Compliance with Foreign Counterparties to Avoid Potential Risks in Economic Activity

Posted in Markets Compliance, Sanctions Compliance on November 6, 2023
Compliance With Foreign Counterparties

The compliance with foreign counterparties requirements must be ensured regarding the potential risks encountered in conducting economic activity and measures to minimize and avoid them that fully meet all the requirements of the applicable legislation. 

Under the globalization of the world economy, business entities are increasingly striving to establish foreign economic relations and international cooperation. In turn, foreign economic activity, particularly international trade, such as the import and export of goods and services, significantly affects the economic growth of any country.

Although such cooperation with non-residents is interesting and promising, it is also complex work that requires solving many practical issues. However, it can be simplified if you understand the main aspects that must be considered while establishing business relations with a non-resident.

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There are several aspects to working with non-residents. By analyzing, it is possible to identify areas where such risks are most common and determine the risk level of a particular economic transaction. Conducting compliance expertise of a potential counterparty lifts confidence that the economic transaction will yield a positive result and satisfy the interests of both parties, and will not lead to a protracted legal dispute in the future.

Compliance With Foreign Counterparties

Compliance with Foreign Counterparties in Terms of Potential Risks

It is proposed to consider the compliance of a foreign counterparty in terms of the potential risks that may be encountered in the process of conducting economic activity and measures to minimize and avoid them that fully meet all the requirements of the applicable legislation

In practice, it is appropriate to distinguish three groups of risks:

  • Tax risks are risks of accrual of tax liabilities;
  • Legal risks are risks of non-performance or breach of an agreement by a counterparty; and
  • Risks in the banking sector are the impossibility of fulfilling an agreement because the bank refused to write off and/or credit funds.

Tax Risks or Risks of Accrual of Tax Liabilities

The national legislation establishes special rules for the taxation of transactions with non-residents. This issue is also regulated at the international level, particularly through the conclusion by states of conventions for eliminating double taxation. At present, Ukraine is currently a party to 79 such conventions.

The correct application of the provisions of the national legislation in conjunction with the conventions for eliminating double taxation is the key to a successful economic transaction without any negative consequences. It is important to consider that conventions have a higher legal force than national legislation. Their application is not unconditional but must be accompanied by a certificate stating that a non-resident is a resident of the country with which Ukraine concluded an international agreement.

The legislation defines the following criteria that have the biggest influence on the procedure for taxation of transactions with non-residents:

  1. The Subject of the Agreement

The issue is divided into two conditional parts:

  • The first one is the requirements of the national legislation of Ukraine on the tax consequences of concluding a certain agreement with a non-resident. In particular, for some types of agreements with non-residents, the tax consequences are the need to pay, as a tax agent, income tax with the source of origin in Ukraine. Therefore, it is necessary to determine whether an economic transaction is subject to income tax with the source of origin in Ukraine. If the answer to this question is yes, then it is necessary to move on to the second part.
  • The second part of this issue is that different tax rules can be established by the conventions for eliminating double taxation, which has a higher legal force than the norms of national legislation. Each convention for eliminating double taxation defines specific tax consequences for different legal relations, such as contracts of carriage, payment of royalties, income from entrepreneurial activity, payment of interest, etc.

The terms of the conventions with different states may differ significantly. Therefore, to correctly determine the procedure for taxation of each specific transaction, it is necessary first to analyze it in the national legislation. In terms of the convention for the elimination of double taxation, errors in the correctness of defining the subject of the agreement are unacceptable.

Compliance With Foreign Counterparties
  1. The Place of Performance of the Agreement

At first glance, it is a simple question. But when it comes to cross-border transactions, it is more challenging to determine where exactly the income was received. But it is necessary to determine this from the point of view of the tax legislation. The Tax Code states what is meant by income with the source of origin in Ukraine. The Tax Code of Ukraine or TCU refers to income received by non-residents on the territory of Ukraine to the objects of taxation.

Thus, to correctly determine the tax regime, it is important, along with the correct definition of the subject of the agreement, to determine whether income received by the non-resident corresponds to the sign of income received on the territory of Ukraine. Having correctly defined the subject of the agreement and the place of its performance at the stage of conclusion, you can be sure that the agreement will be in full compliance with the norms of the tax legislation and the tax regime will be determined correctly.

  1. Transfer Pricing and the Place of Registration of the Counterparty

Transfer Pricing, or TP, is a fairly new and complex structure without a consistent case history but with huge penalties for violations. Without going into the essence of TP within this lesson, we will tell how TP and compliance are related.

