The exchange of employees between companies has become common practice amongst international companies in Ukraine. The word "secondment" no longer attracts the question "What is it?" but rather is used in HR circles instead of long explanatory phrases like "a business trip/assignment to work abroad for a certain period of time to acquire knowledge, skills and share experience". (Secondments may also be for the purpose of implementing projects, introducing new processes and management technologies, etc.).
The concept of secondment
Despite the fact that the general meaning of secondment is clear, namely the transfer of an employee to work abroad, in international companies neverthelss, secondment does not refer to the transfer of an employee to another company. In general, and depending on the structure of the employment relationship for the period of the work abroad, international companies distinguish between the following two options for relocating employees:
- secondment – an employee maintains an employment relationship with his/her employer (the sending company) and is sent to work in a foreign company (the receiving company) for a certain period of time. The employee is paid at the place of employment (i.e. by the sending company), but performs his or her work by order of the employer – at the place of the receiving company and in accordance with its instructions.
- transfer – the employment relationship between the employee and the sending company is terminated for the period of employment abroad and a new relationship is established with the foreign, i.e. receiving company.
Also, in practice, a dual employment option can be applied, where the employment relationship with the sending company is maintained and at the same time a new work relationship is also established with the receiving company for whatever reason (e.g. due to legal requirements of the receiving country). Dual employment is not prohibited by the law of Ukraine.
Below we consider tax planning options for secondments in situations where a Ukrainian company sends its employee to work for a foreign company, as well as situations where, in order to optimise tax costs, it is advisable to transfer the employee instead of secondment.
Tax planning in the formation of an employee's compensation package
When deciding whether to undertake the secondment or transfer of an employee, an important issue to consider is the nature of the employee's compensation package, and whether it includes elements and arrangements that encourage the employee to work abroad. If however the tax efficiency of the compensation package is not assessed, it may not be cost-effective nor attractive for the company or the employee.
When forming the employee's compensation package, it is important to consider the tax liabilities that arise in both countries so as to avoid double taxation of the same income (i.e. wages, compensation payments, additional benefits) in the respective countries. With a secondment, any remuneration from the Ukrainian company is be subject to taxation in Ukraine. The same remuneration may also be subject to taxation in the receiving country.
At the tax planning stage, the following issues need to be taken into account: 1) the employee's residence status for tax purposes in both countries (tax residency), 2) the source of remuneration and 3) the period of residence in the receiving country.
Let's consider and analyze why these questions are important.
Criteria for international taxation of individuals
The right to tax the income of an individual is traditionally based upon factors that determine the relationship of that individual with the tax jurisdiction of a particular state. The concept of tax jurisdiction includes the right of a state to tax certain entities in its territory.
There are two criteria that determine the limits of the tax jurisdiction of the state with respect to individuals:
Tax residency – implies taxation of the income earned by a resident both in and outside the country of residence.
Source of income – defines the tax obligations of both residents and non-residents only in relation to income derived from a source located on the territory of the state.
Among the general criteria for tax residency of individuals used in various countries are the following:
- Length of stay in the country;
- Homeownership in the country;
- Centre of vital interests, that is, the closest personal or economic ties (family, work or business, real estate, etc.);
However, the criteria for determining residency may differ from country to country. Therefore, a situation may arise where the same individual may be recognised as a tax resident in more than one country.
To solve this problem, international agreements known as double taxation treaties provide rules that take precedence over domestic legislation. These treaties allow for a test in which the individual's ties with specific countries are judged according to the following criteria:
- Homeownership in the country;
- The close personal and economic ties;
- The country of permanent residence;
If this test does not establish the tax residency of the individual, then the issue shall be resolved by mutual agreement between the countries.
