Taxation feature of tolling in foreign economic relations

Oleg Vysochan, Olesya Ostriychuk

Taxation feature of tolling in foreign

economic relations

Annales Universitatis Mariae Curie-Skłodowska. Sectio H, Oeconomia 46/4,

851-860

A N N A L E S

U N I V E R S I T A T I S M A R I A E C U R I E - S K Ł O D O W S K A L U B L I N - P O L O N I A

V O L . X L V I, 4 S E C T IO H 20 1 2

Lvov Polytechnic National University, Departm ent of Accounting and Analysis

OLEG VYSO CH AN , OLESYA O STRIYCH U K

Taxation features o f tolling in foreign economic relations

Cechy opod atk o w an ia opłat tollingow ych w ekonom icznych sto su n k ach m iędzynarodow ych

K e y w o r d s : to llin g , g iv e -a n d -ta k e ra w m a te ria ls, to llin g c o m p an y , ta x a tio n , ta x ev asio n

S ło w a k lu c z o w e : o p ła ty to llin g o w e , su ro w c e o d d a n e do p rz e tw o rz e n ia , f ir m a to llin g o w a , o p o d a tk o ­ w an ie, u c h y la n ie się o d p o d a tk ó w

Introduction

Tolling operations, as a form of foreign economic activity, require organization of timely, efficient and continuous economic control at state level, including tax control, in order to minimize potential threats to the state economic interests. Stud­ ies of tax control over tolling operations implementation organization are especially important, taking into consideration the fact that income from collecting customs, duties and charges constitutes a significant portion of all tax revenues to the State Budget of Ukraine.

G. Bednarchuk, N. Vasilyuk, M. Kovenko, T. Lapenko, I. Shevchenko viewed tolling taxation problems in their writings. However, tolling operations in foreign eco­ nomic relations have not been sufficiently discussed in the publications o f researchers in the context of tax control over their implementation efficiency.

The aim of this research is to outline tolling taxation features in foreign economic relations. In order to achieve this goal, it is necessary to solve the following tasks:

• to give definitions of “give-and-take raw materials” and “tolling operation” in various national legislative and regulatory acts;

• to analyze the shortcomings of the existing tax control system over tolling operations im plem entation and opportunities for shadow tolling schemes implementation;

• to consider tax com pliance by entities, which carry out give-and-take raw materials processing in foreign economic relations;

• to examine the income tax features of tolling companies.

Dynamics of give-and-take raw materials imports and finished products exports in Lviv Region

Significant specificity o f tolling operations (long-term raw m aterial processing, treatm ent processes complexity, the percentage of raw m aterials in the total value of finished products, etc.), and their considerable proportion in the structure o f foreign trade cause taxation features o f tolling operations.

Foreign customers im ported in Lviv Region give-and-take raw m aterials to the tune of 294.5 m illion dollars in 2010, which made 9.3 per cent o f national index (see Fig. 1). Exports of finished products m anufactured from im ported give-and-take raw materials in 2010 totalled 383 million dollars. Despite some volatility in both give-and- take raw m aterials imports and finished products (m anufactured on tolling scheme) exports, a stable upward trend takes place in the balance between these indexes. This provides more tax revenues to Lviv Region budget and to U kraine in general.

□ Exports of finished products manufactured from give-and-take raw materials □ Imports of give-and-take raw materials

□ Balance

Fig. 1. D ynam ics o f give-and-take raw m aterials im p o rts and fin ish e d products exports in Lviv Region, m illio n dollars

Source: personal development on the basis of The State Statistics Committee data, Foreign Trade of Lviv Region: statistical collection. Lviv 2010, 78 pp.

TAXATION FEATURES OF TOLLING IN FOREIGN ECONOMIC RELATIONS ₈₅₃

Legislative regulation of tolling operation in Ukraine

Implementation of tolling operations is regulated by the Law o f Ukraine “On Tolling Operations in Foreign Economic Relations” adopted on 15.09.1995, № 327 (hereinafter the Law № 327). According to the Law № 327, under give-and-take raw materials one should understand raw materials, materials, semi-finished products, component parts, energy carriers imported into the customs territory o f Ukraine by a foreign customer (or purchased by a foreign customer for foreign currency in Ukraine), or exported from the customs territory of Ukraine by a Ukrainian customer, for use thereof in the manufacturing o f finished product. The foreign customer may not purchase the give-and-take raw materials at the customs territory of Ukraine for the national currency of Ukraine or obtain them in the result of other operations, including barter operations. The customer shall enjoy the rights of ownership to give­ -and-take raw materials at each stage of their processing, as well as to the products manufactured thereof1.

