted by Cabinet of Ministers of Ukraine (CMU) came into effect. Those Procedures establish an algorithm for commodities pricing when calculating the exporter’s taxable profit. Will those Procedures bring a simplification or, instead, another challenge?

Crux of the matter

Traditionally, multinational groups sell their products through foreign traders. The main reasons for that are as follows: such traders know the market better, are able to attract funds from foreign banks at lower interest rates, and purchasers consider them more reliable business partners than other entities in the group located thousands of kilometers away.

The practice of such businesses in Ukraine is not an exception and, after the start of the full-scale war, it has only intensified. The Ukrainian agricultural and steel industries sell their products through related foreign companies located, for instance, in Switzerland, a country that is the world leader in terms of trade in commodities.

Exporters pay a corporate income tax based on the amount of their operating profits generated from sales of goods. Therefore, it is important for the state budget of Ukraine that export prices are not understated and that Ukrainian entities do not decrease the amount of payable taxes by setting understated prices for foreign companies with which they have common interests.

Therefore, Ukraine, along with more than 110 other countries, has implemented transfer pricing rules. Those rules stipulate that the terms and conditions of transactions with companies of the same group should be determined based on the arm’s length principle and, thus, be market-based.

How to prove that the price of commodities is market-based? To do this, the trader’s margin should be calculated. Such a margin should correspond to the level of profitability of other similar traders abroad. In this case, the export price set by a Ukrainian manufacturer for its foreign company will be treated as market-based.

However, the Ukrainian tax legislation has specific rules for commodities, in particular, it requires comparing prices, not profitability.

Effective from 2023, the CMU`s Procedures determine how to compare prices by using stock quotes or data from price agencies, such as Refinitiv or Platts. At first glance, this seems reasonable, since price agency quotes cover fairly standard terms and conditions and publish prices for fairly homogeneous (similar) products. However, in practice, this may turn out to be a complicated task, especially in the wartime. The data used for comparison should be as accurate as possible, which is not always possible.

Do you have wheat for delivery from Chornomorsk?

Let us analyze on a hypothetical example – sales of wheat with 11.5% protein from Chornomorsk, with delivery on board the vessel (in business language, FOB/Free on Board delivery) in 2023. To determine whether the price for this wheat is market-based, the data obtained, e.g., from Refinitiv Eikon (the London Stock Exchange Group) are used. Quotations disclose the price with reference to the quality of products, volume, and delivery terms and conditions.

However, even in peacetime, it was difficult to cover all the nuances. For instance, it isn`t always possible to separate transportation costs, adjust for differences in supply volumes, or consider different commodity market conditions.

Currently, due to the war, information on quotations is limited, and, for certain periods, it is completely missing. Accordingly, it is impossible to compare prices without obtaining access to those data.

The case is complemented by factors that have always complicated the process of price comparison – volumes of batches, different approaches applied to distributing functions and risks between parties to transactions, and their different business strategies. In addition, comparing prices in each individual delivery transaction is not always objective.

This approach does not consider various factors impacting pricing, such as the need to export goods at lower prices to avoid underloaded vessel costs or the incapacity to store products.

One more nuance should be mentioned here: if the product is exported at a price lower than the market price, the Ukrainian entity should additionally accrue an income tax. And if the price exceeds the market price, it is impossible to decrease the amount of taxes paid according to the legislation.

What approaches are applied by the tax authorities

Ukrainian tax authorities (UTA) prefer applying the method of comparing prices rather than profitability. From their standpoint, this ensures greater reliability, since it is difficult to review the profitability of foreign traders. Besides, complexities arise when it is required to find a sufficient number of comparable traders to compare the profitability of “our trader” with foreign ones.

Such UTA`s approach may lead to additional taxes charged, and those amounts are likely to be material. E.g., for a transaction of UAH 1 billion, additional taxes may amount to UAH 20 million. Furthermore, effective from 2021, transfer pricing adjustments of tax base may be recognized as dividends and require accruing a withholding tax in the amount of up to 15%.

What does the court says

Businesses often go to courts to have such increase in tax base withdrawn, and there has already been a range of successful cases when the tax authorities' decisions have been overruled, concluding: the method of price comparison should only be applied when it is as reliable (or more) as the profitability method.

Courts emphasize that the burden of proof lies with the tax authorities. Therefore, if company has conducted a qualitative analysis, the tax authorities should first challenge its approach and only then apply their own method.
Counterarguments to apply prices for comparison are as follows: it is impractical to compare different commodity markets (Ukrainian and foreign), it is impossible to correctly consider transportation costs and the difference in freight for different types of vessels (Panamax and Capesize), price information does not take into account the quality and technical characteristics of goods.

However, some courts support the position of the UTA, arguing that those aspects are not of crucial importance. One of the courts expressed its position that only one database, namely Platts, should be used when comparing export prices for iron ore.

At the same time, the tax legislation does not limit a taxpayer to only one database but allows using a wide range of sources. Such a position is also supported by international practice, namely, the OECD Guidelines (the primary source of transfer pricing rules). The Guidelines do not mention the need to use either a single source of information or a single method for analysis.

By the way, even the UTA don`t always use the same source of information during their tax audits.

Actions for domestic businesses

When auditing commodities transactions, the UTA are increasingly applying the method of price comparison, including in view of the CMU’s Procedures. So what should companies which have decided to analyze profitability after all do?

First, be prepared for increased attention from the UTA and be ready to justify in detail why you have chosen to analyze the trader’s profitability rather than compare prices.

Secondly, companies should analyze how algorithms of the CMU’s Procedures apply to their business, what sources of information can be used, and what adjustments may be required to understand the scale of a “possible disaster”, i.e. tax risks and additional tax charges.

Thirdly, transfer pricing policy needs to be designed. The policy shall disclose a detailed formula as to how company sets prices in transactions with its trader abroad. This cannot serve as a “panacea” in disputes with the UTA, but it will help demonstrate good faith and willingness to comply with the legislation.

Thus, Ukrainian exporters are facing a new challenge: how to adapt to new rules of the game and, at the same time, not lose their competitive abilities while minimizing tax risks.

The article has been written in cooperation with Vitaliia Polytska, Tax Managing Associate of Transfer Pricing Practice at Deloitte Ukraine.

Source: Forbes Ukraine