Review of the Tax System in the Kyrgyz Republic March 2024 THE REPORT IS CO-FUNDED BY THE GLOBAL TAX PROGRAM AND THE WORLD BANK The report has been prepared by a World Bank team comprising Oleksii Balabushko, Gohar Gyulumyan, Bakyt Dubashov, Dusan Vujovic, and Lee Burns The team benefited greatly from insights and discussions with numerous officials and experts from State Tax Service, Ministry of Economy, Ministry of Finance and other government officials. . 2 CONTENTS Executive Summary .......................................................................................................................................................5 Macro-Fiscal Context and Scope for the Review ...........................................................................................................8 Tax revenue structure and trends .................................................................................................................................9 Key Tax instruments ....................................................................................................................................................11 Personal Income Tax ................................................................................................................................................11 PIT Rate ................................................................................................................................................................12 PIT Base................................................................................................................................................................13 PIT recommendations ..........................................................................................................................................14 Corporate Income Tax (CIT) .....................................................................................................................................15 CIT Rate ................................................................................................................................................................15 CIT Base ...............................................................................................................................................................16 CIT exemptions ....................................................................................................................................................17 International Tax Considerations .........................................................................................................................18 CIT Recommendations .........................................................................................................................................19 Base erosion and profit shifting project ..................................................................................................................20 Value added tax and sales tax .................................................................................................................................21 VAT.......................................................................................................................................................................21 Imported digital services .....................................................................................................................................24 Sales tax ...............................................................................................................................................................25 Concessional Tax regimes ........................................................................................................................................26 Free Economic Zones ...........................................................................................................................................26 High Technology Parks .........................................................................................................................................27 Small business taxation ...........................................................................................................................................27 Excise Tax .................................................................................................................................................................28 Mining taxation........................................................................................................................................................30 Property taxation .....................................................................................................................................................32 Property tax applicable to residential and commercial buildings .......................................................................32 Property tax on agricultural land .........................................................................................................................33 Property tax on vehicles ......................................................................................................................................33 Tax gap .........................................................................................................................................................................33 Top-down approach to evaluating tax gap ..........................................................................................................33 Bottom-up approach to evaluating tax gap .........................................................................................................34 Evaluating Tax Gap by tax instrument .....................................................................................................................36 3 PIT Tax Gap ..........................................................................................................................................................36 CIT Tax Gap ..........................................................................................................................................................37 Mining Tax Gap ....................................................................................................................................................37 VAT Tax Gap .........................................................................................................................................................38 Property Tax Gap .................................................................................................................................................41 Tax Administration Contraints .....................................................................................................................................42 Conclusions and Recommendations ............................................................................................................................44 Informal economy ...................................................................................................................................................44 Tax expenditure Gap................................................................................................................................................44 Tax Efficiency Gap ....................................................................................................................................................45 Tax Compliance Gap ................................................................................................................................................45 Annex 1. Tax Gap Framework ......................................................................................................................................47 Annex 2. data tables ....................................................................................................................................................49 Annex 3.reconciling alternative Tax Gap estimates.....................................................................................................53 4 EXECUTIVE SUMMARY 1. Tax revenues to GDP ratio in the Kyrgyz Republic is higher than most lower middle income countries at above 28 percent of GDP in 2022, but complex tax structure, narrow base and remaining weaknesses in tax administration pose risks to sustainability and create unequal tax burden across taxpayers. Revenue performance in 2021-23 improved significantly due to improvements in tax administration, but significant share of the improved tax collection is contributed by VAT on imports which is likely attributed to trade diversion after imposition of trade sanctions on Russia. The transit trade driven by the sanctions has increased substantially during 2022-2023 period. Assuming that the relative share of imports would have stayed at the actual 2021 level (64.5 percent), we estimate that the transit trade contributed to increase in VAT revenues of KGS 25.2 billion (equivalent of 2.6 percent of GDP) in 2022, and an estimated KGS 37.9 billion in additional VAT revenues (3.3 percent of estimated GDP) in 2023. These one-off exceptional revenues should be isolated and treated separately when making medium-to-longer run tax revenue forecasts and when considering tax policies. 2. This report looks into three major issues –tax gap and how it could be reasonably reduced over the medium term; needed tax policy changes; and how administration provisions in tax legislation can support the same level of tax revenues, with more equitable distribution of tax burden promoting growth and lowering compliance costs. The report touches briefly on tax administration key issues, as ongoing tax administration reform agenda supported by the World Bank funded project is currently underway. 3. Complex tax structure, narrow tax base and remaining weaknesses in tax administration, the tax gap is significant and has been increasing as a share of GDP. Tax expenditure gap Tax compliance gap 15 10 5 0 2018 2019 2020 2021 2022 4. The Government of the Kyrgyz Republic needs to improve revenue efficiency by fighting the informal economy, reducing widespread tax gaps and advancing structural reforms . On the policy side, there is a number of reforms which can broaden the tax base: a. Broaden the base of PIT. Moving to progressive personal income taxation has potential to be revenue neutral and lower burden of taxation on poor and vulnerable in a way that is better targeted that exemption in consumption taxes. Personal income tax has flat rate (at 12 percent) undermines equalization power of the personal income taxation. 5 b. Broaden tax base of CIT. The standard corporate income tax rate is low – 10 percent. Taxpayers in agriculture, energy sector, remote areas in addition to Free Economic Zones, Creative Industries Zone and High Technology Park regimes are exempt from CIT or pay lower rate. The proposed 15 percent global minimum effective tax rate for large MNEs may result in companies operating in the Kyrgyz Republic taxed in other jurisdictions. Tax holidays are also likely to be incompatible with the global minimum tax. Cost-based incentives (such as accelerated depreciation for investment) that are essentially timing benefits are likely to be protected under the global minimum tax and tend to better incentivize investments. Increasing the rate to 15 percent with simultaneous rationalization of tax exemptions can increase revenues, while preparing the Kyrgyz Republic for global minimum tax. Gradual shift to cost-based incentives in CIT can be more effective in promoting investments, while creating level playing field among taxpayers. c. Streamline consumption taxes, while broadening the base. VAT rate is low compared to most regional peers and internationally, and recent increase of the registration threshold from KGS 8 million to KGS 30 million combined with opportunity for businesses choose simplified regime even if they operate above the new threshold would narrow the tax vase. The VAT refund on exports has issues with many refund delayed. VAT has a number of exemptions on intermediate supplies, which break VAT chain and together with sales tax results in cascading effect of tax. Sales tax applies only to domestic supplies and not imports, which means that imports are more lightly taxed than domestic production. Excises taxes are well designed, but some rates could be increased in line with Kyrgyz commitments on climate changes (petroleum), alignment with WHO (tobacco). The Kyrgyz Republic should consider eliminating sales tax, increasing VAT rate, and removing exemptions on intermediate goods. This will simplify administration and eliminate tax cascading. Increases in excises can be a non-distortive way to increase revenues. d. Gradually move to market value property taxation. Property taxation does not align with market value of properties, resulting in low and declining share of property tax in tax revenues (below 0.4 percent of GDP). Property taxes are based on area and geographical coefficients, and in case of agricultural land use of the plot. Moving to market value should be done gradually. The Government could establish a set of qualitative criteria for determining the value of property. Examples of these criteria could be size of building on the land, surface area of the land, proximity to services, access to education and healthcare facilities, square footage of building, rental versus owned property etc. Once these criteria have been established, they could be verified using photographic information, reported information by taxpayers or just visiting properties. The government could take this information and correlate it with the sales data and create a series of parameters with a relative ranking for each region or local government area. This approach multiplied by a flat tax rate would yield differences in property value assessments and differential tax rates for more valuable properties. 