In Article 16 of the Tax Code of Ukraine adopted on 02.12.2010, № 2755-VI (hereinafter TCU) there was found a slightly different definition o f give-and-take raw materials: raw materials, materials, semi-finished products, component parts, energy carriers owned by one entity (customer) and transferred to another entity (manufac­ turer) in order to produce the finished product, with subsequent transfer or return of such product or its part to their owner or on his behalf - to other entity2. Apparently, TCU is not limited in foreign economic aspect o f give-and-take raw materials.

Lets consider in more detail, what is meant by the tolling operations. According to Article 1 of the Law № 327, the tolling operation is an operation on preliminary supply of raw materials for their further processing (treatment, enrichment or use) into the finished products for the corresponding remuneration regardless of the number of performers, as well as stages of processing o f these raw materials under condition that the value of give-and-take raw materials at each stage o f processing is not less than 20 percent from the total value of the finished products. Transactions, which do not provide for preliminary supply o f raw materials for receiving finished products, or if the value of raw materials is lower than the specified 20 per cent, shall not be considered as operations with give-and-take raw materials3.

It should be noted that according to recent amendments to the Law № 327 adopted on 09.12.2011, the possibility o f assigning the Ukrainian Government at the submis­ sion o f the Ministry o f Economic Development and Trade of Ukraine o f certain types of transactions in which there is no change in code according to Ukrainian Goods Classification o f Foreign Economic Activity (taking into account the technological features of processing) to tolling operations in foreign economic relations, is expected.

1 O n Tolling O perations in Foreign Econom ic Relations: Law o f U kraine adopted on 15.09.1995, № 327/95. 2 Tax Code o f U k rain e adopted on 02.12.2010, № 2755-VI.

A ccording to A rticle 16 of TCU tolling operation is a processing operation (processing, enrichment or performance) o f give-and-take raw materials (regardless of customers num ber and perform ers and stages (operations)) in order to obtain finished goods for corresponding fee. Tolling operations are operations in which give-and-take raw m aterials value on a particular stage of processing is not less than

20

Thus, the Law № 327 and TCU contain sim ilar definition of tolling operations, which clearly indicates that the share of give-and-take raw m aterials in the total value of finished products should be not less than

20

Characteristically, the tolling operations m ay be perform ed also by residents o f Ukraine, but so far there is no special legislative act that would regulate these relationships.

Ordinary bills in tolling operations

A rticle 14 of TCU determines that tolling operations in foreign economic rela­ tions should be perform ed in the m anner prescribed by the Law 3275. Article 2 of this Law states that U krainian perform er shall carry out paym ent o f im port duties, taxes and fees (except for customs fees) through issuance o f an ordinary bill to the body o f state tax adm inistration at perform er’s location. The term of payment shall be equivalent to the period of performance o f operation with give-and-take raw materials, but not longer than 90 calendar days from the day o f legalization of the im port cargo customs declaration. The amount specified in the bill shall be paid in the currency defined in the contract on perform ance of operation w ith the give-and-take raw m aterials6.

In case of exporting the whole volume o f finished products determ ined by the contract from the customs territory of U kraine the bill shall be cancelled, and import duties, taxes and fees (except for customs fees) shall not be paid. Products m ade on tolling conditions are not subjected to licensing and fixing quotas, except for goods for special purposes determ ined by U krainian government. If exported excisable goods are m ade from raw materials, they are exempt from excise tax.

The bill shall be cancelled as well in case o f partial export o f finished products, determ ined by the contract, from the custom s territory o f U kraine, provided the U krainian perform er docum entary confirm s the paym ent o f im port duties, taxes and fees which had to be paid when im porting into U kraine the part of raw m aterials, used for m anufacturing the finished products not exported from Ukraine. In order to determ ine the am ount of im port duties, taxes and fees, the value o f give-and-take

4 Tax Code o f U k rain e adopted on 02.12.2010, № 2755-VI.

5 Ibidem .

TAXATION FEATURES OF TOLLING IN FOREIGN ECONOMIC RELATIONS ₈₅₅

raw m aterials shall be converted into the national currency of U kraine at the rate of the National Bank o f U kraine as o f the day o f paym ent o f the bill7.

