One Proposal for Ukrainian Tax Changes – An Initial Evaluation

The Ukrainian Government’s proposal for tax reform is critically evaluated below.  The stated objectives of the proposal are to: Reduce […]

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The Ukrainian Government’s proposal for tax reform is critically evaluated below. 

The stated objectives of the proposal are to:

  1. Reduce the number of rates;
  2. Increase the revenue base for local budgets;
  3. Simplify the Enterprise Tax;
  4. Improve the Agricultural Tax; and
  5. Reform small and medium business taxation.

The proposal appears well intended and is, in an overall sense, consistent with the stated objectives. Three important objectives are not stated, however, and should underlie any evaluation of the proposal: (1) the economic incentives created by the changes, (2) revenue adequacy, and (3) administrative feasibility.[1] Income distributional aspects of the proposed changes may also be important. We have no means to measure revenue adequacy at this time. Distributional changes cannot be evaluated without additional information and an explicit statement about the government’s intent to use the tax system as a distributional device. For these reasons, the discussion will be focused on administrative feasibility and potential incentives.

The comments are preliminary because they are based on documents supplied to us and we have not had the benefit of interacting with others to clarify intent, technical detail, or potential ambiguities in wording. Thus, this document is intended to promote discussion both about understanding the proposal as applied as well as the economic consequences of implementation.

The comments are critical but should not be interpreted as negative; we are not suggesting that the proposals are ill-intentioned or inappropriate in concept. The Government should be given credit for the effort and intent of the proposals. Rather, my critical approach is intended to generate a discussion about how items might be improved and to note the practical consequences of implementing some of the proposals.

I. Enterprise Profits Tax (EPT)

a. Tax Privileges

Some significant changes have been proposed in the EPT, including cancellation of some tax privileges (alternative energy producers, for instance) to be replaced by other tax holidays or cancellation of taxes on some products (software, however defined, for instance). These new privileges are supposed to be limited to two years. It is not clear, however, whether the ability to grant privileges lasts two years or whether the privileges themselves last two years. If the interpretation is the latter (as appears to be a more reasonable interpretation), then the incentives would provide benefits only for qualifying firms with taxable profit. Firms with losses, including smaller entities or those making significant investments, will not benefit because profits are either small or nonexistent in the first two years of a significant investment project. For this reason, cancelling the privilege after two years will not enable those who are making an investment to benefit much, if at all. The investment cycle of the targeted industries, even software, is longer than two years so that taxable profit will not accrue before the expiration of the incentive. Moreover, the incentive appears to be granted to the entire enterprise rather than only the profit from the “ring-fenced” investment project itself. This poses the danger that some profitable enterprises would start otherwise useless investment projects in order to obtain a tax holiday. At the current exchange rate, the 20 million UAH threshold is only about 1.28 million USD. Even moderately profitable enterprises might be willing to start an inefficient loss-making investment project in order to avoid paying profits tax at 18% or even 16% rate for two years.

If the intent of the wording is to limit the time when privileges can be granted but the actual benefits can extend beyond the two years, then some additional issues arise. First, the incentive presumably is directed at new “incremental” investment, but the proposal does not appear to contain a definition of “incremental.” Thus, investors may obtain the benefit even if the investment was already planned. A pure income redistribution will result, with perhaps little or no incremental investment. Second, there is also no clarity with respect to duration, reporting or other matters related to the privileges, such as limitations and recapture in case the investor sells the assets or entire business with the tax benefit capitalized into the value of transaction. Given the ambiguity, it is reasonable to require the government and legislature to be specific about both the legislative intent of the policy and how that intent is to be reflected in application.

