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LLM, Head of Department, Attorney, Gramatskiy & Partners Attorneys at Law
Diia City: the New Legal Framework for the IT Industry
The Ukrainian IT industry has demonstrated a consistent tendency to grow over the past decade and it has become a powerful part of the Ukrainian economy. To make it more attractive for big companies and start-ups the government has launched a new project called Diia City.
Diia City creates a new legal framework for the IT industry and has ambitions to set up in Ukraine the most powerful IT hub in Central and Eastern Europe. According to the promoters, there will be no limits to investment, job creation and the development of new technologies. The government believes that Ukrainians and entrepreneurs around the world will be able to quickly and effectively implement the most ambitious ideas of innovation and business, which will result in an increase in IT products and services of up to 10% of Ukraine’s GDP.
The proposed legal framework consists of two Laws: Law No. 4303 On Stimulating the Development of the Digital Economy in Ukraine of 2 November 2020 (Digital Economy Stimulation Law) and Law No. 5376 On Amending the Tax Code of Ukraine to Stimulate the Development of the Digital Economy in Ukraine of 14 April 2021 (Digital Economy Tax Stimulation Law).
Regulatory Incentives for the IT Industry
The Digital Economy Stimulation Law, drawn up by the Ukrainian government, provides a new legal framework for the IT industry in Ukraine. The proposed legislation will create a new IT cluster called Diia City with favorable and flexible regulation making it clearer and more understandable for big companies when they enter the Ukrainian market. The Digital Economy Stimulation Law consists of specific features such as gig contracts and gig specialists that align Ukrainian business practice in the IT sector (including individual (private) entrepreneurs) with the expectations of big players who often lack understanding of such practices and have high-risk expectations.
According to the Digital Economy Stimulation Law, businesses that meet the legal requirements can be registered as residents of Diia City and benefit from the preferences of that residence. One of the key changes deals with the recognition of the contractual relationships between an IT company and its specialists. The residents of Diia City will have the right to hire gig specialists who will formally receive benefits similar to those of employees. For example, annual paid leave for seventeen (17) business days, social insurance, maternity leave, sick leave, a 40-hour week, etc. At the same time, gig specialists are not considered employees. Moreover, relationships within Diia City are explicitly excluded from the regulation by the outdated Labor Code of Ukraine. Diia City residents will have the right to terminate the gig-contract with a 30-day notice period, control and monitor the performance of the contract, bind the gig specialist via corporate policies, etc. Copyright, an important issue in the IT field, has also been given its specific regulation in line with the existing legal framework — economic rights belong to the company and the moral rights remain with gig specialists.
To strengthen the position of companies, The Digital Economy Stimulation Law recognizes such agreements as non-disclosure agreements (NDA), non-competition agreements (NCA), and non-solicitation agreements (NSA), which are widely used by the parties but currently lack regulatory support and recognition. To be enforceable, the agreements should be made in writing. The Digital Economy Stimulation Law allows these agreements to be effective tools for protecting businesses. Thus, the NDA should indicate the scope of confidential information and the period of non-disclosure. Should the gig specialist or an employee breach the non-disclosure obligation then the compensation indicated in the NDA should be paid. Such compensation is not limited, as opposed to existing regulation of similar compensation to labor relationships. The essential terms of the NCA embody the following: the period of its validity, which should not exceed twelve (12) months following the termination of contractual or labor relationships; the territory covered by the NCA; specific list of activities that are treated as a competition; compensation for compliance with the NCA to be paid to the IT specialist. The NSA shall contain an obligation not to solicit clients and/or specialists for the period that should not exceed one (1) year after termination of the contract. In the event of a breach, the breaching party shall pay penalties set out by the agreement.
Furthermore, The Digital Economy Stimulation Law introduces a model that is absolutely new for Ukrainian law, like share options as a motivation plan for employees and gig specialists. Detailed regulation of the share purchase option should, however, be provided for in separate legislation. In addition, the new law will explicitly address cases of misrepresentation and the liabilities incurred as a result of such misrepresentation.
Thus, the proposed regulation of the above-mentioned agreements and models will become powerful protective means for companies and potential investors in the IT business compared to the existing status quo.
