An improvement in the liquidity of banks, as well as the need for an additional injection of money, became crucial for Ukrainian banks in the aftermath of the recent global financial crisis. An Increase in the number of non-performing loans (NPLs) negatively impacted the overall liquidity of Ukrainian banks by forcing them to hold mandatory reserves.
By removing their NPLs, banks are able to release reserves set aside in connection with these NPLs and thereby raise money. Therefore, the sale (or other form of disposal) of NPLs represents an attractive instrument for the reduction in the number and volume of NPLs, and the recapitalisation of the bank’s liquidity.
In July 2009, in an eff ort to rescue the banks and other fi nancial institutions, the Ukrainian parliament amended several tax and banking laws to facilitate the banks’ ability to deal with and restructure their NPLs.
LEGAL ALTERNATIVES TO NPL WRITE-OFFS
Under Ukrainian banking legislation, banks have to set aside reserves to cover possible loss occurring in connection with borrowers’ failure to repay loans or debts under any other lending issued in both foreign and national currencies. The reserves have to be formed from net capital to cover losses that may occur due to non-repayment of principal, but only if a loan was recognised as a ‘bad debt’.
As long as debts and NPLs are held on bank balance sheets, they are obliged to form such reserves. Therefore, by removing the NPLs from the balance sheet, they become off -balance-sheet assets that do not have to be secured by the mandatory reserves.
According to Ukrainian legislation, the transfer of the portfolio of NPLs may be structured either through an outright sale of the NPLs or a factoring of the NPLs to a special purpose vehicle (SPV) or third party.
Sale of NPLs through assignment of loan claims
The sale of NPLs represents the sale of a bank’s right to claim under the loan agreements arranged with borrowers (loan claims). The Civil Code of Ukraine (Civil Code) stipulates that rights to claim have to be sold and purchased through assignment.
Assignment of loan claims must be carriedout through the execution of a sale andpurchase agreement between the sellingbank and a buyer. Transfer of the loanclaims is not subject to notarisation, unlessloan claims are transferred along withmortgaged collateral.
Transfer of the loan claims to a new creditor(ie buyer) requires no prior approval fromthe borrower unless otherwise stated in theloan agreement. According to Ukrainian law, a creditor under a loan agreement cannotbe replaced or changed if this is strictlyprohibited in the agreement.
The law allows the transfer of loan claims toboth Ukrainian and foreign buyers. Becauseloan claims represent monetary claims,there is an ongoing discussion in Ukraineas to whether a company, which does nothave a banking or fi nancial services licence,can be a buyer of claims arising from loanagreements. Ukrainian legislation does notimpose any restrictions, with respect to abuyer of monetary claims, and althoughit could be assumed that the purchase ofNPLs would not require any special licences,it is still advisable to obtain a comfort letterfrom a responsible state authority and/orthe National Bank of Ukraine (NBU) prior tothe transfer of loan claims.
Factoring of NPLs
As an alternative to a sale, the loan claimscan be transferred by a Ukrainian bank inaccordance with a factoring agreement.
Under the Civil Code, factoring is atransaction through which a bank wouldreceive fi nancing from an entity providingfactoring services (factoring entity) inexchange for assignment of the rights toclaim under the loan agreements. Financingmay be provided either in the form of apurchase price for the loan claims payable(by the factoring entity to the bank underthe sale and purchase agreement), or inthe form of a loan provided by the factoringentity to a bank and secured by the loanclaims granted by the bank.
Accordingly, under the factoringmechanism, a Ukrainian bank receivesmoney in the form of a purchase price forthe loan claims. In return, the bank pays thefactoring entity a fee in the amount agreedby all parties.
Ukrainian legislation requires that afactoring entity holds a banking orfi nancial services licence. However, thisrestriction can be circumvented if thefactoring entity is a non-resident companyand the factoring agreement itself isgoverned by the laws of a jurisdictionother than Ukraine, provided that:
a) the laws of such a jurisdiction do notrequire the factoring entity to be a bankor other fi nancial institution; and
b) the factoring entity is eligible to act assuch under the laws of the jurisdictionof its incorporation.
This issue should also be addressed if aUkrainian bank plans to involve foreigninstitutions in the disposal of its NPLs.
SERVICING AND ADMINISTRATIONOF DISPOSED NPLS
Administration of the assigned NPLs may becarried out by:
a) a Ukrainian bank that sold (assigned)the loan claims;
b) a Ukrainian collection agency that hasobtained a relevant licence; or
c) a foreign company.
However, the cross-border administrationof loan claims by a foreign company isuncertain under the law. Therefore, theadministration of the loan claims by aforeign company would be permissible onlyon the receipt of a written consent from theNBU. In the absence of such consent, theadministration of the assigned NPLs maybe provided by a bank assignor or collectionagency that should act in the capacity oftrustee by performing activities for thebenefi t of a buyer.
The concept of administration of propertyrights (including loan claims) is expresslyaddressed in the Civil Code. A buyer transfersits assets (NPLs) into paid administration toa trustee (bank or other collection agency)for a certain period. The trustee performsthe administration of such assets on itsbehalf, for the benefi t of the buyer. Thus,the administration of the NPLs is based on amanagement agreement between a buyerand a bank or collection agency.
Administration of NPLs encompassesthe following:
a) collection and maintenance ofpayments under relevant loans fromthe borrowers;
b) deposit and safekeeping of fundsreceived from the borrowers ininternal accounts;
c) monitoring of the borrower’s compliancewith the terms of relevant loans; and
d) enforcement of the loan repayment ondefault of the borrower.
