Shedding Light on Coming Out of the Shadows

It's time to come out of the shadows," the tax authorities have been urging us, in advertisements on television and on billboards around town.

Indeed, tax reform and other recent legislative changes have been credited with reducing the size of Russia's shadow economy, which is often cited as one of the government's most vexing problems and has been estimated to account for as much as 30 percent to 50 percent of the country's gross domestic product.

In this big semi-legal sector, sometimes called the gray economy, companies have been bending the rules in order to avoid tax or get around difficult laws. For many, it has been seen as a matter of survival, essential for business competitiveness; others simply say, "Why pay taxes, when it's just going to get stolen anyway?"

The recent changes that have been luring individuals and businesses out of the shadows include tax reform, notably the flat 13 percent income tax rate and the reduction of the corporate profit tax to 24 percent, as well as the streamlining of customs regulations. Some experts say it is crucial to further simplify tax procedures to make it worthwhile for some companies to play by the rules, for example by introducing a simpler import tariff regime. Others argue the government still has a long way to go in instilling confidence that the revenues won't be squandered, and trust that those emerging from the shadows won't be penalized by increased tax rates in future.

For those who decide to leave the shadow economy, there can be real dangers in making the transition. Going legal requires careful planning -- and in some cases even professional help.

The 'Coming Out' Trend



"The shadow economy has started to shrink and is becoming more legal," Finance Minister Alexei Kudrin told an American Chamber of Commerce luncheon last month.

Kudrin said the government's reform effort over the past two years can be called a success for bringing 400,000 new small and medium-sized enterprises above the radar.

"This is the most sensitive sphere to changes in the economy. And if the flow is increasing, it means we are doing the right thing," Kudrin said.

It's not just government officials who are seeing evidence of a trend. Even the experience of individual wage earners indicates that change is underway. For example, a Moscow-based employee of a respectable Western company, who did not wish to be identified, said his official salary rose several times to match his real salary this year, after the flat 13 percent income tax rate was introduced.

"What is interesting is that when I mentioned that to my friends at a party, all of different trades, a few said that was the case with them as well," he said.

And it's not just individual wage earners who are starting to go legal.

Steve Henderson, CIS partner in charge of tax and legal services at Deloitte & Touche, said there is clearly a trend for businesses to come out of the shadows.

"I believe this is driven by multiple factors, and the Russian government should be applauded for its contributions," Henderson said. "First of all, the tax reforms in the country have been drastic, relatively clear, and the tax rates have become among the most competitive in Europe. Secondly, many businessmen have simply decided that they have made plenty of money in the past with limited taxes and they would like to become legitimate -- partly driven by the increasing threat of the authorities catching up with them and partly from a desire to be known as upstanding people in the community.

"The other major factor influencing business to emerge from the shadows is the need for outside financing. In order to obtain money from banks or other investors, audits provided by one of the Big Five firms are generally required. Most often, such an audit cannot present a favorable picture until the business has been restructured in a legitimate manner."

Others agreed.

"At this point, it simply doesn't pay to be an nontransparent company because attracting investment is dependent first of all on transparency," said Anatoly Sedykh, general director of the steel major United Metallurgical Company. "The stock market is the main source of investment, and a nontransparent company doesn't have a chance there."

Increased confidence in the legal system is also playing its part.

"The general legal environment is improving so that more and more business is being done according to legal agreements that are enforceable in Russian courts, and expected judicial reforms should increase this demand," said Bob Wallingford, a tax and legal partner at KPMG. "There is greater willingness to use the court system, so tax and nontax litigation is growing."

Derek Bloom, a partner at Coudert Brothers in St. Petersburg, said that for some, it was simply a matter of learning from mistakes.

"There were a lot of gray-market schemes back in the mid-1990s to avoid paying VAT and import duties, especially among equipment providers," Bloom said. "The Western partner was drawn into arrangements to make its goods more cost-competitive. They were using false contracts, false documents and uncertain legal arrangements. When things fell apart after the crisis, the Western partner usually did not have adequate legal recourse to get his money back. Companies were badly damaged and they don't have the appetite for those games anymore. There are fewer gray schemes today, thanks in part to reduced import duties and taxes. Westerners are less cynical about the Russian legal system and are doing things by the book."

The Risks



Whether you're an individual wage earner or the head of a large company, the decision to come "out of the shadows" is not one that's taken lightly. Of course, staying in the shadows carries dangers -- but does coming out of the shadows increase the risks of getting caught for past misdemeanors?

"There is certainly risk involved in the process," said Henderson of Deloitte & Touche. "Presumably, a business in the shadows is concealing profit and salaries from taxation. If, all of a sudden, the business shows significant income and there is no clear explanation for the tax authorities, they may attack the previous periods and assess costly interest and penalties on prior years' tax liabilities."

Henderson said each case must be looked at independently to determine the best approach, and new levels of taxable income may often be controlled through careful tax planning with an adviser.

"If you assume that most businesses are in the shadows in order to avoid tax on significant amounts of income, simply putting it all on the table the next day in a basic manner will likely result in taxes greater than the amount that may be arranged through professional planning and greater risk involving the prior periods," Henderson said.

"By keeping the transition less drastic, risk of attacks on prior years may be controlled," he added.

Some consider that small fry may still be better off staying in the shadows if they don't have to attract foreign investment, since the tax authorities often can't be bothered going after them.

