Leasing in Ukraine

Project Manager Ukrainian Leasing Development Project International Finance Corporation

By: Ernst Mehrengs

September 2005

Contact details: Tel: + 380 44 490-6400 E-mail: emehrengs@ifc.org Website: www.leasing.org.ua

Objective of this article In this Article, we will provide a background to the leasing situation in Ukraine with a view to supporting potential investors in their decision-making processes with respect to investing in the Ukrainian leasing market. For this purpose, we will describe the activities of the IFC (International Finance Corporation) in developing the leasing sector in different countries. Furthermore, we will address the current status of the leasing market in Ukraine, including the leasing portfolio of leased assets, the total lease portfolio, types of leasing and the activities of leasing companies. In order to describe the current market for potential investors, we will also illustrate the tax and legal framework that affects leasing today. Access to financial resources is one of the most important impediments to the development of leasing in Ukraine. Within this scope, we will describe the financial potential for leasing and the challenges and opportunities that leasing companies are facing nowadays. It should be noted that most of the information contained in this article applies today, but might soon be obsolete. We recommend, therefore, that you log onto our website1 where we will publish regular updates on the leasing market in Ukraine. Why does the IFC support the development of leasing? The IFC (International Finance Corporation) has introduced, led and implemented technical assistance programs for the development of leasing in many countries throughout the world. The IFC believes that leasing facilitates the development of emerging economies in that it is a flexible form of finance, which supplements traditional banking and increases access to financing and the overall capital base in a country's economy. Furthermore, leasing is a medium-term financial instrument for the procurement of machinery, equipment, vehicles and other assets. Leasing is based on the proposition that profits are earned through the use of assets, rather than through their ownership. Leasing focuses on the borrowers' ability to generate cash flow from business operations and use this cash flow to pay lease installments, rather than concentrating on the borrower's balance sheet or past credit history. This is why leasing is particularly advantageous for newly established, small and medium-sized businesses that do not have a long credit history, or a significant asset base for collateral. In view of this, it is of vital importance for Ukraine to develop this financing method. Investments through leasing also have a positive impact on the employment rate in Ukraine. According to a report from March 2004 “The Economic Contribution of the Equipment Leasing Industry to the US Economy”, from the Global Insight, Advisory Services Group, which was prepared for the US Equipment Leasing Association the estimates imply that, on average, for just $60,000 of additional equipment investment generated through leasing, one job is created in the U.S. economy. Background to the IFC Leasing Development Project in Ukraine The IFC leasing project in Ukraine was launched in 2004 and is financed by the Dutch Ministry of Economic Affairs. The project focuses on increasing the volume of leasing through a step-up in the resources of stakeholders, creating an enabling legal environment and enhancing public awareness of leasing. A supplementary objective that is of particular importance to the project is to attract foreign investment to the Ukrainian leasing market.
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www.leasing.org.ua
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Contact details: Tel: + 380 44 490-6400 E-mail: emehrengs@ifc.org Website: www.leasing.org.ua

The IFC leasing project in Ukraine comes under the scope of the IFC's PEP program, which is an acronym for "Private Enterprise Partnership." PEP is the IFC's technical assistance program in Eastern Europe and Central Asia, which is managed by IFC's Central and Eastern Europe Department. PEP has a presence in 11 countries, involving 36 projects. The 278-strong workforce is based in eight capital cities and 23 regional offices throughout the region. The PEP management team is based in Moscow and Kyiv. The IFC's technical assistance projects serve a different purpose than its investment activity, which involves the provision of equity or loans only to for-profit projects at market rates. It goes without saying that there is a strong synergy between the two activities, particularly with respect to the objective of attracting foreign investments. Political situation in Ukraine The Ukrainian government has developed and partially implemented a comprehensive economic reform program to liberalize the economy. The new government of Viktor Yushchenko has set clear strategic goals: (1) raising the standard of living for the poorest Ukrainians; (2) combating corruption; (3) supporting macrofinancial stability; and (4) accessions to the WTO and the EU. To achieve these goals, the Cabinet of Ministers of Ukraine has plotted a strategic course to offer foreign and domestic investments in the country a safe and secure environment. The political situation in Ukraine is in a state of flux, and recently came to a head when President Viktor Yushchenko dismissed his government on Thursday, September 8, 2005, as the team that led the "Orange Revolution" less than a year ago broke apart as a result of infighting and accusations of mass graft. Overall, there is an increased understanding of the importance of innovation and replacement of Ukraine's obsolete equipment and industrial machinery. The fact that leasing could greatly support the innovation process does not seem to have sunk in with the key players in the (former) government. Despite increased attention, legislative measures to promote leasing are not among the government's priorities, and the pursuit of higher budget revenues makes the government's top decision-makers reluctant to offer tax benefits for leasing. However, several amendments to the leasing legislation might be submitted to the Parliament at the end of the year with a view to improving conditions for leasing activities in the country. Whether these improvements will also lead to an increased inflow of foreign investments in the leasing market will be contingent on various factors. Recent economic developments2 The Ukrainian economy has performed well since the Russian crisis in 1998. In 2004, it achieved the highest growth rate in Europe. It has enjoyed a substantial trade surplus and has consequently accumulated a large pool of international reserves. Under these favorable circumstances, households and businesses have gained confidence in the banking system, which has resulted in accelerating monetization of the economy. However, these successes were achieved under an economic and legal structure that has not been sufficiently transformed to assure investors that the economy is on a sustainable growth path. Recent political events have highlighted tensions in the system, which, if not addressed, could impede further economic progress. Current status of fixed assets in Ukraine
2