The Tax Code of Ukraine defines one of the conditions for classifying transactions as “controlled” in the mandatory combination with other criteria defined by the TCU, such features as a place of registration of the counterparty, organizational and legal form of the counterparty, income tax rate in the country of registration of the counterparty. These lists should be considered both in terms of TP and generally in terms of evaluating your potential partner.

In general, three lists established by the legislation will be considered here. They are important both in terms of TP and in terms of assessing legal and banking risks.

Legal Risks 

Legal risk is the risk of non-performance or breach by a counterparty of the contract or agreement terms.

In particular, the risks that a counterparty will not pay for the delivered goods or will not deliver the paid goods are meant. Compliance expertise in this context serves primarily to determine the possibility of compulsory protection of own interests in case of breach of an agreement by a counterparty. 

For example, if the goods are delivered to a non-resident with payment terms after delivery, it is necessary to be sure that such a counterparty has property and money in the sufficient amount for being collected if such a counterparty does not make the payment. The clauses of an agreement with penalties will not work if a counterparty does not have the resources for the compulsory execution of a judgment. The availability of assets in a company contributes to its reliability. Such a company has something to lose and is honest about responsibilities.

So how to check this? In some jurisdictions, a company’s financial indicators, audit opinions, balance sheets, etc., may be in the public domain. However, this applies to a greater extent to corporations, which, according to the local legislation, must publish such information. It is desirable to seek as much information as possible from open sources and sources that can be accessed for an additional fee.

If such information is not available in the public domain at all, as happens in most cases, it is necessary to request it from a counterparty. In particular, information about the assets of a company deserves the most attention. At the same time, it is necessary to analyze what exactly the assets consist of. This is important because there are situations when a counterparty has large assets, but they consist only of accounts receivable and, therefore, in fact, the possibility of collecting money from such a counterparty by force is next to none.

Risks of the Banking Sector or the Impossibility of Fulfilling an Agreement Because of the Bank Refusal to Write Off and/or Credit Funds

Under the conditions of strengthening banking supervision, the introduction of Know Your Customer or KYC procedures and a risk-oriented approach by banks. On the one hand, banks protect their customers from dubious transactions but, on the other hand, create barriers to fair economic activities and block payments.

At the same time, the registration place of a counterparty strongly influences the level and detailing of the study of a transaction itself by a bank. Suppose a counterparty is registered in a state included in the List of States That Meet the Criteria in the Tax Code of Ukraine or falls under the List of Organizational and Legal Forms of Non-Residents That Do Not Pay Income Tax or Corporate Tax. In that case, such a transaction shall be studied in detail. The payment to the account of such a counterparty may be delayed. Therefore, it is necessary to specify this in agreements.

Compliance With Foreign Counterparties

Compliance with Foreign Counterparties: a Bank as a Criterion of Risk

Along with the registration place of a counterparty, the bank in which the counterparty has an account may be a risk criterion. Why? Banks are obliged to verify their customers and to check them at the time of account opening and during conducting business activities. But different banks do it differently. For example, very few banks will open an account for an offshore company.

The bank’s prestige plays a big role, and an account in a large bank significantly reduces the risk of working with such a counterparty. Vice versa, an account in a small bank with a dubious reputation leaves many questions because such a bank can terminate its activity at any time, and you will not receive payment from your counterparty. Thus, analyzing the bank where the counterparty has an opened account is an important element of compliance expertise.

In summary, it should be admitted that for the analysis of a foreign counterparty, it is important to find out the following information:

  • The subject of an economic transaction;
  • Country of registration of a counterparty;
  • The organizational and legal form of a counterparty;
  • Servicing bank of a counterparty; and
  • The financial condition of a counterparty; and 
  • The terms of a convention for the elimination of double taxation with the country of registration of a counterparty.

Conducting compliance expertise of your potential foreign counterparty is a mandatory element for conducting foreign economic expertise, and analysis of tax, legal, and banking risks is the key to a successful economic transaction.

Final Thoughts

The risks associated with foreign agents or counterparties for money laundering or terrorism financing are similar to the risks presented by domestic agents. For example, the domestic Money Services Business’s foreign agent may have lax anti-money laundering policies, procedures, and internal controls, or may be complicit with those attempting to move illicit funds. Foreign agents may pose a greater risk than domestic agents in some cases because they are not subject to the Bank Secrecy Act regulatory regime; the extent to which they are subject to anti-money laundering regulation, and the quality of that regulation, will vary depending on the jurisdictions in which they are located.