Protection from arbitrariness and Bitcoin regulation: what Diia City offers Ukraine’s IT sector

In the coming years, Ukraine aims to become one of the world’s largest IT hubs and, in the longer term, to grow the market to $12 billion. To this end, the Ministry of Digital Transformation has developed a special legal regime Дiя City

ForkLog has found out what will attract IT specialists to the country and what role cryptocurrencies may play in this.

A Few Figures

Around 200,000 people are employed in Ukraine’s IT sector, working in about 6,000 companies. The industry contributes to the budget more than $4 billion each year, with growth rates averaging up to 20% per year. Exports of IT services are growing by 19% annually, and employment in the sector is growing by 17%.

In 2019, the IT sector paid nearly 10 billion hryvnias in taxes (about $354 million). Half of that — 5.2 billion hryvnias — was the single tax. The second-largest contribution was personal income tax and the military levy — 2.2 billion hryvnias. VAT for that period amounted to 1.4 billion hryvnias.

Challenges for Ukraine’s IT Sector

The legal environment in Ukraine is not aligned with international norms for running IT business. Many mechanisms convenient for foreigners are either illegal or require additional addenda to contracts. This does not promote investment attractiveness of the state.

Outdated labour norms foster shadow work.

As a result, everyone loses: workers without rights protection, companies that cannot attract foreign investment, and the state that misses out on billions in taxes.

Without investment and a conducive environment, Ukraine cedes leadership to Western peers and remains peripheral for high-tech industries. Qualified professionals are migrating abroad.

Under the current labour, tax and corporate laws, Ukraine’s IT sector cannot compete. The Ministry of Digital Transformation sees Diia City as an alternative, which represents a win-win solution for the industry and the state.

What Diia City Offers?

The project develops a comprehensive set of conditions for IT specialists to realise themselves and to work in top global tech companies without leaving Ukraine.

It will also offer opportunities for developing and scaling businesses, including the opening of R&D offices.

Local IT companies will gain access to foreign venture capital, and Ukrainian industry investors will receive profit reliefs, linked to the size of their investments.

To make the production of IT products profitable, the project offers a unique employment model – GIG.

This is a hybrid of an employment contract and a contract for services: the specialist has defined rights and duties, while the employer gains a flexible form of cooperation and a lower tax burden on the worker.

The initiative draws on the experience of developed countries: envisages adopting English law tools and the ability to approach foreign courts.

Head of the Blockchain Association of Ukraine (BAU) Natalia Drik views this innovation positively.

“English law is a must. If we want investment, we must speak the language of investors, not impose our own charter, which we change every two years,” she told ForkLog.

The expert cites Kazakhstan, where certain English-law institutions have already been embedded in civil relationships.

“In a dedicated zone this is more than feasible. Let’s see if Ukrainian policymakers can pull it off,” Drik added.

Integrating Anglo-American law-system institutions into the Roman-Germanic framework to which Ukrainian law belongs is no easy task, says Sergey Ovcharenko, development director at Alcor, a lawyer.

Legal aspects of doing business under English law are more progressive than in Ukraine and have a substantial base of judicial precedents. However, the relevance of English law without its use in Ukrainian courts raises doubts with the expert.

“English law is not aligned with Ukrainian realities. To apply foreign law in Ukraine, one must first overhaul a whole block of laws and sub-laws, not merely point to declarative provisions,” Ovcharenko said.

Otherwise this would introduce inconsistencies into any deals and create legal collisions, adds the lawyer.

Partner at Dexis Partners, attorney Oksana Dankevich also believes that fitting the entire system of English court precedents into Ukraine’s legal field is impossible.

“It’s like sewing a wheel onto a horse and hoping it will turn,” she says.

The Ministry of Digital Transformation noted that the bill does not provide for cross-referencing or references to foreign law. Agreements will continue to be governed by Ukrainian law. However, it will introduce new tools that foreign investors are used to, which should not create legal conflicts.

What About Taxes?

Diia City liberalises the tax regime for the IT sector to make it a driver of Ukraine’s economic growth.

As part of the draft bills for launching Diia City, it is proposed to reduce personal income tax to 5%, and to tax the single tax at 22% on the minimum wage.

Profit tax would be replaced by a tax on distributed capital at 9%. The bill also provides additional incentives, such as a zero rate on distributed capital if dividends have not been withdrawn for more than two years.

A 5% personal income tax is a safety cushion for the IT sector in case of reforms to the FOP regime and tax hikes, explains BAU head Natalia Drik.

Lowering the single tax to 22% also aligns with a progressive development strategy, since the current payroll tax rate sits at 41.5%.

An additional advantage to business would come from replacing the profit tax with a tax on distributed capital. The rule is already used in a number of neighbouring countries and is due to be adopted in Poland soon.

“The introduction of this tax for Ukraine is not a whim, but the only way to survive. And ideally, it should be applied nationwide, not only in the special zone,” notes Drik.

According to her, Diia City will be a testbed for the new tax model that could, in time, be extended to the whole country.

The lawyer Sergey Ovcharenko, for his part, sees a substantial risk for companies in the lack of clarity about when tax rates will be set.

Mask Show Stop!

One of Diia City’s priorities will be protecting IT business from improper interference by security agencies. The project authors propose to raise sanctions for investigative actions and criminal proceedings.

Investigations against Diia City residents would be initiated only by a prosecutor at or above the level of the head of the regional prosecutor’s office.

A Diia City resident would obtain the status of a special subject in criminal proceedings. A special procedure for criminal proceedings would apply to them, alongside lawyers and local council deputies.

Law enforcement would be barred from seizing equipment, allowing only digital copies of information, so that companies do not incur losses from downtime.

