The Legal Framework for FDIs

Although tangible incentives for foreign direct investments have yet to be developed in Ukraine, the government is paying increasingly close attention to the issue. A framework law on foreign investments is already in place. Foreign arbitration is available. A presidential council on foreign investments, which includes representatives of all major foreign companies operating in Ukraine, has been set up and meets regularly to discuss problems. In addition, a special committee for resolving tax disputes involving foreign companies is working at the State Tax Administration.

Top government authorities have repeatedly declared their commitment to attracting foreign investment to Ukraine, and key laws on FDI have been approved, including the law on foreign investments (passed in 1996) and the law on production sharing and concessions (approved in 1999), both of which offer foreign businesses largely equal treatment with local companies. But enforceability of legislation (not only FDI-related) at lower government levels still leaves much to be desired, which highlights the urgency of administrative and regulatory

reforms. Indeed, it is Ukraine's confusing regulatory environment, that foreign investors here name among primary deterrents to their business.

Due to budgetary constraints, the government has substantially cut subsidies to the industry in recent years. However, they are still applied, especially in sectors of particular significance to the economy. Enterprises may either be granted lower tax rates, receive energy supplies at below market prices, or be allocated production inputs for free or below cost. However, the practice of subsidizing is virtually non-existent in industries, which attracted significant FDI, as these sectors are largely privatized.

In foreign trade, Ukraine employs general (full-rate) and preferential (lower-rate) tariffs.

Imports from Western countries are usually granted preferential tariffs. The size of import duties usually depends on whether a similar product is made in Ukraine.

Imported goods are subject to sanitary, veterinary, radiological and ecological control.

Ukraine's numerous certification bodies operate as independent entities. Many products require multiple certifications from different agencies on the federal and local levels. Product testing may sometimes require an official inspection of the company's production facilities at its expense.

The government is trying to overcome the above-mentioned hurdles by reforming foreign trade legislation according to the requirements of World Trade Organization (WTO). Ukraine hopes to get a membership in WTO in 2004. Ukraine has negotiated the required bilateral agreements with a number of WTO member countries and is gradually adapting its legislation.

The new tax draft laws envisage a lower number of taxes and smaller tax rates as well as abolish many of the existing tax privileges and exemptions. The total number of taxes is proposed to be cut to 25, or by about a dozen. Recently, amendments to the corporate income tax law were approved, cutting the tax rate from 30% to 25% as of January 1, 2004. The new VAT rate would be set at 17% and personal income tax at 10% to 20%. Reduction of payroll taxes is also being discussed in the framework of pension reform.

These radical changes underscore the cumbersome nature of Ukraine's current tax system.

Among the main problems of the existing tax legislation is the lack of clarity causing conflicting interpretations. Along with 22 central government taxes there are 16 regional ones, which make proper tax accounting very difficult and time-consuming. Foreign companies

EU’s New Neighbours: The Case of Ukraine

located and operating in Ukraine are taxed based on their Ukrainian business, while Ukrainian companies are paying taxes on their worldwide activities.

Income earned in Ukraine by foreigners not residing in the country on a permanent basis is subject to the withholding tax. The regular withholding tax rate is 15% for interest, dividends, royalties, property rent, capital gains, income of non-incorporated joint ventures, and other types of income. A 30% rate is levied on income from interest-bearing bonds, T-bills, and some other instruments. A 6% rate is used for taxing freight services. Income from the government bonds is exempt from the withholding tax.

In several double taxation treaties, signed by Ukraine, special provisions for taxation of dividends, interest, royalties and other types of income prevail over the regular withholding legislation. Double taxation treaties have been signed with countries such as Austria, Belgium, Canada, Cyprus, the Czech Republic, Denmark, Finland, France, Germany, Hungary, Italy, the Netherlands, Norway, Poland, Russia, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States.

Protection of investments is guaranteed by the Law on Foreign Investments (approved in 1996): Guarantees against adverse changes in the investment environment during a time period of 10 years; Guarantees against expropriation, except in case of national emergency and with proper compensation; Adequate compensation for losses due to negligence of state authorities; The right to repatriate the original investment and income earned in foreign currency.

