Leasing in Ukraine 2005

8/7/2019 Leasing in Ukraine 2005

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Tel: + 380 44 490-6400E-mail: [email protected]

Website: www.leasing.org.ua

Leasingin Ukraine

By: Ernst MehrengsProject Manager

Ukrainian Leasing Development Project

International Finance Corporation

September 2005


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Website: www.leasing.org.ua2

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 withrespect to investing in the Ukrainian leasing market. For this purpose, we willdescribe the activities of the IFC (International Finance Corporation) in developingthe leasing sector in different countries. Furthermore, we will address the currentstatus of the leasing market in Ukraine, including the leasing portfolio of leasedassets, the total lease portfolio, types of leasing and the activities of leasingcompanies. In order to describe the current market for potential investors, we willalso illustrate the tax and legal framework that affects leasing today. Access tofinancial resources is one of the most important impediments to the development ofleasing 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. Werecommend, therefore, that you log onto our website1 where we will publish regular updates on theleasing market in Ukraine.

Why does the IFC support the development of leasing?

The IFC (International Finance Corporation) has introduced, led and implemented technical assistanceprograms for the development of leasing in many countries throughout the world. The IFC believes thatleasing facilitates the development of emerging economies in that it is a flexible form of finance, whichsupplements traditional banking and increases access to financing and the overall capital base in acountry'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 areearned 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 isparticularly advantageous for newly established, small and medium-sized businesses that do not have along credit history, or a significant asset base for collateral. In view of this, it is of vital importance forUkraine to develop this financing method.

Investments through leasing also have a positive impact on the employment rate in Ukraine. According toa report from March 2004 The Economic Contribution of the Equipment Leasing Industry to the USEconomy, 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 equipmentinvestment 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 ofEconomic Affairs. The project focuses on increasing the volume of leasing through a step-up in theresources of stakeholders, creating an enabling legal environment and enhancing public awareness ofleasing. A supplementary objective that is of particular importance to the project is to attract foreigninvestment to the Ukrainian leasing market.

1www.leasing.org.ua


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The IFC leasing project in Ukraine comes under the scope of the IFC's PEP program, which is anacronym for "Private Enterprise Partnership." PEP is the IFC's technical assistance program in EasternEurope and Central Asia, which is managed by IFC's Central and Eastern Europe Department. PEP has apresence in 11 countries, involving 36 projects. The 278-strong workforce is based in eight capital citiesand 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, whichinvolves the provision of equity or loans only to for-profit projects at market rates. It goes without sayingthat there is a strong synergy between the two activities, particularly with respect to the objective ofattracting 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 strategicgoals: (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 domesticinvestments 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 ViktorYushchenko dismissed his government on Thursday, September 8, 2005, as the team that led the "OrangeRevolution" 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 innovationprocess does not seem to have sunk in with the key players in the (former) government. Despite increasedattention, legislative measures to promote leasing are not among the government's priorities, and thepursuit of higher budget revenues makes the government's top decision-makers reluctant to offer taxbenefits for leasing. However, several amendments to the leasing legislation might be submitted to theParliament 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 leasingmarket 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 thehighest growth rate in Europe. It has enjoyed a substantial trade surplus and has consequentlyaccumulated a large pool of international reserves. Under these favorable circumstances, households andbusinesses have gained confidence in the banking system, which has resulted in accelerating monetizationof the economy. However, these successes were achieved under an economic and legal structure that hasnot 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 impedefurther 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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Effective from 2000, real GDP in Ukraine has continued to grow. The highest GDP growth was noted in2004, although the growth rate is expected to slow down in 2005 as a result of temporary uncertainties inthe new government's economic policy.

105.9

109.2

105.2

109.3

112.1

106.5

100

102

104

106

108

110

112

114

2000 2001 2002 2003 2004 2005

Real GDP Growth

Percenta

geofgrowth

comparedtothepreviousyear

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 renovationand replacement of Ukraine's obsolete equipment and industrial machinery. As mentioned above, leasingis a financial instrument for the procurement of machinery, equipment, vehicles and other assets and, assuch, 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 replacefixed assets in these sectors has shown that every measure should be taken to facilitate mechanisms suchas leasing in order to allow for the quick replacement of fixed assets. Renewal of fixed assets is crucial toUkraine's efforts to achieve its social and economic objectives formulated and to improve its standard ofliving.