Worldbank Country Assistance Strategy for Ukraine May 19, 2005. www.worldbank.org/ua
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Contact details: Tel: + 380 44 490-6400 E-mail: emehrengs@ifc.org Website: www.leasing.org.ua

Effective from 2000, real GDP in Ukraine has continued to grow. The highest GDP growth was noted in 2004, although the growth rate is expected to slow down in 2005 as a result of temporary uncertainties in the new government's economic policy.

Real GDP Growth
114
Percentage of growth compared to the previous year

112.1 109.2 105.9 105.2 109.3 106.5*

112 110 108 106 104 102 100 2000 2001 2002 2003 2004 2005

Year
* Estimates of the Ministry of Economy of Ukraine as of September 2005

In order to keep up this pace of economic growth in Ukraine, there is an urgent need for the renovation and replacement of Ukraine's obsolete equipment and industrial machinery. As mentioned above, leasing is a financial instrument for the procurement of machinery, equipment, vehicles and other assets and, as such, it is one of the most suitable instruments to support the renovation and replacement of these assets. Identification of the level of obsolescence in different sectors and the investments required to replace fixed assets in these sectors has shown that every measure should be taken to facilitate mechanisms such as leasing in order to allow for the quick replacement of fixed assets. Renewal of fixed assets is crucial to Ukraine's efforts to achieve its social and economic objectives formulated and to improve its standard of living. According to official data3, approximately 50% of the fixed assets4 of all enterprises in Ukraine are obsolete, whereas, according to estimates, the obsolescence rate of machinery, vehicles and equipment has mounted to 80% to 90%. The total investment volume required to renew Ukraine's fixed assets is approximately USD 90 billion. If we compare this to the Ukrainian GDP of USD 65 billion, it becomes clear that Ukraine is on the verge of a technical catastrophe.

3 4

President of Ukraine to the Ukrainian Parliament (Verkhovna Rada of Ukraine). Kyiv 2004. pp. 234, 276, 278 Fixed assets, including immovable assets and movable assets
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Contact details: Tel: + 380 44 490-6400 E-mail: emehrengs@ifc.org Website: www.leasing.org.ua

The highest rates of obsolescence can be found in the fishing industry, the processing industry, the generation and distribution of electricity, gas, and water, the construction sector, water-based transport, education, healthcare and social services. Ukraine is currently sourcing a large portion of its investment goods abroad and will most likely increase imports of capital equipment and technologies in the near future. Foreign capital will then have to become a major source of financing for Ukrainian investments. Leasing has great potential for becoming the preferred tool of foreign investors and its share in the investment volume will most likely show steady growth in the coming years. Development of leasing in Ukraine Coming from a very low level, leasing in Ukraine has developed rapidly in recent years. At the end of 2004, the value of the total leasing market portfolio was approximately USD 221 million compared to USD 94 million at the end of 2003. The growth of the leasing market in Ukraine can be illustrated based on different indicators of growth, i.e.: - Total value of leased assets leased during a year; - Total value of leasing contracts concluded during a year; - Volume of leasing contracts' portfolio. The total value of leased assets in Ukraine increased by nearly 90% relative to 2003. In the same period, the total value of leasing contracts increased by 120% and the total leasing contracts' portfolio (as indicated above) increased by 135%. Despite the increases in several indicators, the Ukrainian leasing market is still in its infancy. Based on a typical correlation between the GDP and the volume of leasing, and, moreover, the share of the leasing market in the total volume of investments in fixed assets of enterprises, it is estimated that the total value of lease contracts concluded could reach USD 395 million in 2005 and USD 452 million in 2006. Leasing portfolio by types of leased assets Analysis of the structure of the leasing contracts' portfolio in terms of the value of leased assets demonstrates that, as of December 31, 2004, aircraft account for the largest share in the leasing contracts' portfolio (almost 29%, i.e. slightly over USD 68 million). This is attributable to the high cost of such assets. Trucks account for the second largest share in the structure of the leasing portfolio (slightly over 24%, i.e. USD 57 million), whilst passenger cars rank third (slightly over 21%, i.e. USD 50 million). It should be noted, however, that 67.7% of Ukrainian leasing companies count passenger cars among their leased assets.

