Ruslana Tiutenko,
Consultant at the TP Department
Does a loss-making transaction automatically mean a lack of business purpose? We explore how to protect your financial result and correctly justify the economic rationale behind operations with non-residents from “high-risk” lists.
Table of Contents
Tax Differences and the 30% Adjustment
If a corporate income tax payer purchases or sells goods, including non-current assets, works, or services, to certain categories of non-residents whose legal form (or country of registration) is included in the “high-risk” lists approved by the Cabinet of Ministers of Ukraine (Resolution No. 480 dated July 4, 2017, and Resolution No. 1045 dated December 27, 2017), and these operations do not meet the criteria for controlled transactions nor fall under exceptions according to the TCU, the taxpayer must increase their financial result by 30% of the amount of such expenses or income. This adjustment is based on sub-paragraphs 140.5.4 and 140.5.5¹ of paragraph 140.5 of Article 140 of the Tax Code of Ukraine (TCU).
In other words, tax differences arise.
The Exception: If the operation is not controlled and the amount of such expenses/income is substantiated by the taxpayer using prices determined by the “arm’s length” principle (following the procedure established by Article 39 of the TCU), the requirements for the 30% adjustment of the financial result before taxation do not apply
Please note that if the enterprise does not apply tax differences (e.g., if the company’s annual income does not exceed UAH 40 million), these adjustments are not made, and an increase in the financial result does not occur in any case.
For example, let’s consider operations involving the sale of goods to a non-resident that are subject to adjustment under sub-paragraph 140.5.5¹ of the TCU. To substantiate the transaction terms according to the procedure set by Article 39 of the TCU, the Transactional Net Margin Method (TNMM) was applied, using the net cost plus markup indicator (net profitability of expenses). According to the analysis conducted, the segmented net profitability of the transaction’s expenses is slightly below the lower bound of the arm’s length range of values for comparable companies.
Business Purpose vs. Loss-Making
We have a practical case where tax authorities interpret “negative profitability” as evidence of a lack of business purpose for a transaction. In the absence of business purpose, controllers intend to increase the financial result before taxation by the full amount of the sale. However, the controlling body has not proven the circumstances indicating that the export operations were conducted without a valid business purpose, as required by sub-paragraph 39.2.2.12 of paragraph 39.2.2 of Article 39 of the TCU.
Here we face a practical problem: tax authorities equate loss-making with a lack of business purpose, and on this basis, they attempt to assess additional corporate income tax liabilities.
It should be noted that loss-making does not mean a lack of business purpose.
The market range in transfer pricing evaluates the “marketness” of terms (price/profitability), rather than the motives behind the transaction.
At the same time, it is crucial to understand that the mere fact of a taxpayer’s overall loss-making activity, or the presence of individual loss-making transactions, does not indicate that the activity or operations lack a reasonable economic cause (business purpose). Loss-making operations can be a legitimate element of a taxpayer’s business activity, considering, for example:
- Business strategies applied in a specific market (e.g., market entry or share protection).
- General market conditions that may affect other taxpayers operating in the relevant market for goods, works, or services.
Definition of Business Purpose Under the TCU
According to sub-paragraph 14.1.231 of the Tax Code of Ukraine (TCU), a reasonable economic cause (business purpose) is a reason that can only exist provided the taxpayer intends to obtain an economic effect as a result of business activity.
The economic effect includes, but is not limited to, the growth (preservation) of the taxpayer’s assets and/or their value, as well as creating conditions for such growth (preservation) in the future.
For tax purposes, a transaction conducted with non-residents is deemed to have no reasonable economic cause (business purpose) if:
- →The primary goal or one of the primary goals of the transaction is the non-payment (underpayment) of taxes and/or a reduction in the taxpayer’s taxable profit;
- →Under comparable conditions, the party would not have been willing to purchase (sell) such goods, works (services), intangible assets, or other items of business transactions from unrelated persons.
Sub-paragraph 14.1.231 of the TCU applies for the purposes of Article 39 of the TCU, including when proving circumstances that indicate a lack of business purpose in cases defined by Article 140.5 of the TCU, which involve the application of relevant provisions of Article 39.
Therefore, the fact that a transaction’s result falls outside the positive range does not, in itself, equate to a lack of business purpose.
This conclusion is supported by the norms of the TCU. According to sub-paragraph 140.5.5¹, the financial result before taxation is increased by 30% of the value of goods sold to non-residents registered in low-tax jurisdictions (List 1045) or specific legal forms (List 480).
These requirements do not apply if the transaction is not controlled and the income amount is substantiated by the taxpayer using prices determined by the “arm’s length” principle according to Article 39, without filing a report.
However, if the sale price is lower than the “arm’s length” price, the adjustment is made only on the difference between the arm’s length value and the actual sale value.
Important Note: If the controlling authority does not recognize (disregards) such an operation following an analysis under Article 39, the financial result is increased according to the procedure in sub-paragraph 140.5.2-1. In this case, other adjustments under this sub-paragraph are not applied, and the adjustment amount is reduced by any self-applied adjustments previously made by the taxpayer.
Adjustment Logic: Two Cases Under the TCU
The Tax Code of Ukraine provides for two distinct cases of adjustment:
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Financial result adjustment is performed if a transaction does not fully comply with the “arm’s length” principle. In this case, the adjustment is limited to the difference between the value determined based on the “arm’s length” price level and the actual sale value.
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The controlling authority disregards (does not recognize) such a transaction based on an analysis under Article 39 of this Code, following the application of sub-paragraph 39.2.2.12. This occurs only when a lack of business purpose has been proven.
The simultaneous application of both mechanisms contradicts the TCU and constitutes grounds for appeal.
Furthermore, the controlling authority is obligated by the TCU to prove circumstances indicating a lack of business purpose (pursuant to sub-paragraph 39.2.2.12). Proving that a transaction meets the criteria defined in sub-paragraph 14.1.231 of the TCU must:
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Firstly, clearly demonstrate that the primary goal of the operation was the non-payment (underpayment) of taxes or a reduction in taxable profit, or that under comparable conditions, the party would not have been willing to sell such goods to unrelated persons.
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Secondly, clearly distinguish the transaction from those that constitute the taxpayer’s ordinary course of business.
In this regard, the controlling authority must analyze the potential availability of alternative agreements (transactions) that the taxpayer could have entered into with the same counterparty (or counterparties) to achieve the same or a more favorable result.
The practical algorithm for the controlling authority to determine the presence or absence of a “business purpose” is set out in the General Tax Consultation regarding the practical application of the set of norms concerning the existence of a “reasonable economic cause (business purpose)” during audits, approved by Ministry of Finance Order No. 11 dated January 13, 2022.
However, if the controlling authority fails to fulfill its obligation to prove circumstances that would indicate a lack of reasonable economic cause (business purpose) in the execution of the transaction—as prescribed by the aforementioned algorithm—the analyzed operation cannot be disregarded for the purpose of determining taxable profit.
Consequently, legal grounds for the non-recognition of its results are absent.
Conclusion
Business purpose is not an indicator of profitability, but rather the presence of economic rationale behind a transaction. Since 2021, the description of an operation’s business purpose has been a mandatory section of Transfer Pricing (TP) Documentation. Therefore, when preparing documentation—whether for TP purposes or for the 30% adjustment—taxpayers must pay special attention to this section.
Important to remember:
Proper substantiation of business purpose allows you not only to meet legislative requirements but also to minimize tax risks and ensure the transparency of business operations. It is crucial for taxpayers to properly document the economic reasons for their transactions and confirm that even loss-making operations have strategic value, as this guarantees confidence in the company’s position during an audit.
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