Diia City General Requirements
Diia City residents are allowed to engage in the following business activities:
- Software development and testing, including games;
- Release and distribution of software, applications;
- Provision of the software online;
- Teaching computer literacy, programming, testing, software technical support;
- Data processing and website management;
- Digital marketing and adverts using software developed by residents;
- R&D in IT and Telecom;
- Providing services related to the flow of virtual assets.
The general requirements for Diia City residency are quite reasonable and they are aligned with the current position. They consist of the following: 1) conducting IT business (as listed above) and receive at least 90% of their income from such activity; 2) average monthly remuneration of employees and gig specialists should not be less than USD 1,400; 3) the average number of employees and gig specialists should not be less than nine (9) per month.
There are also certain restrictions on Diia City Residency. Such restrictions, inter alia, include the following provisions:
- the company should be registered in Ukraine and its beneficial owners should be disclosed;
- the company should not have shares owned by the Ukrainian government (or local authorities) exceeding 25%; likewise,
- shareholders holding 25% or more should not be registered in the territory included in the FATF-list;
- direct or indirect shareholders holding 10% or more cannot be a resident of the aggressor state (Russia);
- the company should not be under sanctions under Ukrainian law; the company should not be in the process of winding up or bankruptcy;
- the company should not have an outstanding tax debt exceeding ten (10) minimum salaries (i.e. UAH 60,000 as of 2021) for more than thirty (30) days.
The promoters claim that the Diia City regulation will be effective for at least fifteen (15) years. However, if the law changes during that period it will apply to Diia City residents if the changes improve their conditions. For example, decrease in tax rates, decrease in liabilities, etc.
To become a resident of Diia City, the company should submit an application with information proving its eligibility for Diia City benefits. The application is to be considered by the state authority for ten (10) business days. Furthermore, if approved, the company will be registered as a Diia City resident in a special register.
In addition, Diia City residents have to file a report of compliance with the requirements. For the first time, such a report is to be submitted not later than the last day of the fifth month following the month of registration as a Diia City resident and the report should then be filed before 1 June for the previous year on a regular annual basis.
Another major feature of the Diia City system is taxation, which will be governed by the Digital Economy Tax Stimulation Bill. The promoters of Diia City insist that the bill on taxation will set out low tax rates compared to the conventional regulation and provide the following tax rates: 5% personal income tax (PIT); 1.5% military levy and 22% social tax of the minimum salary. Moreover, Diia City residents will not be subject to corporate income tax (CIT) with its regular rate of 18%. Instead, certain transactions which result in capital outflow will be taxed at the rate of 9%.
Such transactions embrace dividends, royalties, interests and other transactions with foreign parties unless the funds eventually return to Ukraine.
One of the most controversial provisions is the inclusion of transactions with simplified (unified) taxpayers (exceeding 20% of expenses for any activity of the Diia City resident) in the tax base. The promoters declare that this provision will be postponed for three (3) years. However, The Digital Economy Tax Stimulation Bill (as of May 2021) indicates that this limitation will come into force from 1 January 2024. For this reason, many small and middle-sized IT-outsourcing companies who benefit from cooperation with the simplified (unified) taxpayers oppose the new regulation.
It should be observed that the special tax regime is not automatic and it is not enough to merely be registered as a Diia City resident. In order to be entitled to use the benefits of the special tax regime a Diia City resident has to submit an application to the tax authority within ten (10) days after their registration in the Diia City Register. The special tax regime will be effective from the first month of the quarter following the one when the Diia City resident is registered with the Diia City Register. However, the Diia City resident registered with the Diia City Register who failed to file the application for use of the special tax regime will pay regular taxes, i.e. CIT 18%, PIT 18%.
The intended legal framework is aimed at finding a compromise between the interests of state and IT-business — the model, which, on the one hand, includes protection of gig specialists, and provide them with almost the same benefits as regular employees have and, on the other hand, the companies receive flexibility in engaging gig specialists and control over their performance without onerous employment regulations. In addition, reasonable taxes are promised to be an integral part of the Diia City regimen. The authors of the Diia City project do not conceal their primary intention to create attractive conditions for IT product companies, as opposed to IT outsourcing companies booming in Ukraine. For this reason, the IT industry is not unanimous in its evaluation of the proposed regulation.