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Prohibition on gross-up clauses in cross-border transactions

Bate C TomsSvitlana Stepaniuk

Under the new Tax Code of Ukraine, there is an express prohibition on the inclusion in cross-border agreements, including in particular for cross-border loans, of a so-called gross-up clause.

Under a standard gross-up clause, interest and other taxable amounts which are to be paid by a Ukrainian debtor under the typical cross-border loan agreement must be grossed-up for an amount equal to the withholding tax due by the non-resident creditor to the Ukrainian tax authorities. The gross-up clause thereby shifts the tax burden from the creditor to the debtor, which must then pay by withholding the amount of the tax due by the creditor.

Before the adoption of the Tax Code, this issue, on compensating a non-resident lender for the amounts due under Ukrainian withholding tax, was regulated by the Law of Ukraine on the Taxation of the Profits of Entities (No 334/94-BP, December 28 1994, still partially in effect), which expressly prohibited such compensation.

Since the relevant provision had arguably vague language, however, in practice contractual tax gross-up clauses were always inserted into cross-border loan agreements.

In response to this practice, the State Tax Administration, in its Letter No 14086/5/22-5016, clarified its official position on the possibility of using such gross-up clauses for cross-border transactions, by expressly prohibiting them. Although the letter expressly referred only to cross-border loans, it was thought also to be applicable to all cross-border transactions. Nonetheless, many Ukrainian lawyers continued to take the position that this letter was merely an opinion that could be disagreed with and ignored (see this firm's IFLR briefing of June 3 2010).

Apparently in response, the prohibition on the gross-up clause has been expressly included in Article 161 of the Tax Code. Article 161 prohibits the insertion of gross-up clauses into any kind of cross-border agreement. Any gross-up clause that is nonetheless included in a cross-border contract is voidable. As a consequence, the National Bank of Ukraine should refuse to register agreements which contain such gross-up clauses (for which registration is required for payments to be made abroad in accordance with applicable exchange control rules), and the servicing bank (the bank through which payments abroad under an agreement must be made by a resident debtor under Ukrainian exchange control rules) should refuse to make transfers abroad based on such agreements.

There still appear to be some possible ways to avoid or mitigate the negative consequences from the prohibition of contractual tax gross-up clauses in cross-border agreements. One possible solution, especially in the context of a fixed-rate loan agreement, would be to include in the cross-border loan agreement a fee (for example, an arrangement fee) payable to the foreign creditor that might roughly equal to the total amount lost through the withholding tax on interest. Borrowers might want a proportional reduction of this upfront fee in case of prepayment of the financing. Such a fee could allow a foreign creditor to receive the equivalent of the full interest that would otherwise be due on a financing. Under Ukrainian exchange control laws and NBU regulations, however, if the amount of the fees paid for services exceeds €100,000 ($132,000), a certificate of Price Expertise of the State Informational and Analytical Monitoring Centre for External Commodity Markets is required for transfer of the excess amount abroad, which in practice may be time-consuming and sometimes difficult to obtain.

Another possible solution to avoid the effects of the prohibition on gross-up clauses is, at the outset, to increase the interest rate due on the financing to the extent necessary in order for the bank to receive a sufficient interest income after withholding. On this basis, there would be no extra withholding to respond to, and thus no need for a gross-up clause, unless the applicable withholding tax would be subsequently increased, which could be addressed by making this a ground for early termination. Under Ukrainian law, though, there are limitations on the maximum interest rates allowed for cross-border loans: for long-term fixed-rate loans for more than three years in euros and US dollars, 11% per annum; for medium-term fixed-rate loans for one to three years in euros and US dollars, 10% per annum; for short-term fixed-rate loans for less than one year in euros and US dollars, 9.8% per annum; and for a floating interest rate, three-month Libor in US dollars plus 750 basis points. If such interest rate limitations are exceeded, a loan agreement may not be registered, and payments may not be made abroad under it. (These interest rate limitations also previously could limit the effectiveness of gross-up clauses, which was not always understood by lenders.)

As a consequence of the cited restrictions on fees for services and the interest rate limitations, and the relatively high interest rates set for most Ukrainian borrowers, the solution to mitigate the effects of the gross-up clause prohibition will usually be a combination of the two approaches, by imposing additional fees and higher interest rates. If the lender only reacts to the gross-up problem when registration is refused for its agreement, and then adds fees and additional interest to cover the withholding tax, this will appear to be done to replace the tax gross-up clause and may consequently be subject to attack as a disguised attempt to shift the tax burden and violate the prohibition on Ukrainian borrowers bearing the Ukrainian withholding tax on their lenders.

Bate C Toms and Svitlana Stepaniuk

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