The consequences of the pandemic are also leaving their mark on Ukraine. Ukraine’s GDP declined by 4.6% in 2020, compared to expected growth of 3.7% before the pandemic. However, unemployment has (officially) only risen from 9.0% to 9.9%, which may be related to the fact that a large proportion of the workers affected by redundancies were in the informal sector, i.e. not officially employed.
These economic consequences have also had an impact on commercial property. Vacancies have increased and rents have fallen. In the area of premium offices (class A), vacancy rates have risen by around 4% to around 7 to 9% according to various estimates. Even in existing rents, tenants were able to negotiate temporary rent reductions of 30 to 50% in some cases.
In addition to the economically uncertain situation, home office work became popular in some industries and may potentially decrease demand in office space. However, after an initial “euphoria” about the home office at the beginning of the lockdown, a certain disillusionment has spread among many employers: very few employees have an undisturbed workplace at home and many employers have accordingly recorded a significant decline in productivity. It is therefore doubtful whether these so-called new forms of working will lead to a significant reduction in the office space required in the long term.
When assessing the Kiev office market in particular, the total space on offer should not be forgotten. Kiev with its almost 3 million inhabitants offers office space of about 1.8 million sqm, while Warsaw with its almost 1.8 million inhabitants has an office space of about 5.6 million sqm. Budapest, with a population of just under 1.8 million, has around 3.7 million sqm of office space, and Prague, with a population of 1.3 million, has also just under 3.7 million sqm of office space. If one adds to this the fact that the service sector in Kiev is developing strongly, especially the IT sector, the demand for high-quality office properties should pick up again significantly in the medium term.
The current situation can therefore be very interesting for investors to enter the market.
The following overview is intended to provide an introduction to Ukrainian real estate law. Of course, it cannot replace advice in individual cases, but it can perhaps sharpen the eye and provide a feeling for where real estate investors should take a closer look.
II Real Estate Law in Ukraine – The Basics
Over the last 30 years, Ukrainian real estate legislation has developed into a secure framework for foreign investment. However, there are special features that continue to surprise foreign investors.
For example, the ownership of the building and the ownership of the land may be in different hands, and in practice this is often the case. As far as the ownership of the building is concerned, the owner has a legal right to use the underlying land if this is necessary for the use of the building. The owner of the building also has a right of first refusal over the land. In such cases, the ownership of the land usually belongs to the State or the municipality. However, if an owner of a building has also acquired land and transfers ownership of the building to a third party, ownership of the land must also be transferred. In the long term, ownership of the building and the land plot can be expected to be the same.
- Real estate register
In 2013, a single property register was introduced, covering ownership rights to buildings and land. Rights to buildings and land can be officially recognised only after their registration in the Real Estate Register. The data in the register is publicly accessible and can be accessed by anyone via the Internet using a digital key. However, the register is not complete yet, as the historical records on real estate rights that were made in paper form before 2013 were not “automatically” transferred to the new register.
Every plot of land has a specific purpose, which determines how the land can be used. Within certain limits, the purpose of a plot of land can also be changed. There are 9 different categories of zoning, including for residential buildings and general development, agricultural purposes, recreational areas and others. Office buildings and shopping malls may only be constructed on land for public construction.
A significant step towards transparency and consolidation of data in the construction industry has been taken. In particular, a unified state e-system in the construction sector has been introduced, including the register of authorisation documents (i.e. building permits, commissioning certificates, building permits, etc.). This register allows the verification and tracing of permits and authorisation documents relating to any construction works and provides investors with more detailed information on the actual construction.
- Transfer of real estate
Both buildings and land are transferred by notarised contract. In the case of simple transactions or lower transaction prices (flats, family houses), the contract is typically prepared by the notary on the basis of standard contracts. Usually “bought as seen” and liability of the seller is excluded. However, in larger real estate transactions, especially in the commercial sector, the purchase contract is usually drafted and negotiated by the advising lawyers; in this area, there are often special arrangements regarding subsequent obligations, deferred payments, warranties, etc.
The transfer of ownership takes place with the registration of the right of ownership for the purchaser in the Real Estate Register. The notary public or a state registrar can make the entry. Notaries may not notarize agreements outside their official district and may carry out registrations of real estate only within their region.