One additional incentive for small business is troubling. The proposal is to exempt small businesses that have net income less than UAH 3 million and whose employees are paid at least twice the minimum salary. This is not a small business exemption but a profit tax exemption. Large enterprises may also experience losses and have periods of negligible profits. The proposal, at least as stated, adds complexity to the system relative to simply having a two-rate system where the first UAH 3 million is exempt and the residual is taxed at the applicable marginal rate.[2]

Finally, it is unclear whether the privileges proposed in the new law are given at the discretion of the Council of Ministers. If they are, this would be another disturbing aspect of the proposal. Such executive or administrative discretion should be prohibited as a matter of policy. There is no reason to believe that the executive branch has sufficient information about the actual facts and circumstances to determine the merits of any particular investor, particularly relative to an open, transparent process determined by legislative procedures. Such discretion will probably result in inefficient application at best, and at worst will be subject to political influence and possibly graft.

b. “Easing” of Accounting

It is proposed that EPT taxpayers be required to maintain only one set of accounts, as opposed to the current two sets of accounts: one for financial purposes and one for book purposes. As we understand the process, the starting point for the computation of taxable income will be accounting profit with adjustments for differences between tax and financial reporting concepts. We understand that differences will include: depreciation, reserves, and, perhaps, a thin capitalization rule. This proposal might be viewed as a simplification but, in fact, the change may be merely form as opposed to actual substance.

Almost all countries rely on some accounting standards as the basis for determining taxable profits. Some countries, such as Belgium, begin the computation of the tax base with financial income, however defined, as proposed in Ukraine. The United States requires entities to begin the tax computation with gross income, as defined, and then to derive taxable income. The United States tax law is silent, or accepts, generally accepted principles as the basis of many, if not most computations, however. Thus such computations are identical for tax and accounting purposes. The difference then between the proposed Ukrainian method and the US system is one of degree and the extent to which tax rules differ from tax accounting rules for the particular elements of the income computation.

To be clear, the tax law should not provide that taxable income is equal to financial income with the exception of a list of clearly defined items for at least two reasons: one methodological and one practical. First, accounting principles, such as international accounting principles, are developed relative to standards that may differ from economic standards. Economic income should be measured on full accrual methods and the tax law should reflect the economic reality as opposed to accounting standards to every extent possible. This is because the investors make decisions at the economic income, not accounting, margins. Thus, relying on accounting rules that are developed by standards different from economic classifications may lead to inaccurate measurement of both economic income and the incentives created by the tax law.

Second, differences between tax rules and accounting rules can be different and, even in Ukraine, will be more extensive than the three items noted above. For instance, Ukrainian source rules may differ from those used for accounting purposes. More importantly, transfer pricing rules for financial and tax purposes will differ, even if OECD standards are applied. In addition, there will be differences in what is allowed as a deduction. For instance, organizational expenses for an enterprise may be disallowed, immediately expensed or amortized, with the amortization period differing between tax and financial purposes. There are also items such as tax loss carry forwards in the tax law that are not part of standard accounting. Finally, Ukraine might choose to revalue assets (or all income) for changes in inflation; an adjustment that is not generally part of financial accounting.

The important point is that relying on financial accounts is not a simplification but the basis for all tax law. Policy makers should not be under the impression that relying on financial accounts relieves the state from its responsibility to use the change in accounting rules as a means to reduce abuse, to increase incentives, or to develop an alternative estimate of economic income for tax purposes.

II. Personal Income Tax

Two proposals are made with respect to the personal income tax. The two-rate system (15% and 17%) is maintained for wage income but the rate of non-wage (so-called passive) income is increased to 15% from 5%. Second, there is a proposal for a type of tax amnesty.

Aligning the rate of wage and non-wage income is a welcome change. The incentive to re-characterize income will be reduced and, if withholding is employed, revenue should increase. There is an issue, however, with the two-rate system. The 2% difference in marginal rates has little impact on progressivity, either statutory or economic. Thus, it might be more cost effective, and more progressive, to simply impose a flat rate tax of 17%, and perhaps expand the amount of exempt income. It also would be good to unify the enterprise rate (currently 18% to be reduced to 16%) with the personal income tax rate. There is little basis, either administrative or economic, for keeping any differential. In addition, unification of rates may help the public understand that the personal income tax and the EPT is really one tax on comprehensive income, as an economic matter, as opposed to two separate taxes. Such understanding will help lay the foundation for future reforms where explicit coordination, via a type of integration for example, might be considered.