6 5. The Kyrgyz Republic needs to continue advancing on tax administration to reduce informal economy and ensure low cost of compliance. Cutting the share of informal economy in half could increase tax revenues by 2.5 - 4.3 percent of GDP. The focus on awareness and advocacy campaign, training of taxpayers, and combination of fiscal incentives and strengthened tax discipline can help achieve this objective. On tax administration side, the STS has undertaken a number of digitalization measures—e- invoice, e-filing, goods e-tracking system, and introduction of online cash machines. However, compliance management is not based on risks yet. The findings of the recent 2022 Tax Compliance Cost Survey of 1,100 businesses showed that ten years after reforms were initiated, companies spent more time complying with the VAT obligations than at the beginning of the reform process. These rising compliance costs in the face of reforms that aimed at reducing such costs do not enhance trust in government fairness or in long-term business development plans. To change this, business processes need to be updated, IT infrastructure upgraded for adequate service provision, and new modern techniques based on data analytics can both strengthen enforcement and lower burden on taxpayers. Compliance risk management should be developed and implemented across registration, filing, payment and audit. 6. Combined, these measures can help broaden the tax base and, in the future, allow to lower tax burden on select few while improving business environment and promoting economic growth through the tax system. 7 MACRO-FISCAL CONTEXT AND SCOPE FOR THE REVIEW 7. The Government of the Kyrgyz Republic is faced with a difficult task to curb inflationary pressures, maintain balanced fiscal position and rebuild macroeconomic buffers needed to strengthen resilience to possible external shocks. Kyrgyz economy grew at 9 percent in 2022 driven by gold production, trade, transportation, and agriculture. Annual headline inflation increased to over 14.7 percent due to high global food and fuel prices, while core inflation followed, reaching double digits. The preliminary official estimates suggests GDP growth in 2023 at 6.3 percent despite global economic slowdown and the impact of Russian economy contraction. In the medium-term (2024-2028), GDP growth is projected to return to its potential rate and stabilize at around 4 percent, below the level needed to lift people out of poverty. Headline inflation declined to below 10 percent at the end-2023, and is expected to further slow to 8 and 5.5 percent in 2024 and 2025 respectively. The medium-term outlook is subject to many risks including deceleration of growth, acceleration of structurally disrupted inflow and decline of remittances, high imported energy and commodity prices, the global economic slowdown, and increasingly limited access to concessional financing. Policymakers will be faced with an increasingly complex challenge to strengthen macroeconomic stability, rebuild fiscal policy space to respond to future shocks and accommodate the expected debt service hikes, mobilize financing for development needs, and raise longer-term growth potential by advancing structural reforms. 8. Fiscal policy will face a formidable task to maintain deficits at sustainable levels while ensuring tax burden does not inhibit business and activities and creating space for priority spending on infrastructure and social services (health, education, and social protection). Revenues as a share of GDP increased from 31.4 to 36.5 percent between 2021 and 2022, and to an estimated 38.5 percent in 2023. An increase of more than 7 percentage points. At the same time total public expenditures increased by 4.2 percentage points (26.1 percent of GDP in 2021 to an estimated 30.3 percent of GDP in 2023) mainly due to higher investment, public sector wages, and social benefits. The general government deficit narrowed from 0.7 percent of GDP in 2021 to 0.3 percent in 2022 with estimated small fiscal surplus in 2023 of around 0.1 percent of GDP, mainly due to better revenue performance based on exceptional improvement in tax administration and payment of back taxes. Improved fiscal performance allowed the government to reduce total public debt from 56 percent in 2021 to 49 percent in 2022, and an estimated 47 percent at the end of 2023. A fiscal deficit is likely to return in 2024 and projected to reach 3 percent of GDP by 2028. The authorities project a significant increase in tax revenues (from nearly 31 percent of GDP in 2023 and to over 37 percent by 2025) combined with a sharp decline in investment (to 6 percent of GDP in 2023 and 5.3 percent in 2025), as well as stagnant or declining share of the wage bill and other spending. However, these projections are not based on specific tax policy and administrative measures. As such the revenue projections appear excessively optimistic compared to more conservative World Bank and IMF staff projections. As shown in the table below, during the 2023-2025 period, Government revenue projections exceed World Bank forecasts between 2 and 7.5 percent of GDP. The gap is even bigger vis-à-vis IMF numbers (from 5.2 percent of GDP in 2023, 8.1 percent in 2024, and as much as 11.4 percent in 2025) 9. A decisive set of measures is needed to improve revenue and spending efficiency by fighting the informal economy, reducing widespread tax gaps and advancing structural reforms to mobilize additional concessional financing. Growth-friendly fiscal consolidation can be achieved by significantly reducing tax expenditures, optimizing tax policy and scaling down informal and underground economy, strengthening tax and customs administration, reducing budget outflows (on public sector wage bill and energy subsidies), and boosting non-tax revenues by channeling dividends from the state-owned Kumtor Gold Company to the budget. 8 Table 1. Tax Revenues as a Percentage of GDP 2019 2020 2021 2022 2023 2024 2025 Tax Revenues % of GDP Kyrgyz MoF 19.4 17.4 20.2 26.8 31.0 34.0 37.0 World Bank 23.5 21.9 24.2 28.8 29.0 29.3 29.5 IMF 19.6 17.4 20.5 26.8 25.8 25.9 25.6 Memo: Gap WB-Kyrgyz 4.1 4.5 4.0 2.0 -2.0 -4.7 -7.5 Gap IMF-Kyrgyz 0.2 0.0 0.3 0.0 -5.2 -8.1 -11.4 10. This report provides a comprehensive overview of the key issues and trends in tax policy and administration. The report: a. Reviews of the design of the different tax instruments, b. Assesses tax gaps based on State Tax Administration (STA) data by key tax instruments for the 2018-2022 period, c. Examines the sources of identified tax gaps, and d. Proposes a range of regulatory, institutional, policy, and administrative reforms to reduce and/or eliminate some chronic sources of “tax expendituresâ€? with high cost to the budget and public welfare with unclear economic and social benefits. TAX REVENUE STRUCTURE AND TRENDS 11. Kyrgyz Republic’s tax structure is characterized by heavy dependence on indirect taxes and a narrow base for direct taxation. Indirect taxes average 71 percent of total tax revenues with VAT is the single most important tax, averaging 55 percent of total tax revenues. This promotes regressive distribution of tax burden as lower income groups spend a greater share of their incomes on consumer goods and services. Furthermore, the low share of direct taxes does not promote tax paying compliance culture since: (i) almost half of the PIT tax due is withheld at the source and does not require filing, (ii) property taxes represent a very small (2 percent) and declining share of tax revenue, and (iii) about 20 percent of direct taxes are paid by Kumtor, a state-owned gold extraction and processing company. Table 2: Structure of tax revenues (in percent) 2018 2019 2020 2021 2022 2023e Direct taxes 25.3% 27.0% 32.9% 28.9% 36.0% 26.1% PIT tax 9.8% 10.6% 11.4% 10.3% 8.8% 8.3% CIT taes, interest income etc. 6.7% 14.0% 18.9% 16.5% 25.8% 16.4% CIT and other direct taxes related to gold 6.4% 6.9% 12.2% 9.3% 15.9% 7.7% Property tax 2.4% 2.4% 2.6% 2.1% 1.4% 1.4% Indirect taxes 74.7% 73.0% 67.1% 71.1% 64.0% 73.9% VAT , sales and excise taxes 57.8% 53.6% 48.9% 53.6% 54.5% 62.6% Foreign trade taxes 15.7% 18.1% 16.2% 15.4% 7.8% 9.7% Natural resource taxes 1.2% 1.4% 2.1% 2.2% 1.8% 1.6% Total tax revenue 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% Source: Kyrgyz National Statistical Committee (NSC) e) Estimate based on January-October actual data. 9 12. The structure of tax revenues changed significantly in 2022 due to a marked increase in corporate income tax (CIT) and resource taxes as a share of GDP. The increase was partially due to large on-time payment of tax liabilities from previous years by Kumtor. The following figure shows tax revenue projections under conservative (IMF), modest (World Bank), and optimistic scenario (KR MoF). Figure 1: Kyrgyz Republic – Tax Revenues: Historic data (2009-2022) and forecasts (2023-2027) 40.0% 40.0% Import duties 35.0% 35.0% Excise tax 30.0% 30.0% Sales tax 25.0% 25.0% VAT 20.0% 20.0% Property tax 15.0% 15.0% Resource tax 10.0% 10.0% CIT 5.0% 5.0% PIT Optimistic 0.0% 0.0% Kyrgyz MoF Moderate WBank Source: Kyrgyz MoF, World Bank, IMF. 13. The structure of revenues changed again in 2022-2023, when the Kyrgyz Republic revenue performance benefited from capitalizing trade opportunities and re-export to Russia. Kyrgyz Republic as a EAEU member country applies the common tariff on goods and services entering the single market and receives an agreed 1.9 percent share of custom duties collected by the EAEU. It also imposes country specific VAT on imported goods which can be claimed as tax credit by enterprises operating in any country of the EAEU. Following the imposition of trade sanctions on Russia, the basic parameters of the agreements underlying the EAEU have changed, but rules have remained the same. As a result, the transit trade driven by the sanctions has increased substantially during 2022-2023 period. Assuming that the relative share of imports would have stayed at the actual 2021 level (64.5 percent), we estimate the transit trade driven by sanctions at close to KGS 255 billion or 26.2 percent of GDP in 2022, and almost KGS 360 billion or 31.7 percent of GDP in 2023. This increase in transit trade contributed VAT revenues of KGS 25.2 billion (equivalent of 2.6 percent of GDP), and an estimated KGS 37.9 billion in additional VAT revenues (3.3 percent of estimated GDP) in 2023. These one-off exceptional revenues should not be considered when comparing VAT revenue performance with comparator countries. More importantly, they should have been treated separately to improve country-cyclical nature of fiscal policy when making medium-to- longer run tax revenue forecasts and when considering tax policies. 10 Table 3: The impact of sanctions on imports and VAT revenues Increase over 2021 1 2 Items 2018 2019 2020 2021 2022 2023 2022 2023 GDP Total 569.4 654.0 639.7 782.9 971.0 1,134.0 971.0 1,134.0 Exports of goods and services 179.9 218.9 189.2 280.3 298.7 387.1 Exports as share of GDP 31.6% 33.5% 29.6% 35.8% 30.8% 34.1% Imports of goods and services -383.0 -398.6 -316.1 -504.6 -880.6 -1,090.1 -254.7 -359.2 Imports as share of GDP 67.3% 61.0% 49.4% 64.5% 90.7% 96.1% 26.2% 31.7% VAT on Imports (bn soms) 40.9 38.8 28.8 48.3 87.2 115.0 25.2 37.9 from EAES (bn soms) 17.9 18.0 17.4 24.7 30.5 31.5 8.8 10.4 Other countries(bn soms) 22.9 20.9 11.4 23.6 55.9 81.3 16.4 27.5 VAT on Imports (% of taxes) 35.1% 32.0% 26.9% 32.4% 37.7% 39.8% from EAES (% of taxes) 15.4% 14.8% 16.3% 16.6% 13.2% 10.9% Other countries (% of taxes) 19.7% 17.2% 10.7% 15.8% 24.2% 28.2% VAT on Imports (% of GDP) 7.2% 5.9% 4.5% 6.2% 9.0% 10.1% 2.6% 3.3% from EAES (% of taxes) 3.1% 2.7% 2.7% 3.2% 3.1% 2.8% 0.9% 0.9% Other countries (% of taxes) 4.0% 3.2% 1.8% 3.0% 5.8% 7.2% 1.7% 2.4% Effective VAT rate on imports Total imports 10.7% 9.7% 9.1% 9.6% 9.9% 10.6% 9.9% 10.6% Imports from EAEU 4.7% 4.5% 5.5% 4.9% 3.5% 2.9% 3.5% 2.9% Imports from other countries 6.0% 5.2% 3.6% 4.7% 6.4% 7.7% 6.4% 7.7% 1 Preliminary data. 2 Staff estimate based on January-October data. Starting from 2019 data are calculated according to the SNA 2008 standard. KEY TAX INSTRUMENTS 14. This section discusses the design of the main tax instruments in the Kyrgyz Republic including tax rates, tax base, and exemptions provided, and identifies reform options. The tax instruments are imposed under the Tax Code of the Kyrgyz Republic, which came into force on January 1, 2022. The Government has continued to make policy changes to the Tax Code since its enactment. The most recent amendments were in March 2023 and December 2023. 