These proposals seem like half measures, says lawyer Sergey Ovcharenko. Moreover, it remains unclear how non-residents of Diia City would be treated under such pressure.

“To avoid ‘strange’ inspections and regulate this matter, a law ‘Mask Show Stop – 3’ is needed. It sets out all the necessary conditions to prevent such situations. Illicit searches and investigations harm not only the company but the country as well, since investors do not want to risk their capital,” explains the lawyer.

Limiting the initiation of investigations seems a weak solution, but probably the best available for now, says Natalia Drik.

Only a full and successful reform of the prosecutor’s office and judiciary can resolve the pressure on business, she notes.

Continuity of Expertise

For consultation in developing Diia City from Belarus invited the senior partner of the law firm Aleynikov & Partners, Denys Aleinikov, who participated in the creation of the state decree “On the Development of the Digital Economy” and the High-Technology Park (HTP).

His tasks include preparing tools and mechanisms for the functioning of the new legal regime.

According to Aleinikov, the project creates unprecedented incentives for the IT industry and serves as a tool to attract international capital into the Ukrainian economy, while barely requiring state subsidies.

Cryptocurrency as an Additional Incentive

Ukraine already ranks in the top three countries by the number of blockchain developers. In the view of the Ministry of Digital Transformation, creating a legal field for tokenisation would spur new innovative projects in this area.

It is not out of the question that investments in virtual assets could surpass investments in other IT sectors.

The Diia City authors regard the government’s approach to legalising the virtual assets market as ambitious and constructive:

“The draft law On Virtual Assets takes into account the interests of the market, the state, and other stakeholders and largely responds to the demands of business. For future Diia City residents it is important to work through the normative acts in the relevant bill, the AML law, changes to the Tax Code and the money-laundering monitoring procedures,” they add.

When is the Launch?

The Diia City project is in the final stage of development.

Launch will hinge on the passage of the bills that establish the legal basis for the operation of Diia City: “On Stimulating the Development of the Digital Economy in Ukraine” and “On a Special Procedure for Investigating Criminal Offences to Ensure Appropriate Conditions for the Development of the Digital Economy.” On 2 November they presented them for consideration in the Verkhovna Rada.

Diia City’s plan over five years is to grow the IT sector to $12 billion, representing up to 10% of the country’s GDP, and to create more than 450,000 new jobs.

“The Belarus experience, when after the launch of PVT 2.0 the export of the IT sector doubled, shows that this is quite feasible. Ukraine, in my view, has enormous potential and a number of strong competitive advantages,” emphasised Denys Aleynnikov.

Aspiration vs. Reality

One of the most innovative and controversial aspects of the Diia City project is its extraterritoriality. The consequences of its application remain unclear.

“Whatever is done in the separate zone, it would be desirable if meaningful changes were also seen in the country itself,” reflects Natalia Drik, head of BAU.

According to her, in five years the IT sector must move from a raw material (outsourcing/outsourcing) model to a product one. Otherwise, specialists will soon be replaced by algorithms.

A key factor is the awareness of IT leaders and their willingness to build a full ecosystem, not merely to view the initiative through the lens of keeping taxes low, emphasises Drik:

“If business wants money to be managed not by the state, its willingness to fund the ecosystem itself is crucial.”

Not all proposals from working groups were incorporated into the final Diia City draft, says Kuna founder Mikhail Chobanian.

“This is simply a very trimmed version of the private-city project our team proposed. Accordingly, it does not address judicial, banking and law-enforcement questions. The benefit of the ‘lower’ tax is limited if all other issues before tax are not resolved. Unlike the Diia app, I do not see much point in this project,” he says.

Ukraine still operates under the 1971 Labour Code and the 1999 presidential decree on the simplified taxation system. The authors of Diia City plan to add a third category, GIG, which would effectively sit between FOP and a company employee.

“The idea is good, but given the ‘old’ legislation, implementing it will be difficult. You cannot regulate something new with old rules, as Diia City proposes,” notes lawyer Sergey Ovcharenko. “I think it would be better to preserve the contractual form of cooperation between a company and IT specialists.”

The expert does not rule out that the creation of a new state-owned enterprise, which could in the future become a regulatory body for IT, could give rise to corruption ties, opacity and waste.

“In my view, first transform and improve legislation, especially the Labour Code, test the model, and then implement the special zone project for the creative industries,” Ovcharenko said.

The draft bill regulating the creation of Diia City contains a fairly vague formulation that “the special legal regime is established for not less than 15 years from the date of entry into force.” It does not explain the duration of the regime, says attorney Oksana Dankevich.

Concerns are raised by the “peculiarity” of the IT sector’s status and the “greenhouse” conditions for Diia City residents. The exclusion of other sectors and IT firms that are non-residents is a hard discrimination, notes the expert.

“So far it is unclear who will be the ‘central body’ running the resident registry. This is an extra channel of administrative pressure, since losing resident status would have serious consequences for a company,” she adds.

Moreover, to become a Diia City resident, IT-KVED codes must be present not only in the registry but also in the charter.

“Imagine what will happen when all IT companies rush to amend their charters, since they do not necessarily contain KVEDs,” Dankevich warns.

Also unclear are the qualification requirements for service providers dealing with turnover of virtual assets.

According to the expert, tax incentives and special statuses are undoubtedly welcome but not when given in exchange for obedience. In this case — in exchange for compliance.

“Given Ukraine’s realities, the benefits could be withdrawn, but returning to FOP work without risk from the State Labour Service will be impossible. It sounds like a one-way ticket. Though perhaps there is a bright future,” concludes Oksana Dankevich.

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