Will tax reforms help or hurt Ukraine’s growing information technology sector?
This question is on the mind of most tech professionals and the companies that employ them, as the government again considers taxation changes that will affect most of the industry.
Millions of Ukrainians work as “individual entrepreneurs,” which allows them to pay a low, simple tax rate of 5% on their work income. And according to a survey by the industry publication DOU, almost 90 percent of IT earnings go to private entrepreneurs.
Alternatively, regular employees pay a 19.5% tax on their work income, while their employers pay an additional 22% tax on the gross salary.
In many cases, individual entrepreneur status makes sense. Many IT specialists have flexible conditions, do work for multiple employers, or develop their own projects.
However, it also opens up the segment for abuse by companies, when a big firm hires programmers as if they are simple employees but, then, asks them to register as individual entrepreneurs to save on taxes.
And as the legality of using individual entrepreneurs is ambiguous, it creates a tax risk: law enforcement agencies can use it as a reason to conduct searches of IT firms, which makes room for corruption and thus discourages foreign investors.
Hence, plans to change how individual entrepreneurs are taxed have been in the works for years. There has always been a challenge of how to separate actual individual entrepreneurs from those who simply uses this status to save their companies’ money.
“Every time a new administration comes to power, they say let’s change IT taxes,” said Kira Rudyk, the deputy chair of the Verkhovna Rada Committee on Digital Transformation and head of the working group on IT tax reform.
According to the Ministry for Digital Transformation, a total of 158 individual entrepreneurs and 59,806 employees worked for 15,423 employees in the first six months of 2019.
A controversial bill to place individual entrepreneurs in IT into a new, higher tax category failed in the previous parliament: it was widely criticized by the industry players.
Hence, more recently, the parliamentary committee on digital transformation and the Ministry of Digital Transformation have started working on several alternatives, including yet another tax category or a restructuring of payroll taxes for companies.
Although no changes are expected to take place until the start of 2021 at the earliest, many IT professionals are already worried about how these reforms would be implemented. If mishandled, the changes will, at best, have no effect, and at worst, torpedo the sector’s growth, driving companies and top talent overseas.
And ensuring the industry’s growth, according to Rudyk, is the government’s top priority.
Pros and cons
While the low simple tax rate for individual entrepreneurs encourages business, it’s often applied in an inconsistent, ambiguous way.
Most regular full-time employees in the IT industry are listed as individual entrepreneurs, which lets companies get out of paying higher taxes but also avoid employer obligations.
“There is huge abuse here, like our own internal offshore,” said Constantin Solyar, a tax partner at law firm Asters. “In many cases, it’s hidden employment.”
Roman Kachanovskyi, a lawyer who works for IT professionals, said that many of them don’t fully understand tax law and are shepherded into the individual contractor role by the companies that employ them.
Others enjoy the simplified 5% tax rate and support it. For many, it’s a reason not to join the steady stream of professional emigres leaving the country.
The system helps foreign companies hire local talent, overrides some downsides of doing business in Ukraine and helps with flexible working conditions. For many, individual entrepreneurship is the best way to go.
Still, the gray area of using individual entrepreneurs as employees presents a huge tax risk — tax authorities could crack down at any moment. This discourages investment from top firms that are strict on compliance and already cautious about Ukraine’s weak court system.
“A significant number of investors interested in the Ukrainian tech sector refuse to participate in investment rounds upon finding out that employment structure involves individual entrepreneurs,” Volodymyr Kryvko, managing partner of Chernovetskyi Investment Group, wrote in an email.
“At the same time, some companies remain profitable only by using individual entrepreneurs and their liquidation will significantly decrease their marginality.”
Industry caution
Industry representatives have also cautioned that over-eager changes that raise effective tax rates may cause the industry to pack up and leave.
Konstantin Vasyuk, the executive director of the industry association IT Ukraine, wrote in an email that total tax burden on IT companies’ payroll funds should not exceed 10–12%.
“If tax fees for IT professionals in the simplified tax system change upward, Ukraine will become uncompetitive on the international IT market,” Vasyuk wrote.
Denis Belozorov, who remotely configures computers and websites, said that a simplified tax system enables him to work legally. He is worried about possible changes that may make it harder for him to make a living.
“Now we have begun to feel some kind of instability,” he said. “I have not felt this since 2009, when I registered as an entrepreneur.”
According to Belozorov, when monthly income is between $500 and $1,000, even a 5% tax increase is significant.
Many IT professionals distrust the government’s plans to reduce reliance on individual entrepreneurs and fear that higher taxes would go into officials’ pockets.
Yulia Sychikova, the chief operating officer at big data solutions company DataRoot Labs, said had it not been for low taxes, mobile tech professionals would have preferred another country to Ukraine.
“Engineers can work from anywhere, the low taxes have actually stimulated many people to stay here,” she said.
Sychikova heard some outrageous stories of what people are willing to do to avoid taxation, including moving full time to other countries or spending 180 days per year on a boat in international waters.
According to her, outsource companies usually have 15% profits and every percent tax increase hurts that margin.
“That being said,” Sychikova said, “I think that Ukrainians and the IT sector as well have to understand that at some point, they have to pay taxes. We have to grow up a little and not compete just on price.”
Creating new tax group
Officials told the Kyiv Post that they hope to propose tax changes before the year ends. But then, it might take at least a year for the changes to come into force.
Ukraine’s State Tax Service splits entrepreneurs into four groups depending on their revenues and line of work. The third group is the simplest and most numerous. Private entrepreneurs registered in the third group pay a 5% revenue tax and a social tax of $360 per year.
Rudyk said that her committee is working on several versions of a new tax structure for IT, to help do away with the ambiguity of the third group and reduce the tax risk. One option is to create a fifth group encompassing existing companies that work with individual entrepreneurs; it would have its own tax rate.
Aleksandr Bornyakov, the deputy minister of digital transformation in charge of developing the IT sector, said that he is not a fan of this method because it’s “just another employer-entrepreneur relationship, not too different from the previous attempts.”
The bill that failed in August, for example, would also have create a fifth group, although it was structured differently. The idea of a fifth group highly unpopular, with 80% of IT experts rejecting it outright, according to a DOU survey.
While officials said that this fifth group would be voluntary for companies, 91 percent of surveyed IT professionals believe that everyone will be forced to switch. Kachanovskyi believes this will most likely be done indirectly.
Taxing enterprises
Another possible method would be to stimulate companies into incorporating in Ukraine and switching their labor force from entrepreneurs to employees, according to Rudik. This could improve investment but has major difficulties in making foreign companies register in Ukraine.
The challenge is how to provide a strong enough incentive, as the gap between individual entrepreneur and employee taxes is extremely large. Legal professionals believe that the state must reduce that gap before meaningful reforms can be effected.
Bornyakov envisions a plan to replace a tax on individual employees’ paychecks with a unified tax, which would be lower than the current payroll taxes. Smaller enterprises and companies would get to keep their individual entrepreneur model, but larger firms would need to restructure and use employees.
The exact cutoff has yet to be determined. Bornyakov suggested that companies might apply to use individual entrepreneurs if their payroll expenses are above 60% and if 70% of their revenue comes from abroad.
He added the law would leave the actual individual entrepreneurs alone and they would continue to enjoy the same tax rate.
Lawyer Solyar said that this kind of “group” tax model for a company’s total income is used in more sophisticated economies. However, those economies also have sophisticated incentives, which are absent in Ukraine.