The way in which a bank disposes ofits NPLs and further accepts them foradministration as a trustee, is an attractivesolution for them as it gives the sameeconomic eff ect without impacting theirliquidity. A Ukrainian bank, acting in thecapacity of trustee, is not liable to formmandatory reserves for the NPLs that itadministers.
BANKING SECRECY REQUIREMENTS
Sale of the loan claims would also involve the disclosure, by the selling bank to the buyer, of information on the borrower. Suchinformation is subject to banking secrecyprotection under Ukrainian law.
At the same time, any banking information that falls under banking secrecy lawscan be disclosed by a bank if the relevant client has consented (in writing) to such disclosure. A written permission may already exist in a loan agreement in the form of a confi dentiality clause.
Otherwise, in the absence of written permission, or a confi dentiality clause in a loan agreement, the validity of an agreement on the sale of loan claims would be challengeable.
At the same time, applicable law allows limited disclosure of information on loans,mortgages, pledges and other borrowings,where such disclosure is not viewed as a breach of banking secrecy requirements.
In most cases, a confi dentiality clause is included in the standard form of loan agreements used by the Ukrainian banks. Therefore, banking secrecy requirements should not jeopardise the transfer of NPLs to a buyer. However, if the selling bank has failed to incorporate such a clause, this bank should continue servicing the NPLs in the capacity of trustee on behalf of the buyer,so as not to breach banking data protection requirements. Otherwise, a selling bank would be allowed to disclose only a limited amount of information that does not fall under banking secrecy requirements.
Assignment of NPLs to a third party through sale of factoring also raises a number of taximplications for Ukrainian banks.
Before the recently adopted legislation,the tax deductibility of NPL disposals was unclear and contained many tax risks for the banks. In these situations, the banks could either sell the NPLs at face value or count such discounts as non tax-deductible expenses. Naturally, both of these options were considered to be commercially unattractive and, therefore, the mechanism of disposal of NPLs was not implemented.
Assignment of NPLs through sale
According to the new taxation rules, selling bank has to conduct separate taxaccounting of the sale or purchase ofmonetary claims under debt obligations.
On the initial assignment, a Ukrainian bank is allowed to deduct the nominal value of the loan, which encompasses the principal of the loan, as well as accrued interest and other payments (commission fees), if such interest and other payments were included in the taxable income of the bank in the previous periods. At the same time, such banks would have to increase their taxable income by the amount of funds or assets received in consideration for the assignment. Thus, if the price for the assignment of loan claims to NPLs was lower than the nominal value of such NPLs, a bank can account such losses as tax deductions.
Assignment of NPLs through factoring
Factoring transactions are not separately addressed in the Ukrainian tax legislation. By adopting new taxation rules, Ukrainian legislators created ambiguity in the taxation of factoring transactions because, for the purposes of tax legislation, factoring maybe viewed as an assignment (assignment approach) or a fi nancial service (financial service approach) with differing tax consequences.
Based on the tax ruling issued by the StateTax Administration of Ukraine, the tax authorities treat any factoring arrangement as an assignment of the right to claim by an initial creditor to a second creditor, but not as a specifi c financial service provided by one legal entity to another. Thus, the Ukrainian tax authorities are likely to apply the same tax regime applicable to the assignment of claims through sale (see previous section).
Financial service approach
At the same time it is possible to argue that a factoring transaction is not simply a regular assignment, but an agreement on provision of fi nancial services. In keeping with the Civil Code, a factoring is a paid financial service that contemplates the financing of banks or other financial institutions in exchange for the assignment of the loan claims. Because the Civil Code differentiates between factoring and an assignment (and recognises factoring as a service), factoring should have similar tax treatment applicable to the provision of all services. If the fi nancial services approach is maintained, all expenses related to theprovision of factoring services have to be tax deductible.
To the best of our knowledge, factoring transactions have not yet been tested in Ukraine and, therefore, both of the approaches discussed above would need to be clarifi ed by the Ukrainian tax authorities in their tax rulings.
Adjustment of mandatory reserves
In keeping with the recent change to the Corporate Profit Tax Law, Ukrainian banks may deduct 80% (and 100% from2011) as business expenses of the mandatory reserves formed by banks on issuance of loans.
On the assignment of loan claims, either through sale or factoring, the gross taxable income of the selling bank wouldbe increased by the amount of excess of such bank’s mandatory reserves (loan loss provisions), resulting from the removal of the assigned NPLs from the bank’s balance sheet.
Ukrainian transfer pricing restriction
Assignment of loan claims to NPLs either through sale or factoring would fall within Ukrainian transfer pricing restrictions if such an assignment was carried out between related parties or with a foreign counterparty. In this case, the purchase price of the loan claims, as well as the factoring fee, should correspond to ‘arm’s length price’. Even though this concept has not yet been developed in Ukrainian legislation, the tax authorities frequently apply transfer pricing restrictions to increase the applicable tax burden.
According to VAT law, the assignment of NPLs by Ukrainian banks and other financial institutions (through sale or factoring) is expressly exempt from VAT in Ukraine.
Although the VAT law exempts the assignment of loan claims and factoring from taxation, VAT would still be applicable to the factoring fee, including the amount of discount to the face value of the NPLs,if such discount is viewed as an actual factoring fee. The factoring fee would be subject to VAT at the rate of 20%.