According to official data

3

, approximately 50% of the fixed assets

4

of all enterprises in Ukraine areobsolete, whereas, according to estimates, the obsolescence rate of machinery, vehicles and equipmenthas mounted to 80% to 90%.

The total investment volume required to renew Ukraine's fixed assets is approximately USD 90 billion. Ifwe compare this to the Ukrainian GDP of USD 65 billion, it becomes clear that Ukraine is on the verge ofa technical catastrophe.

3 President of Ukraine to the Ukrainian Parliament (Verkhovna Rada of Ukraine). Kyiv 2004. pp. 234, 276, 2784 Fixed assets, including immovable assets and movable assets


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The highest rates of obsolescence can be found in the fishing industry, the processing industry, thegeneration 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 increaseimports of capital equipment and technologies in the near future. Foreign capital will then have to becomea major source of financing for Ukrainian investments. Leasing has great potential for becoming thepreferred tool of foreign investors and its share in the investment volume will most likely show steadygrowth 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 of2004, 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 basedon 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 (asindicated above) increased by 135%. Despite the increases in several indicators, the Ukrainian leasingmarket is still in its infancy.

Based on a typical correlation between the GDP and the volume of leasing, and, moreover, the share ofthe leasing market in the total volume of investments in fixed assets of enterprises, it is estimated that thetotal value of lease contracts concluded could reach USD 395 million in 2005 and USD 452 million in2006.

Leasing portfolio by types of leased assets

Analysis of the structure of the leasing contracts' portfolio in terms of the value of leased assetsdemonstrates 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 suchassets. Trucks account for the second largest share in the structure of the leasing portfolio (slightly over24%, i.e. USD 57 million), whilst passenger cars rank third (slightly over 21%, i.e. USD 50 million). Itshould be noted, however, that 67.7% of Ukrainian leasing companies count passenger cars among theirleased assets.


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12,282

187

402

1,597

3,440

3,852

3,876

6,711

11,658

12,116

47,156

53,992

63,806

0 10,000 20,000 30,000 40,000 50,000 60,000 70,000

USD, thousands

Other

Telecomunication

equipment

Medical equipment

Computer equipment

Food p rocessing

equipment

Buildings

Printing equipment

Passenger transport

Production equipment

(accept food processing)

Agricultural machinery

Passenger cars

Trucks

Aircrafts

Portfolio of Leasing Companies by Types of Assets

as of December 31, 2004

Imported equipment accounts for most of the leasing transactions. This means that economic growth inUkraine 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 statisticsof the State Commission for the Regulation of the Financial Services Market in Ukraine ("theCommission"). The Commission oversees and monitors the development of the market of leasing servicesand 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 andinexpensive. On July 1, 2005, 74 leasing companies had registered with the Commission. However, weestimate 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% ofUkrainian 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 theUkrainian economy where holdings with head offices in Kyiv predominate. There is a great potential for


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regional expansion of leasing in the country. Currently, there are only six leasing companies that coverlocal regions in the country through agency networks. In most Ukrainian localities, leasing isunderdeveloped.

Types of ownership of leasing companies

If we break down the majority shareholding structure of leasing companies, we can identify the followingpattern: 16.1% have majority shareholdings by banks and other financial institutions, 3.2% by stateleasing companies, and 80.7% by individuals and legal entities. At the same time, 23% of the surveyedleasing companies are wholly owned by foreign legal entities and another 9% of companies have foreignequity.

According to the survey results, 29% of leasing companies are bank-related; this offers them theopportunity 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 activein the passenger car industry.

It is particularly interesting to see that, until today, the banking sector has been a relatively small player inthe leasing market. This situation is changing rapidly considering the number of banks that recentlylaunched 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 bothfinancial 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 thatthey 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 toleasing companies by potential lessees. In 2004, Ukrainian leasing companies received 2,784 leasingapplications, 1,431 of which were approved. In other words, the rejection rate for leasing applications in2004 was 48%. This shows a positive trend toward a moderate decrease in the rejection rate relative to2003 (55%). The high rejection rate can be attributed to factors such as: general conservative approach oflessors, insufficient solvency of potential lessees and lack of adequate financial resources for leasingtransactions.

