The Ukrainian Tax System – Positive Trends
The Ukrainian Tax System has developed radically since Ukrainian independence until the present. The first major reform to the tax system was undertaken in 1997 with the main aim of increasing budget revenues, primarily by reducing the number of tax exemptions and simplifying and streamlining compliance procedures. However, this reform did not tackle the key problem, which was and remains the extremely high tax burden placed on business and individuals. The positive news is that this long-awaited reduction of the tax pressure on business and individuals is the core element of the tax reform that will take effect at the beginning of 2004.
Readers might be wondering why I decided to comment on the 1997 tax reform and not limit myself to the 2004 tax reform. The reason is that to establish the trend of the reforms and thus the direction, in which the Ukrainian tax system is heading, it is necessary to analyse not only the current picture but also to analyse the historical pattern of tax reforms introduced by Ukrainian lawmakers. This, in turn, is important for business, as the trend of the reforms is a key element to be factored into investment decisions. As it is impossible to discuss all the tax issues in a brief article like this one, I will concentrate on the core elements of the 1997 and 2004 reforms to the tax system.
Structure of the tax system
Ukraine has yet to introduce a Tax Code, which is likely to happen in 2004. However, the existing Law “On the System of Taxation”, the current Ukrainian equivalent to a Tax Code establishes the regulatory framework for the operation of the tax system. It contains fundamental norms, albeit not extensive, common to Tax Codes of more developed legal jurisdictions, like, for instance, norms establishing precisely the taxes and mandatory payments due, norms establishing the competence of authorities regarding tax issues, norms providing that reforms to tax laws may only be introduced by tax laws, and norms regulating the entry into effect of reforms to tax laws, to mention a few.
As mentioned above, this law contains the list of state and local taxes and duties applicable. At the time of drafting, there are 20 state taxes and duties, the most significant being corporate profits tax; VAT; personal income tax; payroll taxes; import duties and excise tax. In addition, there are 16 different local taxes and duties, whose value is normally not significant for business. As an encouraging trend, the number of taxes were reduced during the 1997 tax reform (and also subsequently by several other reforms to specific laws), will further reduce, although only slightly in 2004 when two local duties are cancelled and will likely reduce further when the Tax Code is passed, hopefully in 2004. Thus, if this positive trend continues, the number of state and local taxes will reduce to acceptable levels and the administration of taxes by business will become less complicated.
Corporate Profits Tax
Prior to the 1997 tax reform, the Ukrainian corporate profits tax was everything except for a tax on profits, with a nominal tax rate of 30%, but an effective tax rate significantly higher, reaching the point of prohibitive. Thus my comment that is was not really a tax on profits.
The 1997 tax reform introduced significant changes. Amongst the most important ones was establishing principles for the deduction of costs and expenses, rather than the very limited and restrictive list of deductible expenses previously in force, which significantly increased the effective tax rate. Like in other more developed legal jurisdictions, the tax reform of 1997 also introduced a list of non-deductible expenses, list that in my view was very reasonable. Another key point of this tax reform is that it specifically banned the tax authorities from imposing any additional limitations or restricting the deductibility of expenses, unless the law stipulated those restrictions. Despite all these positive points, as I mentioned earlier the 1997 tax reform felt short in accomplishing a reduction of the tax burden on business.
Noteworthy, one of the core elements of the tax reform that will take effect at the beginning of 2004 is the reduction of the tax burden on business. In fact, from 1 January 2004 the tax rate has been reduced from 30% to 25%. Moreover, this has been accompanied by a significant increased of the depreciation rates for fixed assets, which will result in the reduction of the gap between financial and taxable profits. In addition to this, the reform has introduced clearer procedures for taxation of lease transactions and the tax treatment of bad debts. It has also removed the 5-year limitation on tax losses carry forward. Finally, it has introduced much more developed transfer pricing rules. Overall, the changes brought in by the 2004 tax reform will be very significant in reducing the tax burden on business. Thus, a well-managed business will begin to see that from 2004 the gap between the nominal tax rate of 25% and the effective tax rate ought to reduce. This is my opinion a very important trend, and one that should encourage investors.
Personal income tax
The 1997 tax reform failed to improve the outdated personal income tax norms, except for a reduction in the top marginal tax rate from 50% to 40% (in 2003 the effective tax rate levied on personal income exceeding approximately USD 300 per month was 40%). Thus, most of the 1992 norms governing personal taxation continued in effect until 2003, except for a reform introduced in 1998. This reform, however, was enacted solely with the aim of stimulating small businesses and entrepreneurial activities. This controversial reform introduced a “single tax regime” for private entrepreneurs, with simplified tax reporting and a very low flat tax payment (which substitute most other taxes otherwise payable). Leaving aside the intention of this reform, it is clear that it failed to set clear anti-abuse (or anti-avoidance) rules, with many businesses rushing to re-register their employees as private entrepreneurs (under a civil rather than labour relationship) to benefit from the system by abusing it.