15. The tax system comprises personal income tax (PIT), corporate income tax (CIT), value added tax (VAT), excise tax, and sales tax. There are also a number of special tax regimes. Some special tax regimes are for small businesses (such as the single tax), while others target particular sectors (e.g., e- commerce tax, crypto-mining tax, and gambling activity tax). In addition to tax-specific concessions, there are concessional regimes that apply across a range of taxes, particularly the Free Economic Zones and High Technology Parks regimes. PERSONAL INCOME TAX 16. The personal income tax (PIT) is imposed on income of individuals, other than individual entrepreneurs (who are subject to CIT). Tax is calculated as the difference between the total taxable income derived by an individual for the year and the total personal deductions allowed to the individual for the year. 1 No deductions are allowed for expenditure incurred by an individual to derive income subject to PIT. Given that there are unlikely to be significant expenditures relating to income amounts subject to PIT (particularly, employment income), this is both a simplification and an integrity measure. 1 Article 187.1 of the Tax Code 11 Citizens, residence permit holders, and individuals with kayrylman status2 are subject to PIT on worldwide income.3 All other residents are subject to PIT on domestic source income only.4 This is primarily relevant to expatriates posted to work in the Kyrgyz Republic for more than 6 months: the fact that they are not taxed on their foreign income can act as an incentive to attract skilled labor to the Kyrgyz Republic similar to temporary residence rules applying in some countries. There are no rules under the PIT for determining the source of income (see below).5 PIT RATE 17. The PIT rate is a flat rate of 10 percent.6 A lower rate of 5 percent applies to employees: (i) registered and working in a preferential border settlement; (ii) registered and working in an administrative-territorial unit with preferential status or working in a preferred industrial activity; or (iii) working in a High Technology Park.7 18. A flat rate structure with a minor personal deduction raises concerns that the Kyrgyz Republic does not utilize PIT potential to redistribute income. The standard deduction set at a nominal subsistence level provides some progressivity for low-income earners, however it is only KGS 650 a month (USD 7 equivalent). A progressive marginal rate structure taxes individuals according to their ability-to-pay tax. While a flat rate PIT is used in Kazakhstan, Turkmenistan, and Moldova (10 percent), in Tajikistan8 and Uzbekistan9 (12 percent), and in Georgia (20 percent), a flat rate PIT is less common outside CIS and Eastern European countries.10 19. The flat rate PIT has been in place for 17 years, so it is appropriate to review the impact that it has had and whether it has achieved its policy goals. The income distribution in the Kyrgyz Republic is unequal with current flat rate PIT does not contribute significantly to reducing income inequality. A mildly progressive PIT structure (10 percent, 15 percent and perhaps 20 percent) with a larger standard deduction would improve progressivity and could generate increased revenue from the PIT. 2 In broad terms, “karyrylmanâ€? status is a temporary legal status of an individual waiting citizenship. 3 Article 186.1(1) and (2) of the Tax Code 4 Article 186.1(3) and (4) of the Tax Code 5 There is a reference to income being derived from sources in the Kyrgyz Republic regardless of the place of payment (Article 186.2 of the Tax Code). 6 Article 197.1 of the Tax Code 7 Article 197.2 of the Tax Code 8 The 12 percent rate applies only to employment income paid by an employee’s main employer. Other income of individuals is taxed at 15 percent. 9 A lower rate of 5 percent applies to interest and dividends. 10 Mauritius was one of the few countries with a flat rate PIT but it replaced it with a progressive rate scale from July 1, 2023. 12 Figure 2. Mean Taxable Income and After-tax Income by Income Decile, KGS Taxable Income After tax income 600000 500000 400000 300000 200000 100000 0 1 2 3 4 5 6 7 8 9 10 Source: Household Survey, 2019 PIT BASE 20. While employment income comprises salary and the value of employee benefits-in-kind, 11 there are limited rules for the valuation of employee benefits-in-kind. 12 This can result in under- valuation and even non-reporting of employment income. Valuation rules should be provided for all the main classes of employee benefits-in-kind, including: employer-provided housing, motor vehicles provided for personal use, and waiving repayment of employee loans, with a residual rule based on market value for other benefits in kind. Best practice for valuing employer-provided housing is market value. However, this may be difficult from administration and political points of view. A compromise approach is to value housing based on prescribed values. A simple two-tier structure of prescribed values could apply with separate values specified for urban and regional areas. The prescribed values should be regularly reviewed and updated. A prescribed value approach could also apply to the valuation of motor vehicles provided for personal use. An alternative approach is to base valuation on a formula that more closely aligns with the value of the benefit. The formula can be designed to factor in the value and age of the vehicle and running costs if paid by the employer. CAPITAL GAINS 21. Capital gains on the disposal of movable and immovable property, including shares and other securities, are subject to PIT. An exemption applies to residential property owned for more than 2 consecutive years, transfer of property between spouses or former spouses resulting from divorce, or on the transfer of property to a close relative by way of inheritance or donation. 22. Some of the capital gains tax exemptions could be streamlined. It is usual to exempt only the taxpayer’s principal residence from capital gains taxation with the exemption commonly applying regardless of the period of ownership. Gains on the disposal of other residential properties are usually taxed no matter the period of ownership. If a husband and wife own separate residential properties, the principal residence exemption should apply to only one property. 23. Non-taxation for the donation (gift) of property to a close relative may give rise to tax planning opportunities. Even if the transferee takes over the transferor’s cost, the transferee may be subject to 11 Article 189.1(1) and (2) of the Tax Code 12 Article 189.1(2) and 190 of the Tax Code. Valuation rules are only provided for interest-free or discounted interest loans, and goods provided free of charge or for a discounted cost. 13 lower taxation in relation to the gain. For example, the transferee may be entitled to the lower 5 percent PIT rate. It is best practice to limit the non-taxation rule to transfers on the breakdown of marriage and on death. Property donated to a close relative should be valued at market value at the date of the transfer. PIT EXEMPTIONS 24. There are a significant number of PIT exemptions.13 While some exemptions are consistent with international norms (such as scholarships, alimony, personal injury pay-outs, and death benefits paid to dependents) or are justified on social policy grounds (such as exemptions for disabled persons), other exemptions14 should be reviewed to ensure that they are appropriately targeted: • Interest income derived from a deposit with a bank in the Kyrgyz Republic . The exemption is intended to encourage bank savings in the Kyrgyz Republic. However, high wealth individuals have greater capacity to save and derive tax-free interest income. When combined with the dividend exemption (see below) it means that high wealth individuals deriving solely or primarily investment income may pay little or no PIT; whereas an employee pays 10 percent tax on their salary or wages, which gives rise to horizontal equity issues. Given that the 10 percent PIT rate is low by international standards, it should apply to all interest income derived by individuals, including bank interest. • Income under a Mudaraba agreement with an Islamic financial institution. If the exemption is applied to income that is not subject to the Mudaraba agreement, it may be used for avoidance through related party transactions. If the exemption for bank interest is removed, the exemption for income under a Mudaraba agreement should also be removed. If the exemption is retained, the scope of the exemption should be limited to a Mudaraba agreement with an Islamic financial institution. • Interest paid in relation to securities listed on the Kyrgyz Stock Exchange and gains on disposal of such securities. It is common to provide exemptions in relation to listed securities during the start-up phase of a local stock exchange to encourage investment in such securities. As the Kyrgyz Stock Exchange has been in operation now for nearly thirty years, it is appropriate to review whether the exemption is still necessary. • A dividend paid by a domestic company to a resident individual. This is discussed below in relation to the profits tax with the recommendation to include a small final withholding tax on dividends paid to resident individuals. • The return of capital on equity interests. It is usual to treat any excess above the par value of the equity interest as a dividend. PIT RECOMMENDATIONS • Replace the existing flat PIT rate structure with a more progressive structure (for example, 10 percent and 15 percent) while increasing the standard deduction. • Provide valuation rules for all employee benefits. Apply a prescribed value approach for employer-provided housing and a formula approach for motor vehicles provided for personal use. 13 Article 191 of the Tax Code 14 Article 191.7 of the Tax Code 14 • Limit the CGT exemption for residential properties to the taxpayer’s principal residence. • Remove the tax-free transfer rule for gifts to relatives. The transfer should be valued at market value of the transferred asset at the time of the transfer. • Remove exemptions for bank interest and the return under a Mudaraba agreement. • Review the necessity for exemptions for interest and gains relating to securities listed on the Kyrgyz Stock Exchange. CORPORATE INCOME TAX (CIT) 25. The profits tax (CIT) applies to legal entities and individual entrepreneurs on an annual basis by reference to the calendar year. Consistent with international norms, the tax base under the CIT is net income, i.e., the total income of a taxpayer for a calendar year is reduced by the total deductible expenditures for the year. A net loss for a calendar year can be carried forward for five years. Domestic organizations and resident individuals operating as individual entrepreneurs are subject to CIT on worldwide income. 15 A foreign organization carrying on business in the Kyrgyz Republic through a permanent establishment (PE) and a non-resident individual entrepreneur obliged to register as an individual entrepreneur are taxed on income derived from sources in the Kyrgyz Republic. 16 A foreign organization without a PE deriving income from a source in the Kyrgyz Republic is taxed on gross income under the withholding tax regime.17 CIT RATE 26. The Kyrgyz Republic has a 10 percent CIT rate, one of the lowest globally and regionally.18 In the region, only Turkmenistan has a lower CIT rate (see Table 4). The 10 percent CIT rate is well below the global average CIT rate for 2021 (23.54 percent), and both the Asia and Europe average CIT rates (19.62 percent and 19.84 percent, respectively) (see Table 5). 27. The CIT rate could be increased to 15 percent to mobilize CIT revenue and still be competitive internationally. This would align the nominal CIT rate with the 15 percent global minimum effective CIT rate proposed under Pillar Two (see below). Table 4. CIT Rates Central Asia Country 2020 2022 Kazakhstan 20% 20% Kyrgyz Republic 10% 10% Tajikistan 15% 18% Turkmenistan 8% 8% Uzbekistan 7.5% 15% 15 Article 209(1) of the Tax Code 16 Article 209(2) of the Tax Code 17 Articles 209(3) and 210.3 of the Tax Code 18 Barbados (5.5%), Turkmenistan (8%), and Hungary and Montenegro (both 9%). In the case of Montenegro, a progressive CIT rate scale applies with 9% the lowest rate applying to taxable profits up to 100,000 euros. The highest rate is 15% applying to taxable profit above 1,500,000 euros. 