Defence City: a new era in the development of Ukraine’s defence industry

Why is this important?

Since the start of the full-scale invasion, Ukraine’s defence industry has faced numerous internal and external challenges. Access to combat-tested technologies and an accelerated development cycle due to active hostilities has undoubtedly given Ukrainian weapons manufacturers a competitive edge.

At the same time, exporting military technology and products has been complicated by the requirement to obtain permits from the State Export Control Service. This process was cumbersome and lengthy – typically taking 6 to 18 months – which often rendered the exports obsolete due to the fast pace of modern warfare. Drone manufacturers suffered the most. These restrictions discouraged investors, limiting financial inflows to young defence companies.

The new changes are designed to simplify the export of military goods and provide tax incentives to defence companies, which will encourage them to develop their own businesses. We are confident that these changes will have a positive impact creating a more favourable investment climate across the industry.

What is defence city?

Defence City is a special legal regime for businesses in the defence industry operating in Ukraine, aimed at creating favourable conditions for the development of Ukraine’s defence industry and attracting investment in the defence industry.

Defence City extends its effect to its residents – legal entities listed in Defence City Register, provided that they comply with the special conditions established by the Tax Code of Ukraine, the Customs Code of Ukraine, the Law of Ukraine “On National Security of Ukraine” and other laws and regulations.

What does Defence City offer?

Defence City offers substantial procedural easements and tax benefits for its residents, provided they meet certain obligations to support growth and scale of the company.

• Export of Military Goods

Residents of Defence City gain the right to export military goods without prior authorization from the State Export Control Service, as otherwise required under Article 13 of the Law “On State Control over International Transfers of Military and Dual-Use Goods.”

• Corporate Income Tax Exemption

To qualify for exemption from corporate income tax, a company must file a request with the tax authority. However, it may not simultaneously be a Diia City resident or distribute dividends, except when dividends are paid to the state or an entity 100% owned by the state.

Profits exempt from taxation must be reinvested into business development – such as infrastructure, facilities, intellectual property, R&D, or corporate rights – by the end of the calendar year following the year in which the profits were earned.

Failure to use tax-exempt profits as required results in taxation on the unused portion. Companies may also lose the exemption if they violate the law or lose Defence City resident status. In such cases, taxes are retroactively applied from the start of the reporting period.

Resident may submit an application for termination of income tax exemption, but this option becomes available only after the end of the next calendar year following the start of the tax exemption, i.e. after two years.

• Land and Property Tax Exemption

Residents are exempt from land tax starting the month after gaining residency, applicable to (1) land plots with production facilities used in resident’s business activities; (2) land temporarily unused due to relocation, provided it is not transferred to third parties.

Exemption from property tax applies to (1) real estate in relocation zones, provided it is not leased and is used for resident’s operations or employee housing; (2) “Industrial and warehouse buildings” (Code 125 under the 2023 Building Classifier) that are unused during relocation and not transferred to third parties.

• Environmental Tax Exemption

Residents are exempt from environmental tax starting the reporting period after gaining residency and until the period in which residency ends.

Can a company be both a Diia City and Defence City resident?

A legal entity may be a resident of both Defence City and Diia City at the same time. However, dual residents cannot claim exemptions from income tax, land tax, property tax, or environmental tax.

Additionally, such companies must pay personal income tax (PIT) on employee salaries at the standard 18% rate, instead of the 5% rate for Diia City-only residents. They also lose eligibility for reduced social security contributions applicable for Diia City-only residents.

Who can become a resident?

Defence City residents may become (1) companies whose qualified income accounted for at least 75% during the previous calendar year; (2) aircraft manufacturers whose qualified income accounted for at least 50% during the previous calendar year.

Qualified income is considered to be income from the sale of domestically produced defence goods, the performance of work and/or the provision of services for the development, manufacture, repair, modernization, or disposal of defence goods, and other income directed toward the production and supply of defence goods.

Qualified income also includes income received by a subcontractor of a Defence City resident in the course of joint/subcontracting a government contract, in terms of income from materials used to manufacture defence goods. To include such income in qualified income, confirmation from the relevant government customer is required.

Defence goods include weapons, military and special equipment (drones, electronic warfare and reconnaissance systems, counter-intelligence devices), arms, and ammunition.

A company cannot be a resident if it:

1. is not registered in Ukraine;
2. is not a VAT payer;
3. has outstanding tax or social contribution debts;
4. is listed as a non-profit entity;
5. fails to disclose UBO and did not remedy such violation;
6. is on the sanctions lists or has ties to russia, e.g. participant/UBO is russian resident;
7. has breached its obligations under a government contract for defence procurement within the last 12 months, as established by a court, resulting in the termination of such contract or the imposition of penalties, except in cases where the company voluntarily complies with such court decision;
8. is in bankruptcy proceedings; or
9. operates in temporarily occupied territories.

How to become a resident?

Residency is granted upon a decision by the MoD and entry into the Defence City Register, following submission of an application filed to MoD. The application review period is 10 working days.

Applications must include:

1. a compliance report with appendices;
2. supporting documents defined by the Cabinet of Ministers.

The compliance report must confirm:

• absence of disqualifying circumstances under Article 37 of the Law “On National Security of Ukraine”;
• applicant’s qualified income share;
• fulfilment of contracts supporting the qualified income level.

Attachments must include annual financial statements and an auditor’s report on the results of the compliance report audit.

The procedure and method for applying for Defence City resident status and accompanying documents will be determined by the Cabinet of Ministers of Ukraine.

What to expect now?

The signing of this law marks the beginning of a new era for Ukraine’s defence industry. These reforms aim to protect and stimulate the sector, develop domestic defence production, and establish the industry as a key driver of the economy in the post-war period.

In the near future, we expect:

1. adoption of numerous regulations ensuring smooth operation of the Defence City;
2. growth in investment in Ukraine’s defence industry;
3. expansion and localization of defence production;
4. increased investor interest in established defence companies, which can now gain residency and export military goods without export control authorization;
5. significant growth in exports of UAVs and other military products to the EU and the US;
6. rising interest in relocating defence enterprises due to ongoing russian aggression.