Debt Set-off: Tax Implications

Quite often, companies face certain circumstances that lead to the impossibility of fulfilling contractual terms. Due to non-compliance with contract requirements, companies incur debts, which in turn can be mutual. In our opinion, the most appropriate way to settle mutual debts is a financial and economic instrument such as offsetting.

According to Art. 601 of the Civil Code of Ukraine, several conditions must be met simultaneously for settling debts by offsetting:

1. The debts must be mutual, meaning each company must be simultaneously both a debtor and a creditor to the other party.
2. The claims being offset must be homogeneous (monetary – a situation where goods have been shipped, services rendered, but monetary obligations are unfulfilled; or commodity – if only an advance payment has been made, but goods have not been shipped, services not rendered).
3. The term for fulfilling obligations has arrived, is determined by the moment of presenting the claim, or is not established.

As practice shows, single tax payers of groups 1-3 must be very careful with offsetting claims, as according to p. 291.6 of the Tax Code of Ukraine, settlements for goods and services for this category of taxpayers must be exclusively in monetary form. Therefore, to avoid changing their tax system, single tax payers of groups 1-3 will not apply offsetting to settle mutual monetary debts.

Art. 602 of the Civil Code of Ukraine defines a number of criteria that do not allow for offsetting. First and foremost, these are obligations for which the statute of limitations has expired, and other cases established by contract or law.

The basis for offsetting debts can be a statement from one party (which can be in any form) or a bilateral act and an agreement on offsetting mutual homogeneous claims. The executed documents must confirm the fact of business transactions, highlight specific obligations subject to offsetting, and reflect the amounts and dates of the transactions.

VAT Tax Implications

For VAT payers who determine the date of tax obligations based on the first event, offsetting mutual homogeneous monetary claims will not affect VAT accounting, as such offsetting will be the second event and the tax for such an operation has already been accrued.

However, VAT payers using the cash method, when offsetting obligations for mutual supplies, must make appropriate VAT adjustments. We believe that in such a case, offsetting mutual claims is another type of compensation for the value of goods and services supplied, and therefore the date of the offsetting act is the date of occurrence of tax obligations and, accordingly, tax credit. Thus, a tax invoice must be issued.

Regarding Corporate Income Tax

Offsetting does not affect the financial result in accounting. The Tax Code does not provide for differences by which the financial result before taxation is adjusted due to the offsetting of mutual homogeneous claims.

In practice, companies quite often resort to offsetting to terminate obligations, but it is worth emphasizing the need for a detailed study of all nuances that may prevent the settlement of debts without tax consequences.

If you need consultations on accounting and tax accounting, please contact us, we will be happy to help you.