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.1
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 effort to rescue the banks and other financial 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 carried out through the execution of a sale and purchase agreement between the selling bank and a buyer. Transfer of the loan claims is not subject to notarisation, unless loan claims are transferred along with mortgaged collateral.
Transfer of the loan claims to a new creditor (ie buyer) requires no prior approval from the borrower unless otherwise stated in the loan agreement. According to Ukrainian law, a creditor under a loan agreement cannot be replaced or changed if this is strictly prohibited in the agreement.
The law allows the transfer of loan claims to both Ukrainian and foreign buyers. Because loan claims represent monetary claims, there is an ongoing discussion in Ukraine as to whether a company, which does not have a banking or financial services licence, can be a buyer of claims arising from loan agreements. Ukrainian legislation does not impose any restrictions, with respect to a buyer of monetary claims, and although it could be assumed that the purchase of NPLs would not require any special licences, it is still advisable to obtain a comfort letter from a responsible state authority and/or the National Bank of Ukraine (NBU) prior to the transfer of loan claims.
Factoring of NPLs
As an alternative to a sale, the loan claims can be transferred by a Ukrainian bank in accordance with a factoring agreement.
Under the Civil Code, factoring is a transaction through which a bank would receive financing from an entity providing factoring services (factoring entity) in exchange for assignment of the rights to claim under the loan agreements. Financing may be provided either in the form of a purchase price for the loan claims payable (by the factoring entity to the bank under the sale and purchase agreement), or in the form of a loan provided by the factoring entity to a bank and secured by the loan claims granted by the bank.
Accordingly, under the factoring mechanism, a Ukrainian bank receives money in the form of a purchase price for the loan claims. In return, the bank pays the factoring entity a fee in the amount agreed by all parties.
Ukrainian legislation requires that a factoring entity holds a banking or financial services licence. However, this restriction can be circumvented if the factoring entity is a non-resident company and the factoring agreement itself is governed by the laws of a jurisdiction other than Ukraine, provided that:
- the laws of such a jurisdiction do not require the factoring entity to be a bank or other financial institution; and
- the factoring entity is eligible to act as such under the laws of the jurisdiction of its incorporation.
This issue should also be addressed if a Ukrainian bank plans to involve foreign institutions in the disposal of its NPLs.
Servicing and Administration of disposed NPLs
Administration of the assigned NPLs may be carried out by:
- a Ukrainian bank that sold (assigned) the loan claims;
- a Ukrainian collection agency that has obtained a relevant licence; or
- a foreign company.
However, the cross-border administration of loan claims by a foreign company is uncertain under the law. Therefore, the administration of the loan claims by a foreign company would be permissible only on the receipt of a written consent from the NBU. In the absence of such consent, the administration of the assigned NPLs may be provided by a bank assignor or collection agency that should act in the capacity of trustee by performing activities for the benefit of a buyer.
The concept of administration of property rights (including loan claims) is expressly addressed in the Civil Code. A buyer transfers its assets (NPLs) into paid administration to a trustee (bank or other collection agency) for a certain period. The trustee performs the administration of such assets on its behalf, for the benefit of the buyer. Thus, the administration of the NPLs is based on a management agreement between a buyer and a bank or collection agency.
Administration of NPLs encompasses the following:
- collection and maintenance of payments under relevant loans from the borrowers;
- deposit and safekeeping of funds received from the borrowers in internal accounts;
- monitoring of the borrower’s compliance with the terms of relevant loans; and
- enforcement of the loan repayment on default of the borrower.
The way in which a bank disposes of its NPLs and further accepts them for administration as a trustee is an attractive solution for them as it gives the same economic effect without impacting their liquidity. A Ukrainian bank, acting in the capacity of trustee, is not liable to form mandatory reserves for the NPLs that it administers.
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. Such information is subject to banking secrecy protection under Ukrainian law.
At the same time, any banking information that falls under banking secrecy laws can 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 confidentiality clause.
Otherwise, in the absence of written permission, or a confidentiality 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 confidentiality 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 or factoring also raises a number of tax implications 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, a selling bank has to conduct separate tax accounting of the sale or purchase of monetary 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 may be viewed as an assignment (assignment approach) or a financial service (financial service approach) with differing tax consequences.
Assignment approach Based on the tax ruling issued by the State Tax 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 specific 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 financial 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 financial services approach is maintained, all expenses related to the provision 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 clarified 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% from 2011) 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 would be 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. comment
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%.
- A loan is non-performing when the payment of principal and/or interest are overdue for more than 90 days, or repayment of the loan was extended for 180 days or more, or there are other valid reasons to doubt that payments would be made in full.