Russia's Taxes: 9 Flaws That Need Fixing

The Russian tax system, long considered oppressive and decrepit by taxpayers and government officials alike, is due for a facelift -- if not total reconstructive surgery.


Already, the Finance Ministry has submitted to the State Duma, or lower house of parliament, the first two sections of a new seven-part Tax Code.


The start of the long overdue overhaul is a red letter event in Russia's business calendar. According to Lyudmila Anisimova of the Finance Ministry's tax reform department, it marks the first time that the finance and economics ministries, State Tax Service and State Customs Committee have ever agreed on a tax document.


Euphoria may be a little premature however. Given the difficulty of fixing one of the world's sickest tax systems in one hit, it is not surprising that the reform is complex and this has some analysts worried.


The first two sections of the new code amount to 416 articles contained in more than 100 pages. And that is just the overview of general principles. On April 30, tax authorities devising the document submitted another few sections to the government for approval.


Even more worrying is the fact that getting the new code passed may take some doing. No one wants to touch the issue until after the election and the legislature's summer break in August, analysts say. The complex document is unlikely to get signed by December, the deadline for implementing it in 1997.


The biggest problem is that reforming the tax system is hard at a time when the government desperately needs money and has little room to maneuver.


Revenues are static and low. The budget take, both federal and regional, came in at just 27.3 percent of gross domestic product -- compared to 50 percent in the Czech Republic and 47.7 percent in Poland.


Russia's budget deficit has been narrowed in recent years, but this has only been achieved by cutting back on expenditures in real terms, almost 50 percent from 1993 to 1995.


Because of all these problems, reforms are needed and here is a basic list, compiled from tax experts, on where they should start.





1. Too Many Taxes


The most striking aspect of the government's proposed tax code is its reduction in the sheer number of levies applied to business. Currently, enterprises face as many as 180 local and federal taxes, depending on the region.


In some cases, localities were so quick to tax they never issued rules for payment, leaving businesses either praying the tax will go away, or collecting money and holding it for the day the inevitable occurs.


Presently, tax laws and decrees can be imposed by President Boris Yeltsin, Prime Minister Viktor Chernomyrdin and the Duma. Regulation on any single tax can be written simultaneously by the State Tax Service, the Finance Ministry, or the Central Bank -- with Finance Ministry and Tax Service officials rarely agreeing in their views.


But under the new tax regime, Yeltsin and Finance Ministry officials say this potpourri of assessments will be narrowed to no more than 30 with federal and regional powers clearly defined.


Tax specialists and business leaders agree that this is a case where simpler also means more efficient. It will be a big relief just to ease the number of checks that must be written -- usually at different times of the year to different government accounts and often guided by conflicting procedures drawn up by rival agencies.





2. The Right to Appeal


Attorneys and tax specialists say that perhaps more frightening than the Byzantine codes and regulations currently facing commercial enterprises is the lack of any satisfactory process for appealing a fine or instruction.


This problem is aggravated by the fact that most penalties are pre-determined and final, with little or no room to change according to the severity of the infraction. Clerical errors can easily be treated as flagrant violations.


"I think one of the biggest areas, if not the biggest, is the tax penalty structure," said Alexander Chmelev, an attorney with Baker & McKenzie. "There really isn't a difference between getting penalized because I have a different interpretation of the law ... and something that was way off the wall."


Peter Charow, executive director of the American Chamber of Commerce in Moscow, said, "You drive people out of the tax system because they're so terrified of making a mistake that they don't want to pay."


Penalties are very high. For example, there is a standard 100 percent fine for understating income.


The interest rate on late payments alone amounts to 0.7 percent a day, or 255 percent per annum -- a penalty that can dwarf the actual liability, according to Scott Antel, an attorney with Arthur Andersen.


Even if a company succeeds in overturning a decision by the tax inspectorate, Russia's system of confiscating the revenue in question before allowing an appeal can mean additional headaches for the victorious taxpayer. "Once they've taken the money out, it's not that easy to get it back," Chmelev said.