"It's a matter of how big you are," said the head of a shipping company, who did not wish to be identified.

"We are turning from a small company into a medium-sized one, so people start to notice us, and we don't want the boys with badges to knock on our door."

However, Henderson said there is no doubt that it is safer for any business to come out of the shadows.

"Being in the shadows means you are breaking the law," he said. "Eventually, chances are that you will be discovered, and the consequences may be harsh, particularly if you did not come out voluntarily.

"As a business adviser, I have to advise that every business should come out of the shadows and conduct business legally. There are cases, however, where careful planning for emerging from the shadows would suggest that an older company or legal entity should remain where it is. Transferring a business to a new entity is sometimes a way to start fresh and leave the past behind. An individual, however, does not really have the option of beginning again with a new identity."

Maryann Gashi-Butler, a partner at Phoenix Law Associates, said her firm had been spending more time helping clients defend against investigations by regulatory agencies, tax police and others, "as well as helping to set up systems to avoid problems in the first place."

"Many clients take the attitude there is 'no law' in Russia so why even try," Gashi-Butler said. "That is a big mistake."

She said that what the regulators look for are lapses in proper documentation.

"Clients can avoid a lot of unpleasantness if they properly document transactions," Gashi-Butler said. "It is important to understand what the investigators look for -- how they try to hang a client, often on details, whether the client has done anything wrong or not. After all, everybody has a quota to fill!"

Misguided Reforms?



Some experts say the government is heavy-handedly carrying out its reforms and occasionally missing the mark completely.

For example, the 13 percent income tax rate is expected to draw more salaries out of the shadows, but it brings little relief for many companies because the social tax paid out of the company salary fund remains a heavy burden. Although higher-paying companies may benefit from the regressive nature of the tax, which drops from 35.6 percent to 2 percent as salaries rise, average-paying companies still fall into the higher tax bracket. While it may be seen as providing an incentive for employers to bring full salary amounts out of the shadows and even raise them, some experts consider that for most companies the rate is still too high.

"The main deterrent for raising salaries is taxes on corporate salary funds, which have been reduced at a very slow pace," said the State Duma budget committee's deputy head, Sergei Shtogrin. "Therefore, by lowering the income tax but leaving the social tax at a high level, we haven't promoted the cause of taking salaries out of the shadows," he said.

Tatyana Rumyantseva, senior tax manager at KPMG, agreed.

"The government is talking first of all about making taxpayers comply by cutting the income tax, which was reduced in 2001," she said. "But there's also the social tax, which for most companies is still at 35.6 percent. Not much is going to change until it is reduced."

"Small businesses are the ones that will lose out. For them, the new profit tax and accounting rules are too complicated because they are the same as for big companies -- they are out of proportion with their business," Rumyantseva added. "This is why they will most probably stay in the shadows; they have no economic reasons to pay taxes in full."

Similarly, some experts say the corporate profit tax reforms have had the effect of punishing some companies instead of helping them. An exemption of up to 50 percent, which companies enjoyed if they invested in production, was dropped when the rate was cut to 24 percent.

"Now that this exemption is gone, those companies that used it effectively, financed capital investment and built new facilities, have seen their tax burden grow," Rumyantseva said. "This applies mostly to large producers. Now the tax rate is formally lower, but in reality for them it is up from 17.5 percent to 24 percent."

If the company never paid taxes before, a shift from 35 percent to 24 percent profit tax won't make it start paying, other experts said. But tax reform still matters for companies that look to tap foreign markets and need to show their tax records.

Shadows Still Entice



Caution may keep some in the shadows, at least in the short term.

"It's not clear today how consistent the government's tax policy will be. It should take at least two to three years for people to believe in this," said Evgeny Astakhov, a tax partner with Ernst & Young.

It would make sense for the government to adopt a clear tax amnesty policy, which has worked in former Soviet states such as Kazakhstan, but so far it has not gone beyond general statements on this, he added.

"Short-term wariness will outbalance the desire to come to the surface. In a few years, the latter will undoubtedly outweigh the former, unless, God forbid, the government does something that would make one doubt its determination, like raising tax rates again. Then no one will trust it again," he said.

Hermann Schmitt, a partner at Clifford Chance, said that was unlikely.

"There is speculation that the authorities may increase taxes again once they know what everybody earns. Some people may still have concerns and say, 'It is too early to declare one's income fully,' but I think that this is rather unrealistic," Schmitt said.

"For one, even though the tax rate was lowered lately, tax collection has increased, so there is no need to increase taxes, and it was proven that it would have a negative effect on total revenues. Second, this would be a blow to the credibility of the Russian government's long-term economic policy. You can see that if you reduce tax rates, tax collection rises. Likewise, if you do away with restrictive currency regulations, probably more companies will see there is no necessity for capital flight, and the money will remain or even stream back. Of course, there is no proof that capital flight would really decrease if you dramatically liberalize the currency control regime, but I think the lesson learned from the tax reform is that it probably would," Schmitt said.

Shtogrin of the Duma budget committee said poor enforcement of tax laws was another disincentive to come out of the shadows.

"Unless tax control is tight and punishment is severe, people will continue to use gray schemes," Shtogrin said.

And old habits die hard.

"The main obstacle to becoming transparent is a psychological one, it is not economic considerations," Astakhov said. "Companies are just not ready to come to the surface."

Todd Prince and Jennifer Chater contributed to this report.