An offshore flood of untaxed wealth

| Kyiv Post
Kyiv-based investment bank  Dragon Capital commented on the 2011 third quarter losses of listed company MMK Illicha, another Metinvest subsidiary. “Such disappointing results lead us to believe that the company widened its transfer pricing practices. The reported average realized steel price was abnormally low, falling $40-60/t short of the average market price in 3Q11,” the bank wrote in a note to investors.

Anywhere between $21 and $32 trillion is stored away offshore, according to a recent report by the U.S-based think tank Tax Justice Network.

That’s one reason why government debts are ballooning, since much of this money remains hidden from tax collectors.

Yet in nations such as Ukraine, using offshore holdings is sometimes the only way to conduct business, with tax minimization serving as an added bonus.

The past several decades have seen an explosion of private banking and offshore havens, used to funnel both legal and ill-gotten gains from developing countries to secure locations in the most industrialized nations.

Independent since 1991, Ukraine is a newcomer to the global offshore scene. It is already punching above its weight, however, and is ranked 15th in terms of capital flight. Used by companies and high net worth individuals, a number of schemes allow capital to exit the country at little cost to its owners, but at great expense to the country of origin, its taxpayers and their futures.

Even if one assumes all the money flooding offshore jurisdictions is of legitimate origin, however, the problem of taxation remains. According to the Tax Justice Network, some $150-160 billion is lost each year by developing countries in foregone tax revenues.

The most common method of evading these taxes is transfer pricing, which moves a corporation’s profits to the district with the lowest corporate tax rate.

“Ukrainian groups commonly structure import-export transactions through foreign trading companies located in low-tax jurisdictions,” said Igor Chufarov, a partner at international auditing and accounting giant Ernst & Young. They leave most of the profit margin offshore, leaving little taxes to be paid in Ukraine, he added.

“This is the most complicated issue regarding taxation – not just in Ukraine, but worldwide,” said Alexey Khomyakov who specializes in tax and corporate issues at leading law firm Asters.

Technically, it is illegal for Ukrainian businesses and citizens to have a foreign holding company without individual license from the National Bank of Ukraine, said Chufarov. “In reality, Ukraine citizens and businesses commonly evade licensing requirements. They use nominal directors to register foreign holding companies, thus concealing from Ukraine authorities their affiliation.”

Ranked 15th in a list of capital flight source countries, Ukraine has contributed some $166.8 billion to the global offshore industry. The Tax Justice Network estimates that $21 to $32 trillion – of which $9.4 trillion belongs to less than 100,000 individuals – has escaped the mainstream financial system, depriving nations’ of badly needed tax revenues. While other companies comply with Ukraine’s regulations, the widespread practice is cause for worry among investors. This particularly true of larger companies engaged in commodity-based sectors like mining or metals.

These include subsidiaries of Metinvest, owned by Ukraine’s richest man Rinat Akhmetov, like publicly traded Azovstal, which posted significant losses for last year.

While noting these were partially caused by weaker global demand, analysts at international investment bank Troika Dialog informed investors: “We believe the results were distorted by transfer pricing employed within Metinvest group.”

Kyiv-based investment bank Dragon Capital similarly commented on the 2011 third quarter losses of listed company MMK Illicha, another Metinvest subsidiary. “Such disappointing results lead us to believe that the company widened its transfer pricing practices. The reported average realized steel price was abnormally low, falling $40-60/t short of the average market price in 3Q11,” the bank wrote in a note to investors.

Metinvest’s press service issued a written response to the Kyiv Post.

“All transactions between Metinvest’s enterprises are performed based on the arm’s-length principles, i.e. Metinvest sells and buys products intragroup based on the prices which are used with unrelated third parties,” the statement said. The losses, they claimed, where caused by downturns in the volatile international markets or increased prices in inputs.

“Even despite of those cases, overall Metinvest Group’s enterprises are constantly paying and reporting considerable amounts in taxes. To illustrate, in 2011, [just] the consolidated taxes paid by the Metinvest Group enterprises were Hr 12.5 billion,” the press service added.

Ukraine companies often use holding structures based in Austria, the Netherlands or Luxembourg – all tax-friendly jurisdictions with efficient administrations – to move, manage and protect their wealth. Yet it is the tiny Mediterranean island of Cyprus that holds the key to Ukraine’s financial back door, with a tax treaty between the two nations that legalizes tax avoidance or calls for minimal taxes across the board -- on dividends, transfers, royalties, etc.

Such structures are certainly not without their merit, though. Foreign ownership means assets are better protected from being raided, a serious problem in Ukraine, and helps a company operate in international markets. Without offshore holdings, Ukrainians and their businesses would not be able to own and raise money abroad, or see their firms go public.

Given the preferential tax treatment accorded to foreign investment, offshore holdings are also a major source of investment capital. With a population of less than 1 million, Cyprus is Ukraine’s biggest source of foreign investment, ahead of the world’s fourth biggest economy, Germany.

In order to minimize their tax burden but remain within the limits of the law, companies should focus on rational and proper documentation, said Khomyakov of Asters law firm. As long as solid arguments for each part of a holding company exist, as well as clear documentation explaining the relations, the business is much more likely not to be abusing the law and will be seen as such by the tax authorities.

Technically, aggressive transfer pricing can avoid running afoul of the law by ensuring the transactions between related parties are valued at market prices, said Chufarov. The problem, he added, is the wide range of market prices for different types of goods, and the fact that some goods cannot be adequately priced.

“Elsewhere in the world a detailed set of rules and methods has been designed to address this problem and provide a fair basis for tax assessment. There is a talk of such rules introduced in Ukraine, but little progress has been made so far,” he explained.

One problem is that the current system is beneficial for most of the involved parties – from private bankers to politicians influenced by powerful lobbying groups. Part of the blame is also laid on the controllers, both public and private.

A highly competitive market means that auditors often offer their services at a loss, explained Gernot Hebestreit, a member of the global business development board of auditor Grant Thornton’s office in London. Auditors have to make up for this with financial and tax consulting services, he added, which leads to conflicts of interest.

Public institutions have also shown complacency. In theory, a tax information treaty between Cyprus and Ukraine could slam the breaks on the most abusive practices, leaving the more or less legitimate holding structures in place. But it remains more of an ad hoc solution than a systemic response.

“It is not a widespread [practice to exchange information],” said Khomyakov from Asters. “Ukraine only approaches the Cypriot authorities when a specific case of a crime comes up, or some other extraordinary event.”