The concept of "tax resident of Ukraine" is set out in Article 14.1.213 of the Tax Code of Ukraine (hereinafter, the Tax Code). The Tax Code provides a consistent procedure for determining residency status according to the following criteria (whereby compliance with one previous criterion (its availability) no longer requires the availability (compliance) with subsequent criteria):
- a place to live in Ukraine (owned or rented);
- a place of permanent residence in Ukraine. The tax legislation does not define the concept of "place of permanent residence" and the period from the expiry of which a person is deemed to have a place of permanent residence in Ukraine. By analogy with other areas of law, it can be considered that such a period must exceed 6 months per year;
- centre of vital interests in Ukraine;
- staying in the country for at least 183 calendar days during the period or periods of the calendar (tax) year. If it is not possible to determine the residency status of an individual using these criteria, an individual is considered to be a resident of Ukraine if he/she is a citizen of Ukraine.
Thus, in most cases an employee is deemed not to be a tax resident of Ukraine where he/she has moved to work in another country for an extended period (more than 6 months), his/her family has also moved to that country and he/she has spent most of the year in another country.
The source principle
In contrast to the residence principle, which binds an individual to a tax liability if there is some connection between the individual and the state, the source principle establishes a tax liability if there is some connection between the state and the income (the object of taxation). The criteria for determining source are the following:
- place of business (in the case of entrepreneurial activity);
- location of the payer of income. Used for passive income, for example, if the payer is located in a particular country, the income is recognized as having a source in that country;
- location of the property. Used for real estate income;
- place of actual work. Used in determining the source for income from employment.
Domestic legislation of a country may establish a list of income and rules for determining the source of income. For example, source income from Ukraine includes (Article 14.1.54 of the Tax Code) dividends, interest, income from the rental of property, wages from a Ukrainian employer and wages from a foreign employer for work performed in Ukraine.
General rule of taxation of individuals in Ukraine
Ukrainian residents are taxed in Ukraine on all income received from various sources, both in Ukraine and in other countries. Non-residents – only on income originating from Ukraine.
Avoidance of double taxation
In international secondment tax planning, particular attention should be paid to the issue of avoiding double taxation of an employee's income, which may arise when both the employee's home country and the host country are entitled to tax the same income under the local laws of each country. This issue can be resolved by international double taxation treaties where the member states agree between themselves which is entitled to tax the income of an individual. Such treaties are drawn up on the basis of model tax conventions. The most commonly used is the Model Tax Convention of the Organisation for Economic Co-operation and Development (hereinafter referred to as the Convention). Such treaties prescribe the rules for taxation of certain types of income, mechanisms and procedures for avoiding double taxation.
Let's take a closer look at how the Convention regulates the double taxation of income from employment.
This type of income is dealt with in Article 15 of the Convention, which provides the following rule. If an individual resident in country A is sent by company A to country B to be employed by company B, the remuneration received by the individual from employment in country B may be taxed in country B (if required by domestic law). However, such remuneration will only be taxable in country A (and exempt from tax in country B) if the following conditions are met:
- the period of stay of an individual in country B does not exceed 183 days in any twelve-month period beginning or ending in the reporting year (some treaties specify the stay limit as 183 days in a calendar year), and
- the remuneration to the individual was paid by company A, which is not a resident of country B, and
- the costs of remuneration are not borne by the permanent establishment or permanent base that the employer has in country B, nor are these costs recharged to company B.
If these conditions are not met, the remuneration may be taxed in country B. Then the issue of double taxation is resolved through other mechanisms provided for by the relevant international treaty. The most common one is a tax credit – when one country (namely the country of residence of an individual) sets off the tax paid in another country against its own tax.
The procedures for applying double taxation treaties have practical features in each country. For example, in Ukraine, in order to offset the tax paid in another country against the Ukrainian tax on the basis of the relevant international treaty, it is necessary to submit to the tax authorities along with the tax return an original document issued by the competent authority of another country, confirming the amount of income received and tax paid.
Let's consider examples of applying the above rules in practice.
