ANALYSIS: Roman Bryl, Ukraine Analyst
IntelliNews - Ukraine This Week
President orders to restore some tax breaks for investors working in SEZ and TPD

President Victor Yuschenko ordered government to develop a system of compensating losses investors incurred after the liquidation of special economic zones (SEZ) and territories for priority development (TPD).

SEZ and TPD were offering investors a variety of tax privileges and aimed to create favorable conditions to promote investments in Ukraine.

When creating SEZ, government hoped they could bring an extra USD 18bn of FDI in 5 years. Although this period was not finished yet, government decided to abolish tax preferences for SEZ in March 2005. The government making that decision was guided by several factors.

FIRST, SEZ and TPD failed to attract the planned amount of FDI. By the start of 2005 only USD 2.1bn of FDI was attracted through SEZ.

SECOND, government received many evidences proving that tax breaks in SEZ had created conditions for unequal competition.

For instance, in Donetsk region it was unveiled that a company imported equipment using preferential taxation and then sold it at dumping prices.

THIRD, the state budget suffered huge losses due to introduction of the breaks.

Main types of privileges:
[1] Tax breaks given to investors in SEZ and TPD;
[2] Special customs duties;
[3] Profit tax break (from 20% to 50%);
[4] No tax on investment (most of SEZ and TPD);
[5] No entrance customs duties and VAT;
[6] No obligation to exchange funds in foreign currency (most of SEZ and TPD);
[7] Lower rent for land (50% for 3-10 years on average).

By abolishing SEZ government wants to destroy illegal schemes of money laundering By disbanding SEZ, government hoped to destroy illegal schemes designed by mischievous investors. But government obviously took a wrong measure to prevent these breaches, in our view.

It would have been better to develop effective measures for custom services and other regulatory authorities to prevent activities of such investors. That would have not harmed investors that operated in SEZ without breaking the law.

Government fails to determine how to estimate investors' activity within SEZ

Before government decided to abolish SEZ and TPD, EconMin and FinMin had made separate analyses of the efficiency of such territories. The results of the analyses were similar: only 4 investors working in SEZ fulfilled all investment obligations. Ministries did not reveal which methodology they had used that produced such a pessimistic outcome.

According to another official source, secretary of national security and defense council Anatoliy Kinakh, out of 590 projects examined 170 fulfilled all necessary investment obligations. The main reason of the contradictions was that there was no unified methodology for determining whether investors made needed obligations.

According to existing methodology, activity of investors working in SEZ was examined using 7 criteria. The performance of an investor was considered sufficient when he satisfied all 7 criteria. But practice showed that investors could over-perform on one criteria but temporary failed to satisfy
on another.

Perhaps the entity was not an infringer but he was treated as one. It would be more correct to estimate activities of investors in SEZ using softer criteria. For instance, more than 1/3 out of 60 projects in Kharkiv region TPD fulfilled their obligations by 80%, which could be regarded as positive

Most heads of SEZ and TPD considered that activities of investors were not properly analyzed. It took more then a year to make proper analysis of such kind taking into consideration existing bureaucratic procedures. In particular, investors needed more than 1 year to prove they met all promises.

Most SEZ suffer from abolishing preferences

Abolishing tax breaks forced investors to cease their activities in SEZ. Among 142 projects realized in Donetsk region, 137 entities needed to revise their business plans. In Lugansk region all 32 projects were mostly stopped after abolishing privileges.

At the end of 2004 authorities of Zhitomyr region TPD coordinated 8 investment projects but currently only 1 was launched. And this project was launched only due to its reliance on internal investments (equipment for the project was bought in Ukraine). Zakarpattya SEZ expected to attract USD 158mn in 2005 but failed to attract any.

There were 9 investment projects in Mykolaiv region and 2 of them have been cancelled already. Even previously most successful SEZ and TPD suffer at present from closure of companies.

Yavoriv SEZ, where 77 projects out of 90 were regarded as highly profitable and successful, started to fire employees and decrease production volumes. Slavutich SEZ can be regarded as an exception: 16 companies continue to realize 19 projects. There is only one reason: government is too inconsequent in its attitude to SEZ and rules of the game can be changed once more.

Government: proposal to launch promissory notes on VAT refunds to favor investors

Government, observing the negative impact on investors and SEZ decided to restore tax breaks. But only partially. Government sent to all investors a draft that offers investors to give customs authorities promissory notes for VAT reimbursement when importing goods to Ukraine. The reimbursement period is set at 180 days.

This draft can hardly be regarded as restoration of tax privileges. But this is better than nothing. Investors were attracted to SEZ by a wide range of breaks including income tax, land lease, customs duties, etc.

Still, government's latest proposal is not relevant because it favors only importers of equipment, while in most cases the equipment had been imported already. Nevertheless, some companies import different parts, assembling them into end products, and then exporting the products.

These investors mostly work in the Western part of Ukraine that is close to the EU border. But these entities hope that after implementing the new reimbursement scheme, government will make the next step and restore preferential customs duties.

Investors want all privileges to be restored

We must note that government's initiative cannot be approved by a governmental order. The liquidation of tax breaks was done via law. Another special law would have to be passed to restore or present new kinds of tax benefits. It would take a lot time to approve this legislation due to political reasons.

Also, in Ukraine promissory notes are a widely used mechanism for financial manipulations. It is possible that investors will not wait 180 days to redeem notes and will sell them to banks at discount rates. The banks can re-sell them further disfiguring the real price of promissory notes.

In any case, notes will not help attract investors into SEZ and TPD. Investors are waiting for full restoration of preferences.
To be continued
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