15 Table 5. Global average CIT rates (2021)19 Asia 19.62% Europe 19.84% North America 26.37% OECD 23% G20 26.75% World 23.54% CIT BASE 28. The CIT base is broadly stated with inclusions in income and allowable deductions largely consistent with international norms. However, the CIT base is narrowed through exemptions and tax concessions. Some specific CIT base issues are mentioned below. DEPRECIATION 29. Fixed assets are depreciated on a pooling basis with assets divided into six groups. Asset groups are depreciated on a declining balance basis except buildings, which are depreciated on a separate asset straight-line basis. The 10 percent depreciation rate for buildings is high by international standards. Buildings are commonly depreciated at 2.5 percent (based on useful life), or 4 or 5 percent (with acceleration). The depreciation treatment of intangibles should also be reviewed to better align with effective life. In particular, intangibles are normally depreciated on a straight-line basis. RESEARCH AND DEVELOPMENT EXPENDITURE 30. The deduction for expenditure on research and development (R&D) activities encourages innovation but could be better targeted. Experience in other countries is that a deduction for R&D expenditure can be the subject of tax planning and avoidance arrangements. The deduction should be limited to expenditure on experimental activities undertaken for the purposes of discovering new knowledge relating to business operations, particularly new or improved materials, products, devices, processes, or services. The outcome of genuine R&D activities cannot be determined in advance based on current knowledge or experience (i.e., an R&D activity produces new knowledge). R&D activities must involve a systematic scientific process based on established principles of scientific research. This should be made clear in the definition of “innovation activityâ€?. RELIANCE ON FINANCIAL ACCOUNTING STANDARD S 31. The tax base is calculated by reference to the Accounting Law, but subject to specific tax accounting rules in the Tax Code20. There are specific accounting rules for depreciation21 and long-term contracts22. The Law on Accounting requires the application of International Financial Reporting Standards (IFRS) by listed companies, banks and other financial institutions, insurance companies and investment funds, with IFRS for Small and Medium Sized Entities (SMEs) required for other entities. 19 Tax Foundation, Corporate Tax Rates around the World 2021, accessed at https://taxfoundation.org/publications/corporate-tax-rates-around-the-world/ 20 Article 210.2 of the Tax Code 21 Articles 225 – 228 of the Tax Code 22 Article 216 of the Tax Code 16 32. The preparation of a single set of accounts for both tax and accounting saves compliance costs, but some adjustments will be needed for tax purposes, particularly the add back of reserves and provisions. This may eliminate or reduce the tax arbitrage possibilities that can arise if countries use different tax accounting rules, such as in relation to cross-border leases. Further, Pillars One and Two (discussed below) rely on financial accounting based on IFRS or United States Generally Accepted Accounting Principles (US GAAP). 33. There are some risks with too close an alignment of tax and financial accounting. First, this cedes “sovereigntyâ€? to financial accounting standards with the result that the tax law can, in effect, be changed by the International Accounting Standards Board (IASB) with responsibility for IFRS rather than by Parliament. Changes in accounting standards or in official interpretations of accounting standards may have unintended consequences for tax policy and create anomalies in the application of the tax law. Second, the IFRS are largely principles-based rather than prescriptive. This puts pressure on interpretation of IFRS for tax purposes. The materiality thresholds inherent in the principles-based approach under IFRS may not be appropriate for tax purposes and result in integrity risks. Third, given the principles-based approach under IFRS, STS will be interpreting and enforcing both IFRS and the tax law. While greater alignment may save compliance costs, it can increase administration costs. 34. The current relationship between tax and financial accounting should be reviewed. A case-by- case approach is preferred as it retains greater control over the accounting rules that apply for tax purposes and limits unintended tax consequences arising from changes in the terms, or interpretation, of IFRS standards. CIT EXEMPTIONS 35. There are a number of CIT exemptions.23 These are in addition to tax concessions under the Free Economic Zones and High Technology Park regimes, which provide for CIT, VAT, and sales tax exemptions (see below). Some exemptions would benefit from streamlining: • Agriculture. Agricultural producers,24 agricultural cooperatives,25 entities operating machine and tractor stations,26 and trade logistic centers for agricultural purposes27 are exempt from CIT. When combined with the VAT exemptions for agricultural inputs and outputs (see below), there is very little tax is collected from the agricultural sector. Taxation of the agricultural sector should be reviewed. • Energy. New producers of electric and thermal energy, gas, and renewable fuel in gaseous state, and liquid biofuel resulting from the use of renewable energy sources can be granted a 5 year tax holiday.28 • Remote Areas. A taxpayer registered and operating in a border settlement receives preferential treatment. 29 This is a remote area incentive. Experience with remote area incentives is that they are rarely effective in attracting capital investment unless there is good infrastructure in place and availability of skilled and unskilled labor. 23 Article 239 of the Tax Code 24 Article 239.1(3) of the Tax Code 25 Article 239.1(4) of the Tax Code 26 Article 239.1(9) of the Tax Code 27 Article 239.1(11) of the Tax Code 28 Article 239.1(10) of the Tax Code 29 Article 239.1(12) of the Tax Code 17 36. STS is developing a methodology under the new Tax Code for the regular evaluation of the effectiveness of CIT exemptions and other tax incentives.30 Annual preparation of a tax expenditure statement to calculate and report the revenue loss from tax incentives is good policy for monitoring tax incentives. 37. The need for, and design of, CIT incentives should be reviewed because the standard CIT regime is already favorable to investors. The CIT regime is already very favorable by international standards. The standard CIT rate of 10 percent is well below the global average CIT rate of 23.54 percent. Even taking account of the 10 percent withholding tax on dividends paid to non-residents, the effective tax rate on foreign investment of 19 percent is still below the global average CIT rate. The 10 percent withholding tax on interest and royalty payments to non-residents is moderate by international standards. Further, Kyrgyz Republic has entered into a significant number of tax treaties where the rates on dividends, interest, and royalties are lower than 10 percent. There is also a degree of acceleration under the existing depreciation regime applicable to capital investment. Consequently, it can be argued that the standard CIT regime provides a favorable tax environment for foreign investors without the need for tax incentives. 38. Tax incentives should not be provided where the investment would have been made anyway, such as an investment that is producing goods for the local market or taking advantage of location- specific economic rents such as access to natural resources. Tax incentives are not necessary to attract investment for the extraction of mineral resources. Providing tax incentives to attract investment in sectors or industries that are not driven by tax considerations leads to a waste of government resources as investments would be made even without tax incentives. 39. Cost-based CIT incentives are more effective than income-based incentives in incentivizing investments. CIT tax incentives may be either income- or cost-based. Income-based incentives involve either exempting income from tax permanently or for a specified period (tax holidays) or taxing income at a lower rate. Cost-based incentives target investment in specific assets, particularly plant and machinery, and technology assets. Cost-based incentives may take the form of an investment allowance, accelerated depreciation, or investment tax credit. As no depreciation deductions are allowed during the holiday period, tax holidays may actually discourage capital investment with taxpayers delaying making significant capital investment until the end of the holiday period so as to obtain the benefit of depreciation deductions. Cost-based incentives are preferred because they are directly linked to investment expenditure (e.g., investment in plant, machinery, and technology). They are targeted at lowering the cost of capital, which can make investment projects more profitable at the margin. 40. The proposed 15 percent global minimum effective tax rate for large MNEs (see below) will have an impact on the effectiveness of tax incentives. Tax holidays are likely to be incompatible with the global minimum tax. Cost-based incentives (such as accelerated depreciation) that are essentially timing benefits are likely to be protected under the global minimum tax. The review of tax incentives should assess incentives in light of the global minimum tax proposals as they proceed to implementation. INTERNATIONAL TAX CONSIDERATIONS 41. International tax aspects of the income tax arise in relation to the taxation of foreign income of residents and the taxation of domestic income of non-residents. The Kyrgyz Republic is a capital importing country and, therefore, the main relevance of international tax is the taxation of income derived by non-residents from sources in the Kyrgyz Republic. The taxation of non-residents is “schedularâ€? in nature meaning that different rules apply to different classes of income. For this reason, the starting point 30 UNDP, Tax Incentives to Facilitate Achieving SDGs in Kyrgyzstan , August 3, 2022, https://www.undp.org/kyrgyzstan/stories/tax-incentives-facilitate-achieving-sdgs-kyrgyzstan 18 for non-resident taxation is classification of the income derived. The classification of income then identifies the rule to apply in determining whether income is sourced (and, therefore, taxed) in the Kyrgyz Republic, the basis of taxation (assessment or final withholding), and the rate of tax. Key considerations in the review of international tax include: • Review income definitions relevant to source rules and non-resident withholding tax. For example, the definition of “interest incomeâ€? 31 follows the traditional notion of interest income being an amount paid under a debt claim. This means that an amount can be interest only if there is an underlying debt claim to which the amount relates. Given the flexibility of modern financial instruments, there are many amounts that may be economically similar to interest but which may not involve an underlying debt claim, such as bill discounts, premiums, payments made under a notional principal contract, and payments made under derivative instruments. A transaction could be structured by a non-resident to earn an interest-like amount but which is not interest as defined to avoid Kyrgyz Republic tax. The definition of “interest incomeâ€? should be modernized to accommodate the wide range of possible financial instruments. Other relevant income definitions should also be reviewed, particularly “dividendsâ€? and “royaltiesâ€?. • Include a comprehensive set of source rules in the Tax Code. Because of the schedular nature of non-resident taxation, it is usual to provide a separate source rule for each class of income. The rules should be aligned with source taxing rights under the UN Model Tax Treaty (2021). • Update the definition of “permanent establishmentâ€?. The Tax Code should expressly specify the methodology for the attribution of profits to permanent establishments. • Strengthen the taxation of gains on indirect transfers of immovable property in Kyrgyz Republic. Extend the scope of non-resident capital gains taxation (direct and indirect) consistent with new Articles 13(6) and (7) of the UN Model Tax Treaty (2021) relating to direct and indirect transfers of naturally occurring resources in the Kyrgyz Republic. • Provide rules to counter international tax avoidance, particularly thin capitalization and transfer pricing rules. • Provide relief from international double taxation for residents in non-treaty cases. • Develop a tax treaty policy to ensure that future tax treaty negotiations protect the tax base. CIT RECOMMENDATIONS • Increase the CIT rate to 15 percent. • Review the depreciation regime, particularly the treatment of buildings and intangibles. • Ensure that the research and development deduction is properly targeted at genuine scientific research. • Review the relationship between tax and financial accounting. • Review CIT exemptions. • Strengthen international tax rules applicable under the CIT. 31 Article 4.2(32) of the Tax Code 19 BASE EROSION AND PROFIT SHIFTING PROJECT 42. Many countries have amended their international tax rules over the last few years to implement reforms proposed under the joint OECD and G20 Base Erosion and Profit Shifting (BEPS) Project under the BEPS Inclusive Framework (IF). 