R&D Offices in Ukraine — the Company Law Options

If you are looking to extend your development department by outsourcing or outstaffing then you might know that Ukraine is Offshoring Destination of the Year. But what about legals? A little bird told us that there is no rule of law in Ukraine, intellectual pro­perty is not protected at all, and bears are freely walking on the streets.

Not only those rumors are false, but it is relatively easy to launch an R&D office in Ukraine. Let’s have a closer look at the business structuring.

Setting-up an R&D Office: Preliminary Considerations

Do I need to set up a company in Ukraine or direct service contract is fine?

The answer depends on the scale and size of the activities — liabilities to be incurred, developers to be engaged, and transactions to be executed on behalf of the “office”. If you are making only the first steps in Ukraine, you may easily omit any formal presence and limit your R&D activities to a contracting only, meaning that you will only:

— enter into simple services agreement with a few developers located in Ukraine;

— carefully discuss the question of the employee vs. individual contractor dilemma.

This option is easy to establish and administer. If the developers are also private entrepreneurs (PEs) — that is probably the case — this model is likewise favorable from the tax optimization and accounting standpoint, as PEs often qualify for the simplified taxation system with its 5 million annual turnover limitation and 5% effective tax rate.

This model is not rare. A list of the Ukraine-based R&D offices, even with thousands of people on board, are structured without incorporation of a legal entity that would otherwise accept the payments from the parent company and then pay remuneration to the developers.

Despite the peculiarities of the model discussed, many IT businesses decide to set-up a legal entity as a more transparent model preferred by decision-makers or required by investors or the market. Traditionally, these are:

— IT businesses, generally known in public, which consider the affiliation of their companies as simply a fact that matters;

— companies planning to relocate their Ukrainian developers outside Uk­raine. To this end, these companies structure their business in a way to then enable the developers to be eligible for a work permit; and, lastly,

— The “newcomers”, largely unaware of the domestic market, that have not ­explored all the benefits of working with PEs yet.

There are no requirements concer­ning the minimum authorized capital and the presence of a national in its executive bodies. The registration itself takes just a few days. Afterwards, there is no need to pay a visit to any other state official.

One should, however, understand the following nuances. Logically, a Ukrainian LLC cannot function without a director. If you want, however, to appoint a non-resident for the director position, you should go through the formal procedures beforehand, in particular you should obtain a work permit. As this takes some time, it is worth considering the temporary appointment of a Ukrainian resident as a ­director.

Just to mention: since 2018, you can, likewise, settle a flexible shareholders’ agreement under the newly adopted Law of Ukraine “On the Limited Liability Companies and the Companies with ­Additional Liability”. Should you decide to incorporate, you also need to understand what tax implications to expect.

Taxation and R&D Office

In Ukraine, there are general and simplified systems of taxation. Under the general tax system, the entity is subject to 18% corporate income tax (“CIT”) with a wide range of deductible business-related expenses, allowing to significantly reduce the tax base.

In turn, despite being available for the PEs and the companies, simplified system of taxation group 3 is often a choice for the developers only. Why? The reason is in the requirements. The simplified tax system provides, in the IT context, a 5% tax, which:

— applies to the turnover during a fixed period. The fixed period here is a quarter;

— is open to the individuals and ­companies, having an annual turnover of less than UAH 5 million per year (approx. USD 190 000).

Needless to say that the 5 million turnover is not viewed as a serious financial result by most UA market newcomers. In addition, the subsidiaries, having 25% and more of capital owned by a foreign entity, cannot qualify for the simplified tax system in Ukraine by virtue of the explicit provision of the law (Art. 291.5.5. of the Tax Code of Ukraine).

Having chosen the business model from those discussed, pay attention to a further 2 aspects — relations between the R&D office and parent company; the R&D office and the developers plus other personnel.

R&D Office and Parent Company Relations: What to Consider?

One should decide on how to finance the initial operations of the R&D office. Debt and equity financing are common options. The latter — through the contribution to the authorized capital — is suitable for the subsidiaries. As to the debt financing, loans remain a solution for an independent LLC with the interest, then paid to the lender, being deductible for the CIT purposes.

Ukrainian R&D offices, however, tend to rely on a third option, that is to regulate all the fees and expenses questions in the services agreements between the customer (parent company) and the contactor (the Ukrainian LLC), particularly with regard to the payments then made to the Ukrainian PEs.

For the software development offices, a way out may be the services agreement. There, it should be laid down how the IP is to be transferred between the companies. Hardware R&D officers are to additionally draft the supply agreements bearing in mind the prospective customs export & import aspect.  For example, R&D offices, dealing with hardware programming, or any company, requiring the temporary admission of certain equipment, can use the customs regime of temporary admission that, in the end, allows to omit import VAT.

Having decided upon that, let’s turn to the engagement of developers.

Developers Engagement

Before opening an R&D office, one should consider the following possible engagement forms — employment, subject to labor laws, or services (or any other) agreement with a developer, subject to the contract law. A few facts regarding both forms are worth noting.

In short, employment legislation is inflexible. For example, it does not allow non-solicitation or non-compete clauses, which are automatically rendered invalid. Limitations exist also as to the working hours, particularly during official holidays and non-working days. There is also a strict procedure to wind up the company with the employees. But the most crucial for the decision-makers is the financial aspect of employment. For your understanding, a USD 1000 monthly salary will be subject to the following duties to be covered by the company:

— USD 180 (18% income tax), deducted from the employee’s salary and paid by the employer as the employee’s tax agent;

— USD 15 (1.5% military duty), deducted from the employee’s salary and paid by the employer as employee’s tax agent;

— USD 220 (22% unified social security contribution), charged on salary but paid by the employer separately.

That said, with a salary equivalent to USD 1000, the employee will obtain USD 805 (private income tax + military duty), while the employer will have to pay USD 1220 (the salary + SCC).

A different option is to engage the developers and the personnel both as PEs through a services agreement. In such case, the developer as a contractor is to pay 5% of the unified tax, typically charged from each sum credited to the PE’s account, instead of the private income tax and military duty. In addition, the developer shall pay approx. USD 25 as a fixed unified social security contribution at a minimum possible level. Needless to say that both the company and the developers are the beneficiaries of such an option.

“Simply to choose the civil contracts, in view of the figures, would be too simple” — said the state authorities before scheduling and launching the labor inspections. These inspections are, among others, designed to detect the hidden labor relations, namely when behind civil relations one attempts to mask the labor ones. Should the authorities come up with such a conclusion, then the company will be fined for each “employee” and required to pay the taxes and contributions.

In short, the risks are high if a UA-based company (a) lets (sub-lets) the premises for the developers, (b) provides the developers with equipment, (c) is interested in their constant “work”, but not the specific deliverables and (d) sets the working hours and labor guarantees, such as insurance, sick leave etc. If these red flags are missing, the risks logically decrease.

To sum up, Ukraine and its tech potential are becoming more and more attractive for foreign companies to launch R&D capacities here. The upside is clearer (and risks mitigated) if the R&D office is properly structured, bearing in mind the aspects discussed in this article.