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. Last Updated: 07/27/2016

Here Comes The New Tax Code Fiscal Salvation or 'Tax Hell'?

The Great Tax Battle has begun.


The government finally sent the final three sections of a new draft tax code to the State Duma last month, urging deputies to put it at the top of their agenda.


The proposals would radically simplify Russia's current tax system, which is based on a 1992 tax code and has grown to include a patchwork of local and regional taxes, conflicting instructions and taxes that cost more to collect than they earn.


The 400-page package of reforms calls for sweeping changes to these reviled and antiquated tax laws and reduces the number of federal, regional and local levies from around 200 to just 30, wiping out a series of bizarre local taxes on everything from water wells to soccer teams.


The draft code proposes to ease the overall tax burden, abolish anachronistic taxes on turnover, eliminate loopholes and vastly expand deductions for business expenses.


In its current form the code would simplify the tax system and ease the burden on enterprises and individuals. At the same time, the government is gambling that it will be able to offset lower projected revenues by slashing spending and widening the tax base.


While such steps are undoubtedly welcome news to Russian business, some tax experts have warned that the new code could cause more headaches than peace of mind if it is not properly implemented.


Many complain that the complex document clearly shows the hand of U.S. and European technical assistance and reflects far more the concerns of policy makers than average businesses. Some say certain sections have literally been cut and pasted from the U.S. Internal Revenue Code.


"Just imagine the U.S. Internal Revenue Code administered by Russian tax inspectors. My vision of this is Dante's fiscal hell," said Trevor Link, a tax partner at Arthur Andersen and co-chair of the American Chamber of Commerce's tax committee. "The devil is in the implementation."


"You can write what you like in the code, but it still comes down to how it is implemented," he said. Link noted that thousands of accountants and tax inspectors would need time to properly understand the new code, portions of which use concepts alien to Russian law.


Others have suggested that a more effective route would be to simply amend current laws, the bulk of which came into effect in 1992. "Most tax practitioners would prefer the draft tax code simply went away," said Alexander Chmelev, a tax partner at the law firm Baker & McKenzie and co-chair of the AmCham tax committee.


Chmelev said there was a certain degree of predictability now because the tax authorities had issued guidelines on many of the provisions, spelling out how they are to be implemented. "With the new tax code we are back to 1992, wondering how the tax authorities are going to implement it."


But others believe there is no choice but to throw out the current system and start from scratch.


"The ultimate goal is a rational tax system. The structure and concepts in current legislation do not form such a system," said one tax specialist, who asked not to be identified. "Incremental ad hoc adjustments to the current system could be more costly than doing it in one or two stages."


Many observers stress that the draft code is far from a panacea to current ills and is still a work in progress.


But the government will resist attempts by the parliament to fiddle with the legislation, said Deputy Finance Minister Sergei Shatalov, author of the proposed reforms. The Duma's Budget Committee is expected to begin considering the bill at the beginning of June, but it is unlikely to come to a vote any time soon.


"I once described the Duma as a black box. You hand in one thing and a totally different product comes out," Shatalov told a roundtable of business leaders last week.


Shatalov, who has devoted the last few years of his life to creating Russia's draft code, vowed to push the reforms through the Duma and the Federation Council this year with "minimal compromises" so that it could come into force at the start of 1998.


But both chambers of the Russian parliament are expected to put up a fight, despite a growing consensus on the need for tax reform to help resolve the budget crisis and end the crippling wage and pension arrears crisis. The International Monetary Fund made submission of the tax code to the Duma a condition for resuming lending to Russia, but the IMF has few powers of persuasion over deputies often hostile to reforms.


For the Duma, the tax code is a key bargaining chip in its battles with the reformist Cabinet over spending cuts. Opposition deputies who dominate the lower house of parliament are likely to balk at the Finance Ministry's estimate that implementation of the code will reduce budget revenues by 73 trillion rubles ($12.7 billion), forcing the government to drastically slash spending.


Likewise, the Federation Council is expected to oppose government proposals to limit the powers that regional governments have to play with tax rates to attract investment. Under the draft tax code, a unified profit tax rate of 35 percent would be imposed across the country, rolling back the ability of regional governments to reduce profit taxes to encourage businesses to set up shop locally.


