UKRAINE: FINANCE MINISTER ON TAXES, BUDGET, AND

C O N F I D E N T I A L KIEV 002293

SIPDIS

SIPDIS

DOE FOR LEKIMOF,CALIENDO
COMMERCE FOR ITA/LUCYK
TREASURY FOR NLEE, BCOX, MGAERTNER

E.O. 12958: DECL: 06/13/2016
TAGS: EFIN EPET UP
SUBJECT: UKRAINE: FINANCE MINISTER ON TAXES, BUDGET, AND
RUSSIAN NATURAL GAS

REF: A. KIEV 1370

B. KIEV 1941

Classified By: Deputy Chief of Mission. Reasons 1.4 B) and D)


1. (U) This message contains a guidance request, see
paragraph 9.


2. (C) Summary. In a June 6 meeting with DCM, Minister of
Finance Viktor Pynzenyk discussed his concerns about budget
performance and energy supplies. He denied the Ministry of
Finance had asked the State Tax Administration to delay
payment of VAT refunds to companies such as Cargill, which is
owed over $40 million. Although Ukraine would be able to
address its 2006 budget problems, he said, uncertainty over
gas prices and their impact made prospects for the 2007
budget worrisome. Ukraine needed tax and budget reforms that
would be difficult to pass in a Rada filled with wealthy
deputies. One measure, for which he sought U.S. support,
would be to renounce Ukraine's double taxation agreement with
Cyprus. Pynzenyk said Russia's energy maneuvers constituted
a threat to Ukraine's sovereignty. He feared that
UkrHazEnergo would usurp the role of state gas and oil
company NaftoHaz, and was acting in the interests of the
Russians. End Summary.

VAT Refunds: Not My Responsibility
--------------


3. (SBU) We requested the meeting specifically to discuss the
State Tax Administration's (STA) failure to refund to Cargill
over $40 billion of VAT the company had paid for inputs for
the exports it ships from Ukraine. While the STA had
promised significant refunds in April and May, and had paid
as much as $150 million in refunds to other firms, it had
made only a token payment to Cargill. DCM noted that in an
earlier conversation with Ambassador (ref A),Pynzenyk had
suggested that delaying VAT repayments was a deliberate
tactic to keep the budget deficit from expanding beyond
planned parameters. Pynzenyk responded that he had no
authority over the STA, but could write a letter on the
matter. He said he had encouraged the STA to stay up to date
on VAT refunds, but could not order the STA to repay a
specific firm.


4. (SBU) He acknowledged that some oblast tax authorities who
had fallen behind in their tax collections may be "saving
face" by delaying VAT refunds. Budget performance for 2006
was staying within planned parameters (i.e. a deficit below
2.5% o GDP) despite lower revenues in part, Pynzenyk said,
because VAT refund claims were two billion UAH lower than
expected. He then acknowledged that local STA authorities
had failed to submit reports of VAT refunds claimed, making
it impossible for the Treasury to disburse the funds.
(Comment: Pynzenyk thus indirectly admitted that VAT refunds
were suffering in order to meet budget goals, but implied his
own Ministry bore no responsibility. End comment.)

2006 Budget in Some Trouble...
--------------


5. (SBU) Pynzenyk reiterated that the GOU was collecting less
tax revenue in 2006 than in 2005. VAT receipts were 350
million below plan, but the real problem was lower corporate
income tax receipts. Rather than increase collections, tax
authorities wanted to revise the plan's monthly revenue
projections downward. This would make it appear that
revenues had met the plan for the first 11 months of the
year, but in the 12th month there would suddenly emerge a
huge shortfall. He denied anecdotal reports we had heard
from some companies that the STA was asking firms to pay
taxes in advance as a way of keeping the books close to
balanced. He said that the problem was not that oblast tax
authorities were failing to turn over their tax receipts to
the Treasury; tax receipts automatically went to the
Treasury.


6. (SBU) Customs offices, however, often delayed turning
their tariff revenues over to the Treasury in order to
collect interest on the float, Pynzenyk said. The GOU was
transferring all Customs accounts to the State Treasury in
order to address this problem. To date, the accounts of
seven of 50 customs offices were already transferred; the
rest would be by the end of the year, he said.


