It is common for Ukrainian joint ventures to be structured in a foreign jurisdiction. Much reform effort is devoted to bringing such joint ventures “on-shore” to Ukraine and significant legislative progress has been made in this regard.
Oft-cited reasons for structuring outside of Ukraine include corrupt Ukrainian courts, tax planning, and flexibility in structuring the business relationship. The first two issues are not the focus of this article. I think the court system is slowly improving in Ukraine and tax structuring is a complicated stand alone matter that generally needs to be addressed on a bespoke basis for each joint venture and each investor.
As to creating more flexibility in business structuring, it is worthwhile for Ukrainian practitioners and reformers to consider what “flexibility” means in other jurisdictions and how other jurisdictions treat certain business forms that also are common in Ukraine.
I appreciate that Ukraine is harmonizing its legislation to that of the EU and Ukrainian legislators are no doubt studying various EU Directives. However, as Ukraine looks increasingly to the United States as a strategic partner, I think it also advisable to take business structures in the United States into consideration as potential examples. At a minimum, an understanding of such structures can facilitate negotiations, as Ukrainians can better understand the starting expectations of their US counterparts.
Limited Liability Companies
When parties form a simple “joint venture” in the United States to start and operate a new business, it is very common to establish a limited liability company structure. Ukrainians tend to do the same, but a Ukrainian limited liability company is far more restrictive than its US counterpart, which essentially is an altogether different entity.
The US limited liability company operates in many respects as a partnership, but with limited liability for its members. It is extremely flexible, primarily because it is not a stand-alone taxpayer structured around the concept of dividends to shareholders. Rather, it focuses fundamentally on distribution of operating profit directly to members who, in turn, pay taxes directly on such profit. The limited liability company generally becomes a “pass-through” structure for profits and tax consideration. This avoids the “double-taxation” of dividends issue that is common to joint stock companies.
US limited liability company members also are not restricted to allocating profits in proportion to their percentage interests. Managing members are routinely incentivized by receiving “carried interests” and “promotes” that afford them essentially bonuses based on performance of the joint venture with payments structured, for example, around completion of construction (completion of a start-up phase) and/or sale of a building (exit from the business). This is popular with real estate developers but can and is applied across the board to virtually any business with performance milestones and/or where one or two members take more active management roles.
Additionally, it is very common for principal investors to require a “return of equity capital” before pro rata distributions to members take effect but, in turn, often additional capital contributions can be made with no change to percentage ownership interests. Complicated “waterfall” (tiered distribution) provisions are commonly incorporated into profit distribution clauses in limited liability company operating agreements (the equivalent of Ukrainian corporate agreements), setting priorities and rewards for joint venture performance. The frequency of distributions is also the subject of agreement, very often being quarterly.
Further, members providing “sweat equity” in the business can be offered equity percentages for zero capital contribution with profit based solely on performance. Physical persons as members also can structure revenue distribution partially as “salary” or as “guaranteed payments” per the US Tax Code (each with different tax consequences). Parties are free to agree.
Investors also can set up various classes of equity interests with different returns on profit, particularly for new members or “passive” investors looking simply for returns on investment and not interested in management issues. This is similar to various classes of shares in US corporations.
As a caveat, however, tax advice in structuring US limited liability companies is crucial and “operating agreements” contain detailed tax provisions in marked contrast to standard Ukrainian corporate agreements. This also goes to show how much tax structuring of a business in the US is elective.
Voting also is flexible. Virtually all authority, for example, can be delegated to a “managing member” or a “management board,” with parties then free to structure voting. At the member (investor) level, although members generally would vote in proportion to their percentage interests, investors can set up various super-majority voting arrangements around key issues. Further, when establishing different classes of equity interests, investors can establish different voting preferences for each class. Again, all of this is governed by the operating agreement.
Joint Stock Companies
There are a number of key differences between US and Ukrainian joint stock companies. In the US, unless stock is publicly traded, it generally does not require registration with the Securities Commission. Private sale of stock also does not need to registered if it is to “accredited investors” (i.e. sophisticated investors with certain minimum net worth). Stock can be authorized but not issued. In other words, the company may have “dormant” stock to sell without having to register a new share issuance. Issuance of various classes of shares, including various classes of common stock and preferred stock with different dividend and voting rights, are routine.
Meanwhile, shareholders have limited influence over the day-to-day operation of the company with decision-making held at the Board and Management levels, and smaller companies can generally choose their tax status as either a C-corp (taxed as a stand-alone entity with dividend payouts to shareholders) or as an S-corp (a flow-through tax entity with tax paid by the shareholders).
The principal advantage of corporations (as C-Corp structures) in the US over limited liability companies is the ability to issue unlimited numbers of shares to the public and to create both public and private share class structures. Limited liability companies, in contrast, generally are restricted memberships.
Partnerships are also common in the US, particularly limited partnerships with two or more classes of partners (general partners active in management and limited partners with passive management roles). Partnerships are not legal entities and are governed solely by their partnership agreements. This is common in various asset management firms and among law firms.
Partnerships are, by their nature, flow-through structures for tax purposes. They often serve as the “investors” in joint ventures and corporations, and are convenient arrangements for raising capital to be invested by the general partner. Although Ukraine has similar structures (general partnerships, limited liability partnerships, and even joint operating/investment agreements), to date these are not common for tax and liability reasons.
The downside to flexibility is compliance with securities laws in the US and a complex federal structure. A fundamental difference between US and Ukrainian securities laws is US securities laws extend to all types of business entities (corporations, limited liability companies, partnerships). Although stock may not need to be registered, any such business entity needs to consider whether the equity in such businesses can be considered as “securities,” with such companies needing to be compliant with both state and federal securities laws. This means that a corporation located in one particular US state may need to review securities laws in other states depending on where its investors reside and where it engages in business.
The federal structure also means that businesses incorporate in a particular US state and commonly need to register to do business in another state and be mindful of registration requirements and taxes in other states. Often in US legal parlance, a “foreign” jurisdiction is simply another state within the United States and not actually a foreign country. Choice of law is an issue among the different US states, and not just among different countries. This adds a layer of complexity and cost to legal analysis in the US that is not relevant to the unitary legal system of Ukraine.
Ease of doing business is not simply how quickly a legal entity can be registered in a particular jurisdiction and whether this can be done online or not. Ease of doing business also means the ability of investors to choose how they wish to manage their business and how they wish to allocate profits and pay taxes. The extent these issues can be regulated by agreement rather than statute can be a determining factor in deciding where one’s business is incorporated and domiciled.