Contact details: Tel: + 380 44 490-6400 E-mail: emehrengs@ifc.org Website: www.leasing.org.ua

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Portfolio of Leasing Companies by Types of Assets as of December 31, 2004
Aircrafts Trucks Passenger cars Agricultural machinery Production equipment (accept food processing) Passenger transport Printing equipment Buildings Food processing equipment Computer equipment M edical equipment Telecomunication equipment Other

63,806 53,992 47,156 12,116 11,658 6,711 3,876 3,852 3,440 1,597 402 187 12,282

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

USD, thousands

Imported equipment accounts for most of the leasing transactions. This means that economic growth in Ukraine will eventually lead to increasing demand for foreign equipment and technology. State Commission for the Regulation of the Financial Services Market For a good source of information on the Ukrainian leasing industry, we refer to the registration statistics of the State Commission for the Regulation of the Financial Services Market in Ukraine ("the Commission"). The Commission oversees and monitors the development of the market of leasing services and operations. It records information on leasing companies in the State Registry of Financial Institutions and monitors the periodic reports that the leasing companies are required to file with the Commission. The registration of leasing operations has not been a barrier because the registration process is simple and inexpensive. On July 1, 2005, 74 leasing companies had registered with the Commission. However, we estimate that only about 40 of these companies actually conduct leasing transactions. Concentration of the leasing market In the small circle of active leasing companies, there is a considerable degree of concentration. Approximately 75% of new leasing deals in 2004 were conducted by seven leading companies. 79% of Ukrainian leasing companies are based in Kyiv, 6% in Odessa, another 6% in Donetsk and 9% in Lviv. The concentration of leasing companies is a consequence of the specific organizational structure of the Ukrainian economy where holdings with head offices in Kyiv predominate. There is a great potential for
Contact details: Tel: + 380 44 490-6400 E-mail: emehrengs@ifc.org Website: www.leasing.org.ua

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regional expansion of leasing in the country. Currently, there are only six leasing companies that cover local regions in the country through agency networks. In most Ukrainian localities, leasing is underdeveloped. Types of ownership of leasing companies If we break down the majority shareholding structure of leasing companies, we can identify the following pattern: 16.1% have majority shareholdings by banks and other financial institutions, 3.2% by state leasing companies, and 80.7% by individuals and legal entities. At the same time, 23% of the surveyed leasing companies are wholly owned by foreign legal entities and another 9% of companies have foreign equity. According to the survey results, 29% of leasing companies are bank-related; this offers them the opportunity to use the credit resources of the bank. Only 19% of the surveyed companies are captive leasing companies, i.e. they are affiliated with a vendor or producer. These companies are mainly active in the passenger car industry. It is particularly interesting to see that, until today, the banking sector has been a relatively small player in the leasing market. This situation is changing rapidly considering the number of banks that recently launched leasing operations or have indicated to be interested in launching leasing operations. Types of leasing A break down of the types of leasing operations shows that most leasing companies (61%) provide both financial leasing and operational leasing. From the total number of leasing companies 29% only provide financial leasing and 10% only provide operational leasing. 26% of the leasing companies indicated that they are concluding sale and lease back transactions. With respect to cross border leasing only 3% indicated that they are involved in such transactions. Successful leasing applications The demand for leasing services is reflected in the number of leasing applications that were submitted to leasing companies by potential lessees. In 2004, Ukrainian leasing companies received 2,784 leasing applications, 1,431 of which were approved. In other words, the rejection rate for leasing applications in 2004 was 48%. This shows a positive trend toward a moderate decrease in the rejection rate relative to 2003 (55%). The high rejection rate can be attributed to factors such as: general conservative approach of lessors, insufficient solvency of potential lessees and lack of adequate financial resources for leasing transactions. Clients of leasing companies Based on the results of the survey, 73% of leasing companies offer leasing services to small enterprises (sales under USD 0.6 million), 83% of leasing companies offer leasing services to medium-sized enterprises (sales ranging between USD 0.6 and 6 million) and 60% of leasing companies offer leasing services to large enterprises (sales over USD 6 million). Only 37% of respondents were engaged in transactions with individuals.