The entry of the right of ownership in the real estate register proves the right of ownership to third parties. If the owner acquired the property in good faith, i.e. if the owner did not know that the transferor had no right to sell the property and if he could not have known that, the owner can only claim the property back if
- the owner has acquired the item free of charge;
- the owner has acquired the item against payment and
- the item has been lost to the owner or previous owner, or
- if the item has been stolen, or
- If the thing has otherwise been lost from its possession without the owner’s will.
If the owner has acquired the property in bad faith, i.e. if he knew or should have known that the disposing party had no right to dispose of it, the item can be reclaimed in any case.
- Letting of real estate
The owner of a building can let the building without restrictions. Lease contracts with a term of up to 3 years can be concluded in simple written form; lease contracts with a term of more than 3 years must be notarised. The right to rent a building for a term of 3 years or more must be entered in the Real Estate Register.
- Taxation on the acquisition of real estate
a) Taxation on acquisition
When a building is purchased from the previous owner, the following taxes and fees are incurred:
- Notary fee for the notarisation of the purchase contract: 1%, verhandelbar bei höheren Beträgen;
- Pension fund levy: 1%.
- State fee: 1% (It is a common practice that the seller pays the state fee. However, the legislation does not contain any direct provisions for this).
- VAT: 20%, which can be used as input tax or refunded
If the underlaying land is also purchased, the following taxes and fees apply:
- Notary fee for the notarisation of the purchase contract: 1%, verhandelbar bei höheren Beträgen;
- No levy on pension funds.
- State fee: 1%.
- No VAT on the purchase of the land plot
- Note: If the underlaying land plot is purchased in the same agreement and with a joint purchase price, pension fund levy and VAT will apply also to the land plot.
b) Taxation of the real estate owner
The owner of a building used for business purposes (office, shopping, hotel) must pay the following taxes:
- Real estate tax (depending on the municipality, but not exceeding 1.5% of minimum salary as of 1 January of the reporting year per square meter; i.e. for 2021 not more than UAH 90.00 per square meter);
- Rent is subject to VAT (exceptions are possible for small properties)
- Rental income is subject to profit or income tax
Flat or house owners have to pay the following taxes:
- Real estate tax at the rate of 1.5% of the minimum wage per each sqm of the total floor area of a flat (the first 60 square metres are tax-free for owners – natural persons)
- Real estate tax at the rate of 1.5% of the minimum wage per each sqm of the total floor area of a house (the first 120 square metres of living space are tax-free for owners – natural persons)
III Acquisition of real estate (asset deal)
There are basically two ways of acquiring real estate: either the property itself is acquired (building and possibly the land, so-called “asset deal”) or a company is acquired which holds the ownership of the property (so-called “share deal”).
Advantages of the asset deal:
- There is no need to take over a company that has its own individual history, including legal, tax and financial risks;
- Correspondingly reduced due diligence, as it is concentrated on the property;
- Better protection of the bona fide purchaser of the property because the purchase transaction relates to the property itself and not just to the shares. Whether the company itself was acting in good faith when it acquired the property can often hardly be determined retrospectively;
- No authorisation from the antimonopoly authority required, safe to cases where the asset constitutes an integral property complex;
- The book value of the property in the acquiring company corresponds to the purchase price and can be depreciated (in the case of buildings). If the property is acquired in a real estate company, only the historical acquisition value can be depreciated (if at all), which is lower than the current purchase price of the shares.
Advantages of the Share Deal:
- No fees on the acquisition of the shares (pension fund levy / state fee);
- No value added tax.
However, investment income of the seller may be subject to taxes depending on the status of the seller.
If one takes into account that the elimination of taxes (VAT) and fees (2% of the purchase price) comes at the expense of a much more extensive due diligence in legal and financial terms, and if one further considers that the crediting or even refunding of input VAT now basically works well, not much remains of the advantages of a share deal.
The only “problem” with asset deals is the habit of Ukrainian sellers to think of the selling price without profit tax: typically, shares in real estate companies are not held by Ukrainian companies, but by companies in low-tax havens. The sales proceeds are then taxed little or not at all. Fortunately, the possibilities for structuring this have been very limited in recent years and in some cases, it is also possible to use structuring options in Ukraine to reduce the taxation of the sale proceeds. An asset deal is therefore in many cases realistic.