32 There are two ongoing work streams for BEPS implementation: Pillars One and Two. The main component of Pillar One is the implementation of a new source taxing right (referred to as “Amount Aâ€?) applicable to the largest MNEs based on the location of customers and users. Work on devising the Amount A rules is nearing completion. 33 The other BEPS Actions are largely wrapped up into Pillar Two, which proposes the implementation of a global minimum tax (GMT) on large MNEs at an effective CIT rate of 15 percent. The objective of Pillar Two is to put a floor on tax competition and the use of jurisdictions with zero or low CIT rates for tax avoidance practices. 43. While Kyrgyz Republic is not an IF member, there will be implications for the Kyrgyz Republic under both Pillars. Consideration should be given to whether the Kyrgyz Republic can benefit under the new source taxing right provided for under Pillar One and the implications for the e-commerce tax. The implication of Pillar Two for the 10 percent CIT rate and CIT tax concessions will need to be considered, particularly the possibility of revenue being shifted to the ultimate residence country of foreign investors. 44. Pillar Two comprises three rules: (i) the income inclusion rule (IIR); (ii) the under-taxed payments rule (UTPR); and (iii) the subject to tax rule (STTR). The IIR applies where the effective CIT rate in a jurisdiction is less than 15 percent and allows the residence country of the ultimate parent entity (UPE) of an in-scope MNE to impose a top-up tax to ensure that the 15 percent rate applies to the MNE’s profits in that jurisdiction. The IIR and UTPR are referred to as the Global Anti-Base Erosion (GloBE) rules. The STTR is a separate stand-alone rule to counter base erosion under tax treaties. The GloBE rules will be introduced on a “common approachâ€? basis rather than by a multilateral convention. In broad terms, this means that participating jurisdictions introduce harmonized rules developed by the OECD into domestic tax law. 45. The IIR rule was modified to allow source countries to implement a qualifying minimum top-up tax (QDMTT) in priority to the top-up tax in the residence jurisdiction of the UPE. The QDMTT is an optional top-up tax imposed by the source country based on the IIR calculation. The QDMTT allows a source country to reverse the outcome under their income tax rules so as to capture the top-up tax in priority to the residence country of the UPE. The QDMTT does not change the amount of the top-up tax just where it is paid. The effect of the QDMTT is to shift the imposition of top-up tax from the residence country to the source country. The QDMTT is optional for source countries, although there is a strong incentive to implement the QDMTT to ensure that the top-up tax is imposed in the source country. 46. Given the 10 percent CIT rate, and CIT exemptions and tax holidays, the main issue for the Kyrgyz Republic will be application of the IIR rule. Once the GloBE rules are introduced, the residence country of the UPE of an in-scope MNE with operations in the Kyrgyz Republic will impose a top-up tax to collect the difference between 15 percent and 10 percent. This means that, if the 10 percent rate is retained, the Kyrgyz Republic will be forgoing collecting revenue that is then collected by the ultimate residence country of the MNE, which is likely to be a developed country. The foreign investor will not 32 Membership of the BEPS Inclusive Framework is open to all countries and is based in the OECD. Currently, 145 jurisdictions are members of the IF. In central Asia, Kazakhstan and Uzbekistan are IF members. 33 Amount A will be implemented by a multilateral convention (MLC). Those countries that sign up to the MLC will be required to repeal their digital services tax (or similar measure) if they have one. Regardless of whether the Kyrgyz Republic signs the MLC, there will likely be implications for the ongoing application of the e-commerce tax imposed under Chapter 61 of the Tax Code. 20 benefit from the 10 percent CIT rate. In these circumstances, there would seem little point in continuing the 10 percent CIT rate after the GloBE rules come into effect. 47. The IIR will also have an impact on tax concessions offered by the Kyrgyz Republic to attract foreign investment as such concessions will reduce the ETR. As discussed above, there are two types of tax concessions: income-based concessions; and cost-based concessions. If the Kyrgyz Republic provides an income-based concession (such as a tax holiday) to a member of an in-scope MNE, the residence country of the UPE will be required to impose a top-up tax to eliminate the benefit of the tax concession. Tax holidays may result in a direct revenue loss for Kyrgyz Republic without any benefit to the investor. As the calculation of the ETR is based on financial accounting profit, accounting depreciation applies not tax depreciation. Tax depreciation may be accelerated as compared to financial accounting depreciation, including immediate expensing. Cost-based incentives give rise to a deferral benefit only and will not be subject to the IIR. 48. Given that many countries have already implemented the GloBE rules to apply from 1 January 2024, the implementation of the QMDTT is a priority for the Kyrgyz Republic. This will protect against ceding taxing rights to the ultimate residence countries of in-scope MNEs. The QMDTT ensures that any top-up tax is collected in the Kyrgyz Republic. RECOMMENDATIONS • Prepare for implementation of the GMT (Pillar II) QDMTT is a priority. • Review the tax incentives framework to replace income-based incentives with cost-based incentives with a particular focus on attracting sustainable FDI. • Monitor the ongoing development of the Amount A rules under Pillar One and implications for the e-commerce tax. VALUE ADDED TAX AND SALES TAX VAT 49. The value added tax (VAT) is reasonably well designed with a single positive rate and zero-rating of exports of goods and some services. VAT registered persons account for VAT monthly as the difference between output tax and input tax for the month. The Tax Code includes the key design features of VAT, particularly identification of supplies; time, value, and place of supply rules; and the allowance of input tax credits. The key policy issues with VAT are: (i) the rate; (ii) the registration threshold; (iii) the input tax credit mechanism and refunds; and (iv) exempt and zero-rated supplies. VAT RATE 50. The VAT rate is 12 percent. As can be seen from Table 6, the rate is the lowest in the region. Kazakhstan has the same rate, while the VAT rate in the other countries is 15 percent. The VAT rate is lower than the Europe average rate (19.87 percent) and global average rate (15.51 percent), but in line with the Asia average rate (11.79 percent).34 An increase in the VAT rate to a maximum of 15 percent 34 KPMG, Indirect Tax Rates Table 2020, accessed at https://home.kpmg/xx/en/home/services/tax/tax-tools-and- resources/tax-rates-online/indirect-tax-rates-table.html 21 would offset the revenue loss from repeal of the sales tax (see below) while still being consistent with regional and international VAT rates. Table 6. VAT Rates Central Asia Country Kazakhstan 12% Kyrgyz Republic 12% Tajikistan 15% Turkmenistan 15% Uzbekistan 15% REGISTRATION THRESHOLD 51. In theory, VAT should apply to all private consumption and all businesses no matter the size of their operations. However, many small businesses find it difficult to comply with the record-keeping, documentation, and reporting obligations applicable under the VAT, and do not have the financial resources to engage someone to assist with VAT compliance. Further, it is resource-intensive for tax administrations to enforce VAT compliance by small businesses as compared to the revenue raised. For this reason, it is common for VAT to apply to persons only if the value of their taxable supplies (referred to below as “turnoverâ€?) exceeds the registration threshold. Unregistered businesses do not charge VAT on their supplies and cannot claim a credit (or refund) for VAT on their business inputs. In effect, unregistered businesses are “input taxedâ€?, i.e., taxed only on inputs and not outputs. 52. The VAT registration threshold was increased from KGS 8 million to KGS 30 million under the new Tax Code. This is a substantial increase. As can be seen from Table 7, the former registration threshold was consistent with the threshold in other countries in the region (apart from Turkmenistan, which does not have a registration threshold). Kazakhstan reduced its registration threshold in 2022 by approximately one-third. Table 7. Registration Threshold Central Asia Country Amount in Local USD Equivalent Currency Amount Kazakhstan 61,260,000 130,000 Kyrgyz Republic 30,000,000 350,000 Tajikistan 1,000,000 98,000 Turkmenistan 0 0 Uzbekistan 1,000,000 89,000 53. The setting of the VAT registration threshold tends to be country specific. The main factors taken into account are: (i) the level of annual turnover at which a business can be reasonably expected to be able to comply with VAT obligations; and (ii) the number of VAT registered businesses that the tax administration can reasonably cope with in terms of enforcement. The increased use of electronic fiscal devices by businesses (particularly with real time information provided to the tax administration) will have an impact on both these factors and may support a lower threshold. Taking these factors into account the new registration threshold is high by both regional and global standards. As a result of an amendment to the Tax Code in March 2023, businesses can now elect out of VAT and into the simplified tax regime. This 22 includes businesses that exceed the registration threshold. This, in addition to the cessation of the patent regime for trade activities, indicates a policy of moving as many businesses as possible into the simplified regime. 54. The high registration threshold and the option for businesses to elect into the simplified tax regime likely means that few small businesses are VAT-registered. VAT-registered businesses tend to prefer dealing with other VAT-registered businesses to avoid breaks in the input tax/output tax chain that can result in cascading of tax and, because of this, some small businesses will prefer to be VAT-registered. Small VAT-registered businesses may experience cash flow problems under the invoice basis of VAT accounting (i.e., accounting for VAT on taxable supplies before it is received from the customer) and find it difficult to comply with the monthly reporting obligations under the VAT. A longer VAT filing period, such as quarterly, for small VAT-registered businesses can both ease the cash flow burden and reduce the compliance burden for small businesses. INPUT TAX CREDITS AND REFUNDS 55. There is space to improve VAT refund design. VAT refunds should be available to all registered persons that have an excess of input tax credits for a calendar month. It is particularly important that refunds are available and regularly paid to businesses that primarily make zero-rated supplies (essentially exporters) as such businesses will always have excess input tax credits. The refund of excess input tax credits for registered persons primarily making zero-rated supplies has been improved under the new Tax Code. In other cases, excess input tax credits are carried forward indefinitely. While it is acceptable to carry forward input tax credits this should be for only a relatively short period (3-6 months) to allow for a “smoothing outâ€? of excess input tax. After that time, excess credits should be either refunded or applied against outstanding tax debts. 