IT services VAT-able again!
Will it hit Lviv IT services providers?
During the last few years Lviv has become one of the most rapidly growing centres of the IT industry in Ukraine and has every chance to develop further in this direction.
Lviv is one of the regional leaders of the IT industry in Ukraine (along with Kharkiv and Kyiv) due to competitively priced labour, a high number of technically trained and skilled people, low cost of services and relatively-developed infrastructure. International demand serves as a trigger for Ukrainian (including Lviv) IT industry development. Local Ukrainian IT companies have also started to see more opportunities on the domestic market.
Hopefully the growing number of orders from foreign and local clients will drive competition among software companies, which in turn will strive to provide better quality products and services.
Not all IT players are happy
The recent changes to the VAT legislation (effective from 1 July 2011), have reinstated VAT for the local provision of IT related services. Frustrated IT business leaders claim that the change has resulted in a significant increase to the tax burden on the IT sector. Let us recap firstly how these services were taxed up to the implementation of the new 2011 Tax Code and also between 1 January and 1 July of this year. Up to 1 January 2011, IT services provided within Ukraine were subject to 20% VAT. If a Ukrainian entity provided services to a non-resident client, the services as a rule were not subject to Ukrainian VAT. However, there were still many questions of interpretation of the VAT Law provisions (i.e. which services in the area of IT fall within this category and which do not). As a result the tax authorities often challenged transactions where VAT was not charged.
At the beginning of 2011, with the implementation of the Tax Code and article 196.1.14 in particular, VAT exemption on the provision of certain intangible services (including those in the IT sphere) was enforced. This meant that certain IT related services — such as development, supply and testing of software, data processing and IT consulting became exempt from VAT regardless of whether they were provided to local clients or to non-residents.
All change after 6 months
These provisions were valid for six months only. On 1 July 2011, the Tax Code was amended and provision of the those services to local clients became VAT-able again, whilst provision of qualifying IT services to non-residents is still not subject to VAT (since the place of supply of such services is the recipient’s country, not in Ukraine). Removing a tax and then reinstating it within 6 months is not the best way to motivate business people to invest. But let’s consider if these changes really do have significant influence on the IT business.
Where Ukrainian IT companies export services to nonresidents — it can be said that in general there have been no changes. Both before and after 1 July 2011, such services were not VAT-able and the services provider has no right to VAT recovery related to this activity (VAT paid by a Ukrainian exporter on purchased goods e.g. office rent, purchase of fixed assets, Internet and telephone connections, stationery etc, is classed as an irrecoverable cost).
So what about local transactions? It is important to note that VAT is an indirect tax, included into the product or service selling price, and is ultimately borne by the final consumer. Generally, VAT should be neutral for VAT registered entities that are participating in the chain of transactions, as they simply pass it on down the line.
The mechanism of VAT assumes that the supplier adds VAT to his net sales prices. The cash collected from the gross sales price therefore comprises two elements — the supplier’s revenues from the sale (net value of services provided) and the VAT liability, which should be paid to the state. Let’s consider a simple example. A supplier sells his IT services for 100 plus 20 of VAT. He registers revenues of 100 and (assuming he does not have any purchases with VAT that can be offset) will need to pay the 20 VAT to the state. The purchaser who pays 120 for the services, (out of which 100 was the cost of services and 20 was the VAT) will be entitled to offset the 20 VAT paid to the supplier against his own VAT liabilities. Thus, the net cash cost for the purchaser is 100. Who will then pay the VAT? The answer is — the final consumer — the entity/person that is not registered as a VAT payer or is not entitled to a VAT credit. As you can see from the above example, for business to business IT sales transactions (assuming that all parties are VAT registered) the re-introduction of VAT does not impact the revenues or costs of the supplier and purchaser.
Who stands to lose from the reintroduction of VAT?
The re-instatement of VAT will increase the costs of obtaining VAT-able services for entities that cannot recover VAT, e.g. physical persons, tax payers under the simplified tax regime and financial institutions.
For majority of Lviv IT companies it is business as usual
It is well known that many Lviv IT companies provide various types of IT outsourcing for nonresidents i.e. export of services. In fact, nearly 80% of local IT companies are focused on the international outsourcing of products and services and only 20% are focused on local clients. As described above, the recent changes in the VAT legislation do not in practice change the treatment of exported IT services. Thus for 80% of Lviv IT companies it is business as usual.
IT exporters are not being encouraged enough
The other issue is that under Ukrainian VAT legislation, taxpayers cannot recover input VAT related to supplies, which are out of the scope of VAT (e.g. if the place of supply is not in Ukraine). As a result, Lviv businesses that are engaged in the provision of cross-border IT services have to bear higher (in comparison to other countries) costs related to the unrecoverable portion of VAT on their purchase of goods and services in Ukraine (input VAT). The value of the unrecoverable portion of the input VAT increases the overall cost of the provision of services and must be recovered either through higher pricing or smaller profit margins. This does not encourage the exporter of IT services to expand his business.
Ukraine not in line with Europe on VAT
The approach resulting from Ukrainian VAT regulations breaches the basic principles of the European VAT system. The right to deduct input tax is an integral part of the VAT scheme in the European Union, where the recovery of input VAT is granted if the incurred VAT relates to activities carried out (i.e. with the place of supply) outside the
EU Member State where that tax is due or paid and in respect of which the VAT would be deductible, if the activities had been carried out within that EU Member State. During this year, discussions between the government and IT associations have resulted in several new initiatives –— a draft law on the provision of tax holidays for the IT industry and a specific draft law on IT technologies etc. PwC is also involved in the newly founded Domestic and
Foreign Investors’ Advisory Council and through its high technology working group has the ear of the President who is keen to support successful innovative businesses. Lviv’s export-oriented IT industry is in a strong position to earn badly needed foreign currency. We hope that cooperation between government and business will continue to develop and that there will be agreement on the need for more progressive changes in the VAT laws, aimed at allowing VAT recovery to Ukrainian exporters of innovative services to non-residents.
Svitlana Serba (firstname.lastname@example.org) is a Junior Consultant at PricewaterhouseCoopers, employed within the Tax & Legal Services Department. She specialises in payroll, tax management and accounting.
Magdalena Patrzyk (email@example.com) is a Senior Manager at PricewaterhouseCoopers with Tax and Legal Services practice in Ukraine. She is in charge of the Tax Management & Accounting Services team. For almost 3 years Magdalena has managed and developed PwC Lviv office, focusing on provision of tax advisory and legal services to clients in the West Ukraine region.