Contact details: Tel: + 380 44 490-6400 E-mail: emehrengs@ifc.org Website: www.leasing.org.ua

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73% of respondents indicated that they provided leasing services to the SME sector. We would note that the majority of these services are car leases where the risks associated with leasing are generally low compared to other assets. The reality in Ukraine is that the Ukrainian SME sector is in particular need of leasing services to finance capital investment and that leasing companies are hesitant to tap into this market. This is due to the high risks associated with SME financing despite the fact that margins tend to be higher in this segment (worldwide around 10% versus 2.5%-5% for large companies). Capitalization of profits and diversification of investments could, in the future, allow for increasing limits for more highrisk SME financing in the portfolio of leasing companies. Legal framework of leasing As described previously, the improvement of the legislative environment is one of the objectives of the IFC leasing project in Ukraine. Although the legislative environment for leasing has been upgraded significantly in recent years, there are still issues that are in need of improvement. With respect to specific leasing legislation, the Ukrainian Financial Leasing Act provides for comprehensive regulations as to financial leases. For example, it defines financial leasing, and describes the rights and obligations of the lessee and the lessor and the conditions governing early termination of the leasing contract. Moreover, the Financial Leasing Act provides for guidelines as to the protection of the rights of the lessor in case the lessee defaults on a contract. Execution of the law One of the main problems in leasing from a legal perspective is the execution of the law and the, occasionally incomprehensible, interpretation of the law by the judicial system. The latter is due to the fact that the Civil Code, the Economic Code and the Financial Leasing Act all contain leasing provisions and it is not always clear to the judicial system which of these laws apply in any given leasing transaction, notwithstanding the fact that special laws should prevail over general laws. The fact that these laws often contradict each other in their provisions is creating even greater legal uncertainty. Repossession Repossession of assets in case of default by a lessee can be very difficult in Ukraine. Although the law provides rules for relatively easy repossession, the execution of the law, in case of non-cooperation of the lessee, can be a serious problem. Ukrainian leasing companies approach this problem by careful evaluation of potential lessees and thorough structuring of deals based on their experience. According to our survey, leasing companies stress the importance of careful evaluation of potential lessees. This approach is taken by all survey respondents. Based on the survey, leasing companies had to contend with overdue lease installments in only 15% of all concluded leasing contracts. The Financial Leasing Act stipulates that the lessor can repossess the leased asset pursuant to an "incontestable" procedure based on a notary's executive writ. 50% of the surveyed leasing companies that are faced with default of a lessee applied this mechanism in their business operations. In January 2005, however, the Ministry of Justice issued a Resolution5 which approved the format of the Notary writ for repossession of a leased object. This format contains the wording that the underlying lease
5

Resolution of the Ministry of Justice dated 10 January 2005
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Contact details: Tel: + 380 44 490-6400 E-mail: emehrengs@ifc.org Website: www.leasing.org.ua