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-sizedenterprises (sales ranging between USD 0.6 and 6 million) and 60% of leasing companies offer leasingservices to large enterprises (sales over USD 6 million). Only 37% of respondents were engaged intransactions with individuals.


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73% of respondents indicated that they provided leasing services to the SME sector. We would note thatthe majority of these services are car leases where the risks associated with leasing are generally lowcompared to other assets. The reality in Ukraine is that the Ukrainian SME sector is in particular need ofleasing services to finance capital investment and that leasing companies are hesitant to tap into thismarket. This is due to the high risks associated with SME financing despite the fact that margins tend tobe higher in this segment (worldwide around 10% versus 2.5%-5% for large companies). Capitalizationof profits and diversification of investments could, in the future, allow for increasing limits for more high-risk 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 theIFC leasing project in Ukraine. Although the legislative environment for leasing has been upgradedsignificantly 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 forcomprehensive regulations as to financial leases. For example, it defines financial leasing, and describesthe rights and obligations of the lessee and the lessor and the conditions governing early termination ofthe leasing contract. Moreover, the Financial Leasing Act provides for guidelines as to the protection ofthe 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 provisionsand 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 oftencontradict 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 lawprovides rules for relatively easy repossession, the execution of the law, in case of non-cooperation of thelessee, can be a serious problem. Ukrainian leasing companies approach this problem by carefulevaluation of potential lessees and thorough structuring of deals based on their experience. According toour survey, leasing companies stress the importance of careful evaluation of potential lessees. Thisapproach is taken by all survey respondents. Based on the survey, leasing companies had to contend withoverdue 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 thatare 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 theNotary 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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agreement has been notarized. As such this format is triggering the risk that a notary writ could not beissued 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 lessorsimply collects the leased equipment himself, with or without the lessee's consent. The lessor usuallybases the right to take such action upon a provision in the lease contract that expressly allows him to doso.

There is a very active but not a solid second-hand market for used equipment in Ukraine. For a leasedasset that is repossessed by a lessor there may be no possibility to sell it on the second-hand market tocover the lessor's claim. In case of a court case, being unfamiliar with the value of second-handequipment, the court might attribute an unrealistically high value to the equipment, thereby nullifying thelessor's claim for any further monies.

Legal proceedings

Our survey indicated that 36.7% of leasing companies lodged court cases for the recovery of leasedassets. However, the length and uncertainty of such legal proceedings and, moreover, the difficulty toenforce 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. Oursurvey showed that at the time the leasing companies responded to our survey, 33 repossessionproceedings were initiated. In 22 instances the property was recovered, the remaining 11 repossessionprocedures 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. Thedefinition of an operating lease is close to a negative definition as it mainly describes that the term of theagreement (less than one year) is shorter than that of a financial lease (longer than one year). The CIT Actdefines 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 ofthe following conditions:

1. The lease term exceeds the period in which at least 75% of the initial value is depreciated according tothe applicable Ukrainian tax depreciation scheme for the leased asset. Additionally, the lessee is obligedto purchase the leased asset at a price specified in the lease agreement upon expiry of the lease agreementor 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 tothe lessee and the lease installments in the lease agreement constitute at least 90% of the "regular price"

6 Fixed assets, including immovable assets and movable assets7 50% depreciation relative to its initial acquisition price


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upon commencement of the lease agreement, increased by the discount rate of the National Bank ofUkraine for the period of the lease contract.

4. The leased object has been produced according to the lessee's specifications and cannot be used byother entities during the period of the lease agreement due to its unique characteristics (because of itsprocess and quality features).