56. The timely payment of VAT refunds is essential to the effective operation of the VAT. Delays in paying refunds can be detrimental to business cashflows and negatively impact on voluntary compliance and revenue performance. The payment of VAT refunds must be balanced against the risk of fraud and evasion, including through fraudulent invoices supporting exaggerated input tax credit claims. Risk management is central to an effective VAT refund system. Relying on data analysis and established refund processing criteria (including compliance history), refunds can be ranked into low, medium, and high risk. Low risk refunds should be paid without prior payment verification checks; medium risk refunds could be subjected to less intensive verification program checks, including desk audits, single issue audits and registration verification checks; and high-risk cases verified using comprehensive audits, investigation, prosecution, and strong enforcement measures. Using this targeted approach to refund processing helps to deploy resources to high risks. Random audits can be carried out to check the validity of the risk parameters used to screen refunds for risk, with updates made to keep the refund criteria operating optimally. EXEMPT AND ZERO-RATED SUPPLIES 57. There are a number of VAT exemptions that could be streamlined. • Supplies of public utility services for domestic use.35 It is best practice to tax supplies of public utility services. This encourages efficient usage and properly reflects the cost to the consumer of providing the service. It is particularly important to encourage efficient use of energy supplies given concerns about greenhouse gas emissions. If there are concerns about the impact of VAT on utility prices for low income households, consideration can be given to other 35 Article 267 of the Tax Code 23 mechanisms, such as lower tariffs or direct subsidies. If relief is to be provided by way of VAT, then the exemption could be limited to a specified amount of the supply (such as the first 100 kilowatts of electricity per year). • Intermediate supplies. There are a number of exemptions for intermediate supplies, i.e., B2B supplies. These have the effect of breaking the input tax/output tax chain that can result in cascading of tax. These should be eliminated as exempting intermediate supplies can actually increase rather than decrease the cost of goods and services due to the cascading of tax. • Residential premises.36 A supply of residential premises, both sale and rental, is treated as an exempt supply. While many countries adopt the same regime for VAT taxation of residential premises, in the case of sales, best practice is to tax the first sale of residential premises and treat all subsequent sales as exempt supplies. Exempt supply treatment does not apply to the “rental of hotel-type premises, boarding houses, health resorts for recreation and treatmentâ€?. It should be explicitly provided that VAT applies to peer-to-peer short-term rentals through platforms such as Airbnb, VRBO, Homestay. IMPORTED DIGITAL SERVICES 58. Supplies of digital services by foreign suppliers without a place of business in the Kyrgyz Republic are subject to VAT. This is consistent with the imposition of VAT under the destination principle, i.e., the taxing right rests with the country of consumption. Foreign suppliers are required to register and account for VAT on supplies made to customers in the Kyrgyz Republic. This applies regardless of whether the customer is a VAT-registered business (business-to-business (B2B) supply) or a consumer (business- to- consumer (B2C) supply). 59. Digital supplies made through electronic marketplaces and platforms are also subject to VAT. VAT is payable where the operator of the marketplace or platform, rather than the underlying supplier, can be treated as the supplier and required to register if the value of taxable supplies through the marketplace or platform exceeds the registration threshold under the normal operation of the registration rules. Determining whether the threshold is exceeded should take account of the value of third-party supplies made through the marketplace or platform, as well as any service fee charged by the operator. A registered operator of the marketplace or platform should then be the person liable to account for VAT payable on supplies of digital supplies through the marketplace or platform. This will increase compliance as there is a much smaller number of such operators than underlying suppliers. Liability should be limited to cases where the operator of the marketplace or platform has some control over the terms of the supply or is an intermediary for payment for the supply. 60. The norm for B2B supplies of imported services is to apply a reverse charge rule under which the registered person receiving the supply self-charges VAT in respect of the supply. In other words, the normal operation of the VAT is “reversedâ€?. The taxation of supplies of digital services by foreign suppliers could be strengthened by taxing B2B supplies under the reverse charge rule. As the recipient of the supply is a registered person in the Kyrgyz Republic, it will be easier for STS to enforce VAT taxation of such supplies against such person instead of the foreign supplier. VAT RECOMMENDATIONS • If needed, consider increasing the VAT rate to a maximum of 15 percent to offset the revenue loss from repeal of the sales tax. 36 Article 265 of the Tax Code 24 • Revisit the VAT registration threshold and consider lowering it. • Provide cash flow and compliance relief for small VAT-registered businesses through the option of quarterly reporting. • Limit the carry forward of excess input credits to 3 – 6 months after which any uncredited excess is refunded. Improve the VAT refund system to facilitate timely refunds to businesses where risks are low (size of refunds, history of business).Review all VAT exemptions. Eliminate exemptions applicable to intermediate supplies. • Extend the B2C digital supply rules to operators of electronic marketplaces or platforms. • Apply the reverse charge rule to digital services acquired by VAT registered persons. SALES TAX 61. A separate sales tax applies to the sale of goods and services. The sales tax rates are:37 • Taxable supplies of goods by VAT registered persons for cash – 1% • Taxable supplies of services by VAT registered persons for cash – 2% • Cashless supplies of goods or services by VAT registered persons – 0% • Supplies of goods not covered by a) or c) – 2% • Supplies of services not covered by b) or c) – 3% • Supplies by banks – 2% • Supplies by a developer of residential or non-residential property – 2% • Supplies by mobile communications companies – 5%. 62. Sales tax is payable on sales made by both VAT registered and unregistered persons . For VAT registered persons, sales tax is in addition to VAT with no credit allowed for sales tax on purchases, which results in cascading of tax. Further, the sales tax applies only to domestic supplies and not imports, which means that imports are more lightly taxed than domestic production. 63. The sales tax was introduced in 2009 to offset the reduction in the VAT rate from 20 to 12 percent. Applying VAT and sales tax side-by-side complicates compliance and administration. It is recommended that sales tax is repealed and incorporated into other, better targeted, measures. First, with increasing use of electronic payments, the number of cash payments will steadily decline so that over time little or no sales tax will be payable on supplies of goods and services by VAT registered persons. Second, it is better to rely on administrative measures to increase the use of cashless payments. Third, it is common today for services provided by mobile communications companies to be incorporated into the excise tax regime (see below). Fourth, consistent with international norms and as recommended above, VAT should be imposed on the sale of new residential premises. Fifth, the VAT base for financial institutions can be expanded to include financial services where explicit fees are charged. Finally, the revenue loss from the repeal of the sales tax can be compensated by the recommended increase in the VAT rate to 15 percent. SALES TAX RECOMMENDATIONS • Repeal sales tax and incorporate some aspects of the sales tax into other tax measures. 37 Article 368 of the Tax Code; these rates apply from 1 January 2023. 25 CONCESSIONAL TAX REGIMES FREE ECONOMIC ZONES 64. Legal entities registered and operating in a Free Economic Zone (FEZ) 38 are exempt from all taxes, particularly CIT, VAT, and sales tax. 39 Currently, there are five FEZs: Bishkek; Karakol; Leilek; Mainmak; and Naryn. The largest is the Bishkek FEZ. FEZ entities pay a fee ranging from 0.5 – 2 percent of turnover. The highest fee is 2 percent payable by entities operating in the Bishkek FEZ. 65. FEZ entities are expected to produce goods predominantly for export. Initially, it was required that 70 percent of goods produced were exported, but this requirement was subsequently removed so that any entity could be established as a FEZ entity. For VAT purposes, supplies of goods, works, and services from the territory of the Kyrgyz Republic to a FEZ entity are treated as the equivalent of an export and, therefore, zero-rated. Similarly, goods, work, and services supplied into the territory of the Kyrgyz Republic by a FEZ entity are treated as the equivalent of an import and subject to 12 percent VAT. The customs legislation applies to the movement of goods across the border of a FEZ. 66. The VAT treatment is largely consistent with international norms for a FEZ or special economic zone. This allows businesses to produce goods and services for export free of VAT. While VAT on exports can be refunded, refunding can be complex, imperfect, and subject to significant revenue leakage or abuse. Even if VAT refunds are accurate and not subject to abuse, the imposition of VAT followed by a later refund imposes time value of money and administrative costs that can be significant. The costs of refunding are avoided under the FEZ regime where VAT on export production is completely eliminated. If FEZ production is limited to exports and the tax benefits limited to VAT (and other indirect taxes), a FEZ regime is consistent with the standard tax policy of taxing goods and services under the VAT in the country of consumption (destination principle). 67. There are two departures from international norms under the FEZ regime: the level of domestic supplies; and coverage of taxes other than indirect taxes. First, while a small level of domestic supply from a FEZ is to be expected, there should be a strict limitation on the level of domestic supplies. The absence of a limitation risks revenue loss through the misclassification of domestic supplies as exports. Second, the tax benefits under the FEZ regime should be limited to indirect taxes. Direct tax benefits, in the form of exemptions, tax holidays, or reduced rates, are not best practice. As stated above, the CIT exemption should be reviewed in light of the GMT proposal under Pillar Two. There is a risk that the revenue forgone by the Kyrgyz Republic under the CIT exemption is collected by the residence country of the foreign investor. This will depend on the nature of the FEZ activities and the possible application of the QDMTT if implemented by the Kyrgyz Republic. 68. If CIT concessions are to be provided to FEZ entities, these should be cost-base incentives, such as accelerated depreciation for plant, machinery, technology, and similar assets . As discussed above, cost-based incentives will be more effective in increasing the capital base of the country and will be protected under the GMT proposal. RECOMMENDATIONS 38 The operation of FEZs is regulated under the Law on Free Economic Zones. 39 Article 430.1 of the Tax Code 26 • Require FEZ entities to substantially export production as a condition of registration as a FEZ entity. The Kyrgyz Republic previously required 70 percent of exported output as a threshold, which is one option to approach FEZ entities. • Limit FEZ concessions to VAT and other indirect taxes. • If CIT concession are provided, replace the CIT exemption with cost-based concessions, such as accelerated depreciation. HIGH TECHNOLOGY PARKS 69. A resident of the High Technology Park (HTP) is exempt from CIT, sales tax, and VAT .40 The HTP regime is established under the Law on the High Technology Park of the Kyrgyz Republic. HTP activities are software development, export of information technology and software, and establishment of call centers.41 A legal entity or an individual (including a non-resident) can be registered as a HTP resident provided at least 90 percent of the person’s income is derived from HTP activities with at least 80 percent of income derived from exports.42 A resident of the HTP pays 1 percent of turnover to the HTP Directorate. Currently, the tax exemptions apply for 15 years, but there is a recent proposal to make the exemption permanent. 70. The HTP concession operates on a “zonelessâ€? basis. While the Law on the High Technology Park refers to the HTP being a “zoneâ€?, there does not appear to be a specific location for the HTP with persons registered as residents of the HTP regardless of location. 71. The global minimum tax will apply to an in-scope MNE registered as a HTP resident. There is an exemption under the GMT for income derived from a substantial economic presence in the Kyrgyz Republic, but this is determined by reference to tangible assets and payroll. The exemption does not take into account intangible assets, which are likely to be the main assets used by residents of the High Technology Park. RECOMMENDATIONS • Review the HTP exemption, particularly the potential impact of the GMT. SMALL BUSINESS TAXATION 72. Due to a lack of skills necessary to keep proper records and prepare tax returns, and the lack of financial resources to employ or engage a person to assist with tax obligations, small businesses can find it difficult to comply with accounts-based tax systems (such as CIT and VAT). These difficulties can make small business owners reluctant to enter the formal sector. VAT addresses these difficulties through the registration threshold but, for equity reasons, there needs to be a basis for CIT to apply to small businesses. 