The Proposed Amendments to the RF Tax Code will Complicate the Relationship between the Federation and its Subjects
In late October of this year the Draft Federal Law "On Amendments to Part II of the Tax Code of the Russian Federation" (Bill No. 157491-6) 1 was submitted for review to the State Duma. It proposes to provide complete exemption from all federal taxes to the Russian organizations, incorporated in the Subjects of the Far Eastern Federal District, as well as to individuals - citizens of the Russian Federation, permanently residing, registered and engaged in business as individual entrepreneurs in those Subjects.
There are eight federal taxes and levies in the effective tax legislation: value added tax, excise taxes, personal income tax, corporate income tax, MET, water tax, levies for the use of fauna objects and aquatic biological resources, state fees (Article 13 of the Tax Code).
In view of the draft law authors, these measures are needed primarily for the economic support of the Far East, enhancement of local inhabitant’s well-being, as well as settlement of problems related to the low-population areas. It is assumed that the favorable tax environment will attract Russian citizens from other regions to the Subjects of the Far Eastern Federal District. The District includes nine Subjects of the Russian Federation: Republic of Sakha (Yakutia), Kamchatka Krai, Primorsk Territory, Khabarovsk Krai, Amur Region, Magadan Region, Sakhalin Region, Jewish Autonomous Region and Chukotka Autonomous Okrug2.
The idea of the draft law authors looks inappropriate, since total exemption of federal taxes and levies payers and in some Subjects of the Russian Federation creates unfair competitive conditions to the taxpayers of all other RF Subjects , which is inconsistent with the basic principles of taxation and involves significant increase in the cost of tax administration and compliance enforcement.
The Russian tax system is based on the principles of universality and equality of taxation, stipulated in Section 1, Art. 3 of the RF Tax Code. The first principle does not allow exclusion of any taxpayer from financing of public spending, and the second one means equality of all taxpayers before the law. The adoption of measures foreseen in the new draft law would inevitably disrupt those principles, which in turn, will affect the neutrality, fairness and efficiency of taxation.
The adoption of the bill will give rise to a domestic offshore zone, i.e., a territory with not only extremely beneficial tax regime, but with restrictions for control over activities of registered tax entities, exacerbated by the unlimited range of proposed tax exemptions. Thus, the organizations will be granted tax exemptions by the mere fact of registration in one of the Subjects of the Far Eastern Federal District. For individuals, there is a requirement of permanent residence in the Far East, but the bill does not specify, how this requirement should be met in practice, and provides no mechanism for control thereof. There is a requirement to carry out business in the territory only with respect to individual entrepreneurs. However, this requirement may be insufficient, as being engaged in business activities in different federal districts, the share of activities in the Far East can be minimal against the total business scope and can be used by a taxpayer as a cover only to minimize tax liabilities. Therefore, the proposed draft law is rather declarative, and moreover, it needs technical refinement.
Opportunities for tax avoidance and evasion arise out of the fact that persons who are not regarded as taxpayers (e.g., in regard to VAT and corporate income tax), in fact are not subject to tax audits. Herewith, the entities not exempt from taxes may enter into transactions with the exempt ones, registered in the Far East, in order to accumulate the tax base with the latter and reduce the their own tax liabilities. To prevent such actions of taxpayers, the government needs to imply a total control over transactions’ prices, which would require a substantial expansion of tax authorities staff and lead to excessive administrative costs.
In addition, it is possible that in the event the discussed bill is approved, the Far East will be turned into a perfect place for one-day businesses, which will be created for the purpose of tax evasion by the entities whose activities are not engaged in the region development in any way. Extension of this process may result in deterioration of the investment climate not only in the Far Eastern Federal District, but countrywide. This is explained by the situation, when the competitiveness of some entities is maintained by unfair minimization of their tax liability, while other compliant taxpayers are found in an adverse business environment. Along with increased risk of potential disputes with tax authorities and court proceedings in case of selective law enforcement, it will reduce the incentives for business projects implementation in our country.
At the same time, there is an inconsistency in the measures proposed in the draft law, as the number of MET-exempt taxpayers is virtually unlimited. This is due to the fact that tax exemption is proposed to be granted on the basis of mineral production location, namely, its location in the territory of the Far Eastern Federal District Subjects. As a result, correlation of tax exemption with the economic support of the Far East becomes formal: production can be performed by the entities registered in any other Federal Subject outside the above district, so the measure targeting is lost. The same applies to the water tax.
It is important to note that the selective reduction of the tax burden will undermine the competitiveness of the taxpayers who apply regular tax regime. At the same time, competitiveness of exempt taxpayers, dealing with suppliers and customers - VAT payers will be reduced as well. The latter will not be able to refund the value added tax, wherefore they will be looking for other suppliers, not subject to VAT exemption. Herewith, failure of tax exempt entities to refund input VAT will involve higher prices for their products as a result of inclusion the tax in the costs.