Interestingly enough, the Financial Leasing Act stipulates that, upon commencement of a leaseagreement, 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 differenttax 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 theasset 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 thelessee to the lessor, will be subject to corporate income tax at a rate of 25%, and should be included in thelessor's taxable income in the period in which the lease installment becomes payable. The return of theleased asset, if the lessee does not acquire ownership of the leased asset, will be treated for tax purposes8as a sale-back. The transfer value of the leased asset will be the "regular price9" effective on the date ofsuch a sale-back. The regular price may not be lower than the original value of the asset, reduced by theamount of depreciation charged in accordance with the CIT Act (i.e. book value). If the regular priceexceeds the book value of the leased asset, the difference is subject to corporate income tax. As the CITAct does not offer clear rules as to the situation where the asset is repossessed by the lessor, the taxadministration could equate repossession of the leased asset with the return of the leased asset by thelessee, implying that the repossession will also be considered as a sale-back transaction, with the sameconsequences for corporate income tax purposes as the situation where the lessee returns the leased assetto 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 leaseagreement as a financial lease, the lessee will have to increase the balance sheet value of the respective

8 Section 7.9.6 of the Corporate Income Tax Act.9 Section 1.20 of the Corporate Income Tax Act defines the principle of "regular price".


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group of fixed assets upon transfer of the leased asset to the lessee. The lessee will be entitled to claim thedepreciation over the term of the lease.

Besides claiming the depreciation on the leased asset, the lessee can deduct the interest or commissionpart 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 forcorporate 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 (seebelow).

Tax treatment of the lessee

Lease installments under an operating lease agreement paid by the lessee are fully tax-deductible forcorporate income tax purposes. If the leased object is a passenger car, only 50% of the lease installmentsare deductible.

Leasing (i.e. rental) income earned by non-residents is subject to 15% withholding tax unless aconvention 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 termof 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 bereported 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 dataprocessing, connected data reading and printing equipment, other information- related hardware andsoftware, telephones (including cellular), microphones, etc.

These rates are applied on a quarterly basis and are calculated on the basis of the declining-balancemethod.

Land is not be depreciated and intangible assets are amortized by using the straight-line method over theassets' useful life, up to a maximum of 10 years.


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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 thesupply of a good. Upon transfer of the leased asset to the lessee, the lessor is required to charge VAT onthe contract value of the leased asset as agreed in the lease agreement. The contract value cannot dropbelow 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 twicethe 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 regularprice of the leased asset at the time of return of the leased asset. This follows from the rule that the initialtransfer of the leased asset from the lessor to the lessee is, for VAT purposes, considered to correspondwith the transfer of ownership. Although the VAT Act is not clear on this point, repossession of theleased 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 aresident 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 nottreated as a supply of goods and is therefore not subject to VAT. This section does not imply that leaseinstallments under an operating lease are not subject to VAT, i.e. only the transfer of the good fallsoutside the scope of VAT application. The return of the leased asset under an operating lease is notsubject to VAT either.

Section 1.4 of the VAT Act further stipulates that an operating lease is considered as a supply of a serviceand 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 balancesheet as a fixed asset, the input VAT on such purchase will not be recoverable. According to the VATAct, 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 notallowed based on the fact that the CIT Act does not provide for the deduction of VAT.

10 The Ukrainian Value Added Tax Act of April 3, 1997 168/97- (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 theterm "regular price". Although Ukraine has not developed transfer pricing rules, Section 1.20 of the Corporate Income Tax Actrefers 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 isapproximately 9.5%.13 Section 3.2.2 of the VAT Act.


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Importation of goods under cross-border leasing agreements (including the return of the leased asset tothe resident lessor) is subject to import VAT. An exception to this rule with respect to aircraft wasrecently implemented; it was provided that the temporary importation of an aircraft under an operatinglease is exempt from VAT.

Financial aspects of leasing

The leasing companies that participated in our survey indicated that the key condition for developing theirbusinesses was access to financial resources. Leasing companies consider the funding of their operationsas the major problem that impacts the development of their business. The lack of financial resources isdue to the macro-economical instability, high inflation rate, the scarce availability of long-term credit andhigh interest rates and bank charges.

Banking sector

Despite the fast growth of the Ukrainian banking sector, most resident banks still have modest financialresources, including charter capital. The Ukrainian banking sector is still undercapitalized, which hamperslong-term borrowing and results in a limited volume of long-term bank loans.

