Taxation by StephenDonald


									     TA X AT I O N

                 On December 22, 2004, after the completion of the Survey, Parliament adopted a new Tax Code that
                 simplified the tax system and reduced tax rates. The Survey results, therefore, do not reflect the effects the
                 Tax Code may have on SMEs. However, the results do represent the general impression of taxation among
                 SMEs and highlight tax problems that must be addressed by government.

                 Main Findings:
                          Over 80% of respondents considered taxation “rather difficult” and “very problematic” before the
                           new Tax Code was passed. High tax rates (95%), the large number of taxes (90%), and unstable tax
                           legislation (88%) were cited among the biggest problems.10

                          As admitted by respondents, the incidence of tax evasion in Georgia was among the highest in CIS
                           countries. Only 7% of SMEs stated that companies similar to theirs did not conceal revenues from the

                          The simplified small business tax was only used by 7% of SMEs, and was abolished, rather than
                           revised, in December 2004.

                          In December 2004, a new Tax Code was adopted that simplified the tax system and reduced tax rates.
                           However, the Code has yet to prove its effectiveness. A number of issues remain, such as the ability
                           of the tax authorities to enter premises and appropriate cash without a court order, the lack of tax
                           incentives for start-ups, high penalties and strict tax administration, the increased number of inventory
                           counts, and others.

                      These percentages reflect attitudes about the old tax legislation. The respondents’ perceptions of the new Tax Code are discussed in the overview of the new Tax Code,
                      page 23.

Page 20                                                                               Business Environment in Georgia, as seen by Small and Medium Enterprises
                                                                                                                                      TA X AT I O N

Taxation Difficulties
Over 80% of respondents considered taxation “rather difficult” and “very problematic.” High tax rates, the large
number of taxes, and frequent changes in tax legislation were among the key problems cited in 2004. Some of these
issues have been addressed in the new Tax Code, but the extent to which they have been fully resolved can only be
evaluated through future monitoring:

       Chart 12. Problems with Taxation
       (percentage of firms negatively evaluated the below factors on development of their business)
        Old Tax Code                                                                                   New Tax Code
                                   High Tax Rates                       95%                              Tax Rates Decreased

                           Large Number of Taxes                       90%                               Fewer Taxes

                          Unstable Tax Legislation                     88%                               Changes Ahead

                       ComplicatedTax Legislation                      87%                               Less Complicated

                           Tax Payment Procedure                 72%                                     Procedure Simplified

                          Frequent Tax Inspections      43%                                              N/A

Simplified Tax System
To tax SMEs more efficiently and to improve their compliance, governments of many countries have introduced
simplified systems for taxation. In many cases, this resulted in a broadening of the tax net and increased tax collected
(although improved tax enforcement was a necessary precondition for real improvements). In Georgia, a new small
business tax came into effect on January 1, 2004. Under the new system, businesses with annual sales of GEL 100,00011
or less could opt to pay a flat tax of 5% on sales rather than paying tax on profits, as was usual.

At the time of the Survey, few companies had adopted the new simple tax. It had existed for only a few months
and businesses were awaiting more widespread changes to the tax laws. These changes arrived in the new Tax Code,
adopted in December 2004. Surprisingly, the new Tax Code abolished the small business tax altogether.

The small business tax had numerous problems, worth considering if a simplified tax system is again planned for
SMEs. First, the GEL 100,000 threshold was too low. Small enterprises in Georgia are defined as those with sales
up to GEL 500,000. Second, the small business tax mainly addressed tax on profits, not the 20 other taxes to which
Georgian businesses were subject.

