Fictitious Counterparty: Tax Consequences and How to Defend

The tax authority disallows your costs and input VAT credit, arguing that your supplier is “fictitious” or “defective” — even though you actually received the goods, recorded them in your books, and paid for them. This is a familiar predicament for thousands of good-faith businesses. Since the offence of fictitious entrepreneurship was removed from the Criminal Code, such a claim is no longer an automatic verdict against the buyer — but only when you are ready to prove, on paper, that the transaction was real. Below I explain what actually changed in the law, how the controlling authority has adapted, and what a modern taxpayer defense is built on.

Decriminalization of “fictitious entrepreneurship”: what it changed

On 18 September 2019, Law of Ukraine No. 101-IX removed Article 205 “Fictitious Entrepreneurship” from the Criminal Code of Ukraine (KKU), with the changes taking effect on 25 September 2019. Before that, a conviction under this article effectively worked as the “queen of evidence”: once a counterparty’s director was found guilty, the tax authority stripped the buyer of costs and VAT credit across the entire supply chain, without even examining whether the specific transaction was real.

Removing the article did not make the problem disappear. It meant something different: there is no longer a separate criminal offence that allowed the authorities to devalue all of a company’s transactions in one stroke, purely because of its supplier’s status. The state has, in effect, acknowledged that the mere fact a company was registered in the name of a front person does not prove that the goods were never supplied or the service never rendered.

In practice, this strengthened the position of the good-faith taxpayer. But it did not relieve them of the core obligation enshrined in Article 44 of the Tax Code of Ukraine — to support accounting figures with proper primary documents, and therefore to prove the reality of their business transactions.

How the DPS still uses counterparty “defectiveness”

Formally, Article 205 no longer exists, yet the controlling authority — the State Tax Service (DPS) — has adapted and now uses other tools to argue that a transaction was “unreal” or “goodless” (that no goods actually moved):

• convictions under Article 212 of the KKU (tax evasion) against the counterparty’s officers or other links in the supply chain;
• explanations and interrogation records of directors who claim they “have nothing to do” with the company’s activity (so-called nominee directors);
• taxpayer riskiness criteria (the procedure for suspending registration of tax invoices, approved by Cabinet of Ministers Resolution No. 1165), used to block the registration of tax invoices;
• analysis of tax information: the counterparty’s lack of fixed assets, warehouses, transport or employees, a “break” in the VAT chain, and a mismatch of product ranges on the “bought one thing — sold another” principle;
• data from the State Financial Monitoring Service on transactions bearing signs of being doubtful or risky.

Investigation of economic crimes today is conducted by the Bureau of Economic Security (BEB), rather than the former tax police, but the logic of the accusations has stayed much the same. That is why the key is to understand exactly which arguments the audit report advances, and how each one can be answered.

Typical claims in an audit report

Argument of the controlling authority	What is wrong with it	How to respond
There is a conviction under Article 212 KKU against the counterparty’s director	The conviction concerns a specific person and episode, not automatically every transaction	Evidence that your particular delivery was real; check whether your transaction is even mentioned in the conviction
The director stated that he “signed nothing”	An explanation is not conclusive proof; a person may be avoiding liability	Primary documents, signatures, powers of attorney, business correspondence
The counterparty has no resources (staff, transport)	Resources could have been engaged under contracts (lease, outsourcing, subcontracting)	Transport documents, data on the actual carrier and warehouse
The counterparty shows signs of riskiness	Riskiness is a ground for a check, not proof of unreality	Evidence of a business purpose and real movement of the asset

Proper tax due diligence: how to choose a counterparty

“Proper tax due diligence” is the standard of reasonable buyer conduct that shows you could not and had no reason to know about a supplier’s possible bad faith. It cannot be “assembled” after the fact: due diligence is either documented at the moment of the deal, or it does not exist. This is precisely why I advise building counterparty vetting into a company’s internal procedures and retaining the results.

A minimum counterparty vetting checklist

• the EDR (the Unified State Register of Legal Entities, Individual Entrepreneurs and Public Formations) — status, activity types under the KVED (national classifier of economic activities), the head, and whether the entity is in the process of termination;
• the VAT payers register — the validity of registration on the date of the transaction;
• the Unified State Register of Court Decisions (EDRSR) — whether the counterparty appears in criminal proceedings;
• data on tax debt and enforcement proceedings in open registers;
• the signatory’s authority — the appointment order, power of attorney, articles of association;
• factual verification — a real address, a working website, business correspondence, a commercial offer, and communication before the contract was signed.