73. The design of a small business tax regime must strike a balance between simplification of the regime for small businesses and equal tax treatment across all business categories. The tax methodology for small businesses should be simple, inexpensive to administer and comply with compared to the revenue raised, as well as avoiding conflicts with record-keeping requirements under other laws (e.g., professions). An effective small business tax regime should provide incentives for small businesses to 40 Article 434 of the Tax Code 41 Article 4 of the Law on High Technology Parks 42 Article 6 of the Law on High Technology Parks 27 “graduateâ€? to the general income tax. It also needs to provide mechanisms to prevent abuse, such as tax planning whereby employees are “convertedâ€? into individual entrepreneurs because of lower tax costs or planning by some entrepreneurs in structuring their operations to remain under the small business tax regime. The small business tax regime under the Tax Code should be reviewed against these parameters. 74. Small business taxation under the Tax Code is complex with three regimes currently in existence. These are: (i) a voluntary patent regime; 43 (ii) a simplified regime for non-VAT registered businesses based on single tax (in place of CIT, VAT, and sales tax); and (iii) a simplified regime based on retail sales tax. The single tax has different rates for manufacturers and traders in goods, and providers of works and services, and for cash and cashless transactions. The 2023 amendments adjusted the single tax rates and included a special rate for catering services that varies with location. 75. The patent regime is very attractive in terms of tax amount, audit, and reporting procedures, and appears to provide no incentives to move (“graduateâ€?) from the patent to the simplified or to the general tax regimes. There is concern that small businesses operating in the shadow economy can “hideâ€? in the patent regime as they do not report revenue. For this reason, the patent regime was narrowed with more small businesses now under the simplified regime. It is proposed that the patent regime for trading businesses will cease to apply from January 1, 2024. 76. The 2023 amendments allow any business to elect for the simplified regime including a business with turnover above the VAT-registration threshold. This poses a risk of significant revenue loss with larger businesses shifting to simplified regime. RECOMMENDATIONS • Limit small business tax to non-VAT registered businesses. VAT registered businesses must keep records of outputs (revenue) and inputs (expenditures) and, therefore, can calculate taxable profit under the general CIT. • Exclude businesses with turnover above the VAT registration threshold from the single tax. • Small businesses taxed at 2% – 5% of turnover, distinguishing between traders in goods (lower margins) and service providers. EXCISE TAX 77. Excise tax is most commonly imposed on goods the consumption of which results in negative (harmful) externalities. The usual goods subject to excise tax are alcohol, tobacco, fuel, motor vehicles, and more recently sugar products. Consumption of these goods result in a range of harmful externalities (and sometimes internalities), such as the health costs of smoking and consumption of alcohol and sugary drinks; pollution (environmental and health affects), and carbon emissions, road damage, and congestion caused by fuel usage and vehicles. 78. The excise tax regime under the Tax Code includes a number of different excises. • Alcohol. Specific excises apply to ethyl alcohol and alcoholic beverages (which is best practice) with the rates set to rise annually over a 3-year period (2021 - 2023). Best practice is to impose excise based on alcohol content as the external costs associated with alcohol consumption are related to the extent of pure alcohol in a drink. The alcohol content is lowest for beer, then wine, and with spirits having the highest content. The rates could be reviewed to better 43 The mandatory patent regime was not included in the new Tax Code. 28 reflect alcohol content. In particular, the excise rate for wine could be increased. The rate for low alcoholic drinks is higher than for beer and wine, which seems anomalous. • Tobacco products. The Kyrgyz Republic is a party to the Framework Convention on Tobacco Control (FTTC) implemented by the World Health Organization (WHO). The FTTC encourages the use of taxation as a tool to reduce tobacco consumption. Specifically, the WHO’s goal is a tax burden on tobacco of 75 percent of the retail price per pack of 20 cigarettes. The existing rates should be compared to the WHO benchmark. The 2023 amendments increase the excise rates on electronic cigarettes and heated loose tobacco. • Petroleum products. The rates should be determined by reference to the carbon emissions produced by the different types of petroleum products and be aligned with national commitments on climate change.44 Rates can be specified on a per liter basis linked to carbon emissions and adjusted for health and road externalities. Presently, the excise tax on diesel is significantly lower than petrol. This is anomalous as diesel produces higher carbon emissions than petrol. The excise tax rate for diesel should, at least, be harmonized with the rate for petrol but preferably higher to reflect the greater carbon emissions. The same can be said for jet fuel. The excise tax base should be extended to fossil fuels used in energy production, such as coal. 79. Consistent with best practice, specific excises are imposed on alcohol, tobacco, and petroleum products. The alternative of ad valorem excises may provide less stable revenue, particularly for petroleum products whose market price can vary widely and are vulnerable to underpricing practices. Specific excises based on volume or weight are more easily observable and measured and, therefore, harder to avoid. 80. Best practice is to provide indexation of specific excise taxes, at least annually, to preserve the real value of excise tax revenue thereby avoiding the revenue being eroded by inflation over time. The Tax Code empowers the Cabinet of Ministers to change excise tax rates within certain limits.45 It would be a better practice to replace this discretionary adjustment power with a formal process for indexation of specific excise tax rates for inflation at least annually. 81. Excise has recently been applied to non-alcoholic sugary drinks. The excise rate on energy drinks from July 1, 2022, is 1 som per 1 liter (with a subsequent increase to 20 soms per 1 liter from 2023 and 30 soms per 1 liter from 2024). There has been dispute between the STS and producers/distributors of soft drinks concerning the scope of the excise tax as it applies to soft drinks. The rate and scope of excise applicable to sugary products should be reviewed. 82. It is recommended above that the sales tax on mobile communications companies is repealed, and, if taxation of mobile communication is desirable, incorporated into the excise tax regime. It is acknowledged that mobile communications services are vital for increasing productivity and growth, social inclusion, and consumer welfare. Today, important services such as banking, education, and medical services, can be provided through mobile communications networks making them more accessible to users. However, there constraints on competition in the sector that can result in mobile communications companies making above normal profits. First, there are high market entry costs involved in establishing a mobile phone network. Second, and more significantly, there is limited space on the electromagnetic 44 Kyrgyzstan has committed to conditional emissions reduction targets of 36.61 percent by 2025 and 43.62 percent by 2030, UNDP, Climate Promise, Kyrgyz Republic accessed at https://climatepromise.undp.org/what-we- do/where-we-work/kyrgyz-republic 45 Article 336.2 of the Tax Code 29 spectrum for transmission of mobile communications, which limits the number of operators in the market. In the case of the Kyrgyz Republic, there are currently three mobile communications companies. 83. The possibility of earning abnormal profits has seen increased taxation of the telecommunications sector, similar to extractive industries. There are two main options for sector- specific taxation: (i) additional taxation under the CIT (such as through an additional profits tax or CIT surcharge); or (ii) a revenue-based tax. The former may be regarded as best practice and is likely to have limited impact of prices. However, additional CIT taxation can be complex and difficult to administer, particularly because of profit shifting and other profit reduction practices. While a revenue-based tax may have an impact on prices, it is simpler to design and administer and is more difficult to avoid than a profit- based tax. Given the existing (revenue-based) sales tax on mobile communications services, it is recommended that this is converted into an excise on repeal of the sales tax. RECOMMENDATIONS • Ensure that excise tax rates on tobacco products meet WHO guidelines. • Review excise rates on alcoholic beverages, petroleum products, and non-alcoholic sugary drinks. • Introduce rules for automatic adjustment of excise tax rates in line with inflation. • The excise rates for petroleum products should be based on carbon emissions. On this basis, the excise rate for diesel should, at least, be increased to the rate for petrol but preferably higher to reflect the greater carbon emissions from the use of diesel. • Consider broadening the environment-related tax base by expanding the tax base for excisable goods including coal. • Consider introducing excise tax on telecommunications services in place of sales tax. MINING TAXATION 84. Mineral resources in the Kyrgyz Republic are owned by the State.46 The government authorizes investors to develop the nation’s resources and takes it return by way of fiscal instruments.47 In effect, the fiscal regime for the extraction of mineral resources aims to share the nation’s resource wealth between the government and investors, and must balance: (i) the need to attract foreign investors to explore for and develop the nation’s resources against; (ii) ensuring that the government (on behalf of the people) receives a fair return for the country’s mineral resource wealth. 85. The standard design of the fiscal regime takes account of the non-renewable nature of mineral resources, the possibility that mining companies may earn economic rent, and the need for foreign investors to develop the nation’s resources. The non-renewable nature of mineral resources means that an effective fiscal regime must be in place to ensure that the government obtains a fair return for the nation’s mineral resources. There are no second chances once mineral resources have been extracted. There is a desire by governments to obtain an immediate return for nation’s resources once production commences and this is achieved through royalties and bonus payments. 46 Article 3 of the Law on the Subsoil 2018 47 The government may also take an equity interest in a mining company and take a return by way of dividends. In this regard, the largest gold mining company in the Kyrgyz Republic, Kumtor, is now wholly government-owned. 30 86. An investor may earn economic rent from the extraction of mineral resources . In broad terms, economic rent is the excess of revenues in the long run over costs uplifted by the investor’s normal rate of return. Economic rent is possible because of the scarcity of mineral resources and the high capital costs required which act as a barrier to entry. The possibility of economic rent dictates the use of profit-based instruments structured so that the government’s share increases with the profitability of the project. 87. The involvement of foreign investors in mining increases the risk of tax planning and avoidance to shift revenues and profits outside the Kyrgyz Republic through transfer pricing, excessive in-house debt capitalization, and other profit shifting arrangements. There is limited scope under the Tax Code to counter profit shifting. There are no transfer pricing rules. While this may be explained by the low CIT rate, transfer pricing is relevant to royalties calculated by reference to the value of the resource. High royalty rates will encourage the use of transfer pricing practices to reduce the royalty liability. 88. Governments tend to prefer fiscal instruments that provide early and stable sources of revenue, particularly royalties, which are payable from first production. Profit-based taxes, in contrast, are payable later in the project after costs have been recovered. Profit-based taxes may be less reliable, particularly as they are vulnerable to profit shifting arrangements. Investors prefer the opposite with royalties being a cost regardless of the profitability of the project. Overly heavy reliance on royalties may prevent marginal mining projects proceeding and make it difficult to attract investors. 