agreement has been notarized. As such this format is triggering the risk that a notary writ could not be issued anymore if the underlying lease agreements was not notarized (practically all of them). Some companies indicated to have applied so-called "self-help repossession," in which process the lessor simply collects the leased equipment himself, with or without the lessee's consent. The lessor usually bases the right to take such action upon a provision in the lease contract that expressly allows him to do so. There is a very active but not a solid second-hand market for used equipment in Ukraine. For a leased asset that is repossessed by a lessor there may be no possibility to sell it on the second-hand market to cover the lessor's claim. In case of a court case, being unfamiliar with the value of second-hand equipment, the court might attribute an unrealistically high value to the equipment, thereby nullifying the lessor's claim for any further monies. Legal proceedings Our survey indicated that 36.7% of leasing companies lodged court cases for the recovery of leased assets. However, the length and uncertainty of such legal proceedings and, moreover, the difficulty to enforce a judgment if a lessee intentionally conceals leased assets, makes this option less than attractive. This is probably also why disputes concerning leasing transactions are rarely brought before a court. Our survey showed that at the time the leasing companies responded to our survey, 33 repossession proceedings were initiated. In 22 instances the property was recovered, the remaining 11 repossession procedures were still in process. Taxation of leasing in Ukraine Corporate Income Tax The Corporate Income Tax Act (CIT Act) pertains to both operating and financial lease contracts. The definition of an operating lease is close to a negative definition as it mainly describes that the term of the agreement (less than one year) is shorter than that of a financial lease (longer than one year). The CIT Act defines a financial lease based on criteria that distinguish a financial lease from an operating lease: A lease qualifies as a financial lease for corporate income tax purposes6 if the lease contract fulfills one of the following conditions: 1. The lease term exceeds the period in which at least 75% of the initial value is depreciated according to the applicable Ukrainian tax depreciation scheme for the leased asset. Additionally, the lessee is obliged to purchase the leased asset at a price specified in the lease agreement upon expiry of the lease agreement or during the term of the lease agreement. 2. The total lease installments are equal to, or exceed, the initial cost of the leased asset. 3. The lessor has depreciated at least 50%7 of the leased object prior to the transfer of the leased object to the lessee and the lease installments in the lease agreement constitute at least 90% of the "regular price"
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Fixed assets, including immovable assets and movable assets 50% depreciation relative to its initial acquisition price
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Contact details: Tel: + 380 44 490-6400 E-mail: emehrengs@ifc.org Website: www.leasing.org.ua

upon commencement of the lease agreement, increased by the discount rate of the National Bank of Ukraine for the period of the lease contract. 4. The leased object has been produced according to the lessee's specifications and cannot be used by other entities during the period of the lease agreement due to its unique characteristics (because of its process and quality features). Interestingly enough, the Financial Leasing Act stipulates that, upon commencement of a lease agreement, the parties are allowed to qualify a financial lease agreement as an operating lease agreement. Cost of insurance The cost of insurance (except for medical and pension insurance and other mandatory types of insurance) is not deductible if it exceeds 5% of the total deductible costs in a taxable period of one year. Calculation of Corporate Income Tax under a financial lease Tax treatment of the lessor A financial lease qualifies as a sale for corporate income tax purposes. The CIT Act provides for different tax treatments for the transfer of a leased asset from the lessor to the lessee: The lessor should recognize taxable income for the value of the good at the moment of disposing of the asset to the lessee, i.e. when the asset is recorded as a "good". However, if the lessor records the asset as a "fixed asset," the lessor will have to modify the respective group of fixed assets. In both cases, the lessee will be entitled to claim the depreciation over the term of the lease. The interest or commission part of the lease installment under a financial lease, which is paid by the lessee to the lessor, will be subject to corporate income tax at a rate of 25%, and should be included in the lessor's taxable income in the period in which the lease installment becomes payable. The return of the leased asset, if the lessee does not acquire ownership of the leased asset, will be treated for tax purposes8 as a sale-back. The transfer value of the leased asset will be the "regular price9" effective on the date of such a sale-back. The regular price may not be lower than the original value of the asset, reduced by the amount of depreciation charged in accordance with the CIT Act (i.e. book value). If the regular price exceeds the book value of the leased asset, the difference is subject to corporate income tax. As the CIT Act does not offer clear rules as to the situation where the asset is repossessed by the lessor, the tax administration could equate repossession of the leased asset with the return of the leased asset by the lessee, implying that the repossession will also be considered as a sale-back transaction, with the same consequences for corporate income tax purposes as the situation where the lessee returns the leased asset to the lessor. Tax treatment of the lessee If the lease contract qualifies as a financial lease or if the parties to a lease agreement qualify their lease agreement as a financial lease, the lessee will have to increase the balance sheet value of the respective
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Section 7.9.6 of the Corporate Income Tax Act. Section 1.20 of the Corporate Income Tax Act defines the principle of "regular price".
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Contact details: Tel: + 380 44 490-6400 E-mail: emehrengs@ifc.org Website: www.leasing.org.ua

