You're reading: Employers reaping benefits from ‘temporary’ tax break

Ukraine’s so-called simplified tax system first appeared in the late 1990s as a temporary remedy for small businesses struggling under byzantine tax rules.

Since then, however, it has repeatedly expanded in scope, allowing even large businesses to use the breaks to dramatically reduce their taxes and social payments. And far from being temporary relief, it appears to be here to stay – to the detriment of a coherent tax system, critics say, if not also to the amount of tax revenue that government collects.

The legal scheme involves employers signing contracts for services with private entrepreneurs or “SPD,” as users of the simplified tax system are known, instead of registering them officially as staff employees and paying in the general tax system.

Employers are happy with the rules because they get to avoid paying social payroll taxes, which can go from 36.76 to almost 50 percent of the salaries of official employees. By contrast, private entrepreneurs’ social taxes are fixed at slightly less than Hr 400 per month ($50).

This simplified system also enables companies to shift part of their revenue to private entities, taxed at 5 to 10 percent, thus avoiding a 15-17 percent personal income tax or 21 percent corporate tax, for bigger companies.

The State Tax Service estimates that 1.2 million Ukrainians are registered as private entrepreneurs. It may not seem like much in a national workforce of 20 million. But the private entrepreneur system is now so popular and widespread that the government is finding the benefit hard to reduce or take way.

In fact, when officials tried to restrict the categories of private entrepreneurs two years ago, tax protests erupted. The backlash forced politicians to back down.

Yet these tax benefits come at a price for the nation.

While it could be argued that government is losing out on tax revenue through the private entrepreneur system, the truth is that many employers and employees were simply evading official taxes altogether – depriving government of any revenue.

Volodymyr Kotenko, partner at Big Four auditor Ernst & Young’s Ukraine office, said the nation would be better off with a simpler, unified tax system.

“Instead of creating a kind of internal offshore and creating unnecessary competition between the general and so-called simplified tax systems, it’s better to have one system that is equally simple for all, that would encourage [companies] not to hide,” Kotenko said.

Until then, Kotenko said, businesses can hardly be blamed for taking advantage of the ambiguities in how an employee should be registered.

“It is a loophole, but I think it exists for objective reasons,” Kotentko said, referring to the private entrepreneur system. “Life is complicated and it’s hard to predict all possible business and human relations and put them into law.”

Sometimes, however, businesses interpret the rules in ways that are not always legal, such as when they register permanent office staff as private entrepreneurs.

Larger-scale retail and service companies also favor this system. It’s not uncommon that a sizeable retail outlet, restaurant or fitness center is owned by several entrepreneurs. This allows them to spread the income among themselves and still fall below the limits set by tax legislation.

Since the beginning of 2012, private entrepreneurs with profits of up to Hr 3 million ($375,000) a year and hiring up to 20 employees could use the simplified system. On Aug. 8, President Viktor Yanukovych signed the law increasing this limit to Hr 20 million.

The new ceiling is a dramatic increase compared to the Hr 500,000 limit that existed when the regime was introduced in 1995 and when taxes were a fixed Hr 200 a month.

Yaroslav Lomakin, a founder of Moscow-based consultancy Honest & Bright, says the logic behind the increased limit is not clear, but it may be an attempt to improve the business climate. “All instruments can be used in a number of ways,” Lomakin said. “A knife can cut a sausage as well as stab a neighbor.”
Besides lower tax rates, the system is also advantageous because of its simplicity, in contrast to Ukraine’s overall complicated tax system. According to World Bank’s Doing Business report, Ukraine ranks 181 out of 183 countries in ease of paying taxes. The country is also a world leader number of payments – 135 – businesses make yearly.

According to experts, one of the sectors to benefit the most from the simplified tax system is Ukraine’s information technology industry. Some IT companies use hundreds of private entrepreneurs, with few people on their staff payrolls. The benefits of such tax optimization are impressive, since IT outsourcing is one of Ukraine’s most promising industries with annual exports reaching $1 billion and salaries constituting the biggest expense.

“The IT industry pays wages officially. They are simply paid using somewhat different opportunities, as with private entrepreneurs,” said Taras Vervega, president and managing director of SoftServe Europe, a Lviv-based software development company.

Ernst & Young’s Kotenko said the private entrepreneur scheme is used both for tax evasion and simply muddling through. “It is another loophole, which can be perceived both in a negative connotation or positive, as it gives businesses an opportunity provided by legislation,” he said.

But the policy of creating special conditions for one group of businesses leads to abuse, Kotenko argued. He said Ukraine needs to bring business out of the shadows by introducing simpler rules for all, something the nation’s first comprehensive tax code, enacted in 2011, failed to do.

Kyiv Post staff writer Maryna Irkliyenko can be reached at [email protected].