Taxation of property contributions made by individuals to the share capital of legal entity
02.08.2009
The assets of a legal entity could be financed from different sources, but the main of them has always been contributions of its founders (shareholders). The aggregate of founders’ contributions intended to finance the activity of established entity is traditionally known as share capital.
The share capital is one of main subjects of modern corporate law. The share capital contributions lead to initial acquisition of corporate rights and all the transactions with corporate rights have a direct impact on share capital. It is even possible to say that the corporate law begins with share capital. The share capital contributions can be made either in the form of cash deposits or tangible and intangible assets transfer, including rights on intellectual property.
This article considers the question of applying Personal Income Tax (hereinafter PIT) to the property contributions (real and movable property) made by shareholders (individuals) at the time of initial formation or increase of the legal entity’s share capital.
The history of this question is quite interesting. First of all, we should notice that an ambiguity of this issue is caused by different interpretations of some clauses of the Law of Ukraine «On Taxation of Individuals’ Personal Income» (The Law on TIPI). It has resulted in existence of different approaches how to calculate the amount of PIT to be paid by the individual shareholder while his (her) property gets transferred to the share capital.
Approach 1: The initial one.
The transactions of individuals with corporate rights within the framework of Law on TIPI are considered as transactions with investment assets. When individuals realize transactions with investment assets (in particular, corporate rights) their investment income is subject for taxation by PIT. The investment income is defined as a positive difference between income received by a taxpayer from the sale of an identifiable investment asset and its cost calculated as the total amount of charges incurred to acquire such asset (subparagraph 9.6.2 of Law).
Thus, the transactions on contributing of property items to the share capital of a legal entity - resident of Ukraine in exchange for the corporate rights of such entity are considered as acquisition of investment asset. At the same time, the sale of investment asset takes place when such initially contributed cash deposits or property items get withdrawn by the individual as a result of his (her) exit as a shareholder of this legal entity.
Consequently, it is necessary to derive the difference between the income received by individual shareholder from the sale of corporate rights and costs incurred by him (her) to acquire those rights. The positive difference between these two amounts is to be shown by such individual in his (her) annual tax return and is subject to taxation by PIT at rate 15%. The negative difference is to be carried forward to reduce his (her) general investment gain from the transactions with investment assets in the next reporting years up to its full compensation if such future investment gains actually happen.
Accordingly, the subject of taxation for PIT in this case is not the total income from the sale of investment asset but the investment gain (income less cost) calculated by the individual shareholder independently. As a result, the legal entity is not a tax agent for its individual shareholders and should not be kept responsible for withholding of PIT.
Approach 2: The fiscal one.
The State Tax Administration of Ukraine (hereinafter – The STA) initially adhered to the official position that is quite in line with the approach 1 above. However, some time later the STA changed its opinion regarding this issue (according to the STA’s Letters since the beginning of 2008). Thus, the tax event for the purpose of PIT calculation became not the fact of withdrawal (sale) of initial share capital contribution but the fact of such initial contribution itself.
In opinion of the STA, the transfer of property items made by an individual shareholder to the share capital of legal entity and his (her) receipt of corporate rights of this entity in return for the same value has all the features of barter agreement. In its turn, the general provisions of goods (works, services) sales agreements are applied to the barter agreements. Thus, investing of assets being the property (both real and movable) of an individual shareholder to the share capital of limited liability company is regarded to be alienation of that property for such individual.
In this case, in opinion of the STA, a legal entity should be considered as a tax agent of individual shareholder and is responsible for withholding the PIT. The moment (or tax period) when tax liability of the tax agent arises is the next banking day after signing the Act of Property Items Transfer and Acceptance. The STA in its Letters insists on withholding 15% of PIT from the estimated value of property contributions.
Such position of the STA can be regarded as quite controversial. In the absence of the proper legal norm in the Law on TIPI, the STA justifies its position using “workaround” approach by making reference to some provisions of Law of Ukraine “On Taxation of Enterprises’ Profits” and “On Corporate Governance”. After a general conclusion, that in result of contribution to the share capital the property changes its owner (from individual shareholder to legal entity), the STA refers to the articles 11 and 12 of the Law on TIPI that regulates the basis for calculation of taxable amount if the items of real or movable property get alienated by the individuals - payers of PIT.
Conclusion.
Fiscal position of the STA, in my opinion, has many weaknesses from the formally legal point of view as well as and from point of the general understanding of income subject to PIT.
In my opinion, references to other Laws of Ukraine that regulate activities of legal entities to determine the order and base for PIT result in the legal collapse of position of the STA and, in its turn, lead to the range of misleading conclusions.
If the fundamental basis of Law on TIPI (p. 1.2) that the subject of PIT can be exceptionally the individuals’ personal income is taken for granted, then unfair position of the STA becomes quite clear. The point is that by forming the share capital of legal entity an individual shareholder really gets corporate rights in return though this transaction does not stop being an investment transaction for him (her), i.e. the kind of transaction that does not mean receipt of any income. According to Law on TIPI this individual gets his (her) income in the moment when the corporate rights are disposed of and the tax rules in that case are determined by the Law (subparagraph. 9.6.2).
The STA in its Letters tries to find the base for PIT where it does not exist. The property contributions are valued by mutual consent of the parties (shareholders) at the moment when the share capital is formed. Thus, estimated value of contributed property items quite often exceeds its original cost to the shareholder and possibly even its market value at the date of contribution. However, an individual shareholder at this stage disposes of really nothing but just declares the possible estimated value of his (her) property. That’s why we can’t talk about any kind of income at this stage. The actual income can only be determined by the market in the moment when the corporate rights are disposed of.
In this sense, the norm of the Law on TIPI is written perfectly:
“the investment income is defined as a positive difference between income received by a taxpayer from the sale of an identifiable investment asset and its cost calculated as the total amount of charges incurred to acquire such asset” (p. 9.6.2.).
The attempt of the STA to make legal entity a responsible tax agent of its individual shareholder – investor in the time when the latter contributes its property to the share capital looks even more surprising. It should be clear enough that legal entity cannot have reliable information on the cost of asset for an individual shareholder - investor being “the total amount of charges incurred to acquire such asset”. Therefore, the only possible way how the tax agent can calculate the tax liability of the individual shareholder comes to application of 15% rate to the estimated value of the asset. However, such an approach makes impossible for an individual shareholder application of direct norm of the Law on TIPI (p. 9.6.2.) in the future when disposal of corporate rights actually take place. In addition, investor is indisputably entitled to take his (her) property or its agreed compensation back in the moment of exit from the legal entity. As it is well known, the reasons of such exit may be different and quite banal. The STA has failed to comment on this kind of situation. But if they did so, the legal collapse of the STA’s position would have become obvious.
Thus, an individual who intends to contribute to the share capital of legal entity his (her) real or movable property should bear in the mind that at the moment the “fiscal” position of the STA exists on this issue. In my opinion, such position is quite weak from the legal point of view, however it does exist.
Therefore, nowadays every individual investor faces the following choice:
- to register, actually contribute property investments and prepare yourself for the possible «manoeuvres» with the STA at the legal entity level; or
- to register, actually contribute cash deposits and sleep well.
It’s up to you, dear investors and future shareholders!
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