Capital Development of Ukrainian Resident Banks14

Equity capital As of

01.01.03As of

01.01.04As of

01.01.05As of

01.04.05

Equity - total

USD million 1.874 2.416 3.473 3.861

Lack of long-term financial resources

The availability of financial resources is an absolute must for the expansion of the Ukrainian leasingmarket. Currently, leasing companies and Ukrainian banks are forced to reduce lease terms to two orthree 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), whichincreased 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 withlease 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 inUkraine's long-term macroeconomic stability. International commercial banks active in Ukraine admitthat they generally do not finance medium-term investment projects that are not backed by (1) exportproceeds, (2) export credit agencies, (3) multilaterals or (4) OECD-based sponsors, and that involve lessthan several million US dollars. Although the terms of loans that do not meet these criteria tend tobecome somewhat longer as a result of increasing competition from good-quality local borrowers, theyusually still span less than three years. Offering access to cheap long-term financing of capitalexpenditures 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


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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 forbank 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 tobusinesses were between 16% and 18%, and foreign-currency financing charges were between 12% and14%.

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 willcause 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 theturbulent political situation.

Sources of financing

Currently, most Ukrainian leasing companies finance their operations through loans from commercialbanks, while at the same time using equity-financing as well as advance payments made by lessees. Oursurvey of Ukrainian leasing companies showed that the leasing companies use a combination of thefollowing 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 aresecured by a whole range of securing methods. For example, banks require a pledge on the leased asset orassignment of the lease contract, or they demand that they be named the beneficiary of the insurance onthe leased object. Moreover, they usually require third-party guarantees or additional collateral in the

form of real estate, equipment, stock, securities, etc.


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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 financialaccounting practices and the financial management of Ukrainian leasing companies. The currentUkrainian National Accounting Standards are ambiguous and will need to be aligned with InternationalAccounting Standards. Ukrainian leasing companies will also need to recognize the importance of theircash position, forecast future cash flows and, where not already in place, introduce risk managementsystems 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 candramatically increase a company's competitive edge, such loans are difficult to obtain. In addition, manycompanies 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 byinternational certified auditors.

Advance payments and collateralization

Practically all surveyed financial leasing agreements require an advance payment to be made by the lesseefor the purposes of hedging against default by the lessee. This also serves as part of the financing of thelessor's operations. Our survey revealed that the average advance payment made to leasing companieswas about 22% of the cost of the leased equipment, with percentages ranging from 15% to 30%. Withrespect 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 thelaw provides for rules for relative easy repossession, the practice of execution of the law if the lesseerefuses to cooperate is quite different. Ukrainian leasing companies approach this problem by carefullyreviewing potential lessees and prudent structuring of deals based on past experience. Due to these andother issues, foreign leasing companies may want to consider establishing strategic alliances withprominent 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 clientbase, structuring leasing deals so that they comply with Ukrainian regulations, monitoring deals andtransferring 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 morecost-effective long-term financing and foreign equipment vendors, whilst the foreign leasing companywould stand to benefit from the services of an experienced agent with skilled personnel and extensiveknowledge of the local market. Alternatively, international lessors could open a local branch orsubsidiary. This strategy, however, would demand a considerable investment of time before the localmarket can be cornered. An added complication would be that skilled people in the leasing business areextremely scarce.

Conclusion and final comments


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Website: www leasing org ua16

Leasing is a critical tool for capital formation on a worldwide basis and has the potential to contributegreatly to the economic development and growth of Ukraine. The development of the Ukrainian leasingmarket is under pressure as a result of the political instability that arose after last year's OrangeRevolution. The outlook is positive, however, with the country's focus clearly set on integrating into theEuropean Union. The legal system does not yet provide a stable foundation for leasing; the length anduncertainty of legal proceedings has leasing companies carefully assessing the risks prior to concludinglease 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 forUkraine, but rather caused practically all foreign investors to put their plans for investments in theUkrainian leasing market on hold.

Due to the tax reforms that were introduced in March, leasing companies felt that their interests needed tobe 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 theleasing market, it also creates opportunities for foreign investors to provide more cost-effective long-termfinancing. In order to attract foreign investments, the operations of Ukrainian leasing companies shouldbe 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, technicalassistance and industry training should be provided, and government briefings should be conducted morefrequently. Moreover, potential lessees should be targeted to create public awareness of the changes thatleasing can bring about by turning businesses into flourishing enterprises.

Date post:	08-Apr-2018
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Leasing in Ukraine 2005

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