Customs legalization o f the finished products, m anufactured of the give-and-take raw materials im ported from the customs territory of U kraine and exported from the territory o f Ukraine, can be perform ed on the grounds of the copy o f the bill (written commitment) submitted by U krainian perform er to the customs body, as well as copy of the im port cargo customs declaration and, in case of need, conclusion of the Cham ber of Commerce and Industry o f U kraine or that o f regional chambers of commerce and industry, certifying that the relevant finished products have been m anufactured through processing of the give-and-take raw materials, value of which is not less than

20

Transactions between residents and nonresidents of U kraine within their trade turnover should be paid in foreign currency only through authorized banks. The Law of U kraine “On the Order of Payment in Foreign Currency” adopted on 23.10.1994, № 185 provides that the residents’ proceeds in foreign currency should be placed to their foreign currency accounts in authorized banks in term s o f debt paym ent speci­ fied in the contract, but not later than 180 calendar days from the date of exports customs clearance.

Violation of this term provides for the U krainian perform er penalty of 0.3% of non-received proceeds (customs cost of short delivery products) in foreign currency for each day of delay, transferred in U krainian national currency at the official exchange rate o f the National Bank o f Ukraine, which is in force on the day o f debt incurring8. Realization of waste products or scrap rem aining after spoiling o f give-and-take raw m aterials or finished products or after processing of the give-and-take raw m a­ terials at the customs territory of U kraine shall be levied by im port duty and other taxes and fees, charged for imports of sim ilar wastes and scrap in accordance with the legislation9.

Possible tax evasions via tolling schemes in Ukraine

Im perfect tax control m echanism for the tolling operations implementation in foreign economic relations laid in the Law № 327 creates favorable environm ent for shadow schemes realization, and as a consequence - to tax evasion. Foreign customer and domestic agent are beyond the state tax control after im porting give-and-take raw m aterials into the customs territory of U kraine and until the export o f m anufactured finished goods.

7 Р.Л. Х о м ’як, B.I. Л ем1шовський, B.I. В оськало т а iH., Б у х г а л т е р с к и й oôniK та оподат кування:

навч. nociôuuK, з а ред. Р.Л. Х о м ’яка, B.I. Лем1шовського. 3-е вид., доп. i перероб. Льв1в: Б у х г а л т е р с к и й

ц ентр “А ж у р ” 2010, 1220 с.

8 O n the O rder o f P aym ent in Foreign C urrency: Law o f U k rain e adopted on 23.10.1994, № 185/94. 9 O n Tolling O perations in Foreign Econom ic Relations: Law o f U kraine adopted on 15.09.1995, № 327/95.

A fter im porting batch of give-and-take raw m aterials there are all odds for sell­ ing m anufactured finished products in the customs territory of U kraine in order to receive income (without paying duty and the necessary taxes imposed on similar goods importation). Later one can buy a new batch (batches) of the same m aterials inside the state in order to m anufacture finished products over again and freely take it from Ukraine. Also there is an opportunity to export Ukrainian production of higher quality under the guise of finished products m anufactured from give-and-take raw materials.

A typical example o f such fraud is scheme o f sugar production. Raw cane sugar is im ported as give-and-take raw m aterials and processed in U krainian plants. Then finished products are realized on the domestic market. In order to fulfil the external economic contract sugar made from this year sugar beet harvest is exported as finished products. As a result, low-quality products stay in U kraine and high-quality sugar is exported abroad. Such schemes harm the State Budget of U kraine, the national producer and each consum er separately10.

W ithin a single foreign economic activity entity amount of damage inflicted to the State budget of U kraine seems inconsiderable. The amount o f underpaym ent to the budget is quite significant if take into account that tolling operations are about 5% of all foreign economic operation carried out in Ukraine. More and more give-and-take raw materials are im ported in customs territory o f Ukraine every year (for example, in 2010 the amount o f im ported give-and-take raw m aterials exceeded 3 billion dollars).

Implementation of tax control over tolling companies

Lets consider the implementation of tax control over tolling operations in foreign economic relations from the perspective of domestic performer. The procedure o f bill is extremely inconvenient and unprofitable for the perform ers, costly both financially and in term s of time. Commercial bank takes commission for bill avalization service. Commission ranges between 1-2 per cent of the bill. Provision of bank guarantees (aval) is based on the transfer o f property in pawn, which is registered by appropriate mortgage agreement or movable property security agreement and is accompanied by additional notary services costs for performers. In addition, the performer may periodi­ cally take bank credits. As a result much of his property at the tim e of raw materials clearance and bill avalization may already be in bank pawn. Finally, the perform er physically can not have an inexhaustible list o f assets that can be pledged. Banks, in turn, require the transfer o f liquid assets, on which a penalty can be inflicted in case of principal obligation failure.

The procedure of bill avalization is very costly in term s of time. In order to pawn, for example, estate property one needs to make a list o f documents in the bureau of

10 O .n . Б орисенко, Д ер ж а вн е р е гу лю ва н н я т а ф1нансовий конт роль операцш з давалъницъкою

TAXATION FEATURES OF TOLLING IN FOREIGN ECONOMIC RELATIONS ₈₅₇

technical inventory, and coordinate all m atters with notary public who w ill witness a transaction.