The tax amnesty should be resisted. As stated, the amnesty will relieve a noncompliant person from criminal liability if he/she comes forward and pays a 5% tax (the base on which the 5% tax will be paid is not clear). In addition, the tax authority will be given the right to audit the person and determine if income equals “expenditures,” with the excess being taxed at current rates. This proposal is poorly structured for a number of reasons.

First, the tax authority already has the right to audit. The current low rate of monitoring is due to a combination of a lack of resources, a lack of understanding, the inability to withhold on certain payments at the source, and, perhaps, corruption. Taxpayers are aware of the preexisting situation and thus they have no incentive to come forward and be audited when they simply can refuse to comply.

Second, comprehensive income for tax purposes generally will not equal expenditure.[3] Individual expenditures may increase in a period because of loans (a person may buy a house with a value much greater than current taxable income) or current expenditures could be lower than taxable income (a person can save). One interpretation of this provision may be that the tax authorities have the ability to use net worth comparisons to derive income estimates. Such methods are administrative remedies in cases where income is not reported and should always be available to the tax authorities, with appropriate checks to reduce the potential for abuse.

Third, and most importantly, taxpayers have little or no incentive to comply given the absence of any change in transparent, reasonable, and fair administrative sanctions. To the extent that there is corruption, the value of bribes might change a bit, but it may be cheaper to pay off a tax official relative to complying even with an amnesty. In cases where corruption is absent, there is still little incentive to comply if the probability of detection changes after the amnesty period elapses. Criminal sanctions have no value if a person escapes detection. This fact is one reason why tax amnesties have performed poorly throughout the world. The amnesty could be used as an incentive only if accompanied by administrative improvements that are transparent and perceived to be fair while addressing corruption. Thus, it may be more important to address the problem of administrative capacity.

III. The Simplified Tax System

The current simplified tax system consists of a minimum payment for certain taxpayer classifications and a turnover charge for larger individuals or entities. The minimum payment system is in lieu of all taxes, except perhaps employee withholding, while those who qualify for the turnover charge may elect, in some cases, to be subject to VAT.[4] The election is necessary because some businesses need to issue VAT invoices. This system is poorly structured and the proposed amendments do nothing to change the basic structure. Rather, the proposed changes modify various limitations (turnover levels and employment) and rates. In addition, there is a requirement that cash registers be used by at least some taxpayers.

The simplified tax system is not simple either in design or in implementation. Revenue leakage relative to alternatives may be significant and the impact of the charge may be regressive. Persons may have strong incentives to reorganize activities to be eligible for the regime. A common example is for individuals providing services to become “consultants” and “independent entrepreneurs” rather than “employees” in order to arbitrage both the personal income tax and the social charges. The cash register requirement has been tried elsewhere, the Kyrgyz Republic for instance, with little or no success. The simple reason is that the presence of a cash register does not ensure that cash transactions will be recorded by the cash register.

Two of the most vexing areas of taxation are the taxation of cash transactions and the taxation of small businesses. In most cases, the problems are exacerbated because small businesses may rely on cash transactions. Thus, the government should be commended for attempting to address the issue. The proposed solution, however, is not the correct path in my view and may erode revenues from other areas of the tax system. One of us proposed one alternative for Ukraine in 2007 (see references) and believe that alternative continues to be relevant.

IV. Excise Taxation

One of the proposals introduces a supplemental excise tax on retail sales of certain excisable goods that will accrue to local government. The desire to increase revenues to the local level is probably well justified and many countries (Canada and the United States, for instance) allow the use of indirect taxation such as excises at the local level. Thus, my concerns about the proposal are largely administrative. The excise tax should form part of the basis for the VAT and such a stipulation should be clear in the legislation. Small retailers who might otherwise qualify for the simplified tax regime may sell the excisable goods. We understand that producers of excisable goods are prohibited from electing the simplified system but that prohibition may not be extended to the retail sector. Thus, there will have to be some coordination between the simplified system, as currently structured, and the excise tax proposal. Finally, we assume that the State Tax Service will administer the supplemental charge. Given centralized administration, it might be easier to simply increase the basic excise rate and distribute the proceeds of the increment to the localities than to impose an additional charge.[5]

V. Reduction in the Number of Taxes

Some taxes are eliminated, such as the excise tax on security transactions, while others are consolidated.

a. Cancelled Taxes

The elimination of the excise tax on security transactions is welcome. That charge is both inefficient and yields little revenue. The elimination of the excise tax on natural gas and the use of pipelines is more troubling. It is important to examine the relative pricing of pipelines and natural gas consumed domestically to determine whether an implicit subsidy exists. If so, then eliminating the excise should be compensated by changes to ensure reasonable relative pricing.

