When Debt Forgiveness Turns Into a Tax Trap

Ukrainian tax practice in recent years has increasingly revealed a troubling trend: after the end of a long-running loan dispute, an individual may effectively become a debtor for a second time — this time to the state. This is especially evident in cases where banks, following foreclosure on mortgaged property or restructuring of foreign currency loans, report significant amounts of “forgiven debt” in their tax filings, while tax authorities automatically classify those sums as taxable income for the borrower.

At first glance, such an approach may appear formally logical: if a debt is cancelled, the borrower has supposedly received an economic benefit. In reality, however, these situations usually arise after the loss of property, years of litigation, and severe financial exhaustion of the debtor. That is precisely why the core issue in such disputes is not merely the literal interpretation of the Tax Code, but the proper legal understanding of the nature of the debt itself.

A particularly illustrative example is case No. 160/9939/25, considered by the Dnipropetrovsk District Administrative Court and later by the Third Administrative Court of Appeal. The matter originated back in 2007, when the borrower received a USD 55,000 foreign currency mortgage loan. In 2019, the financial institution enforced foreclosure on the apartment under Article 37 of the Ukrainian Law “On Mortgage,” while the remaining debt balance was subsequently cancelled. At first glance, the legal relationship should have ended there. Nevertheless, the tax authority later assessed more than UAH 600,000 in taxes and penalties against the borrower, treating the forgiven debt as an “additional benefit.”

The broader problem with such disputes lies in the fact that tax authorities frequently rely solely on formal indicators from bank reporting — particularly Form 1-DF — without conducting any meaningful analysis of the actual structure of the debt. As a result, principal amounts, accrued interest, penalties, and exchange-rate differences are often merged into a single taxable category, despite the fact that their legal treatment and tax implications differ fundamentally.

This issue becomes especially important in relation to foreign currency loans issued before 2014. Ukrainian tax legislation contains special provisions concerning exchange-rate differences arising from such loans. In practice, however, tax authorities often either ignore those provisions or apply them selectively. Consequently, taxation is imposed not on any real economic gain, but rather on an accounting difference created by years of currency devaluation.

Another major issue concerns the procedure for notifying borrowers about debt forgiveness. Under Ukrainian tax law, the obligation to declare such “income” arises only if the borrower has been properly notified. In practice, however, tax authorities and banks frequently consider the mere sending of a letter sufficient — even where the borrower never actually received it. As a result, individuals may only discover their alleged “income” during a tax audit or after receiving a tax assessment notice.

In case No. 160/9939/25, the court of first instance initially sided with the tax authority. However, the appellate court reversed that decision, focusing specifically on the structure of the debt and the special provisions of the Tax Code governing foreign currency loans. Crucially, a significant portion of the amount that the tax authority classified as loan principal was, in reality, composed of exchange-rate differences and accrued interest, which cannot automatically constitute taxable income.

This case once again demonstrates the dangers of an overly formalistic approach in tax disputes. When a regulatory authority focuses solely on figures in a reporting form without examining the legal nature of the transaction itself, tax law effectively turns into a mechanism for automatic additional assessments “just in case.” This is particularly problematic in loan disputes, where borrowers have often already suffered significant financial losses.

Moreover, the issue extends far beyond foreign currency loans. Similar approaches are increasingly being applied to entrepreneurs, e-commerce activities, complex business transactions, and other areas where tax authorities seek to broaden the concept of taxable income as much as possible. For that reason, modern tax disputes are no longer merely about arithmetic calculations. They increasingly concern a far more fundamental question: where does real income end, and where does an artificially constructed tax fiction begin?