Taking into consideration all foregoing bureaucratic procedures, the perform er loses 2-3 days for give-and-take raw m aterials clearance. As a result delays in de­ liveries of finished products take place and foreign counterparties may implement financial sanctions.

Lets examine international experience of the income tax characteristics of toll­ ing companies. Participants establish tolling companies to build, own and operate production facilities at which the raw m aterials owned by the participants in the joint venture w ill be processed into finished product for use or disposal by the par­

ticipants individually. C. Birch concluded, that w hilst tolling companies facilitate fiscal benefits for participants by transferring the incidence o f income tax in respect of a business activity to them, those fiscal benefits come at the cost of compliance costs. Compliance costs w ill erode the fiscal benefits derived. Tolling companies w ill stop being a favourable tax vehicle when the fiscal benefits associated with their fiscal transparency are less than or equal to the compliance costs from adopting the structure.

A tolling company arrangem ent allows participants to fund expensive capital works necessary for the refinem ent, transportation or conversion o f raw m aterials extracted by the joint venture into a finished product for sale11.

A tolling agreement is a contract between one company that owns raw m aterials and a company that is engaged to process those m aterials, according to the specifica­ tions o f the owner. In some cases, the owner of the raw m aterials m ay retain control of the products that are created as a result of the processing. In other instances, the owner sells the m aterials to the processor, also known as a toller, using pricing that is defined in the term s and conditions of the agreement. W ith both situations, the working relationship is usually designed to enhance the financial position o f everyone concerned12.

The tolling company structure can be illustrated by a simplified example. Assume that a tolling company, which operates a gold refining plant, is owned 50% by Partici­ pant A, 25% by Participant B and 25% by Participant C. Participant A provides the tolling company with raw materials, Participant B provides technology and Participant C provides financial and general m anagement services. Figure 2 usefully illustrates the interrelation of the participants to the tolling company and to the financiers.

11 C. B irch, Tolling com panies a n d th eir incom e ta xa tio n fe a tu re s, "Journal o f A u stralian T axation” 2002, № 5 (2), pp. 213-262.

12 W h a t is a T olling A g re e m e n t? A c c e ss m o d e to p.: h ttp ://w w w .w ise g e e k .c o m /w h a t-is-a -to llin g - agreem ent.htm .

Fig. 2. O rg an izatio n stru ctu re o f a to llin g com pany

Source: C. Birch, Tolling companies and their income taxation features, "Journal of Australian Taxation” 2002, № 5 (2), pp. 213-262.

The tolling company makes capital expenditure to provide a service for the joint venture through funds borrowed from a financier. The shareholders in the tolling company are the participants who, through the use o f that company, ensure that financing is, where possible, non-recourse. Security is provided by the assets o f the tolling company including the contracts with the participants. It is considered that because the assets o f the tolling company are generally highly specific and specialised (and thereby have limited value to other parties), debt securitised over the assets is not disclosed in the participants’ balance sheets13.

Conclusions

According to the results of the research we can conclude that the control tax system over tolling operations in foreign economic relations is characterized by an essential drawback: there is a significant number o f control measures on the stages o f import o f give-and-take raw materials into the customs territory o f Ukraine and finished products export abroad, while manufacturing process of give-and-take raw materials remains completely ignored by the regulatory agencies.

Regulatory framework o f tolling implementation is unfavourable for business enti­ ties and at the same time it does not exclude give-and-take raw materials processing

TAXATION FEATURES OF TOLLING IN FOREIGN ECONOMIC RELATIONS ₈₅₉

shadow schemes realization possibility. This circumstance puts to doubt current tax control system effectiveness.

Apparently, economic security and prosperity o f the state is impossible without well-established and coordinated continuous control o f give-and-take raw materials throughout their stay on customs territory of Ukraine. Besides such control should not only serve fiscal purposes but also should be based on the interest combination of all parties of the tax relationship. Improvement directions o f tax control mechanisms in the field of foreign economic relations, including the tolling operations, require further researches.

In order to improve the organizational side o f public authorities control measures it is necessary to create a separate structural subunit in the structure o f the State Customs Service of Ukraine. Such subunit w ill be entrusted with the functions of the organization and methodical support o f tolling operations financial customs control.

Besides, relevant units should be established in the structures of regional customs offices. Such units will be assigned a function of performing o f scheduled and un­ scheduled inspections of tolling operations in foreign economic activity in the region through which it will be possible to control each subject o f a separate tolling operation with give-and-take raw materials at any stage o f their implementation.