Moreover, unequal taxation complicates relations between the Russian Federation and its Subjects. A number of other regions not granted similar support, will apparently demand tax benefits from federal government, referring to the unfairness of selective tax policy applied in other regions. Therefore, the bill adoption is likely to inspire new legislative initiatives of this type from the Subjects of other federal districts, and not only from the regions with a really low budget provision.
From the standpoint of the government, the adoption of the bill under consideration is impractical also in view of significant losses of tax revenue3. Herewith, the mechanism of compensation is not provided. This means that the government will be forced to cut down funding of budget expenditures by the amount of those losses. As you know, tax revenue is a source of financing social needs, and in this sense the f tax revenue reduction will affect the population. If in order to compensate for lost revenue the decision is made to raise taxes in other federal districts, this in turn will hit not only population, but businesses as well, and will only aggravate the conditions of economic activities in the country.
However, even in the case of adoption of these measures one should not forget, they should be temporary and sooner or later have to be cancelled. This can provoke a number of events that have a negative impact on the economic situation in the Far East. Thus, the taxpayers who are used to work in extremely favorable tax environment, after the benefits abolishment will be unprepared to do business under regular conditions, including competition resistance. Some taxpayers will choose shady schemes to reduce the tax burden. Others, unable to bear the increased tax burden, will be forced to close business. As a result, the state will get entrapped by its own actions, because their abolishment would mean a sharp downfall of economic attractiveness and reputation of the Far East region.
The outstanding problems need to be resolved, but not in contradiction with the basic principles of taxation.
V.V. Gromov, Senior Researcher of Tax Policy Department
1Ref.: http://asozd2.duma.gov.ru/main.nsf/(ViewDoc)?OpenAgent&work/dz.nsf/ByID&A86FB3423D5D184F43257AA00049F575.
2 It is worth noting that there is apparently a mistake in the draft law, because the Kamchatka Krai is called the Kamchatka Region.
3 According to the feasibility study of the draft law (ref: http://asozd2.duma.gov.ru/main.nsf/(ViewDoc)?OpenAgent&work/dz.nsf/ByID&B49D888F3A80709843257AA0004A1B14), the country will lose Rb 40m annually. However, this figure looks underestimated, because it does not account for the loss from tax avoidance and evasion by entities not directly engaged in business in the Far East, but those dealing with tax exempt entities. Herewith, the said amount of losses is assessed on the basis of the fixed number of entities registered in the Far East. In the event the number of the later is extended, the amount of uncollected taxes will be increased as well.
In view of the draft law authors, these measures are needed primarily for the economic support of the Far East, enhancement of local inhabitant’s well-being, as well as settlement of problems related to the low-population areas. It is assumed that the favorable tax environment will attract Russian citizens from other regions to the Subjects of the Far Eastern Federal District. The District includes nine Subjects of the Russian Federation: Republic of Sakha (Yakutia), Kamchatka Krai, Primorsk Territory, Khabarovsk Krai, Amur Region, Magadan Region, Sakhalin Region, Jewish Autonomous Region and Chukotka Autonomous Okrug2.
The idea of the draft law authors looks inappropriate, since total exemption of federal taxes and levies payers and in some Subjects of the Russian Federation creates unfair competitive conditions to the taxpayers of all other RF Subjects , which is inconsistent with the basic principles of taxation and involves significant increase in the cost of tax administration and compliance enforcement.
The Russian tax system is based on the principles of universality and equality of taxation, stipulated in Section 1, Art. 3 of the RF Tax Code. The first principle does not allow exclusion of any taxpayer from financing of public spending, and the second one means equality of all taxpayers before the law. The adoption of measures foreseen in the new draft law would inevitably disrupt those principles, which in turn, will affect the neutrality, fairness and efficiency of taxation.
The adoption of the bill will give rise to a domestic offshore zone, i.e., a territory with not only extremely beneficial tax regime, but with restrictions for control over activities of registered tax entities, exacerbated by the unlimited range of proposed tax exemptions. Thus, the organizations will be granted tax exemptions by the mere fact of registration in one of the Subjects of the Far Eastern Federal District. For individuals, there is a requirement of permanent residence in the Far East, but the bill does not specify, how this requirement should be met in practice, and provides no mechanism for control thereof. There is a requirement to carry out business in the territory only with respect to individual entrepreneurs. However, this requirement may be insufficient, as being engaged in business activities in different federal districts, the share of activities in the Far East can be minimal against the total business scope and can be used by a taxpayer as a cover only to minimize tax liabilities. Therefore, the proposed draft law is rather declarative, and moreover, it needs technical refinement.
