The new ambitious project of the Ukrainian government “Diia City” has been presented in the summer of this year as a concept of a special legal framework for the IT industry. The initiative was reflected in several draft laws, but some have been rejected already. Currently draft law #4303 with its alternative versions #4303-1, #4303-2 is on the agenda.
The government declares beneficial taxation, updated labor regulations and flexible rules of business with individual entrepreneurs (‘IE’). The documents aim to create transparent rules for the IT business and address its sensitive issues.
In general, it is a great idea, the implementation of which may rocket up IT business development and create a unique IT hub in Ukraine. Draft laws have prompted heated debates between industry stakeholders and the government. IT businesses share the sentiment that Diia City is a necessity for the industry, but implementing the draft laws neither suffice needs of the Ukrainian IT business, nor do they measure up to foreign competing projects.
Diia City is the name for the special legal framework that will apply for at least 15 years nationwide to Ukrainian IT companies. Any Ukrainian company carrying out IT economic activities will be able to join Diia City voluntarily by following a simple registration procedure. However, the candidates will have to meet eligibility criteria.
Some residency requirements, such as to pay average monthly salary of USD 1400 to IT sta ff and to have 90 % of the income flowing from IT business activities only, could not be met by many companies. New companies and subsidiaries of international corporations will be turned down for residency, because they could not afford or their business model will not allow them to meet the requirements, although some special rules for startups are prescribed.
Other requirements were for a salary to be 70 % of the product’s cost and for companies to have up to 70 % of export profits since the 2nd year of residency in Diia City. These requirements raised legitimate concern in the IT industry, and later were dropped by the government. IT businesses pointed out that companies developing the product could meet such criteria, but businesses with fully-fledged and completed products will find it difficult. The cost of salary will no longer be the major part of the product’s price after development. Instead, companies will spend more on marketing and support. As for the export profits, the government proposed a very short time span, especially for startups, to find new markets and to capture a market share significant enough to achieve the export threshold.
One of the major concerns of the industry is that a regulator with overly broad powers may be created. The draft laws feed those worries, for instance, by making intricate criteria for residency in Diia City. For example, the authority in charge will have discretion to determine additional characteristics of IT economic activities, which a resident should carry out. In fact, this gives them the power to decide on the eligibility of certain candidates, which may pose risks of corruption and preferential treatment.
In addition to the power to decide who can be a resident, the authority also may get the right to oust ineligible residents from Diia City. Residents, apart from requisite IT economic activities, will be allowed to carry out transactions facilitating their primary business, for example, advertising and M&A. However, that list of transactions is not exhaustive, so there is no clarity on prohibited transactions. At the same time, authorities will be able to define transactions that are incompatible with resident status. Thus, there will be the risk for a resident to be struck off from Diia City on obscure legal grounds at any time.
Regulators’ powers and red tape have always been a problem for businesses in Ukraine. IT businesses should be able to plan long-term, be flexible in business strategies and not to turn their operations into a compliance minefield.
Currently it is unclear what will be the new tax regulations for the Diia City residents, as there is still no draft law linked to #4303. The new tax amendments are yet to come. However the previous drafts #3933 and #3933-1 were not warmly welcomed by the industry.
The pivot of Diia City is supposed to be a lower tax burden for IT companies. The proposals for companies are the lower corporate income tax for all residents at 9 % or to have the same tax only on certain resident’s income at 18 %. Currently business has the opportunity to use limited liability companies registered as a “Single Tax” payers (3% or 5%) to structure their business. Hence, the proposed tax on corporate income is unlikely to impress investors and incentivize them to join Diia City.
The other part of the new mode is taxes on salaries. It is common knowledge that the IT business mostly works with individual entrepreneur contractors registered as a “Single Tax” payers. The tax burden (social security contribution included) on remunerations for contractors is around 7. 5 % versus 41. 5 % on employee’s wages. The new mode offered a lower personal income tax and lower unified social contribution, however the overall tax burden for salary constitutes approximately 19% (Draft Law #3933) or 15% (Draft Law #3933-1), which still concedes to current tax benefits of working with contractors.
In summary, it is obvious that the government shall propose conditions better or at least not worse in order to get the IT business interested.
Contracting with individual entrepreneurs
The IT industry has expected sound rules for dealings with IEs from the Diia City framework. But t he draft laws are silent on the changes in contracting with IEs. Thus, on the one hand, the residents of Diia City will be able to contract IEs as usual under the civil law contracts.
On the other hand, hidden obstacles for contracting with IEs may occur, as we could see from tax draft laws #3933 and #3933-1. For instance, the draft law #3933-1 proposed an additional 18% tax to any payment to an IE who is a “Single Tax” payer (5%) made by a Diia City resident, which makes no economic sense for further cooperation with IEs.
The draft laws introduce a new instrument for Ukraine — gig contracts. Engaging gig-contractors ought to replace contracting with IEs. Gig-contracts will be designed for a natural person, who is not IE, to perform certain tasks or complete projects under the contract in which the parties will determine the majority of conditions.
In essence, a gig-contract will be a civil law contract that has some characteristics of employment contracts. For example, it can be concluded for an indefinite term, the working hours shall not exceed 40 hours per week unless the contractor works flexible or irregular working hours, and the gig-contractor will be entitled to sick leave pay.
Although the gig contracts concept is a great idea, the proposed regulation is far from perfect now and must be more detailed. Moreover, considering the proposed wording of the draft laws, an issue of qualifying a gig-contract as an employment contract and the subsequent liability of the resident of Diia City may arise in practice.
Another novelty is the opportunity to conclude NDAs, non-compete and non-solicitation agreements with employees, gig-contractors and individual entrepreneur s. These contracts are well known in the common law system and are essential in the IT industry. However, currently non-compete and non-solicitation contracts are voidable in Ukraine. It is unclear how these contracts will work considering current judicial practice.
Draft laws implementing Diia City are still at the early stage of legislative procedure and the government is serious about launching the concept at the beginning of 2021. However, at this point, the proposed regulation does not fully meet the expectations of the Ukrainian IT businesses and potential foreign investors. Although the overall concept is great, we hope that the government will not neglect the quality of the law in its “turbo regime” of adopting laws.
The article was published in KyivPost newspaper