The main rule: the vetting must not only be carried out but also documented and preserved — printouts, dated screenshots, saved correspondence. In a dispute, the court assesses not your words about diligence, but evidence that it was genuinely exercised.

The individual nature of taxpayer liability

This is the cornerstone of the defense. Settled practice of the Supreme Court and the Grand Chamber of the Supreme Court proceeds from the premise that legal liability is individual in nature: a taxpayer cannot be held responsible for its counterparty’s tax violations unless its own awareness of the scheme, or coordination of the unlawful acts, has been proven. This approach is consistent with the case law of the European Court of Human Rights (in particular its judgment in Bulves v. Bulgaria), which Ukrainian courts regularly cite in tax disputes.

In other words, a supplier’s bad faith does not, by itself, “transfer” to the buyer. The controlling authority is obliged to prove not an abstract “defectiveness” of the partner, but that your specific transaction did not actually take place, or that you were a knowing part of a goodless scheme. This significantly shifts the burden of proof and gives the good-faith taxpayer room to defend.

Forensic economic examination as evidence of a transaction’s reality

In my expert practice, it is precisely the forensic economic examination that often becomes the instrument shifting a dispute from the realm of assumptions to the realm of documented facts. It is conducted under the rules of the Law of Ukraine “On Forensic Expert Activity” and the Instruction on the appointment and conduct of forensic examinations (Order of the Ministry of Justice No. 53/5), and may be ordered by a court under the relevant procedural code (the Code of Administrative Procedure, KAS, in a tax dispute; the Criminal Procedure Code, KPK, in criminal proceedings) or performed on a contractual basis to build a legal position.

By examining accounting, tax and reporting documents, records of economic activity and financial and credit operations, the expert establishes:

• whether the business transaction is supported by primary documents and accounting data;
• whether the movement of the asset (goods, services) is reflected in the records of both parties;
• whether payment, recognition, and subsequent use or resale are consistent with one another;
• whether the amount of additionally assessed tax liabilities is documentarily supported.

It is important to understand the limits of competence: the expert does not draw legal conclusions about “fictitiousness” and does not establish guilt — he answers economic questions within the bounds of the documents provided. Yet a well-reasoned conclusion that the transaction was real and reflected in the accounts often becomes the decisive evidence in a case.

The line of defense: three pillars of reality

An effective defense is built not on denials but on evidence. I broadly identify three pillars that must be closed out with documents.

1. The counterparty’s resources — and your own. Lease and subcontracting agreements, engagement of transport, the availability of a warehouse and staff — everything that shows the actual capacity to perform the transaction (including with the involvement of third parties).
2. The real movement of the goods or the result of the service. Consignment and transport documents, data on the carrier and route, warehouse accounting, subsequent resale or use in your own activity, and remaining stock.
3. Business purpose. The economic sense of the transaction: why it was purchased, how it affected your business activity, and what income or effect was obtained. A transaction with no reasonable business purpose is always vulnerable.

Typical taxpayer mistakes

• Ignoring an existing conviction. If there is a conviction under Article 212 KKU against the counterparty, pretending not to notice it is a losing tactic. You must analyze whether your particular transaction is mentioned, for what period, and what conclusions the court reached — and build your position accordingly.
• No evidence of diligence. Companies are often sure that “everything was clean,” yet hold not a single document evidencing counterparty vetting at the time of the deal.
• Defects in primary documents. Contracts without specifications, acts without detail, discrepancies in dates and product ranges — the controlling authority reads all of this in its own favor.
• Passivity toward the audit report. Objections to the report and administrative appeal are not a formality but an opportunity to fix your position in the record before the case reaches court.

What to do if a claim has already arrived

The course of action I recommend to clients:

1. obtain and carefully study the audit report and the tax notification-decision — on exactly which arguments the disallowance of costs and credit rests;
2. check the cited convictions and proceedings in the EDRSR — whether they actually concern your transaction;
3. gather a complete package of primary documents and evidence of due diligence for the disputed counterparty;
4. file reasoned objections and, if needed, appeal the decision administratively and in court;
5. consider commissioning a forensic economic examination to documentarily confirm the reality of the transactions.

A claim of a counterparty’s fictitiousness or defectiveness is not a verdict but a dispute — one won by whoever prepares the better evidence. If the DPS has already stripped your costs and VAT credit, or you want to assess the risks in advance, get in touch: at a consultation we will review your documents and, where needed, conduct a forensic economic examination confirming the reality of your transactions.