There is also an issue about items such as parking duties and other charges with respect to whether these charges are really “taxes” as opposed to payments for specific services. The state may own land and other assets for which it should receive a competitive return and charging for the use of such assets, via service fees, is both appropriate and efficient.

b. Consolidated Charges

Whether consolidating three charges into one ecological tax is a simplification depends on whether the charges on each activity will differ. It appears that different collection and valuation methods will be necessary for each charge. For example, the duty for forest use may be a stumpage fee or other payment for the use of a scarce resource, which differs from a vehicle registration fee both with respect to the object of taxation and the rate.

This point is especially important with respect to the consolidated rent payment. Extraction of minerals will have a different base and rate relative to water charges. The same comment is relevant for the differences between the two charges noted and the charge for radio band usage.

It is more important that the base, rate, and intent of each individual charge be clearly defined. For instance, the mineral royalty is not a tax in my view but a return for the sale of minerals on a per unit basis. Investors may treat it as a tax because it is imposed by the government, but the charge is a signal to Ukrainians about the price they are receiving for reducing the value of their country’s wealth via extraction.

In summary, the consolidation of three charges is, at a minimum, a move of form over substance. Even worse, the consolidation may confuse the intent of each separate charge and lead to less efficient pricing.

VI. Other Comments

a. Statutory Language will be Important

Much of the impact resulting from the proposed reform will depend on the statutory drafting, the regulations, and the economic intent of the reform. For instance, there is a proposed change in the definition of “taxpayer” for the profits tax. Whether the proposed changes have any substantive effect will depend on how terms such as “legal entities that perform economic activity in Ukraine” are defined and applied.[6]   Thus, it is important that the draft laws be vetted both internally and publically so that the language is clear. In addition, the law should be supplemented with explanatory notes for the public as well as draft implementing regulations.

b. Items not Addressed

It will be important for future actions on tax policy to be made in the context of the overall economic reform program, of which tax reform is an integral part. For instance, one important issue not addressed by the draft law is the problem with VAT refunds for exports. Various methods, including issuing bonds, have been tried in the past with, at best, limited results. The issue needs to be discussed publically so that Ukrainians understand that by denying, or delaying, VAT refunds the economic intent of the VAT is hampered and the Government is not obeying its own laws. Thus, an important element of signaling the need to increase overall compliance is to have the Government begin to comply by developing refund systems that are reasonable while protecting state revenue and amortizing the Government’s VAT refund debt.

We hope these comments are useful. As always, we will be happy to supply further explanation and look forward to the opportunity to work with Ukraine as the tax reform proceeds.


1. Conrad, Robert F. “Analysis of the Ukrainian Small Business Tax.” Memorandum prepared for Ms. Tetiana I. Iefymenko, Deputy Minister of Finance. March 17, 2007.

2. “Small Business Tax: Drafting Instructions and Regulations.” Memorandum prepared for Ms. Tetiana I. Iefymenko, Deputy Minister of Finance. March 18, 2007.

3.“Small Business Tax Recommendations.” Memorandum prepared for Ms. Tetiana I. Iefymenko, Deputy Minister of Finance. March 27, 2007.


[1] In general, an objective of the tax system should be economic neutrality. That is, the government should attempt to implement a tax system that is capable of raising the necessary funds while interfering with private sector decision making as little as possible. That is, the tax should not distort private sector decisions.

[2] We do not support the exemption but at least there is an increased possibility that the exemption can be administered.

[3] We take it that the income tax is not intended to be a personal consumption tax, in which case the tax base per annum is consumption, not income.

[4] The election is needed because businesses may need to issue VAT invoices in order to interact with other market participants who are VAT taxpayers. For instance, VAT taxpayers need VAT invoices in order to claim a credit for VAT accrued on input purchases. Persons subject to the simplified system who are not VAT taxpayers may not issue VAT invoices and thus may be put at a competitive disadvantage.

