Studies Eastern European Markets
Eastern European Markets
December, 2005

Jon Hellevig, Artem Usov, Tauno Tiusanen
THE RUSSIAN TAX REFORM PAVING WAY FOR INVESTMENTS
Publication 21, NORDI Series. Lappeenranta 2005.

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Introduction

The brisk growth of the Russian economy has clearly affected the investment appetite of major foreign corporations and Russia is clearly on track to meet Presidents Putin’s goal to double the GDP in 10 years. As a consequence we increasingly receive in our legal and taxation practice inquiries about the most feasible ways to carry through a Russian investment. We have therefore decided to focus on an overall presentation of the Russian taxation system, the fruits of the reform and the most important taxation provisions to be considered when making an investment in Russia.

The taxation system, or rather the lack of a transparent, predictable and stable taxation system, has widely been considered as one of the main reasons for the economic woes that Russia has experienced during the 1990s. After the tax reform started in 2001 the taxation system has gone from being the big hinder for investments and economic growth to being the locomotive of Russian economic success.

The success has not come by chance or due to favorable world market prices of oil and other raw materials, but through the Russian leadership’s will to create successful activity. The tax system is one of the cornerstones of the overall competitiveness of a national economy. In his annual address to the Duma (16 May 2003) President Putin clearly demonstrates his commitment to the market reform and deep understanding of the meaning of market competitiveness: “Everything must be competitive: goods and services, technologies and ideas, business and the state itself, private companies and state institutions, entrepreneurs and public servants, students, professors, science and culture.”

In the Soviet Union, the predecessor state to Russia, there existed in practice no real taxation system. This was quite natural against the background that the USSR with its planned economy was meant to be the first ever state without taxes. Practically all production property and assets were state-owned, and the central planning organization did asset and profit allocation. In the planned economy the companies were not actually taxed; they rather transferred certain residual amounts of financing back to the center.

With the downfall of the USSR and the economic reforms in Russia, a tax system started to emerge from the beginning of the 1990s. During these early years of reform the tax laws did not take shape within a unified system, but rather through the ad hoc adoption of laws and regulations. During these years the laws regulating taxation kept changing frequently. There The Russian Tax Reform Paving Way for Investments was a lack of clear provisions for norm hierarchy (knowing which laws would take precedence over others) and a lack of statutory rules defining the authority of various governmental, federal and local bodies.

This led to serious flaws in the legal protection of the taxpayer, who was often left to the arbitrary whim of various authorities. The gradual adoption of the Russian Tax Code has brought order into the taxation system. With the economic reforms started by President Boris Yeltsin, there emerged a need to create a taxation system suitable for a market economy. Anybody who participated in commercial activities in Russia during the 1990s knows that the process of creating an appropriate taxation system has neither been quick nor painless. Considering the results of the tax reform at hand future historians may well take another view and conclude that in less than ten years, starting from scratch to create a market economy, a fairly transparent and predictable taxation system had been established.

With the leadership of President Vladimir Putin, the Russian taxation system has continued to stabilize and has reached a point whereby it in many aspects is better than in many Western countries. Some of the advantages of the Russian tax laws:

  • The personal income tax is the lowest in Europe, a flat 13%
  • Corporate profit tax 24%
  • Wide ranging tax benefits for small and medium businesses
  • Social tax, from 2005, is charged on a regressive scale down from 26% to 2% (the higher the salary, the lower the social tax)
  • VAT down to 18% from 2004
  • Burden of proof with the tax authorities
  • The courts have in the majority of cases ruled in favor of the taxpayer

The big remaining problem is the heavy administrative burden, red tape and bureaucracy that the taxpayers are subjected to. There is, however, a glimpse of hope that in time the administrative burden will be reduced. For us it seems that for the first time in the history of Russia the leaders of the country and the president himself have raised the issue of bureaucracy and red tape as a serious problem. As this problem has now been recognized we hope that continuous de-bureaucratization efforts will follow. The first step towards solving a problem is admitting it exists. Here Putin has showed remarkable strength in speaking out on Russia’s deep rooted vice of bureaucracy. It is the first time a Russian leader puts this problem in the right perspective, focuses on issues that really count. Putin (annual address to the Duma, 16 May 2003):

“Meanwhile the Russian bureaucracy proved to be ill-equipped for working out and implementing decisions that meet the modern needs of the country. And conversely, it has become quite skillful in deriving the so-called “administrative rent” from its position. I spoke about it last year… Our bureaucracy still possesses immense powers, but the number of powers in its hands is still not matched by the quality of power. I must stress that a major source of power is excessive functions of state bodies. In spite of the huge number of bureaucrats in the country there is a dire shortage of personnel at all levels and in all power structures. A shortage of modern managers, efficient people… I believe we must not convince bureaucracy to cut down on its appetite, but to impose restrictions upon it through directives.

The functions of state bodies must be cut radically. The fully developed civil society will emerge only if state functions are cut drastically.” One can only agree with the President. His task in easing the administrative burden and the obstacles it creates to everyday life is not easy, but we can be sure of a real commitment to win this fight.

The favorite topics of Western politicians and economy watchdogs – the banking reform and the reform of natural monopolies – have a minor importance compared with the decisive task of conquering the bureaucracy.

Putin’s quest for competitiveness is evidence in the broad overhaul of the Russian society ranging from scrapping the Soviet institutional social security system and replacing that with social protection of the individual to a broad reform of the judicial system. The reforms implemented during the first years of this millennium include also the land reform that enabled private ownership of land, the reform of the labor laws providing for great flexibility and reducing the destructive influence of labor unions stripping them of their monopoly (one more issue where Russia is in the avant-garde compared to the European Union), an overhaul of the civil laws and corporate laws; a revolutionary revamp of the judicial system with a new Criminal Process Code.

The judicial reform if any is an example of the needed interaction between the legislative decisions, government implementation and the society as a whole. Reforms directed from above needed time to take root in the society. Both presidents Yeltsin and Putin have had to fight for the reforms not only against the political opposition (in fact, during Yeltsin’s presidency the “opposition” had the legislative power), but also much against a disinterested and non-supportive public.

The underdeveloped judicial system also constitutes a direct obstacle to the implementation of the tax laws. The actors on the judicial scene simply do not understand the basics of a market The Russian Tax Reform Paving Way for Investments economy and finance well enough to be able to provide for needed justice. Thus the presidents’ and the Government’s efforts to create a simple, business and growth friendly taxation system are not implemented in society as they should. A striking example is the Russian Constitutional Court’s recent ruling which undermined the fundamentals of the Russian VAT taxation system by claiming that the VAT in expenses paid by using borrowed funds would not be deductible until the borrowed funds are repaid. This position was not supported by legislation (later the court was forced to admit the mistake and reversed the ruling). It is evident that the judges even in the Constitutional Court lack knowledge and experience of the market economy.

Another recent Constitutional Court decision ruled in favor of the tax authorities’ right to postpone field tax audits indefinitely and thus de facto extend the time period for tax audits, the duration of which is limited by law to two months. The court, with its decision of 16 July 2004, proclaimed that the “two months” means “the days of two months”, i.e. a total of 60 days over an indefinite time period. The question that unwillingly comes to mind is what do such resolutions have to do with the constitution and which constitution. These problems with court practice can well be seen as labor pains in the creation of a system producing justice. We remain convinced that courts and court practice will have a decisive and positive role in shaping the tax laws in Russia.

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