IV Due Diligence
Any acquisition of real estate must be preceded by a detailed examination of the legal and technical conditions of the real estate. When acquiring a real estate company, the legal conditions of the company must also be examined, as well as the financial situation.
Typical points of the real estate law examination:
- Right to use the land (ownership, lease, permanent use)
- Conformity of the purpose of the land
- Ownership of the building (originally by construction, acquisition from the previous owner) and freedom from encumbrances
- Existence of the building permit and conformity
- The required connections (electricity, water, district heating if necessary) are available
- Examination of existing rental contracts if necessary (the motto is “purchase does not break rent”)
Typical points of the legal audit of the company:
- Establishment of the company and any subsequent transfer of shares
- Burden-free shares
- Proper appointments of the management, especially with regard to contracts for the property
- Presence of the required approvals of the general meeting
- Audit of essential contracts of the company (rental contracts, employment contracts, facility management contracts etc.)
- Loan Agreements
V Payment processing
An important issue in the negotiation of the purchase contract, both in an asset deal and in a share deal, is the structuring of the payment process and its synchronisation with the transfer of the property or shares. For some years now, escrow accounts have been available for this purpose, which makes settlements easier and more secure.
The typical procedure is then:
- Conclusion of a preliminary agreement between the parties (where necessary; otherwise immediate conclusion of the purchase contract)
- conclusion of the escrow agreement with a bank
- Payment of the purchase price to the escrow account
- Conclusion of the notarial purchase contract
- Registration of ownership of the property / shares
- Payment of the purchase price from the escrow account to the seller
It should be noted that escrow arrangements are still new in Ukraine and few banks offer escrow accounts, and do not have much experience in this field. Time should therefore be allowed for the negotiation. Moreover, bank charges for the service are sometimes considerable, ranging from 0.1% to 1.0% of the transaction amount, sometimes enriched by additional fees for individual payments. In addition, the negotiation of the preliminary contract and escrow agreement causes additional time and effort.
If there is a minimum level of trust between the parties, it may therefore be much easier and cheaper to carry out the transfer without an escrow account. The procedure could then be as follows:
- Conclusion of the notarial purchase contract at the notary’s office; all documents remain with the notary; the parties also remain with the notary;
- Immediate payment of the purchase price. Payments from one Ukrainian bank account to another Ukrainian bank account are instantly processed by Ukrainian banks, which means that the money in the seller’s account is visible a few minutes (in transactions within one bank) or a few hours (in transactions between local banks) after the payment is released;
- Immediate re-registration of the ownership of the property/shares by the notary and handover of the documents to the parties.
VI Tax considerations
There are various ways in which foreign investors can structure real estate investments in Ukraine:
- Real estate company in Ukraine
In the simplest case, a foreign holding company holds the shares in the Ukrainian real estate company. The legal form of the real estate company is typically a limited liability company under Ukrainian law (abbreviated “TOV”). This legal form is the easiest to establish and manage.
At the level of TOV, taxation (simplified) is as follows
- Rental income less expenses is profit,
- The profit is taxed with profit tax of 18%,
- The withholding tax on dividends to foreign shareholders is 15 %, but according to most treaties on the avoidance of double taxation (“DTT”) this rate is reduced to 5%; (there are few DTT left reducing the withholding tax to 0% under certain qualifications to shareholdings and / or investment volume).
In the typical scenario, this means that out of a profit of 100, a profit tax of 18 has to be paid. The remaining 82 are subject to 5% or 4.1 Ukrainian withholding tax. 77.9 are paid out to the shareholder, which means that the effective tax burden in Ukraine is 22.1%.
If the TOV was to finance the acquisition of the property with a foreign shareholder loan, the picture would be as follows:
There is not a profit of 100, but minus the interest burden perhaps of 50. This profit is taxed at 18%. The remaining 41 are subject to 5% withholding tax, i.e. 2.05. The distribution is 38.95. The interest of 50 is, depending on the double taxation agreement, also taxed at 5%, in this case 2.5. The interest payment is therefore 47.5. The total payment to the shareholder is 86.45, which leads to a total tax burden on the income in Ukraine of 13.55%.