...But We Can Handle It
--------------


7. (SBU) Pynzenyk said the GOU would probably not seek
revision to the 2006 budget. (Comment: Up to this point, the
GOU had led us to believe that such a budget revision would
be among the first orders of business for a new Rada.) He
said he was afraid of what the new Rada would do to the
budget if given the chance, especially if public unrest
followed the gas price hikes planned for July 1. Instead,
the GOU would muddle through by simply ignoring some
budget-busting spending mandates such as expanded social
benefits for survivors of World War II that the last Rada had
passed during the election campaign. It would delay other
spending, and ask the Rada simply for increased spending
authority near the end of the year. The new natural gas
price structure would help the budget he said. Rather than
charging a single price for all consumers, and then using
budget funds to subsidize certain categories of consumers as
in the past, the new differentiated prices would offer a
discount to the formerly-subsidized categories, while raising
prices for other consumers.

2007 Budget Could be Worse, Absent Reforms
--------------


8. (SBU) Prospects for the 2007 budget were more worrisome,
Pynzenyk said, than for the 2006 budget. The impact of any
further rises in the gas import price was hard to predict.
If energy costs wiped out corporate profits, the GOU would
lose corporate income taxes. He suggested several areas ripe
for fiscal reforms, although he said he did not know whether
a Rada filled with rich deputies would pass them. His
suggestions, some of which he had already raised with
Ambassador (ref B),included the following:

-- the gasoline excise tax was far below European levels and
should be raised;

-- the VAT exemption for agricultural producers, which made
the Cargill VAT refunds so difficult, was an unbounded
loophole

-- Ukraine's simplified tax option for small and medium
businesses, like the VAT exemption for agriculture, created a
virtual offshore sector; and,

-- the tax exemption on income from interest on bank deposits
not only deprived the state of revenue, but attracted money
away from the stock markets, which would remain undeveloped
as a consequence.

Guidance Request: Ukraine-Cyprus Double-Taxation Agreement
-------------- ---


9. (C) Pynzenyk said that a non-standard double-taxation
agreement with Cyprus made capital flight to that country to
evade Ukrainian taxes a serious problem. As an example, he
cited one company that purportedly paid 200 million UAH/year
to a Cyprus subsidiary as a trademark license fee. Ukraine
had sought unsuccessfully to revise its agreement with Cyprus
to bring it in line with international practices. Now
Ukraine would have to denounce the treaty. Pynzenyk said
Ukraine would like U.S. support for such a move. Post would
appreciate Department's guidance on how to respond to the
Ukrainian request for U.S. support.

Russia's Designs on Ukraine's Natural Gas Market
-------------- ---


10. (C) Pynzenyk told DCM he did not anticipate that Ukraine
and Russia would sign an intergovernmental protocol on
natural gas trade, which some were predicting. What he
feared, he said, was that GazProm would conclude an agreement
directly with UkrHazEnergo, leaving out Ukraine's state-owned
NaftoHaz Ukrainy altogether. (Note: UkrHazEnergo is the
joint venture, half-owned by NaftoHaz and half-owned by
RosUkrEnergo (RUE),that was set up after the January 4th
Russian-Ukrainian agreement as the purchaser of gas imports
from RUE. RUE, in turn, is half-owned by Russia's GazProm,
and, nominally half-owned by two Ukrainian investors. End
Note)


11. (C) Pynzenyk then suggested that UkrHazEnergo Board
Chairman Igor Voronin represented GazProm's interests more
than Ukraine's. Voronin is also Deputy Chairman of NaftoHaz,
and was reportedly a key negotiator of the January 4th
agreement that put RUE at the center of Ukraine's gas
imports. Pynzenyk said "I don't understand how one person
can sit at the negotiating table wearing three
hats...UkrHazEnergo, NaftoHaz, and RUE, ...and perhaps a
fourth (i.e. Gazprom)." Asked explicitly who was behind
Voronin, Pynzenyk said quietly, "Russia." He concluded that
what was at stake was not Ukraine's energy supplies, but
Ukraine's sovereignty. DCM reminded Pynzenyk that the U.S.
would work with Ukraine to increase its energy independence
and to promote greater transparency in the energy sector.
Taylor