Businesses wishing to protest a levy or fine are left with one of three directions; talking things out with tax officials, taking it to the courts or relying on political intervention. Given the tax system's bureaucracy and a lack of judicial expertise in taxation, the third route -- if available -- produces the best results.


"It's probably the most efficient of the three, but probably not the most desirable," Charow said. "It's not a system, it's an emergency measure."


One firm that followed the latter route was Procter & Gamble's personal hygiene division, Johnson & Johnson.


Faced with a potential $7 million hit due to a disagreement over tax relating to its charter capital, the firm lobbied Anatoly Chubais, then first deputy prime minister. With help from the U.S. Embassy, the firm won a reprieve.





3. Too Many Exceptions


The government may fumble on setting guidelines and observing precedents, but granting tax breaks and concessions is something officials know well. The result has been a free ride for some lucky businesses and a huge hole in the budget.


Cutting exemptions is a major goal of the draft tax code, the tax office's Anisimova said. "The biggest problem we're trying to solve is to minimize the tax exemptions," she said.


"At some point in time, the concept of using tax exemptions to stimulate development was misinterpreted, and the number of tax exemptions became unfairly big."


The biggest hemorrhage is in the area of duties on alcohol and tobacco sold by groups such as the National Sports Foundation and the All-Russia Invalids' Society, which gained exemptions from import taxes in 1993.


Although these tax breaks are being reined in, one analysis placed the cost to the government for the sports group alone at 27 billion rubles ($6 billion) last year.


Foreign investors are also beneficiaries of tax exemptions, raising some difficult policy issues. For instance, in an effort to entice investors, the government has implemented a tax break designed specifically for large international companies. The Mars decree -- so-called because the U.S. confectionery firm was the first to avail itself of the break -- allows companies with $100 million or more in direct investments to import half of their products duty-free.


Although the draft tax code allows such tax holidays to continue, economists say that tax breaks, even those determined above-board by specific criteria, are doing more harm than good.


"It's rather dangerous and premature to rely widely on tax breaks for purposes of fostering investment," said Yaroslav Lisovolick, an economist for the Russian-European Center for Economic Policy, adding that the government's No. 1 priority is to get its budget in order. Tax breaks are often political rather than economic, he added, and it can be difficult to ensure that the money a company saves is actually going toward investment.





4. The VAT Mess


If there is one tax that causes more headaches than any other, it is probably Russia's 20 percent value-added tax. This is ironic since VAT was introduced in response to classical economic theory as an easy-to-collect, easy-to-use flat tax.


The problems are in the complicated details of the way the tax is calculated and imposed. For instance, goods purchased for capital investment are supposed to be VAT exempt. But according to Stewart Naunton, a tax partner with Coopers & Lybrand, the problem is that a company can only claim a VAT refund once the asset is in use.


Plugging in a computer leads to a quick refund, he said. Building a manufacturing facility over the course of years can mean long delays.


Another example is the application of VAT to loans from foreign companies to their Russian subsidiaries or joint venture partners. This was introduced in 1993 to cut a tax scam but has captured many companies who use loans to finance local subsidiaries.


Were a firm like Coca-Cola or Pepsi to loan $100 million to its Russian company or partner, it must contribute $20 million to government coffers. In theory, the money is supposed to be refunded by the government when the loan is repaid.


"But in reality, in 4 1/2 years we've seen one VAT refund from the government," said one consultant who asked not to be identified.


Analysts say that recent legislation, as well as the draft tax code, are expected to deal with the problem, but much will lie on interpretation -- a nebulous area where good laws can often go bad.


"It's very disappointing," Naunton said. "The legislature keeps trying to make it better and more sensible, but when the laws are transformed into administrative rulings, I actually feel that the intention of the legislation is being frustrated."





5. Redefining Profits


Most companies accept that they must pay tax on their profits but Russian tax law has a pretty funny way of defining the concept. Under Russian law, taxable profits include start-up costs and business expenses such as advertising, interest, some insurance payments, travel expenses and even personnel training -- all of them necessary ingredients for emerging markets.


"The system needs to recognize the real economic costs of doing business," Antel said. "One thing I find amazing is that if you try to train people, and improve the work force, that that's not a deductible tax."


