IT Industry Development in Wartime

The entire Ukrainian economy faced significant difficulties due to the war in 2022-2023. The IT sector was no exception, as many foreign clients put their projects in Ukraine on hold or reduced them due to war risks. Nevertheless, after Ukraine successfully defended its independence in early 2022 and international support began to flow, many foreign customers recognized significant investment opportunities in Ukraine due to its excellent value for money.

Given the substantial decline in exports from agriculture and heavy industry, the IT sector has become crucial for maintaining Ukraine’s foreign trade balance. In 2022, IT accounted for 44% of service exports, and preliminary results for 2023 indicate that it still represents more than 40% of total service exports. Additionally, the IT industry is showing great potential for growth. Over the past year alone, the number of employees involved increased by 8%, reaching over 307,000. 

Diia.City growth

The Diia.City legal regime has played a significant role in the stability and development of the IT sector. This new legal framework for the IT industry, which offers preferential taxation and flexible employment regulations, was launched just two weeks before the start of Russian aggression in February 2022.

Diia.City enables companies to choose between paying a 9% exit capital tax or the standard 18% corporate income tax. Furthermore, this legal regime provides preferable conditions for the payment of personal income tax (5%, military duty (1.5%), and a single social contribution (22% on the minimum wage). Additionally, Diia.City recognizes and provides legal regulation for many contractual tools widely used globally, such as non-compete agreements, convertible loans, and share options. Together with its flexible employment regulations, Diia.City has become one of the most favorable IT hubs in Europe.

In just two years of its existence, more than 950 companies have joined Diia.City. Notable big taxpayers such as Monobank, Ajax, SoftServe, EPAM, and Sigma Software are residents of Diia.City and enjoy the benefits of its legal regulation.

While Diia.City has significantly contributed to the growth of Ukraine’s IT sector, it’s important to acknowledge its imperfections. In its first two years, several legislative shortcomings were identified. These include controversies over the application of preferential personal income tax rates for certain types of employee payments and the fact that preferential tax rates apply only from the second month after a company becomes a resident of Diia.City, among other issues. However, many of the legal risks associated with these legislative defects can be significantly mitigated with proper contract drafting.

On a positive note, on April 23, 2024, the Ukrainian Parliament passed in the first reading Draft Law No. 9319 On Amendments to the Tax Code of Ukraine and Certain Other Legislative Acts to Stimulate the Development of the Digital Economy in Ukraine. This legislation aims to enable the application of preferential tax rates by startup companies that do not meet all the requirements for Diia.City residency.

Additionally, the initial launch phase of Diia.City faced significant concerns from IT companies hesitant to join the new legal framework due to the obligation to prepare and submit an annual compliance report to the Ministry of Digital Transformation of Ukraine, accompanied by an independent audit opinion. However, on 29 March 2022, the Cabinet of Ministers of Ukraine adopted Resolution No. 382 On Certain Issues of the Functioning of the Legal Regime of Diia.City in connection with the Introduction of Martial Law in Ukraine. This resolution relieved Diia.City residents from the obligation to file these reports and audit opinions during martial law, essentially allowing them to not comply with residency requirements during this period.

After nearly two whole years of war, on February 13 2024, the Cabinet of Ministers of Ukraine adopted Resolution No. 163 On Certain Issues Regarding the Restoration of Reporting by Residents of Diia.City (Restoration of Reporting Resolution). This resolution repealed the Martial Law Reporting Resolution and reinstated the requirement for Diia.City residents to file an annual compliance report with an independent auditor’s opinion, starting in 2024 for the 2023 reporting year. However, the Restoration of Reporting Resolution includes provisions that Diia.City residents will not lose their status based on the reports and opinions filed this year. Essentially, the Ukrainian government is cautiously reinstating reporting requirements for Diia.City residents, establishing 2024 as a transition year when residents must submit reports but will not lose their residency status in the event of non-compliance.

Despite these changes, a significant portion of IT companies still distrust the new legal framework developed by the government and continues to use a standard corporate structure with IT staff registered as individual entrepreneurs. However, an increasing number of IT companies are moving away from this traditional structure, which carries considerable tax and labor risks, in favor of the progressive new regime offered by Diia.City. This regime aims to integrate the best global practices while maintaining privileged tax rates.

War challenges

Mobilization of employees has emerged as one of the most significant risks for IT companies during Russia’s ongoing war. Given that over 77% of employees in the IT industry are men, and this figure rises to 92% among software developers, mitigating the risk of losing employees to army recruitment has become critically important. Current legal regulations allow a company to reserve against recruitment up to 50% of its employees who are liable for military service, provided that the company is recognized as critically important for the economy or the livelihood of the population during the war. This recognition is granted by a relevant ministry or local self-government body based on seven criteria, at least three of which must be met by the company.