Finally, the long-awaited 2004 tax reform will completely overhaul the Ukrainian personal income tax system. In fact, from 2004 Ukraine will introduce a flat personal income tax rate of 13% (taxing most personal income with few exceptions at this rate). This flat tax rate will be increased to 15% from 1 January 2007. The core element of this reform lies in the significant reduction of the tax burden on individuals. It also attempts to streamline and simplify the compliance procedures. However, the reform has also introduced many significant changes, ranging from major changes in the criteria for qualifying as tax and non-tax resident to changes in the taxation of certain types of income. It has also introduced anti-avoidance rules to the “single tax regime” for private entrepreneurs, effectively closing the doors to the abuse of this especial tax regime. In summary, this very positive reform also establishes, or in the case more precisely confirms that Ukraine is introducing reforms with a clear trend of lowering the tax pressure, streamlining compliance and adopting global tax principles.
Through several reforms to the various laws regulating these taxes, the overall rate of payroll taxes due by most employers decreased from 51% in 1996 to the current 37.64%. This 37.64% covers the employers contributions to the Pension Fund; Social Security Fund; Unemployment Insurance Fund; and Fund for Social Insurance of Accidents at Work (the contributions to this last fund, however, depend on the level of risk of accidents for each sector of the economy). In turn, employees are also required to contribute to the State Pension Fund; Social Security Fund; and Employment Insurance Fund (for Ukrainian national employees only), with contributions generally reaching 3%.
Although the rates might be perceived as high, Ukrainian lawmakers introduced a cap on the base subject to social contributions (maximum monthly salary per employee subject to payroll taxes). This cap has been amended several times, but it has always been maintained at reasonable levels, with both employers and employees subject to payroll taxes for 2003 only on the first UAH 2,660 of salary per employee per month. Again to ratify the trend mentioned above, it is clear that taxes are going down and compliance is becoming less burdensome.
Finally, although still on the drawing board, Ukrainian lawmakers have been debating a reduction of the rates of contributions to the various funds, and the simultaneous substitution of all the current payroll taxes with a “unified social tax”, which ought to significantly simplify the current system.
VAT was initially introduced in Ukraine in 1992 and until 1997 it functioned as a form of turnover tax. In 1997 the VAT law completely reformed emulating the main principles under which this tax operates in the European Union. At that point Ukraine introduced a VAT rate of 20% on most transaction, with certain exemptions, and obviously also the 0% (zero rate) amongst other for exports. Despite many shortcomings during the development of the innumerable reforms that have been introduced in respect of this tax, VAT is finally taking the shape of a real tax on the value added by each participant in the chain from producers to consumers. The only really significant issue that still needs to be tackled and which is causing considerable problems is the refund of VAT to exporters, something that Parliament and the Government must deal with and resolve urgently. In any case, there is also a proposal to decrease the VAT rate to 17%.
In 2002 Ukraine adopted the new Customs Code, which becomes effective from 1 January 2004. Among other changes, the Customs Code introduced a new concept of customs value that complies with GATT/WTO requirements. In particular, customs value shall include license and other fees for the use of intellectual property that the buyer must pay, either directly or indirectly, as a condition of sale of the goods if such fees were not included to transaction value. This new Customs is a significant step in WTO accession, which is planned for 2004.
Administration of taxes
Starting from 2002 amongst others the procedures for administration of all taxes and duties, application of fines and appeals against the tax authorities’ decisions, were unified under specific legislation. Among many positive changes, the law limits the number of tax audits by the tax authorities and provides for the possibility of obtaining tax clarifications (although not legally binding) from the tax authorities for use by taxpayers. In summary, this law sets a rather clear framework for interaction between taxpayers and the tax authorities and thus represents a very good step towards further development and improvement of the Ukrainian tax system.
Double taxation treaties and trade agreements
In any countries the Double Tax Treaty network plays an important role in encouraging foreign investment. Ukraine consistently works on widening its treaty network and by the time of writing concluded double taxation treaties with 43 countries. At the same time Ukraine continues honouring the double taxation treaties of the former Soviet Union until new treaties replace them.
Although the process of reforming the tax system will only be completed when the Tax Code is enacted, it is clear that the reforms introduced have modified the tax system and have made it more investor-friendly. It is also clear that the general trend is to reduce the tax burden, streamline the compliance process and introduce tax principles and concepts used in more developed tax systems.
The main purpose of the 2004 tax reforms is to decrease the overall tax burden by means of reducing the tax rates while simultaneously widening the tax base. This is very good step forward.
It is clear that the Ukrainian Parliament and Government have accomplished significant developments in developing the tax system. It is also clear that the 2004 tax reform is likely to encourage new investors. However, it is also evident that Parliament and the Government must continue working to improve the tax system. A clear and friendly tax environment is the cornerstone upon which the investment climate in Ukraine will flourish to its full potential.