B ib lio g ra p h y

1. B irc h C. Tolling companies and their income taxation features, " J o u rn a l o f A u s tra lia n T a x a tio n ”

2 0 0 2 , № 5 (2).

2. Борисенко O .n ., Держаенерегулюеання та фтансоеий контроль onepayiû з даеалъницъкою сировиною, Держава та регюни. "Науково-виробничий журнал” 2 0 0 9 , № 4.

3. Р.Л. Хом’як, B.I. Лемшовський, B .I. Воськало та iH., Бухгалтерсъкий облж та оподаткуван- ня: навч. Пос1бник, за ред. Р.Л. Хом’яка, B.I. Лемшовського. 3 -е вид., доп. i перероб. Льв1в:

Бухгалтерський центр “Ажур”, 2 0 F o re ig n T rad e o f L viv R egion: sta tistic a l c o llectio n . L viv 2010. 4. O n th e O rd e r o f P a y m e n t in F o re ig n C u rre n c y : L a w o f U k r a in e a d o p te d o n 23.10.1994, № 185/94. 5. O n T o llin g O p e ra tio n s in F o re ig n E c o n o m ic R e la tio n s: L a w o f U k r a in e a d o p te d o n 15.09.1995,

№ 327/95.

6. T ax C o d e o f U k r a in e a d o p te d o n 02.12.2010, № 2755-V I.

7. What is a Tolling Agreement? A c c e s s m o d e to p.: h ttp ://w w w .w ise g e e k .c o m /w h a t-is -a -to llin g - a g re e m e n t.h tm

Taxation features o f tollin g in forgein econom ic relations

T h is a rtic le e x a m in e s th e d e fin itio n o f “g iv e -a n d -ta k e ra w m a te ria ls ” a n d “ to llin g o p e ra tio n ” in v a rio u s U k ra in ia n le g isla tiv e a n d re g u la to ry acts. T h e m e c h a n ism o f to llin g ta x a tio n in fo re ig n e co n o m ic re la tio n s is d e s c rib e d . T h e s h o rtc o m in g s o f th e e x is tin g ta x c o n tro l sy ste m fo r to llin g o p e ra tio n s an d o p p o rtu n itie s fo r sh a d o w to llin g sc h e m e s im p le m e n ta tio n are h ig h lig h te d . E ffe c t o f ta x c o m p lia n c e on th e a c tiv ity o f d o m e stic e n te rp ris e s w h ic h p ro c e ss g iv e -a n d -ta k e ra w m a te ria ls w a s fo u n d out. T h is

a rtic le also e x a m in e s in te rn a tio n a l e x p e rie n c e o f in c o m e ta x c h a ra c te ris tic s o f to llin g c o m p a n ie s. P o s­ sible w a y s o f re m e d ia l a c tio n o f to llin g o p e ra tio n s sta te c o n tro l a re o ffered .

Cechy opodatkow ania opłat tollingow ych w ekonom icznych stosunkach m iędzynarodow ych

W a rty k u le z b a d a n o d e fin ic ję su ro w c ó w o d d a n y c h do p rz e tw o rz e n ia (g iv e - a n d -ta k e ) w ró żn y ch u k ra iń s k ic h a k ta c h p ra w n y c h i re g u lu ją c y c h . O p isa n o m e c h a n iz m o p o d a tk o w a n ia o p ła t to llin g o w y c h w e k o n o m ic z n y c h s to s u n k a c h m ię d z y n a ro d o w y c h . Z w ró c o n o u w a g ę n a w a d y istn ie ją c e g o sy stem u k o n tro li p o d a tk o w e j o p e ra c ji to llin g o w y c h o ra z n a m o ż liw o śc i w p ro w a d z e n ia n ie ja sn y c h sc h e m a tó w op łat. O k re ślo n o w p ły w z g o d n o ś c i p o d a tk ó w n a d z ia ła ln o ś ć p rz e d się b io rstw k ra jo w y c h , k tó re p rz e tw a ­ rz a ją su ro w c e g iv e -a n d -ta k e . W a r ty k u le z b a d a n o ró w n ie ż m ię d z y n a ro d o w e d o św ia d c z e n ia d o ty c z ą c e ce c h c h a r a k te ry sty c z n y c h p o d a tk u d o c h o d o w e g o firm to llin g o w y c h . Z a p ro p o n o w a n o m o ż liw e sp o so b y z a s to s o w a n ia śro d k ó w n a p ra w c z y c h w o p e ra c ja c h to llin g o w y c h .