Being a resident of Diia.City counts as one of these seven criteria, significantly enhancing the likelihood of IT companies being recognized as critically important. However, the reservation process involves several stages of approval by different state authorities and can take months before a final decision is received. Additionally, companies can only reserve up to 50% of their employees liable for military service if these employees are properly registered at recruitment centers of the Armed Forces of Ukraine. A common issue is that many IT employees do not have up-to-date military registration documents and are reluctant to appear at recruitment centers due to fear of being immediately mobilized, making their reservation challenging.

Diia.City residents do have certain advantages in this regard. These companies can structure their employment relationships using either a standard employment agreement, which is strictly regulated by labor legislation, or a gig contract, a civil law contract that provides social guarantees for the employee and contractual freedom to regulate relations at the discretion of the parties. Under a standard employment agreement, the company must maintain military records for employees liable for military service and periodically report to recruitment centers. Only employees under standard employment agreements can be reserved against recruitment. By contrast, for employees under gig contracts, the company is not required to keep military records or report to recruitment centers and, therefore, these employees cannot be reserved against recruitment. This flexibility enables Diia.City residents, unlike ordinary enterprises, to adapt their contractual relationships based on different employment scenarios. 

War opportunities

It’s crucial to recognize that the war has not only posed additional challenges for the IT sector but also opened up new opportunities. The ongoing military operations and the strong desire of Ukrainians to support their country’s defense against Russian aggression have fueled the rapid growth of defense technology companies.

In April 2023, the Ukrainian government established the Brave1 defense tech cluster to encourage the development of military innovations and defense technologies. This cluster has already brought together over 800 projects in this domain. Approximately 20% of its members are businesses that make flying drones. Additionally, a significant number of these companies are involved in developing and manufacturing combat robots for various purposes, as well as automated control, communication, and protection systems, and military security systems that require sophisticated software. Many of these companies are startups that emerged as a direct result of the war. The creation of these technologies relies heavily on the expertise of Ukrainian IT firms, which are actively involved in developing military innovations. Consequently, Ukraine has become a hub for advanced defense tech startups.

Upcoming changes

On 27 December 2023, the Ukrainian government approved and published the National Income Strategy for 2024-2030. This strategy has sparked significant criticism and discussion within society, as it proposes further reforms to the tax and customs systems aimed at enhancing Ukraine’s financial independence.

A key change outlined in the document relates to the simplified taxation system, which is extensively utilized by IT companies to optimize taxes on personal income, military duty, and social contributions. Currently, these organizations often employ staff as individual entrepreneurs, who can opt for a simplified tax at a preferential 5% personal income tax rate and a social contribution of only 22% of the official state minimum wage. This regime allows for up to 30% savings in staff costs compared to general taxation norms, which include 18% personal income tax, 1.5% military duty, and a social contribution of 22% of the accrued wage.

However, the National Income Strategy proposes differentiated tax rates for the simplified system, varying from 3% for trading activities to 17% for certain services. Since software development is categorized as a service, the personal income tax for IT staff registered as individual entrepreneurs could rise significantly. Consequently, the IT industry will likely need to restructure to optimize tax burdens.

Importantly, the National Income Strategy does not suggest any amendments to the favorable tax conditions for Diia.City residents. According to Law № 1667-IX, enacted on 15 July 2021, to Stimulate the Development of the Digital Economy in Ukraine, Diia.City’s legal regime and its tax conditions are guaranteed to remain stable for the first 25 years. This indicates that the government has no immediate plans to alter the advantageous tax conditions available to Diia.City residents.

Given that the National Income Strategy aligns itself with one of the IMF’s structural “beacons” for continued financial support of Ukraine, the likelihood is high that this strategy will be implemented as part of Ukraine’s obligations to international partners. This scenario suggests that the IT sector may experience significant corporate changes in coming years, potentially making Diia.City even more appealing for IT companies seeking to maintain preferential taxation.

In summary, while the war has posed significant challenges to IT companies, impacting their business processes, the IT sector remains the cornerstone of the Ukrainian economy with promising growth prospects despite ongoing conflict situations. Moreover, Diia.City has demonstrated remarkable growth in the two years since it was established and is progressively becoming one of Europe’s most attractive IT hubs.

  • Igor Reutov

    Partner, GRAMATSKIY & PARTNERS, attorney-at-law

  • Volodymyr Khomenko

    Senior Associate, GRAMATSKIY & PARTNERS, attorney-at-law

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