In 2019, Ukrainian company A sent its employee to work in Germany at company B. The employee remained an employee of company A. No employment contract was concluded with company B. The remuneration in Ukraine was taxed at the source of payment. The duration of the secondment was 1 year; the period was from the end of May 2019 to the end of May 2020. The employee's stay in Germany in 2019 was 195 days. The worker's family stayed in Ukraine. In accordance with the domestic legislation of both countries and the Treaty on Avoidance of Double Taxation between Ukraine and Germany (hereinafter referred to as Treaty 1), the employee was a tax resident of Ukraine. The employee's remuneration for work in Germany was also subject to taxation in Germany in accordance with domestic law (the employee had to file a tax return and pay tax at the end of 2019). The tax rate in Germany is much higher than in Ukraine (a progressive scale from 15% to 42% is applied). Company A did not recharge the remuneration expense to Company B.
In this situation, double taxation arises though can be eliminated in two ways.
1) Pursuant to Treaty 1, the employee's remuneration is not taxable in Germany if his/her stay in Germany does not exceed 183 calendar days in a calendar year. Thus, when planning an employee's secondment to Germany, the beginning of the secondment could be moved to mid/late June or early July 2019 (taking into account possible short-term departures from Germany) and thus the employee's stay in Germany could be reduced so that it does not exceed 183 days. This approach could also be applied to the end of the 2020 secondment.
2) If it is not possible to comply with the "183 days" condition, then under Treaty 1, Germany is entitled to tax the employee's remuneration. Tax paid in Germany can be offset against Ukrainian tax on the basis of a document issued by the competent German authority confirming the amount of tax paid. However, this method of resolving double taxation issues is less beneficial, as the tax rate in Germany is higher than in Ukraine, therefore, the company or the employee will incur additional expenses. Also, in practice, refund of tax that has already been paid in Ukraine (when remuneration was paid by company A) is a rather complicated and time-consuming procedure.
Ukrainian company A sent its employee to work in Kazakhstan at company B. The employee remained an employee of company A. No employment contract was concluded with company B. The remuneration paid by the Ukrainian company is source income from Ukraine and, in accordance with the Tax Code, is taxable in Ukraine unless other rules of taxation are provided by the Treaty on Avoidance of Double Taxation between Ukraine and Kazakhstan (Treaty 2) (i.e. the Ukrainian company must withhold and pay tax on the remuneration until such time as there is no reason to apply other rules under Treaty 2). The duration of the secondment is 3 years and the period is from the end of January 2017 to the end of January 2020. The employee's stay in Kazakhstan each year exceeds 183 days. In accordance with the domestic legislation of both countries and Treaty 2, the employee was a tax resident in Kazakhstan. The employee's remuneration for work in Kazakhstan was taxable in Kazakhstan under domestic law (the employee was required to file a tax return and pay tax at the end of each year).
In this situation, double taxation arises. This can be eliminated on the basis of Treaty 2, which provides for taxation of the employee's remuneration only in Kazakhstan. However, in accordance with the Tax Code, the application of the provisions of Treaty 2 for the exemption of taxation of the employee's remuneration in Ukraine is permitted only if the employee provides the Ukrainian company with a certificate confirming his status as a tax resident of Kazakhstan by the end of the reporting year. Such a certificate must be issued by a competent authority of Kazakhstan, duly legalised and translated into Ukrainian.
Thus, in this situation the elimination of double taxation on the basis of Treaty 2 is only possible if the procedure described above is followed. Failure to obtain and submit the above-mentioned certificate to the Ukrainian company in due time will result in double taxation and negative tax consequences for the Ukrainian company. This risk cannot be ignored. Therefore, in this situation, the preferred option is to replace the secondment with the transfer of the employee – to terminate the employment relationship with the Ukrainian company and to conclude an employment contract with the company in Kazakhstan.
In order to keep the employee in the social insurance system of Ukraine, it is possible to consider the option of double employment with a minimum amount of remuneration in Ukraine.
Tax planning is an essential part of the process of organizing an international secondment, and should help to optimise the employee's compensation package by reducing tax liabilities and eliminating possible double taxation.
In addition to the application of international treaty rules, avoidance of double taxation and the reduction of tax liabilities for international secondments can also be optimised by planning the working hours and conditions of the employee's stay in the other country (manipulating the tax residency status). This can also be achieved by choosing the source of remuneration to the employee and by determining the optimal structure of employment for the particular situation.