Tax Accounting for the Sale of Financial Investments

Today, we will try to understand a complex issue: the tax accounting of operations involving the sale by a corporate income tax payer of its own financial investments, which were accounted for by it in financial accounting using the equity method.

Let's recall the main nuances (features) of this method:

1. According to National Accounting Standard (NAS) of Ukraine 12 "Financial Investments" (hereinafter – NAS 12), financial investments in associates and subsidiaries, and in joint ventures with the creation of a legal entity, are recognized using the equity method, provided that: a) such financial investments are acquired and held not for the purpose of their sale within twelve months from the acquisition date; b) the investees do not conduct their business activities under conditions that restrict their ability to transfer funds to the investor for a period exceeding twelve months.
2. To determine whether our investee falls under the category of an associate, subsidiary, or joint venture, it is necessary to consider the requirements of paragraph 4 of National Accounting Standard (NAS) 19 "Business Combinations", paragraph 3 of NAS 12, paragraph 4 of National Accounting Standard (NAS) 23 "Disclosure of Information on Related Parties", etc.
3. The carrying amount of financial investments increases (decreases) by the investor's share in the net profit (loss) of the investee for the reporting period, with this amount included in the income (losses) of the period.
4. If the investor acquired assets from the investee, the amount of profit (loss) of the investee from this transaction, attributable to the investor's share, is recognized only after the resale of these assets to other parties or during the depreciation periods of the acquired non-current assets.
5. Concurrently, the carrying amount of financial investments decreases by the amount of recognized dividends from the investee.
6. The carrying amount of the investment increases (decreases) by the investor's share in the change in the total equity of the investee for the reporting period (excluding changes due to net profit (loss)), with this amount included in (excluded from) the investor's other additional capital or (under certain circumstances) additional contributed capital. If the amount of the decrease in the investor's share in the change in the total equity of the investee (excluding changes due to net loss) is greater than the investor's other additional capital or additional contributed capital, then retained earnings (uncovered loss) are decreased (increased) by this difference.

According to sub-paragraphs 140.4.1 and 140.5.3 of the Tax Code of Ukraine (TCU), the financial result of the taxpayer for corporate income tax purposes should not include income and/or expenses recognized by it in financial accounting (calculated according to the aforementioned mechanism). That is, for tax accounting purposes, such an investment will actually always be accounted for on the taxpayer's balance sheet at its cost (unlike in financial accounting).

As you can see, so far everything is more or less clear regarding both tax and financial accounting. However, this is only until the moment the taxpayer decides to sell their financial investment, which they accounted for in previous periods using the equity method.

Issues of tax accounting for the sale by a taxpayer of their financial investments expressed in the form of securities (e.g., shares of a joint-stock company) are legally stipulated in sub-paragraphs 141.2.2 – 141.2.6 of the TCU. However, issues concerning the recognition in tax accounting of operations involving the sale of financial investments expressed not in the form of securities (e.g., shares in the authorized capital of an LLC) are not legally regulated. Accordingly, such operations should be reflected in tax accounting according to financial accounting rules. Thus, we will have a situation where income/expenses recognized in financial accounting for the revaluation of "non-security investments" using the equity method will not be recognized as income/expenses for tax accounting purposes, while in the period of sale of such investments, both financial and tax accounting will reflect the same (identical) result: the difference between the sale price of the investment and its carrying amount (according to financial accounting data – revalued in accordance with the requirements of NAS 12).

Consequently, in the end, a portion of the net financial result from the sale of a financial investment (the difference between its sale price and its actual acquisition costs) will simply "fall out" of tax accounting and will never be taken into account by the seller of the financial investment when calculating their corporate income tax. Of course, if a portion of expenses "falls out" of tax accounting, the employees of the tax authorities are unlikely to be particularly upset by this fact – we will be dealing exclusively with an over-accrual of corporate income tax by the seller of such a financial investment. However, if, as a result of this operation, a portion of the seller's income from the financial investment "falls out," the tax authorities are unlikely to be pleased – most likely, they will demand that the taxpayer adjust the financial result for tax accounting purposes upwards (despite the absence of legal grounds for this).

What is the solution in this situation?

In our opinion, there are only two options:

1. Either choose a "cautious position" – voluntarily agree to the loss of a portion of "tax expenses" (for the amount and in the event that actual acquisition costs of the financial investment exceed its carrying amount at the time of sale), and also voluntarily (without legal requirements) increase "tax income" (for the amount and in the event that the carrying amount of the financial investment at the time of its sale exceeds the actual acquisition costs of such a financial investment).
2. Or be prepared to defend your position in court.

In conclusion, we once again remind you that our specialists are always ready to provide you with more detailed consultations and assistance in disputes with tax authorities on this and any other matters.