group of fixed assets upon transfer of the leased asset to the lessee. The lessee will be entitled to claim the depreciation over the term of the lease. Besides claiming the depreciation on the leased asset, the lessee can deduct the interest or commission part of the lease installment for corporate income tax purposes. Calculation of corporate income tax under an operating lease Tax treatment of the lessor Lease installments under an operating lease agreement received by the lessor are fully taxable for corporate income tax purposes. Under an operating lease, the leased asset will remain on the balance sheet of the lessor. Subsequently, the lessor can depreciate the asset based on the depreciation schedules provided in the CIT Act (see below). Tax treatment of the lessee Lease installments under an operating lease agreement paid by the lessee are fully tax-deductible for corporate income tax purposes. If the leased object is a passenger car, only 50% of the lease installments are deductible. Leasing (i.e. rental) income earned by non-residents is subject to 15% withholding tax unless a convention for the avoidance of double taxation provides otherwise. Depreciation for tax purposes of a leased asset Under a financial lease, the lessee will be entitled to claim depreciation of the leased asset over the term of the lease agreement. Under an operating lease, the lessor can claim the depreciation of the leased asset. As from January 1, 2004, the following depreciation rates have applied and depreciation has had to be reported on a quarterly basis: Group 1: 2% - buildings, constructions; Group 2: 10% - transport vehicles, furniture, office equipment, household equipment, and optical, electronic and electrical appliances; Group 3: 6% - any other fixed assets not included in groups 1, 2 and 4; Group 4: 15% - computers, electronic and computing equipment, other devices for electronic data processing, connected data reading and printing equipment, other information- related hardware and software, telephones (including cellular), microphones, etc. These rates are applied on a quarterly basis and are calculated on the basis of the declining-balance method. Land is not be depreciated and intangible assets are amortized by using the straight-line method over the assets' useful life, up to a maximum of 10 years.

Contact details: Tel: + 380 44 490-6400 E-mail: emehrengs@ifc.org Website: www.leasing.org.ua

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VAT10 treatment of a financial lease Please note that, under the CIT Act, the parties to a lease agreement are allowed to qualify a financial lease agreement as an operating lease agreement upon commencement of a lease agreement. If they do, the lease agreement will also be treated as an operating lease for VAT purposes. For VAT purposes, the transfer of the leased asset under a financial lease agreement is treated as the supply of a good. Upon transfer of the leased asset to the lessee, the lessor is required to charge VAT on the contract value of the leased asset as agreed in the lease agreement. The contract value cannot drop below the regular price11 of the leased asset. Lease installments paid under a financial lease agreement are in principle not subject to VAT. However, if the interest and commission part of a lease installment charged by the lessor to the lessee exceeds twice the discount rate12 applied by the National Bank of Ukraine, the excess (i.e. interest and commission as a percentage less twice the NBU rate) is subject to VAT. If the lessee returns13 the leased asset to the lessor, the lessee will have to account for VAT on the regular price of the leased asset at the time of return of the leased asset. This follows from the rule that the initial transfer of the leased asset from the lessor to the lessee is, for VAT purposes, considered to correspond with the transfer of ownership. Although the VAT Act is not clear on this point, repossession of the leased asset could be equated with the return of the leased asset. Importation of goods under cross-border leasing agreements (including the return of the leased asset to a resident lessor) is subject to import VAT. VAT Treatment of an Operating Lease Section 1.4 of the VAT Act stipulates that the transfer of leased assets under an operating lease is not treated as a supply of goods and is therefore not subject to VAT. This section does not imply that lease installments under an operating lease are not subject to VAT, i.e. only the transfer of the good falls outside the scope of VAT application. The return of the leased asset under an operating lease is not subject to VAT either. Section 1.4 of the VAT Act further stipulates that an operating lease is considered as a supply of a service and is therefore subject to VAT. The consideration that is subject to VAT is the full lease installment. With respect to cars, the VAT Act provides that, if any passenger car is recorded on the lessor's balance sheet as a fixed asset, the input VAT on such purchase will not be recoverable. According to the VAT Act, the lessor can include the VAT as a deductible expense for corporate income tax purposes. However, according to official information from the State Tax Administration, such deduction of VAT is not allowed based on the fact that the CIT Act does not provide for the deduction of VAT.
The Ukrainian Value Added Tax Act of April 3, 1997 року №168/97-ВР (with changes and amendments as of May 1, 2005), hereinafter referred to as the VAT Act. 11 Section 1.18 of the VAT Act refers to Section 1.20 of the Corporate Income Tax Act with respect to the definition of the term "regular price". Although Ukraine has not developed transfer pricing rules, Section 1.20 of the Corporate Income Tax Act refers to terminology such as "fair market value," "identical" or "similar" for the purposes of establishing a comparable price. 12 Set on the date when the interest or commission is accounted for; currently (i.e. in August 2005), the NBU rate is approximately 9.5%. 13 Section 3.2.2 of the VAT Act.
Contact details: Tel: + 380 44 490-6400 E-mail: emehrengs@ifc.org Website: www.leasing.org.ua
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12