[5] There are other, more general fiscal decentralization issues, including whether the proposal enhances or inhibits fiscal imbalances between localities. Such issues should be addressed first; then the use of the local excise can be evaluated in the context of those objectives.

[6] Our preference would be to eliminate the term from the law because it will be a source of confusion and debate. We will be happy to supply suggested wording to the extent deemed appropriate.

Appendix I

Tax reform Proposals (September 2014)

Concept: was adopted by the government in July 2014. Can be downloaded from here.

On September 15 2014, the CMU introduced the new version of the Tax Code (the Draft Law): , which was partly developed according to the Concept.

The number of taxes is reduced:

Current taxes Proposed taxes
State level taxes
Excise tax Excise tax


Ecological tax (levied on sales of fuels)
A duty on electricity and heating tariff (except electricity and heating produced by cogenerating power stations or with renewable energy sources)
Excise tax on operations with securities Cancelled
Ecological tax (except for fuel) Ecological tax
A duty for usage of forests
Payment for the first registration of a vehicle
Payment for extraction of natural resources Rent payment
Payment for usage of radio frequencies
Payment for usage of water
Custom duty Custom duty
Rent for usage of pipelines (gas, oil, ammonium etc.) Cancelled
A duty on natural gas usage tariff Cancelled
A duty directed to development of vineyards, orchards and hop-growing Cancelled
Land tax Transferred to local level

Local taxes

Property tax (excluding land) Property tax (including land)
Single tax (excluding single agriculture tax) Single tax (including single agricultural tax)
A duty for performing certain types of economic activity (123,000 payers) Cancelled
Tourist duty Cancelled
Parking duty Cancelled
Excise tax on retail sales of alcohol, tobacco and fuels


Easing of tax accounting. Now enterprises keep two sets of accounting records – for own purposes (general accounting) and for taxation purposes (tax accounting). The Draft Law proposes to compute taxes based on the “true” (financial) accounting. This will ease tax administration for enterprises a lot.

Tax amnesty is planned for individuals. If a person declares his/her previously undeclared assets during Jan.01, 2015 – Oct.31, 2015, he/she pays 5% tax, and is freed from further criminal responsibility. At the same time, tax authority gets the right to check whether income of a person equals her expenditures (assets). If expenditures of a person are higher than her income, the difference is taxed according to the current rates.

PIT. The Concept considered several variants of progressive (from 10% to 25%) PIT scale. However, in the Draft Law the scale remains unchanged: 15% for part of income that is lower than 10 minimal salaries and 17% for the part of income that exceeds this amount. “Passive” income in the form of dividends, interest income on deposits, income from bond payments etc. remains taxed – so dual taxation is not eliminated. Moreover, the rate of taxation of this “passive” income is lifted from 5% to 15%.

EPT. Basic rate for this tax is 18%. It was planned to reduce it to 17% in 2015 and 16% in 2017. However, the Draft Law does not contain this reduction.

EPT privileges.

Currently, IT sphere has a privileged EPT rate of 5%. It is proposed to cancel this privilege since Jan. 01, 2015.

Under the new Draft Law, the government can free some enterprises that perform investment projects from EPT for the period of Jan. 01, 2015 – Jan. 01, 2017. To be eligible for the privilege, a projects should:

  • Be in one of the following industries:
  • Military complex;
  • Agricultural machine-building;
  • Software;
  • Airplane construction;
  • Extraction and sale of oil and gas from new drills constructed after Dec. 31st, 2014.
  • Project value should be no lower than UAH 20 million, or no less than 100 people should be employed;
  • Minimal salary of employees in a project is at least three times higher than officially set minimal salary.

Under the current legislation, the Cabinet of Ministers could grant this EPT privilege at its discretion, without clearly defined criteria.

Another privilege is introduced for very small enterprises: enterprises net revenue of which does not exceed UAH 3 million, and whose employees get at least twice the minimal salary, are freed of EPT payment until Jan. 1st, 2016. This measure is intended to support workplaces at marginally profitable enterprises.