Deductions are also barred for losses due to exchange differences -- an area in which foreign companies changing hard currency to rubles are particularly vulnerable, Naunton said.


Likewise, depreciation allowances that affect the vital manufacturing sectors are so slow in Russia that the economic costs of investment get blurred.


The result is that in many cases, a company that appears profitable under Russian accounting standards is in fact losing money under the West's Generally Accepted Accounting Principles.


"What you end up with is sort of a pissed-off Western management sitting in London or New York, looking at what looks like an operating loss that somehow they end up paying Russian taxes on," said the consultant who asked not to be identified.





6. Taxes on Payroll


Russia's payroll taxes are another area where firms come under fire, particularly from social infrastructure and social benefits taxes, which can mount up to 41 percent of the salary. The employer also has to withhold between 12 and 35 percent for income taxes. Some consultants estimate that to pay a Russian employee $65 an employer must part with $140.


"It makes employing people here pretty expensive," one analyst said.


Things here have improved slightly. From Jan. 1, the government scrapped the excess wage tax, which slapped on another 35 percent for a staggering total of 111 percent tax on salaries.





7. The Import Game


The problem with Russia's import taxes is not so much that they are high but that they are so inconsistent and take so much time.


Although outrageously high duties have been applied to a variety of products, levels are falling in most areas, with the exception of automobiles, semi-conductors and aircraft. As Russia moves closer to membership in the World Trade Organization, import tariffs are expected to continue falling.


Clearance issues, however, are another matter entirely. Russia's customs force grew from 5,000 to 55,000 personnel in just five years, according to Charow, and the growing pains have been severe.


"We see a lot of the same problems that we see in the tax system overall," he said. "No transparency or predictability, and corruption."


But, in fact, so many people avoid paying import taxes thanks to corruption or government-sanctioned tax exemptions that importers face a very bumpy playing field. Tariff barriers are supposed to protect local industry but there is little reason to invest in domestic production when imported products are effectively being sold duty-free.





8. Securities Markets


Russia's growing stock market has been virtually driven off-shore, largely because the local tax regime cannot cope with a modern wheeler-dealer trading regime.


The law requires anyone buying or selling shares to pay a profits tax on the difference -- a hurdle investors simply dodge by trading overseas, according to Brian Zimbler, managing partner at Leboeuf, Lamb, Greene & MacRae.


"The fact of the matter is, the equity market continues to be overwhelmingly an offshore market," said an attorney at one Moscow brokerage, who asked not to be named. "One of the reasons [investors] don't buy or sell more from Russian entities is because of this whole big question mark over taxes."


The government has, however, improved some areas of securities law, getting rid of a 0.3 percent operations tax on each party in a sale and instead increasing to 0.8 percent the tax on new stock issues beginning with the second such issue.


The debt market offers its own problems for Russian officials and investors alike, bedeviled as they are by a combination of taxes, banking regulations and currency laws, especially given the Central Bank's control over investment accounts.


"Taxes and currency regulations and banking regulations are intimately intertwined," said Naunton, adding that most trading by overseas investors is tax-exempt.





9. Cut Regions' Power


One area where the draft tax code could have a dramatic effect is taxation by the regions, which were given extended authority to raise their own revenues at the end of 1993. The result has been mixed.


Some areas, seeing the road to riches opened wide before them, have imposed a plethora of assessments from the legitimate to the absurd, "so you have a tax collected in the regions to support the local soccer team," said Charow, by way of example.


Some regions like Moscow have even imposed taxes on turnover as high as 4 percent.


Other regions, like Novgorod, have used their new freedom to promise light taxes as a lure for investment. But regardless of whether a region has followed progressive or repressive tax policies, the government is aiming to rein in their abilities with the proposed tax code -- and that, say analysts, could be one of the main stumbling blocks in passing the tax code through parliament.


"The vulnerability of the code is clearly here," said Lisovolick, noting that the Federation Council is made up of the very regional governors whose strength will be cut by the document.


"Politically, a lot of regional bosses will voice their concerns," he said.