Graham Stack in Kyiv -

A visit to Kyiv in late June by Cypriot officials was the latest sign that negotiations are intensifying between Cyprus and a cash-strapped Ukraine wanting to clamp down on tax evasion over a new double-tax avoidance treaty to replace an inherited Soviet-era treaty that was extraordinarily favourable to Cyprus.

Negotiations have been deadlocked since 2008 because a previous Cyprus negotiating team agreed to a new version of the treaty that, ironically, Cyprus' parliament regarded as too generous to Ukraine. "Basically, Cyprus messed up: the Cyprus negotiator focused on blocking Ukrainian demands for more exchange of information, rather than on defending the withholding tax rates [taxes Ukraine would levy on royalties, interest and dividends paid to Cyprus residents]," says Vladimir Didenko, partner for tax questions at leading Ukrainian law firm Magisters. "The final draft of the treaty that the Cyprus team agreed to included a 10% tax rate on interest and royalties, compared to 0% currently, and the Cyprus parliament itself then refused to ratify the new treaty."

Following this, the process of renegotiating the treaty got bogged down in mutual recriminations. In July 2008, Ukraine's parliament even came within three votes of abrogating the treaty in its entirety, which would have subjected all payments to Cyprus companies to a 15% withholding tax.

But now negotiations have restarted, with both countries apparently determined to reach a breakthrough. Uncertainty over the double-tax treaty has started to hurt Cyprus' attractiveness compared to other tax havens, while Ukraine more than ever needs to broaden its tax base to stay within the budget-deficit parameters demanded by the International Monetary Fund (IMF).

Cyprus has one trump card to play in negotiations: It knows that Ukraine's business community, strongly represented in Ukraine's parliament and government, are also not thrilled about the prospect of a 10% withholding tax. According to tax law experts who met the Cypriot finance minister, Charilaos Stavrakis, in a closed-door meeting in Kyiv in late June to try and break the deadlock, Stavrakis commented that Ukraine's negotiating team was playing it tough, "but I'm still smiling."

The Cyprus exemption

It is only since information disclosure improved in 2007 that a real picture of the scale of tax leakage to Cyprus has started to emerge. National statistics show that Ukrainian investment abroad to Cyprus roughly equals the volume of investment coming into the country from Cyprus - $5.5bn-6bn. In fact, around 90% of all Ukraine's investment abroad flows to Cyprus, according to the state statistics committee. "Under the tax treaty with Cyprus, most of the income, including dividends, interest, royalties and capital gains from sales of shares, derived by a Cypriot resident from Ukrainian sources is exempt from Ukrainian withholding tax," explains Sergiy Melnyk of Salans law firm in Kyiv.

"Moreover, the tax treaty with Cyprus does not contain any anti-avoidance rules - such as the requirement for the recipient of income to be the beneficial owner of such income," adds Melnyk. This means that Ukrainian businessmen, and foreign investors, are free to establish holding companies in Cyprus as intermediaries for their Ukrainian assets.

Another feature of the treaty is that it contains no restrictions on "thin capitalisation." This is a form of tax minimisation whereby an offshore holding company capitalises its subsidiary using loans instead of equity. The volume of debt amassed can total many times the formal share capital of the subsidiary, hence the name. As a result, interest payments to the "creditor" - ie. the holding company - on the "loans" swallow up profits. The interest payments are tax-deductible for the Ukrainian company and tax-free for the Cyprus "creditor."

Rounding off the deficiencies of the current treaty is that there is no Ukrainian legislation prohibiting transfer pricing - leaving holdings completely free to configure their internal pricing in a way that minimises tax, ie. realising profits where tax is lowest.

The World Bank, which recommends Ukraine revise the treaty, points out that when Russia suspended a similar but less generous treaty with Cyprus in 2007, tax revenues rose by 0.6% as a result. But Ukrainian analysts say that revising the treaty would just prompt Ukraine's businessmen to look elsewhere for tax minimisation schemes. "My honourable colleagues are too optimistic if they think that just revision of this single agreement will solve the problem," says Vladimir Dubrovskiy, a senior researcher at think-tank CASE-Ukraine. "I'm afraid that Cyprus will be very soon replaced with some other offshores, or other kinds of tax minimization."