Production potential on the EU’s doorstep

  • Production potential   on the EU’s doorstep
Issue 34, April 2011.

Any room to maneuver? Serhiy Verlanov of PwC Ukraine’s Lviv office explores toll manufacturing in Ukraine.
Toll manufacturing – the practice of employing companies to process raw materials or semi-finished goods – has proved particularly suited to the modern Ukrainian economy. There are approximately 100 enterprises in the  Lviv region alone which engaged in toll manufacturing operations in wide range of sectors including automotive and electronic, clothing and footwear, medical equipment and other industries. It is worth analysing what causes them to act in this a way.

Attractive legislation and tax breaks

In general, there are several factors that lead an investor to opt for the  toll manufacturing model. First and foremost, the relevant Ukrainian legislation governing the toll manufacturing sector establishes relatively straightforward and realistic requirements for such structures. Additionally, the current Ukrainian toll scheme grants a VAT and Customs duty exemption
for the import of raw materials, which allows the investor to avoid the pitfalls of the country’s controversial VAT refund system, which is widely seen by international investors as one of the most critical issues facing the Ukrainian economy. As well as legislative convenience, one of the key factors driving the growth of toll manufacturing in Ukraine is the relatively low production costs, including salary expenditures, which the country’s labour market can offer. At the same time, there is also a sufficient quantity of potential employees who are well educated and highly motivated.

Ideal geographical location on the EU’s doorstep

Furthermore, the industry is undoubtedly benefiting from Ukraine’s advantageous geographic situation. This is particularly relevant when considering the growth of toll manufacturing throughout the Western Ukraine region, which lies directly along the eastern borders of the European Union. This factor allows companies to minimize their logistics and transportation costs - a crucial factor in any business plan at present given the fluctuating cost of fuel and the geopolitical instability in the world’s oil-producing regions. Driven by the potential gains to be made by this favourable geopolitical location, some international investors have gone so far as to locate their production facilities within a few kilometres of the EU border. Other investors
have simply relocated their production facilities from Poland and Slovakia to the Lviv region.

Who qualifies as a toll manufacturer?

However, there are still some issues relating to toll manufacturing which remain quite problematic. One of the key requirements for a company to qualify for toll manufacturer status is that the codes of raw materials imported to Ukraine should be different from the code of the finished goods to be exported under the Customs Tariff according to the law of Ukraine. Although this Tariff code was amended and unified back in 2007, there are cases when
assembling of spare parts does not lead to the production of goods with a code different from their individual parts. These operations struggle to gain classification as toll manufacturing and are instead generally labelled as assembling operations – which raises the question of whether they can also benefit from the toll regime. In addressing this question, we would propose to look into one particular scenario which is quite a hot topic today. The investor in question, a producer of electronics for ‘green energy’ needs, is looking to establish a company in Ukraine for manufacturing special electronic devices. It is planned that the Ukrainian company will import raw materials including the various parts of the device (its main components) and some additional components, and then assemble them, producing a complete electronic device ready for export to cus-tomers in Europe. For manufacturing purposes, the Ukrainian company would also purchase and import the appropriate equipment to Ukraine. Initially, the investor planned to structure manufacturing in Ukraine under the country’s existing toll-manufacturing arrangements. As we noted, according to Ukrainian
legislation, raw materials imported under tolling arrangements can only be exempt from customs duty and VAT provided that conditions established by Ukraine’s Toll Manufacturing Law are met ( i.e. the codes of finished goods should be different from those of their raw materials). However, according to the Ukrainian Customs Tariff, the main component of the raw materials is classified under the same tariff code as the finished product, and therefore in this example one of the criteria of the Toll Manufacturing Law would inevitably not be met. In such cases the investor might have to consider other options including importing equipment and raw materials with exemptions from customs duty and VAT. Investors would be well advised to look into the options for equipment import. The classic choice is to import the equipment as an in-kind contribution into the statuary capital of the future Ukrainian subsidiary. Another option is to import the equipment under the provisions of the Ukrainian Tax Code as “equipment, machinery, spare parts, etc. used for the manufacturing of equipment for the production of alternative energy.” However, there are several special permits that should be obtained which would entail a burdensome and timeconsuming process.

The Tax Code and raw material imports

There are several options for importing raw materials. In addition to the aforementioned option under the Tax Code, raw materials can also be imported under provisions of the Code concerning goods imported for manufacturing purposes. Another method is to import within the provisions of Resolution of the Cabinet of Ministers of Ukraine No. 1524 dated 17 November 2004 as goods imported for “assembling and mounting.” Finally, an investor could import raw materials into the Special Economic Zones situated in Western Ukraine. In this case, the future investment project should be duly registered with the local authorities in the respective zone.

Finding the right balance for each individual investment

Considering the above, the general conclusion is that current Ukrainian legislation provides some room for maneuver. Whichever option or combination of options is best for each individual investor is subject to a case-by-case analysis. Any analysis must aim at identifying the most optimal option for importing components and equipment into Ukraine in order to secure maximum exemptions from customs duty and VAT in accordance with effective legislation. The investor also needs to evaluate the feasibility of each option and provide practical recommendations for their implementation. Finally, during any process of analysis the investor may want to approach the relevant Ukrainian authorities in order to obtain their clarifications and explanations.

Serhiy Verlanov is an Attorney at the PwC Ukraine Lviv office. Serhiy specialises in tax litigation and is an active participant of EBA legal, tax and customs committees and working groups