Importation of goods under cross-border leasing agreements (including the return of the leased asset to the resident lessor) is subject to import VAT. An exception to this rule with respect to aircraft was recently implemented; it was provided that the temporary importation of an aircraft under an operating lease is exempt from VAT. Financial aspects of leasing The leasing companies that participated in our survey indicated that the key condition for developing their businesses was access to financial resources. Leasing companies consider the funding of their operations as the major problem that impacts the development of their business. The lack of financial resources is due to the macro-economical instability, high inflation rate, the scarce availability of long-term credit and high interest rates and bank charges. Banking sector Despite the fast growth of the Ukrainian banking sector, most resident banks still have modest financial resources, including charter capital. The Ukrainian banking sector is still undercapitalized, which hampers long-term borrowing and results in a limited volume of long-term bank loans. Capital Development of Ukrainian Resident Banks14 Equity capital Equity - total USD million 1.874 2.416 3.473 3.861 As of 01.01.03 As of 01.01.04 As of 01.01.05 As of 01.04.05

Lack of long-term financial resources The availability of financial resources is an absolute must for the expansion of the Ukrainian leasing market. Currently, leasing companies and Ukrainian banks are forced to reduce lease terms to two or three years due to their inadequate long-term financial base. This development is reflected in our survey, which indicates that 60% of the lease agreements concluded in 2003 have a term of less than three years. In 2004, this percentage dropped to 50% in favor of short-term leases (between one to two years), which increased from 10% in 2003 to 20% in 2004. The number of lease transactions with a term of between three and five years increased slightly - from 20% in 2003 to 23% in 2004. The number of contracts with lease terms of more than five years decreased in 2004 to 7% relative to 10% in 2003. At this time, most foreign investors are hesitant to commit resources due to their lack of confidence in Ukraine's long-term macroeconomic stability. International commercial banks active in Ukraine admit that they generally do not finance medium-term investment projects that are not backed by (1) export proceeds, (2) export credit agencies, (3) multilaterals or (4) OECD-based sponsors, and that involve less than several million US dollars. Although the terms of loans that do not meet these criteria tend to become somewhat longer as a result of increasing competition from good-quality local borrowers, they usually still span less than three years. Offering access to cheap long-term financing of capital expenditures could be a key competitive advantage to foreign banks or leasing companies in Ukraine.
14

Official web page of the NBU: www.bank.gov.ua
13

Contact details: Tel: + 380 44 490-6400 E-mail: emehrengs@ifc.org Website: www.leasing.org.ua

Financing charges In addition to the lack of long-term financing, high interest rates and bank charges do not contribute to a rapid development of the Ukrainian leasing market. Our initial analysis of interest rates and charges for bank loans demonstrated a trend towards a drop in the cost of credit for all types of borrowers. However, financing charges are currently slightly increasing as a result of the recent political changes in Ukraine, high interest rates, and the unpredictable situation on the domestic currency market. In August 2005, average financing charges (i.e. interest rates + bank charges) of national-currency loans extended to businesses were between 16% and 18%, and foreign-currency financing charges were between 12% and 14%. The main causes of the interest rates remaining high are the following: (1) High cost of raised resources (2) Non-repayment of loans due to inadequate risk management practices (3) Unpredictable currency market (4) High cost of operating expenses for banks (5) Political uncertainty (6) High inflation rate It is expected that the cash position of the Ukrainian banks will worsen by the end of the year. This will cause a corresponding increase of the interest rates for bank credits. From the beginning of the next year, interest rates may stay high until the Parliamentary elections, which will be held in March 2006 due to the turbulent political situation. Sources of financing Currently, most Ukrainian leasing companies finance their operations through loans from commercial banks, while at the same time using equity-financing as well as advance payments made by lessees. Our survey of Ukrainian leasing companies showed that the leasing companies use a combination of the following financial resources:
• • • • • • •

100% use advance payment by lessees 87% use loans from commercial resident banks 63% use equity-financing 10% obtain loans from non-resident banks 7% use funds from international financial organizations (IFC, EBRD) 7% use trade/commodity credits of producers/suppliers 7% use state budget funds

Securing loans and obtaining access to financing As indicated above, 87% of the leasing companies acquire loans from Ukrainian banks. These loans are secured by a whole range of securing methods. For example, banks require a pledge on the leased asset or assignment of the lease contract, or they demand that they be named the beneficiary of the insurance on the leased object. Moreover, they usually require third-party guarantees or additional collateral in the form of real estate, equipment, stock, securities, etc.
Contact details: Tel: + 380 44 490-6400 E-mail: emehrengs@ifc.org Website: www.leasing.org.ua