Given the array of obstacles, most observers predict the code will not be implemented in full before 1999 at the earliest, with the possibility of piecemeal improvements along the way.


The head of the State Tax Service, Alexander Pochinok, sounded a pragmatic note. "As an individual, I think the code will be passed by the end of next year. As the head of the Tax Service, I will move heaven and earth to get it passed by the end of 1997," the Russian daily Izvestia quoted him as saying.


If the government does get its way, the impact on the economy and business is enormous. Here is what's at stake.


Companies


In theory, the draft tax code should give a tremendous boost to companies operating in Russia by sharply reducing their overall tax burden. The hated 4 percent taxes on turnover would be abolished, giving enterprises that are struggling to turn a profit some breathing room.


At the same time, it would expand the deductibility of a range of business expenses and bring Russia's tax system closer in line with Western standards.


Under the government's proposals, advertising expenses, interest on loans, insurance, business trips and training costs would be partially or completely deductible from a company's profits tax base, removing the numerous limitations currently in place. The draft code would also accelerate depreciation allowances.


"It would appear to recognize the economic costs of doing business," said Scott Antel, a tax consultant at Arthur Andersen. "Instead of the current situation, it would be a tax on real profits."


While overall profit tax payments would be reduced through expanded deductions, the proposed unified rate of 35 percent across Russia's regions could hurt companies that have won tax breaks from regional authorities.


Currently, there is a cap on profit taxes of 35 percent, but many regions, such as Moscow, have lowered rates to spur investment. Shatalov has said regions would be able to grant investment tax credits to attract businesses, but analysts say the measure is not spelled out in the tax code.


The proposed reforms also would ease the tax burden on parent companies and their subsidiaries by allowing them to pay profit taxes from a consolidated balance sheet.


At the same time, employer payroll taxes to various social funds would be reduced and consolidated into one social tax with the rates linked to the two new tax brackets. Companies paying workers less than 60 million rubles a year ($10,300) would shell out 33.4 percent of the overall wage bill, while employers paying higher wages would pay only about 8 percent.


"The idea is to reduce the overall tax on labor," said one tax adviser who requested anonymity.


The proposed reforms could help boost tax collection. "It will encourage enterprises to bring in unreported wages," the tax specialist said.


One idea that is likely to have a major impact on Russian enterprises is the requirement to move to an accrual basis of accounting, whereby income and expense items are recognized as they are incurred even though they may not have been received or actually paid in cash.


Given the tangled web of debts between enterprises, the transfer from a cash-based system to an accrual method could hit Russia's struggling industrial and manufacturing sector hard.


"It will definitely put a squeeze on enterprises, but it will probably be a healthy one," said Rory MacFarquhar, an economist with the Russian European Center for Economic Policy. "It should do wonders for the arrears problem."


MacFarquhar said it would boost incentives to demand cash in advance for goods and make it harder for enterprises to dodge taxes by bartering. The system would help separate profitable enterprises from loss-making ones and could force heavily indebted enterprises to go under more quickly by requiring tax payments on goods sold regardless of whether cash payments are received.


Duma deputies are likely to resist adoption of the accrual system by arguing that the system would hurt enterprises, said Alexander Ustinov of the Finance Ministry's Economic Expert Group, who has tracked the draft code. "They could consider it a defense of domestic industry."


Individuals


The draft tax code is designed to bring more individuals into the system through simplified and reduced income tax rates, which currently top 35 percent.


The government is proposing to abolish five graduated rates and replace them with two tax brackets: individuals earning up to 60 million rubles a year would be taxed at 12 percent; income above 60 million would be taxed at 30 percent.


Current exemptions for housing allowances and cars have been abolished under the draft code.


In the long term, the government hopes to shift some of the burden from enterprises to individuals. In 1996, individual income tax accounted for only about 10 percent of total budget revenues, which is low compared to Western countries.


VAT and Retail Sales Taxes


Consumers could lose out under the government's draft tax code.


One of the major areas of proposed reform is to value-added tax. The government wants to raise VAT from 20 percent to 22 percent and cancel the reduced rate of 10 percent for "socially significant goods" such as some food products and children's goods.


The increased VAT could also badly affect companies that are importing goods or engaged in investment projects, although the proposed reforms have fewer restrictions on credits for capital construction.


