WHAT DIRECTION WILL GEORGIAN TAX TAKE NOW?

Paul Cooper
(The author heads the PricewaterhouseCoopers tax practices in Armenia and Georgia and is the Chair of the Chamber’s Tax Committee.)

Georgia has made significant headway in changing the design of its tax system. There are still some difficult areas. The inflation coefficients introduced last year to increase the tax base for property tax purposes are confusing. Best practice is to allow VAT input tax credits for a buyer to arise at the same time as the seller accounts for output VAT. The penalty rules need development so that the punishment fits the crime. On the whole though, Georgia has evolved a fairly coherent tax system with low tax rates; something the experts say forms a solid basis for economic growth.

Tax administration though has room for improvement. Some clarifications and instructions issued by the Ministry of Finance are based on old law and many do not contain clear (or any) reference to the statutory provisions on which they are based or interpret the law incorrectly. This might not present a problem if tax officials assessed the merits of such issuances before acting. In practice though, officials tend to give such issuances the force of law, even if they know that the basis of the issuance in incorrect. Erroneous issuances should be removed. Tax officials also need to be empowered to apply the law when they know an issuance is incorrect.

Another concern is tax assessments that arise because an examiner fails to fully understand the business drivers behind normal commercial arrangements, and incorrectly perceives tax fraud to have occurred. What invariably follows is an assessment when the examiner substitutes his or her uninformed judgment on what decisions the business should have made in entering the arrangements. Such assessments are troublesome for affected taxpayers, who face significant financial risk despite no wrongdoing.

VAT is a lucrative target, partly because the rules concerning the time for transactions could be clearer and partly because the law imposes a 100% for issuing “illegal” VAT invoices. The author is aware of one assessment made along the following lines last year: A taxpayer sells a product with a fixed retail price for consumers (GEL 130 for illustrative purposes). The taxpayer engages various distributors to sell the product to consumers.  Many of the distributors are not VAT payers, as their annual turnover is not sufficient to require mandatory registration.

The taxpayer reports 18% output VAT based on the price at which the product is sold to the distributors (GEL 100 plus GEL 18 VAT).

One design feature of VAT is that although the tax is targeted at the final consumer, a portion of the tax is collected at each stage of the supply chain. If a party at the end of the supply chain is not subject to VAT (e.g., because it is a small business), the mechanism still ensures that most of the possible tax is collected. In the example above, the total VAT in a taxable sale of GEL 130 is GEL 20. If our taxpayer and the distributor are both VAT payers, our taxpayer will pay GEL 18 to the government while the distributor will pay the other GEL 2. If the distributor is not a VAT payer, the government loses the revenue from the margin earned by the distributor, but still collects 90% of the maximum possible VAT collection from our taxpayer.

There were some peculiarities with the product involved, but the taxpayer’s approach should have worked. However, the tax authorities essentially argued that because the product has a fixed retail price and GEL 20 VAT could have been collected if the taxpayer sold the product directly to the consumer, the arrangements with the distributors were designed to avoid proper taxes and the taxpayer has committed fraud. However, instead of assessing the taxpayer for VAT on the distributors’ margin, the tax authorities argued that the time of supply should be when the product finds its way into the hands of the final consumer, rather than when the product is provided to the distributor. There was no assessment for underpaid tax. Instead, the authorities issued a fine equal to 100% of the VAT on the invoices based on the argument that the taxpayer issued illegal VAT invoices.

There is clearly a case for looking to improve the integrity of tax audits and assessments if Georgia wants to be seen by the world as a leading investment destination.

Tax settlements – a new development

Even if a tax assessment does not have proper basis, what should a business do if the assessment is made for an outrageous sum, let’s say a fine of GEL 50 million for “illegal” VAT invoices? Georgia has not yet reached the position when a taxpayer can be certain of winning a case, even if the merits of the taxpayer’s position are clear, and fronting with that kind of money would close most businesses down.

Given the need to improve the integrity of tax administration, the new tax settlement rules that the government enacted late last year deserve a mixed reaction. If a taxpayer is assessed for tax in an amount exceeding GEL 10,000, the taxpayer may submit an application to the Revenue Service to conclude a tax contract and make a proposal for settlement, including the amount and payment terms. When such application is made, the Revenue Service presents the application to the Minister of Finance for resolution at a session of the Government. The Government makes a decision about concluding the contract and the amount of payable tax liabilities and the terms of payment are specified. The taxpayer’s tax liabilities are then fixed on the day the contract is concluded for the period and taxed covered by the contract.

Put yourself back in the position of our taxpayer. Would you contest the assessment through formal channels, or will you pursue a tax settlement so you can be certain of preserving your business? In the author’s view, the tax authorities need to pay closer attention to improving the quality of their assessments, so that taxpayers applying the law correctly do not receive large nuisance assessments. Instead, the tax settlement program may only encourage the tax authorities to make looser assessments, in the expectation that settlements can be reached. It is too early to say for certain what will happen. However, tax settlements seem to be a step in the wrong direction.

Over-sophisticated policy may invite a fall

Generally, countries do not object if another country adopts low tax rates as a competitive measure. The OECD project on tax havens and harmful tax practices never objected to countries adopting low or no tax systems that were integrated into their economy. The objections were when havens actively marketed bank secrecy to induce investors to flow money through the haven, and when special regimes were established that were completely insulated from the country’s economy.

Georgia no longer taxes residents on income they earn abroad. Regardless of whether an individual establishes tax residence in Georgia or not, the individual will only pay Georgian tax on Georgian income. However, if the individual is a tax resident, he or she may be able to use Georgia’s tax treaty network to obtain relief on income earned from other countries.

The government amended the tax residence rules late last year. As well as the traditional test based on an individual’s length of presence in Georgia, an individual may now elect to be treated as a tax resident if he or she owns “significant property.” There is no requirement for the property to be in Georgia or for the individual to spend time in Georgia.

Residents may benefit from tax treaties only if they are “liable to tax therein by reason of his domicile, residence, place of management or any other criterion of a similar nature.” Having a home available or spending extended time in Georgia would be an acceptable basis for a person to be treated as a resident for treaty purposes. The mere ownership of property is not sufficient.

Will the authorities issue a certificate of tax residence to an individual who elects to be a Georgian tax resident? That may abet the individual committing fraud against other countries by claiming illegal benefits under Georgia’s tax treaties. This could make other countries quite unhappy.

The government is keeping the doors open for discussions concerning the tax system and how to improve the environment for business. There are still issues to address, but these are surmountable. Provided the government is still prepared to make some challenging decisions.

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