Patchwork Solution

22 July 2013, 16:44

On July 4, the Verkhovna Rada adopted a number of laws that, when enacted, will have a huge impact on businesses that are not controlled by the Family or its close circle of oligarchs. The legislature has introduced treasury notes to cover the government’s debt on VAT repayable to entrepreneurs as well as on other public spending. Control over transfer pricing will now allow fiscal services to reveal transactions where products are “sold” to associated companies at below-market prices in order to minimize taxes. Apart from that, the Rada ratified a Ukraine-Cyprus government convention to prevent double taxation and income tax evasion. This step reveals the instruments with which the government will avert a potential budget disaster prior to the 2015 presidential election and temporarily save the economy with zero growth rates (see Where’s the Money and The Red Card for Corruption).

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The newly introduced treasury notes, control over transfer pricing, and the government convention with Cyprus are perfectly reasonable instruments that have been used effectively in developed economies. However, to understand how these instruments will function in a Ukrainian context, it is important to take into account the proposed procedure for their application and the extent to which the country’s economy is controlled by oligarchs whose nepotism automatically distorts any good intentions.


The Cabinet of Ministers will determine the procedure for the issuance, circulation and redemption of treasury notes. It will also determine budget articles where debts will be repaid with this quasi-money. The government thus expects to cover VAT repayable to enterprises with the newly introduced treasury notes. The vague law only specifies that the notes have a 5% yield and five-year maturity, with January 1, 2013 as the date from which debt is repayable with them. This gives the government almost unlimited power to decide which payables, when and to whom will be settled. Manual issuance of treasury notes runs counter to the Constitution: Art. 92.2.1 requires that the procedure for the issuance and circulation of securities shall be established by Ukrainian law, not by First Vice Premier Serhiy Arbuzov or other ministers.

However, faced with the prospects of either receiving nothing at all or receiving treasury notes that can hypothetically be converted into cash at a discount through an intermediary, entrepreneurs are likely to choose the second option. Previous experience suggests that they will be “advised” on which banks they should use to convert their notes into cash. The owners of these banks may turn out to be close to the ruling party, which guarantees the government’s redemption of the principal amount of the notes to these banks. Experts project that “pocket banks” or banks and companies close to the government will repurchase the notes with huge discounts ranging from 30% to 50%. This scheme essentially legalizes massive kickbacks from VAT reimbursements to entrepreneurs, allowing the government to use entrepreneurs to cover its debts indirectly. Experts suggest that initial discounts on VAT-reimbursement notes may exceed 50%. Given the current system, this “business” is hardly surprising.

Meanwhile, the government insists that the scheme will bring liquidity into the economy. In practice, however, things may turn out quite the opposite if the worst-case scenario unfolds. If entrepreneurs accept treasury notes instead of cash as reimbursement from the government, they are likely to end up with too little cash available to pay their suppliers and service providers. This will cause a liquidity crunch in some supply-chain operations and even whole sectors of economy. Thus, Ukraine will tumble back into the 1990s with the revival of barter schemes, cross-cancellation of debts, payment of salaries with the employer’s products rather than money, and a massive default crisis. This almost drove Ukraine’s electricity supply sector to collapse in 1999, then escalated into a debt crisis when Ukraine failed to service its external debt and its business climate and competitiveness ratings plummeted.

The only way to avoid all this is for the government to redeem treasury notes diligently and transparently. “The question is the scale at which the notes will be used,” comments Ihor Burakovskyi, Chairman of the Institute for Economic Research and Policy Consulting. “If they replace cash, it will deplete in the economy at some point, and the economy can’t operate without cash. Massive circulation of treasury notes will signal troubles in Ukraine’s financial system.”

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The budget deficit in January-April 2013 grew 3.6 times compared to the same period in 2012. Revenues increased by 2.4% compared to the planned 9.2%. Meanwhile, government debt servicing planned for 2013 is 18% higher than that of 2012. This means that the government’s debt liabilities are growing faster than its revenues.

European recipes for long-term and systemic solutions entail public spending cuts and parallel structural changes. “Budget policy, especially public spending, should be revised,” says Ihor Burakovskyi. “Finally, sequestration should be considered. It’s unpopular but there is no other way with a cash-starved budget. Funds from international borrowers, including the IMF, are now critical for Ukraine.”

The instruments offered by Azarov’s Cabinet (treasury notes and control over transfer pricing) can only have maximum benefit when applied transparently and equally to all enterprises and sectors of economy. But the current government cannot and will not ensure this.


The law on transfer pricing that, coupled with treasury notes, is supposed to rescue the budget from a collapse has two curious aspects. First, it entails tax control over pricing in export-oriented transactions and in the companies’ internal transactions. Tax authorities are granted vast powers in setting the value-linked (adequate) prices that should comply with market prices. Second, the law will not fully apply to agricultural, coal, oil, gas, chemical and steel enterprises – the core of oligarch business in Ukraine – until January 1, 2018. They will enjoy 5% variations on standard market prices.

Meanwhile, the law will fully apply to all transactions by other large companies with associated residents, i.e. legally and commercially “friendly” counterparties located in territories and states where the corporate tax rate is at least 5% below that of Ukraine. With the abovementioned
“exceptions to the rules”, the tax authorities are likely to focus on companies producing more technological and innovative products first, despite the fact that technology and innovation rather than coal and minerals are major (if not the only) drivers of long-term economic growth. Given the current global crisis, it is important to struggle for economic growth worth one tenth of the current GDP because this will transform into 0.5-1% of GDP within ten years. Otherwise, Ukraine could be thrown into poverty for decades to come.

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Today, resources that should be channelled to support companies engaged in technological innovation are being gobbled up by companies producing raw materials and semi-finished goods, thanks in part to government favouritism.

The combination of vulnerable public finance, growing tax pressure on non-oligarch businesses and the potential for a liquidity crunch if treasury notes are used non-transparently on a massive scale may well return Ukraine’s economy to a state reminiscent of the 1990s.

The Cyprus saga

The saviours of public finance came up with a third segment of their multi-part solution: a government Convention with Cyprus to prevent double taxation and income tax evasion through Cypriot companies. The Convention will replace a 1982 agreement between Cyprus and the former USSR that prevents double taxation and entails a 0% tax rate for any income earned on the territory of either country and transferred from one country to another. Under the new convention, dividends will be subject to a 5-15% tax. The 0% rate will be replaced by a 10% or 5% royalty tax and a 2% tax on debt income. Income from real estate disposal may be taxed in compliance with the jurisdiction of a party to the deal. However, this Cyprus saga lasted so long that everyone, especially Ukraine’s oligarchs, had plenty of time to withdraw their tax-sensitive assets from Cyprus, which was gradually losing its tax-free charm. Today, Cyprus is no longer the offshore haven that it was in 2003. Since the country joined the EU, requirements for transaction transparency have grown tougher while its fiscal system has become less convenient for entrepreneurs. In 2013, Cyprus introduced a tax on bank deposits. Meanwhile, businesses still have a wide choice of alternative tax havens beyond Cyprus.

READ ALSO: Cyprus ripples are hitting Russia harder than Ukraine

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