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Alternative sources of financing Ukrainian leasing companies will need to structure their operations in a transparent way if they are to raise financing from foreign sources. This should be facilitated by improvements in the financial accounting practices and the financial management of Ukrainian leasing companies. The current Ukrainian National Accounting Standards are ambiguous and will need to be aligned with International Accounting Standards. Ukrainian leasing companies will also need to recognize the importance of their cash position, forecast future cash flows and, where not already in place, introduce risk management systems and contingency plans. Ukrainian leasing companies are naturally inclined to explore alternative sources of financing. However, access to such alternative sources is limited. Although a commercial loan from equipment vendor can dramatically increase a company's competitive edge, such loans are difficult to obtain. In addition, many companies would be interested in raising private investments. Both options require an in-depth analysis of a company's financial position, e.g. through a due diligence review. Such a review is hampered, however, by the lack of application of international accounting standards and the lack of common place auditing by international certified auditors. Advance payments and collateralization Practically all surveyed financial leasing agreements require an advance payment to be made by the lessee for the purposes of hedging against default by the lessee. This also serves as part of the financing of the lessor's operations. Our survey revealed that the average advance payment made to leasing companies was about 22% of the cost of the leased equipment, with percentages ranging from 15% to 30%. With respect to hedging against default by the lessee, leasing companies occasionally require the lessee to provide additional collateral. Partnering of foreign lessors with Ukrainian lessors Repossession of assets if a lessee defaults on a lease contract is a delicate matter in Ukraine. Although the law provides for rules for relative easy repossession, the practice of execution of the law if the lessee refuses to cooperate is quite different. Ukrainian leasing companies approach this problem by carefully reviewing potential lessees and prudent structuring of deals based on past experience. Due to these and other issues, foreign leasing companies may want to consider establishing strategic alliances with prominent Ukrainian leasing companies that already have a good track record. The Ukrainian partner in such a collaborative effort could then be responsible for expanding the client base, structuring leasing deals so that they comply with Ukrainian regulations, monitoring deals and transferring lease installments to foreign leasing companies. The Ukrainian leasing company, for its part, would have a competitive advantage thanks to its alliance with a foreign partner that has access to more cost-effective long-term financing and foreign equipment vendors, whilst the foreign leasing company would stand to benefit from the services of an experienced agent with skilled personnel and extensive knowledge of the local market. Alternatively, international lessors could open a local branch or subsidiary. This strategy, however, would demand a considerable investment of time before the local market can be cornered. An added complication would be that skilled people in the leasing business are extremely scarce. Conclusion and final comments
Contact details: Tel: + 380 44 490-6400 E-mail: emehrengs@ifc.org Website: www.leasing.org.ua

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Leasing is a critical tool for capital formation on a worldwide basis and has the potential to contribute greatly to the economic development and growth of Ukraine. The development of the Ukrainian leasing market is under pressure as a result of the political instability that arose after last year's Orange Revolution. The outlook is positive, however, with the country's focus clearly set on integrating into the European Union. The legal system does not yet provide a stable foundation for leasing; the length and uncertainty of legal proceedings has leasing companies carefully assessing the risks prior to concluding lease agreements. Although in itself, such careful assessment is a positive development, it is not, however, directly supportive of the growth of the leasing market which is much needed in Ukraine. Recent changes in tax laws with respect to leasing will most likely not result in additional revenues for Ukraine, but rather caused practically all foreign investors to put their plans for investments in the Ukrainian leasing market on hold. Due to the tax reforms that were introduced in March, leasing companies felt that their interests needed to be protected. Within this scope, a new leasing association, which protects the interests of commercial leasing companies, was recently established. Although the lack of financial resources in Ukraine is a major impediment to the development of the leasing market, it also creates opportunities for foreign investors to provide more cost-effective long-term financing. In order to attract foreign investments, the operations of Ukrainian leasing companies should be such that they are transparent for financiers and improve financial accounting practices. To facilitate the growth of the Ukrainian leasing market, further laws should be drafted, technical assistance and industry training should be provided, and government briefings should be conducted more frequently. Moreover, potential lessees should be targeted to create public awareness of the changes that leasing can bring about by turning businesses into flourishing enterprises.

Contact details: Tel: + 380 44 490-6400 E-mail: emehrengs@ifc.org Website: www.leasing.org.ua

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