Opportunities for tax avoidance and evasion arise out of the fact that persons who are not regarded as taxpayers (e.g., in regard to VAT and corporate income tax), in fact are not subject to tax audits. Herewith, the entities not exempt from taxes may enter into transactions with the exempt ones, registered in the Far East, in order to accumulate the tax base with the latter and reduce the their own tax liabilities. To prevent such actions of taxpayers, the government needs to imply a total control over transactions’ prices, which would require a substantial expansion of tax authorities staff and lead to excessive administrative costs.
In addition, it is possible that in the event the discussed bill is approved, the Far East will be turned into a perfect place for one-day businesses, which will be created for the purpose of tax evasion by the entities whose activities are not engaged in the region development in any way. Extension of this process may result in deterioration of the investment climate not only in the Far Eastern Federal District, but countrywide. This is explained by the situation, when the competitiveness of some entities is maintained by unfair minimization of their tax liability, while other compliant taxpayers are found in an adverse business environment. Along with increased risk of potential disputes with tax authorities and court proceedings in case of selective law enforcement, it will reduce the incentives for business projects implementation in our country.
At the same time, there is an inconsistency in the measures proposed in the draft law, as the number of MET-exempt taxpayers is virtually unlimited. This is due to the fact that tax exemption is proposed to be granted on the basis of mineral production location, namely, its location in the territory of the Far Eastern Federal District Subjects. As a result, correlation of tax exemption with the economic support of the Far East becomes formal: production can be performed by the entities registered in any other Federal Subject outside the above district, so the measure targeting is lost. The same applies to the water tax.
It is important to note that the selective reduction of the tax burden will undermine the competitiveness of the taxpayers who apply regular tax regime. At the same time, competitiveness of exempt taxpayers, dealing with suppliers and customers - VAT payers will be reduced as well. The latter will not be able to refund the value added tax, wherefore they will be looking for other suppliers, not subject to VAT exemption. Herewith, failure of tax exempt entities to refund input VAT will involve higher prices for their products as a result of inclusion the tax in the costs.
Moreover, unequal taxation complicates relations between the Russian Federation and its Subjects. A number of other regions not granted similar support, will apparently demand tax benefits from federal government, referring to the unfairness of selective tax policy applied in other regions. Therefore, the bill adoption is likely to inspire new legislative initiatives of this type from the Subjects of other federal districts, and not only from the regions with a really low budget provision.
From the standpoint of the government, the adoption of the bill under consideration is impractical also in view of significant losses of tax revenue3. Herewith, the mechanism of compensation is not provided. This means that the government will be forced to cut down funding of budget expenditures by the amount of those losses. As you know, tax revenue is a source of financing social needs, and in this sense the f tax revenue reduction will affect the population. If in order to compensate for lost revenue the decision is made to raise taxes in other federal districts, this in turn will hit not only population, but businesses as well, and will only aggravate the conditions of economic activities in the country.
However, even in the case of adoption of these measures one should not forget, they should be temporary and sooner or later have to be cancelled. This can provoke a number of events that have a negative impact on the economic situation in the Far East. Thus, the taxpayers who are used to work in extremely favorable tax environment, after the benefits abolishment will be unprepared to do business under regular conditions, including competition resistance. Some taxpayers will choose shady schemes to reduce the tax burden. Others, unable to bear the increased tax burden, will be forced to close business. As a result, the state will get entrapped by its own actions, because their abolishment would mean a sharp downfall of economic attractiveness and reputation of the Far East region.
The outstanding problems need to be resolved, but not in contradiction with the basic principles of taxation.
V.V. Gromov, Senior Researcher of Tax Policy Department
1Ref.: http://asozd2.duma.gov.ru/main.nsf/(ViewDoc)?OpenAgent&work/dz.nsf/ByID&A86FB3423D5D184F43257AA00049F575.
2 It is worth noting that there is apparently a mistake in the draft law, because the Kamchatka Krai is called the Kamchatka Region.
3 According to the feasibility study of the draft law (ref: http://asozd2.duma.gov.ru/main.nsf/(ViewDoc)?OpenAgent&work/dz.nsf/ByID&B49D888F3A80709843257AA0004A1B14), the country will lose Rb 40m annually. However, this figure looks underestimated, because it does not account for the loss from tax avoidance and evasion by entities not directly engaged in business in the Far East, but those dealing with tax exempt entities. Herewith, the said amount of losses is assessed on the basis of the fixed number of entities registered in the Far East. In the event the number of the later is extended, the amount of uncollected taxes will be increased as well.