For further protection of foreign investors, Ukraine has signed corresponding agreements with over 50 countries, including Austria, Belgian-Luxembourg Economic Union, Canada, the Czech Republic, France, Germany, Hungary, Israel, Italy, the Netherlands, Russia, Spain, Sweden, Switzerland, Turkey and the United States. Ukraine also ratified the Convention on the Procedure for the Settlement of Investment Disputes between governments and foreign entities and/or individuals. Ukraine is a member of the World Bank's Multilateral Investment Guarantee Agency (MIGA) as well. (Dragon Capital, http://www.dragon-capital.com/) 4.5. Special Economic Zones

Special (free) Economic Zones (SEZs) have been increasingly applied as a vehicle for attracting investments. The law of 1992 has established a framework for SEZs (Table 34), providing separate tax holidays for individual zones. Under Ukrainian Law “On Special

(Free) Economic Zones” adopted in 1997, there are three types of special economic zones in Ukraine:

• Special (free) economic zones;

• Territories with a special investment regime (TSIR);

• Territories of priority development (TPD).

Depending on the type of the zone, many privileges are extended to the subjects in their enterprise activity, including: customs regime benefits for import and export of the goods on the territory of the zones; tax benefits; clearing of land tax payment for the period of development of the real estate.

Table 34. Special Economic Zones of Ukraine

The special regime of investment activity provides the establishment of tax and customs privileges for the subjects of enterprise activity that have concluded the contract with local bodies concerning realization of the investment project in priority branches. The established privileges provide exemption for a certain period (usually 3-5 years): from taxation by the import customs duty and VAT of the equipment (except for excise goods) for realization of investment project; from profit tax of the newly established enterprises, where the size of the investment is determined for each territory separately (but not less than 200 thousands USD).

EU’s New Neighbours: The Case of Ukraine

Main objectives of SEZ and TPD are: new jobs creation; foreign trade stimulation; foreign investment attraction; active exchange of knowledge and technologies; broadening of export base or import substitution.

In the beginning of 2001, 369 investment projects with total value of more than 1.5 billion USD were confirmed in SEZ (126 projects) and TPD (243 projects) (Table 35).

During the realization of investment projects in SEZ and TPD, 429.5 million USD investment were attracted (27 % of the total projects’ value), including foreign investments of 211.9 million USD. 12500 new working places were created and 28900 working places were saved as a result of the SZE and TPD activities.

Table 35. Results of economic activity of SEZ as for 01.01.2001

Economic Results

SEZ “Azov” 60 years since 14.01.99 TPD Donetsk oblast 30 years since 14.01.99

116 (775.1), 43% of FDI 318.1 166.4 SEZ “Yavoriv” 20 years since 17.02.99 45 subjects of SEZ

registered 106.4 - TPD Zhytomer oblast 30 years since 01.01.2000 15 (24.7) 2.0 - SEZ “Slavutich” 20 years since 30.06.99 23 subjects of SEZ

registered (30.5) 2.1 -

SEZ “Porto-Franco” 25 years since 01.01.2000 SEZ “Interport Kovel” 20 years since 01.01.2000

The realization of investment projects has not started by 01.01.2001

Total 568.16 195.14

Source: Authors’ calculations

SEZ and TPD have become significant tax payers to all levels of budget of Ukraine. In 2000 313.9 million UAH were paid in taxes: profit tax – 27.5 million UAH, VAT – 205.9 million UAH, personal income tax – 22.2 million UAH. In 2002, about USD 909 million of investment (both domestic and foreign) was attracted to these zones and territories. Over

5000 investment projects valued at USD2.8 billion were signed in 2002 to be implemented in these zones and territories. In 2002 over 90 000 jobs were either created or preserved due to these special investment conditions.

However, different views and opinions persist as to the future fate of these zones and territories. While the IMF experts suggest curbing their activities or eliminating them altogether, so far the Ukrainian Government has taken no steps to do so because of their importance to the country’s economy at the present stage. The adequate solution is being sought now based on broad international experience.

EU’s New Neighbours: The Case of Ukraine

5. The Investment Rating of Ukrainian Regions