                                                                                                                 “Georgian laws are being modified
Instability of Tax Legislation                                                                               permanently, and it is quite difficult
                                                                                                             to follow all the changes. An inspector
For 80% of companies surveyed, the frequent changes in tax legislation, which in most                        comes and says, ‘Based on article x,
cases became effective as soon as enacted, were an obstacle to business development. Their                    paragraph y, subparagraph z, you are
complaints were well founded. Over 60 changes were made to the tax laws in 2004 alone, up                    fined.’ I say, ‘How? When was this
85% from 2002.                                                                                               subparagraph amended?’ ‘Two weeks
                                                                                                             ago!’ This happens all the time. I just
                                                                                                             do not believe this is not done on
                                                                                                                                - Focus Group Participant
     Approximately USD 55,000.

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     TA X AT I O N

                       Chart 13. Number of Major Changes to Legislation, 2002-2004


                                       2002                                   2003                                 2004

                     Box 1. Changes to Tax Legislation

                     In 2003, the following major changes were made:
                          12 changes to the Tax Code adopted by Parliament
                          12 new sets of instructions on reporting issues by the Ministry of Finance
                          Over 20 changes to regulations on various fee issues - tax liability, excise tax fees, etc.

                     In 2004, the following changes were made:
                          5 changes to the Tax Code adopted by Parliament
                          19 new sets of instructions on various reporting issues by the Ministry of Finance
                          Over 35 changes to regulations on various fee issues - tax liability, excise tax fees, etc.

                  Documentation Requirements
                   Georgian businesses struggle to satisfy the documentation requirements tax authorities impose on them while operating
                   in a still-rudimentary, cash-based economy. Most small businesses do not issue receipts. As a result, SMEs often have a
                   hard time documenting their deductible business expenses. For example, a restaurant that buys food at a farmers’ market
                                             will never be able to document its expenses properly. Its taxable income will be artificially
    “When we can not deduct items
                                             inflated as a result.
 from profits, we end up paying VAT
 on total revenue instead of the value-
 added amount.”
               - Focus Group Participant

Page 22                                                              Business Environment in Georgia, as seen by Small and Medium Enterprises
                                                                                                                                TA X AT I O N

As another example, when two parties concluded a transaction, both had to fill out four copies of special forms, keep
the first and second copies, and submit the third and fourth copies to tax authorities. Since the party responsible for
paying VAT was the buyer, it would have been logical to require only the buyer to file. However, the tax authorities
demanded that both parties to the transaction submit the forms. And unless the amounts shown in the reporting
documents matched, the tax authorities would not credit the buyer’s VAT payments, even if they were made properly
and promptly. Additionally, they would penalize the buyer, applying huge fines even if s/he correctly paid VAT, if the
seller did not report to tax authorities.

     “Last month, I inspected a well-known company, which paid all necessary VAT in accordance with Georgian
 legislation. The company bought goods from another firm, reported it to the authorities, and paid VAT. But because its
 counterpart did not report on the transaction to the tax authorities, I did not count these payments and applied huge
 penalties. To prove its payment, the firm produced bank statement showing that the funds had been transferred from the
 company’s account to the seller’s account. However, because the seller did not transfer funds to the budget account, the
 buyer was in violation. I understand that it is illogical to fine a company when it is properly paying taxes, but since the
 Tax Code provides for this, why would I lose money for the country’s budget?”
                                                                                                              - Tax Inspector

Concealment of Income from Taxation
Because of all of the factors set out above, a significant percentage of enterprises tried to conceal part of their income
for tax purposes. Since respondents are normally reluctant to answer questions that might have alluded to illegal
activities, the Survey asked the question in the following way: “Please estimate, given today’s business conditions,
the percentage of sales that enterprises similar to yours concealed from taxes in 2003.” Only
                                                                                                         “Show me a person who doesn’t hide
7% of respondents claimed that they did not conceal income, 75% refused to answer, and
                                                                                                     sales from the tax authorities – you
20% admitted to evading taxes. The percentage of SMEs reporting that they did not conceal can’t. Such people don’t exist!”
revenue (7%) was the lowest among the CIS countries where respondents were asked a similar
                                                                                                                    - Focus Group Participants
question. In Ukraine, 16% of firms reported all revenues, and in Uzbekistan, 51% said they
reported all income.