At the same time, privileges of several categories of enterprises are cancelled (currently they are free from EPT payment till 2021):

  • Hotels;
  • Light industry;
  • Alternative energy producers;
  • Shipbuilding;
  • Airplane construction;
  • Agriculture machine building;
  • Movies production (have privileges till 2016)

Insurance companies additionally pay 3% tax on their income from insurance contracts (except for contracts on life insurance and voluntary medical insurance). In this way the government wants to stimulate insurance of life and voluntary medical insurance.

Non-residents pay EPT on the same basis and by the same rates as residents. However, there are some clauses presumably aimed at prevention of capital flight: additional tax rates are applied to insurance payments in favor of non-residents (except for “green card” insurance). Also, if a resident pays a non-resident for production and/or distribution of advertising, this resident pays 20% tax on this payment.

Excise tax rate changes:

  • rate for non-filtered cigarettes increased for more than 2 times and is set equal to that for filtered cigarettes;
  • rates for fuels are raised by 6% to 18% for different kinds of fuels;
  • excise tax for electricity is introduced at 3,2% of price;

An excise tax on retail sales of alcohol, tobacco products and fuels is introduced as a local tax. The rate of this tax is set by local authorities and cannot be higher than 5%.

Privileges for property tax are cancelled (in the current Code, 120 sq.m in a flat and 250 sq.m in a house are deducted from the tax base). Maximal rate of this tax is introduced – 2% of the minimal salary per 1 sq.m. In the current Tax Code, there are three possible tax rates, depending on the size of a house/flat. These are cancelled. Property tax base is extended by inclusion of non-housing (commercial) property.

Land tax. In the current Code, land tax is collected to the Central budget, and within cities/towns fixed rates per 1 sq.m are set (depending on the size of a settlement). The Draft Law proposes to transfer this tax to local level and let local authorities decide on the rate. Only the maximal rate is defined – 3% of the value of a land plot in settlements (where prices of land are defined) and 1% of the oblast (regional) average value of a unit of land for agricultural land and 5% for non-agricultural land (in many instances value of land plots is not defined because land market in Ukraine is not developed. Agricultural land cannot be traded at all).

Simplified tax system. Maximal value of revenues under which an entrepreneur is eligible for the simplified tax system is increased – from UAH 150 thous. to UAH 300 thous. for entrepreneurs who have no employees (first group of simplified taxpayers), from UAH 1 million to UAH 1,5 million for entrepreneurs who have up to 10 employees (2nd group), and from UAH 5 million to UAH 20 million for entrepreneurs who works in real estate or jewelry industries and small enterprises (legal entities) – 3rd group of simplified taxpayers. These small enterprises currently should have no more than 50 employees. In the Draft Law this restriction is eliminated. Tax rate for entrepreneurs of the third group is decreased by 1% (from 3% of revenues for VAT payers and 5% for VAT non-payers to 2% and 4% respectively). Simplified tax rate for small enterprises (legal entities) changes from 5% of revenues (for VAT payers) and 7% (for VAT non-payers) to 4% and 8% respectively.

Entrepreneurs will have to use cash registers (except for very small businessmen who trade in food or consumer goods markets).

It is proposed to limit the volume of cash transactions (between individuals, enterprises, individuals and enterprises) to 15 times the minimal monthly salary per day (currently this limit is set by the NBU).

It is proposed to publish a complete list of enterprises that received VAT refund every month. This is important because VAT refund used to be a source of revenues for corrupt officials (enterprises paid bribes to get a refund) and an instrument for punishment of enterprise owners (for example, those who supported political opposition).

Important issues that are not addressed in the Draft Law:

  • Single social payment. In Ukraine, an employer pays over 50% “above” the labor cost to Pension Fund and social insurance funds. Therefore, many employers pay only minimal salary officially and the rest – in cash. To reduce “shadow” part of salaries, these social contributions should be reduced. However, current Draft Law does not address this issue;
  • Electronic submission of tax documents, “single windows”. Currently there is a possibility of electronic submission of tax documents but this electronic submission is difficult because of poor development of respective software by tax administration.


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