Note: This is a simplified calculation. For a structuring in individual cases, the applicable interest rates and the Thin Capitalization Rules in Ukraine have to be taken into account. Also, it is important to review the tax situation of the foreign shareholder.
- Permanent establishment in Ukraine
Within the framework of an asset deal, a property in Ukraine can also be acquired directly by a foreign company, which must be registered with Ukrainian tax authorities prior to the deal. With regard to ownership of buildings, there are practically no restrictions on the acquisition of real estate by foreigners.
Under Ukrainian law, the operation of a property in Ukraine by a foreign company creates a permanent establishment, unless the foreign company acts through an independent agent. The permanent establishment must be registered with the Ministry for development of economy and trade of Ukraine and with the tax authorities. Under the system applicable to Ukrainian legal entities, the permanent establishment must keep its books and pay profit tax (18%). The payment of the net profit by the permanent establishment to the parent company is not subject to any further withholding tax in Ukraine. The total tax burden in Ukraine is therefore 18%.
In case non-resident company rents out property through an independent agent (a real estate agent which acts in course of its ordinary business and represents other persons, i.e. acts not as exclusive representative of one or several related non-residents) then there is no permanent establishment. Rental payments transferred by the agent to the non-resident are subject to withholding tax at 15% rate. In this scenario no corporate profit tax at 18% rate applies due to absence of permanent establishment. However, deduction of expenses is not allowed.
VII Excursus: Real estate investments by foreign natural persons
For smaller real estate investments outside the professional asset management sector, it may be interesting to invest in and rent out flats in Ukraine, especially in Kiev. There are no legal restrictions for foreigners with regard to acquisition. However, in terms of tax law it should be noted that foreigners shall register with the tax authority (obtain a tax identification number) and are not entitled to receive the rent themselves. Non-residents are obliged to appoint a representative (agent) who is commissioned with the rental, receives the rent, pays the tax as a so-called tax agent and pays the rest to the non-resident. The law does not actually provide for any exceptions to this rule, but practice shows that non-residents can indeed care for the rental themselves, including declaring and paying the tax independently.
Non-residents’ rental income is taxed at the standard income tax rate of 18%, plus a currently applicable military tax of 1.5%. It should be noted that all rental income is taxed; deductions for maintenance costs are not possible, even payments for electricity, heat and water cannot be deducted from the income. It is therefore better to insist, where possible, that the tenant makes these payments himself.
Rental income from Ukraine is interesting for foreign private investors for two reasons: firstly, the return on residential property is significantly higher than in Western countries, at around 10%, and secondly, the investor benefits from the relatively low Ukrainian income taxation (as shown, a total of 19.5%). Many Western double taxation agreements exempt foreign rental income from taxation (in Germany, however, the progression proviso remains), so that the 19.5% tax rate remains final.
However, one should not underestimate the administrative effort on site – if one does not transfer the entire administration to an administrator, which again costs a part of the return.
VIII Excursus: Acquisition by investment funds
Finally, real estate investments on a larger scale can also be made through the special legal form of a “venture non-diversified corporate investment fund”. This is a type of so-called corporate investment institute (“Institut sovmestnoi investirovanie”). It is established in the form of a joint stock company. The sole purpose of the joint-stock company is the joint investment, in case of “venture non-diversified” funds, in any asset class. Such a company is managed by a specialised asset management company (in Ukrainian abbreviated as KUA). This structure makes the management of such a fund quite complex. However, special tax rules apply to investment funds, in particular, the profit is not taxed and can be reinvested. Only when a distribution is made to the shareholder will the dividend be taxed in Ukraine and at the shareholder’s place of residence (if applicable).
Dividends distributed by such funds are subject to tax in Ukraine as follows:
- personal income tax at 9% rate + 1,5% of military duty in case dividends are distributed to non-resident individuals;
- 15% withholding tax in case dividends are distributed to non-resident foreign legal persons, unless reduced under the DTT.
By Julian Ries, Senior Partner and Head of International Offices, Integrites