New Tax Code – Unsolved Problems
On December 22, 2004, Georgia adopted a new Tax Code (see Annex 3). Unfortunately, in the rush to get the
legislation through Parliament, ambiguities and omissions were permitted to remain. The Ministry of Finance intends
to issue rules and regulations to fill these gaps. Until it does, however, businesses are left with an unclear and confusing
picture of their tax liability. The new Tax Code, however, does include some positive signs for business as it has:
      Decreased number of taxes (from 21 to 7) and introduced some tax rate reductions:
       - Profit Tax (unchanged 20%)
       - Income Tax (from 20% to 12%)
       - Social Tax (from 31% to 20%)

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     TA X AT I O N

                             - VAT (from 20% to 18%)
                             - Property Tax (1% of the property’s average net balance sheet value)12
                             - Gambling Tax (rates vary)
                            Reduced fines for overdue tax payment (from 0.15% to 0.07% of the overdue amount per day overdue)
                            Simplified tax payment dates; unified fiscal year

                  Despite these positive changes, it is questionable whether the new Tax Code is supportive of SME development.
                            As mentioned earlier, the small business tax, though it was flawed, was designed to benefit smaller businesses. It
                             was abolished, and no tax incentives for small or start-up businesses replaced it.
                            Although some taxes have been reduced, the amount of tax penalties has risen dramatically.
                            Tax inspectors have been granted greater powers. They may enter premises without a court order, summarily seize
                             cash, and demand unlimited inventory stock-taking. The combination of higher penalties and greater power for
                             inspectors created the risk of a rise in the incidence of unofficial payments to inspectors. One paragraph caused
                             specific concern among SMEs, as well as among legal experts, because it seems to be unconstitutional. The tax
                             authorities are now entitled to withdraw cash from safes and cash registers without a court order.13 The Georgian
                             Constitution prohibits anyone from entering premises and conducting a search without the permission of the
                             owner or a court order, except in cases of undelayable public necessity.14 Tax-indebtedness hardly seems to be the
                             “undelayable public necessity” contemplated by the Constitution.

                     Last but not least, businesses have always considered themselves at a disadvantage in disputes with the tax authorities.
                     Courts are widely perceived as favouring the government. In part to address this concern, the new Tax Code
                     permitted taxpayers to use private arbitration to settle tax disputes. Arbitration promised to be fast, fair, and efficient.
                     Arbitration takes an average of two months to settle a dispute, compared to the months or years it takes to settle a
                                              case in court. Business applauded the move as a positive step toward improving the business
     “After losing a few big cases, the       environment. Unfortunately, after a few arbitration decisions went against the government,
 Minister of Finance stated that if           in the spring of 2005, Parliament abolished the arbitration provision.
 all businesses appealed to private
 arbitration, the government would not
 have the funds to pay pensions! This
 was the only hope that businesses could
 operate fairly, with proper security, and
 they took this hope away.”
               - Focus Group Participant

                       This rate applies to legal entities.
                       Tax Code, Article 90, Section 1.
                       Constitution of Georgia, Article 20, Section 2. Similarly, Article 21 of the Constitution forbids the taking of private property by the state, except in cases of public necessity.
                       The special cases when property may be taken from the public are clearly defined in Article 2 of the Fundamental Law on Taking Property in Cases of Undelayable Public
                       Necessity. These cases are ecological catastrophe, natural disaster, epidemic, or other episodes that may affect the public well-being. Prompt payment of taxes is not
                       mentioned as a public necessity.

Page 24                                                                                      Business Environment in Georgia, as seen by Small and Medium Enterprises
                                                                                                     TA X AT I O N

 1. Continue work on addressing the deficiencies in the new Tax Code, and include business
    representatives in discussions and analysis.

 2. Consider the option of reintroducing an improved small business tax.

 3. Conduct campaigns to spread information about the new Tax Code.

 4. Introduce an adjustment period of at least six months before legislative changes may come into

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