However, the changes would move VAT closer to what it was intended to be: a flat non-distorting tax that is easy to collect.


The draft tax code also plans to allow regional governments to slap a retail sales tax of up to 5 percent on top of VAT. Local governments can also levy a tax of up to 10 percent on luxury goods, which could affect imports such as cars.


"Allowing VAT and retail sales tax at the same time is fairly unusual but not unique," said Link. However, the resulting rise in consumption costs could slow down economic growth, some economists said.


Taxes on Capital Income


Investors earning income from dividends should applaud the draft tax code, which stands to give them relief over the current system. However, those earning income from interest on bank deposits stand to lose out.


Enterprises that pay a 15 percent tax on dividends would see that rate reduced to zero under the proposed changes if the dividends are paid out of profits that were already subject to tax. Individuals' income on dividends, currently taxed at the applicable personal income tax rate, would also be exempt.


Interest on government securities would be taxed at 12 percent, a tax reduction for enterprises but a new burden for individuals, who currently are not taxed on GKOs. Individuals would also stand to lose through proposed higher taxes on interest from bank deposits. Tax on interest which exceeds the Central Bank Rate, CBR, would shoot up to 35 percent from the current 15 percent for individuals. Rates for enterprises remain the same.


Penalties


The draft tax code calls for a radical overhaul of Russia's onerous penalty system, which has been blamed for being so draconian that it has actually scared away potential taxpayers who feared being severely punished for making innocent mistakes. Penalties can sometimes amount to two or three times the actual tax liability.


The number of penalties would be increased and diversified, but the overall level of fines would be scaled back. Fines on late payments would be slimmed down from the current burdensome 0.3 percent per day -- 109 percent a year -- to a reduced rate linked to the CBR.


The draft code contains dozens of articles on penalties that should bring greater clarity to the current system, but problems remain. "The concept of guilt is not defined," said Yevgeny Astakhov, an associate partner at Baker & McKenzie in St. Petersburg.


Many tax specialists have complained that the present penalty structure fails to distinguish between an honest mistake and criminal negligence. While the draft code makes improvements in this area, it may not go far enough.


"The code allows for taxpayers to present justification for their violations. If a taxpayer can prove that his failure to pay was reasonable, he can reduce or eliminate penalties," said one tax specialist. "In theory it sounds good, but it may be difficult to administer because the tax authorities have a lot of leeway in the way it is implemented."


For the Economy


If and when the tax code gets passed, it could have major implications for Russia's budget, economy and federation. Among the biggest concerns about tax reform are new proposals to divide revenues between the federal center and the regions. Under the present budget system, revenues from VAT and profit tax are split between the center and the regions. The government is now calling for all VAT revenues to go to federal coffers and all profit taxes to go to regional budgets.


Although the proposals are separate from the tax code -- they appear in the budget code -- they will be linked in the minds of the legislators considering the reforms. Regional leaders are unlikely to welcome a bill which saddles them with a profit tax that could produce reduced revenues due to expanded deductions. Analysts said the government has proposed giving regional governments the power to impose an easy-to-collect retail sales tax as a way to patch up local budget holes and make the package look more attractive.


Federal revenues are expected to suffer as well under the proposed tax reforms. Shatalov pledged that the government will not allow the budget deficit to balloon under proposed reforms and said it plans to keep the budget deficit in line by slashing spending.


"It is a tough decision, of course, but it can stimulate economic growth," he said. He said the government would make up for revenue shortfalls caused by the reduced tax burden by closing existing loopholes, which he said were costing the government some 170 trillion rubles every year.


At the same time, the government is counting on the reforms bringing more people into the system. "We hope the tax base will grow fast enough," Shatalov said. "But the first year will be difficult."


The first year is what worries many tax specialists.


"If the tax code is just dropped on everybody's desk, it could just cause more problems than solutions," said Link. "Everyone needs time to understand how to use it."


Other tax experts have noted that the reforms, while in principle better for business, won't necessarily mean a boon to foreign investors.


"It will take several years before we get guidance on how this tax code will be implemented," said Chmelev. "Investors don't like turmoil. If they can't make economic decisions with a degree of certainty, they just won't come here."