89. To balance the interests of the government and investors, the fiscal regime for mining usually involves a mix of instruments and the respective “takesâ€? of the government and investor is determined having regard to all fiscal instruments over the life of the project. The fiscal regime includes royalties to ensure revenue to the government from first production, but because these do not recognize costs, royalty rates are usually modest. The fiscal regime includes a profit-based instrument (or instruments) that increase the government’s share as the profitability of the project increases. This may be done through a variable CIT rate (common for mining in African countries) or through a separate resource rent tax applying only when an investor is earning economic rent from a project. 90. The largest mining company operating in the Kyrgyz Republic is Kumtor, which is fully state- owned. A separate tax regime applies to Kumtor as provided for by agreement. 91. The Tax Code applies to other mining companies. The fiscal regime comprises a production-based royalty between 3 – 5 percent,48 and CIT rate ranging from 1 – 30 percent of gross proceeds of sale.49 The CIT rate varies depending on the price of the resource. There is no deduction for costs and, therefore, the CIT operates as the equivalent of an additional royalty. Initially, this regime applied only to gold but has been extended to other minerals under the 2023 amendments. 92. While described as a CIT, the fiscal regime operates as the equivalent of a royalty payable by reference to gross revenues at very high rates internationally. Under this regime, the government’s take from mineral resource operations is high. e redesigned to align with international norms with a modest royalty applying from first production and a progressive profits tax that increases the government’s share as the profitability of the project increases. The tax regime for mining should not be subject to negotiation. RECOMMENDATIONS 48 Chapter 45 of the Tax Code 49 Chapter 33 of the Tax Code 31 • Revise the mining regime to better align with international norms with a modest royalty and profit-based taxation with the Government’s take increasing with profitability of the project, including: o Introducing CIT for all minerals; o Make the rate of royalty variable and linked to gold prices or reduce the windfall tax threshold. PROPERTY TAXATION 93. The property tax regime comprises separate taxes on: (i) residential and commercial buildings; (ii) non-agricultural land plots; (iii) agricultural land; and (iv) vehicles.50 Property tax is imposed annually by reference to the calendar year. The tax base for the property tax on immovable property is based on a formula specified in the Tax Code rather than cadastral or market value. As explained in the next chapter, this leads to a significant tax gap in relation to the property tax. PROPERTY TAX APPLICABLE TO RESIDENTIAL AND COMMERCIAL BUILDINGS 94. Property taxes payable for residential and commercial buildings are assessed based on the area, an industrial index and geographic coefficients. The tax assessment is calculated according to the following formula: AxBxCxDxE where: A is the taxable value of 1 square meter of the property. The value depends on the expected life of the building and the materials used. The value varies from 5,000 – 15,000 KGS depending on construction material and age of the building.51 B is the taxable area of residential premises or the total area of commercial premises. C is the industrial index for the property. For residential premises, it is 1 and, for business premises, it varies between 0.2 – 1.6.52 D and E are regional and zone coefficients that vary from 0.1 – 2.53 95. The tax rate is 0.35 percent for residential buildings and 0.8 percent for commercial buildings. An exemption applies to residential buildings depending on location and size. For large urban areas (such as Bishkek), residential homes up to 150 square meters and, for apartments, up to 80 square meters. There is a 50 percent reduction in property tax for buildings that meet energy and resource efficiency as determined by the Cabinet of Ministers. Property tax on residential property is paid annually and on commercial property is payable quarterly. 96. The rate of property tax on non-agricultural land plot is 1 percent. The tax is payable quarterly. The tax base for the property tax on non-agricultural land plots is based on the following formula: AxBxCxD where: 50 Section XIII of the Tax Code 51 Article 386.1 of the Tax Code 52 Article 389 of the Tax Code 53 Articles 387 and 388 of the Tax Code 32 A is the taxable value of 1 square meter of the plot. The value varies from 90 – 290 depending on the population of the settlement where the land plot is located.54 B is the zonal coefficient of the plot. This is set by the local kernesh where the property is located and is in the range 0.3 – 2.55 C is functional coefficient of the plot which depends on the use and ranges from 0.001 – 50. D is the inflation coefficient for the year. PROPERTY TAX ON AGRICULTURAL LAND 97. The property tax on agricultural land is imposed separately for the homestead and the agricultural land itself. The tax base for the property tax on the homestead depends on location of the land plot56 and the tax base for agricultural land depends on the location and use of the land.57 The rate of property tax on agricultural land is 0.01 percent, payable in three instalments during the year. PROPERTY TAX ON VEHICLES 98. The tax base for a vehicle with an internal combustion engine is based on the engine volume and age of the vehicle, and for a vehicle without an internal combustion engine is based on the accounting value of the vehicle. The tax rate for vehicle with an internal combustion engine is 1 percent and for any other vehicle is 0.5 percent. An exemption applies to vehicles that are fully electric. The tax is payable annually. RECOMMENDATIONS • Gradually move to market value as the base for property tax on immovable property based on an updated register of property values. TAX GAP 99. The tax gap will be evaluated using both the Top-down approach based on national accounts data and shadow economy estimates, and the Bottom-up approach utilizing specific data by tax instrument provided by the Kyrgyz State Tax Service (STS). TOP-DOWN APPROACH TO EVALUATING TAX GAP 100. Top-down approach crucially depends on the estimates of the shadow economy. Based on three data sources58 presented in the Figure 3 below, we have developed two shadow economy scenarios for estimating tax gap for direct and indirect taxes. Figure 3: KR - Alternative estimates of shadow economy 54 Article 404.1 of the Tax Code 55 Article 404.4 of the Tax Code 56 Article 397 of the Tax Code 57 Article 401 of the Tax Code 58 Kyrgyz statistics, World Bank shadow economy databank based on DGE model and MIMIC model estimates. 33 45.0 y = -0.2717x + 39.977 R² = 0.8376 40.0 35.0 y = -0.1047x + 38.208 R² = 0.2462 30.0 25.0 y = 0.3121x + 18.498 R² = 0.4868 20.0 15.0 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 WB DGE WB MIMIC KR Stat (excl AGRI) Linear (WB DGE) Linear (WB MIMIC) Linear (KR Stat (excl AGRI)) Source: Kyrgyz NSC. Staff estimates based on World Bank shadow economy databank. 101. The results show that the shadow economy (i.e. informal and underground economy) generates a total tax gap averaging 4.3 percent. Table 8 below and annex tables 2 and 3 show that the tax gap ranges from 3.5 to 5.0 percent of GDP in the low case scenario (based on Kyrgyz NSC estimates). In the high case scenario, the average tax gap is 7.2 percent, ranging between 6.2 to 8.7 percent of GDP. In both scenarios about 30 percent of the gap relates to direct taxes, and 70 percent to indirect taxes. Table 8: Top-Down estimates of tax gap due to informal economy 2018 2019 2020 2021 2022 Low shadow economy scenario Direct tax gap (as % of GDP) 1.2 1.2 1.1 1.2 1.8 Indirect tax gap (as % of GDP) 3.6 3.2 2.3 2.8 3.2 Total Tax gap (as % of GDP) 4.8 4.4 3.5 4.0 5.0 Low Scen. Shadow economy as % of GDP 23.4% 23.5% 20.8% 21.0% 21.0% High shadow economy scenario Direct tax gap (as % of GDP) 1.8 1.9 2.0 2.0 3.1 Indirect tax gap (as % of GDP) 5.4 5.0 4.1 5.0 5.6 Total Tax gap (as % of GDP) 7.3 6.9 6.2 7.0 8.7 High Scen. Shadow economy as % of 35.5% 37.0% 36.9% 36.8% 36.7% GDP Source: Kyrgyz NSC. Staff estimates based on World Bank shadow economy databank BOTTOM-UP APPROACH TO EVALUATING TAX GAP 102. The analysis is based on detailed STS data on key individual tax instruments and standard tax gap methodology (see annex 1). Full set of analytical tables is given in the annex 2: Summary annex tables 4-7 present the results of tax gap analysis, while individual analytical tables with detailed tax gap calculations for each tax instruments are presented in the next section. 34 103. The overall tax gap for Kyrgyz Republic has increased during the past five years from about 9.7 percent of GDP in 2018 to 13.1 percent in 2022 (see table 9 below). The brunt of the overall tax gap (81 – 85 percent) comes from the combined impact of VAT and excise tax gaps on domestic consumption and imports. The remainder of the gap is split between direct taxes owed by households (PIT and property tax gaps) on the one hand, and the corporate sector (CIT and mining tax gaps) on the other. Table 9. Tax Gap by tax instrument, 2018-2022 2018 2019 2020 2021 2022 PIT Tax Gap (bn soms) 5.7 5.0 5.7 8.2 8.5 CIT tax gap (bn soms) 1.9 2.0 2.0 3.5 5.6 Mining tax gap (bn soms) 0.0 0.2 0.0 2.8 3.8 Property tax gap (bn soms) 3.1 2.1 2.4 2.6 2.5 Total direct tax gap (bn soms) 10.7 9.3 10.1 17.1 20.4 Total direct tax gap (% of GDP) 1.9% 1.4% 1.6% 2.2% 2.1% VAT tax gap (bn soms) 38.4 46.3 51.5 65.1 95.0 VAT on M tax gap (bn soms) 4.1 4.2 3.9 7.2 8.1 Excise on M tax gap (bn soms) 1.7 1.3 1.1 2.1 3.0 Excise on D tax gap (bn soms) 0.3 0.2 0.1 0.2 0.6 Total indirect tax gap (bn soms) 44.5 52.0 56.5 74.6 106.7 Total indirect tax gap (% of GDP) 7.8% 8.0% 8.8% 9.5% 11.0% TOTAL TAX GAP (bn soms) 55.2 61.3 66.6 91.7 127.1 TOTAL TAX GAP (% of GDP) 9.7% 9.4% 10.4% 11.7% 13.1% Source: State Tax Service, Kyrgyz Republic 104. With few exceptions, such as the PIT tax gap which showed a minimal variation around the five year average, most tax gaps showed a tendency to increase over the 2018-2022 period. The single most important tax gap (VAT tax gap) grew at 9.7 percent and almost reached the 10 percent of GDP mark in 2022. In terms of structure, the share of Tax Expenditure gap in the overall VAT tax gap remained relatively stable at around 41 percent, indicating that key discretionary policies causing the “tax expenditureâ€? did not change much. By contrast, the share of the PIT Tax Expenditure gap gradually decreased from around 60 to 50 percent of the total PIT tax gap indicating softer discretionary government decisions and/or interventions regarding personal income taxation. Table 10. Tax Expenditure Gap by tax instrument, 2018-2022 35 2018 2019 2020 2021 2022 PIT Tax Expenditure Gap (bn soms) 3.4 3.0 3.3 4.1 4.3 CIT Tax Expenditure gap (bn soms) 1.9 2.0 2.0 3.5 5.6 Mining Tax Expenditure gap (bn soms) 0.0 0.2 0.0 2.8 3.8 Property Tax Expenditure gap (bn soms) 3.1 2.1 2.4 2.6 2.5 Total direct tax expend gap (bn soms) 8.4 7.3 7.6 13.0 16.2 Total direct tax expend gap (% of GDP) 1.5% 1.1% 1.2% 1.7% 1.7% VAT Tax Expenditure gap (bn soms) 15.7 17.8 22.0 25.3 42.4 VAT on M Tax Expend gap (bn soms) 4.1 4.2 3.9 7.2 8.1 Excise on M Tax Expend gap (bn soms) 1.7 1.3 1.1 2.1 3.0 Excise on D Tax Expend gap (bn soms) 0.3 0.2 0.1 0.2 0.6 Total indirect tax expend gap (bn soms) 21.8 23.5 27.1 34.8 54.1 Total indirect tax expend gap (% of GDP) 3.8% 3.6% 4.2% 4.4% 5.6% TOTAL TAX EXPEND GAP (bn soms) 30.2 30.8 34.7 47.8 70.3 TOTAL TAX EXPEND GAP (% of GDP) 5.3% 4.7% 5.4% 6.1% 7.2% Source: State Tax Service, Kyrgyz Republic EVALUATING TAX GAP BY TAX INSTRUMENT PIT TAX GAP 105. PIT is assessed on all registered wage and salary incomes provided by the STS for the 2018-2022 period, which does not allow a reliable assessment of PIT tax gap. Based on data reported under category “Income not subject to PITâ€? and “standard deductionsâ€? (with combined share of 21 percent of income subject to PIT) and limited additional information available, we have estimated PIT tax gap to be tentatively 26 percent of the potential PIT tax, or about 0.9 percent of the GDP for the entire 2018-2022 period. 36 Table 11: PIT Tax Gap, 2018-2022 2018 2019 2020 2021 2022 Average Registered Personal Income (PI) (bn soms) 112.4 124.8 130.2 140.7 208.0 143.2 PI subject to PIT (bn soms) 89.3 99.5 102.9 111.3 165.3 113.6 Actual PIT Paid and Due (bn soms) 21.8 19.8 21.6 31.0 33.0 25.4 Effective PIT rate 24.4% 19.9% 20.9% 27.8% 20.0% 22.4% Potential PIT @effective PIT rate (bn soms) 27.4 24.8 27.3 39.1 41.5 32.0 Total PIT Tax Gap (bn soms) 5.7 5.0 5.7 8.2 8.5 6.6 PIT efficiency gap (bn soms) 2.2 2.0 2.4 4.1 4.2 3.0 PIT tax expenditure gap (bn soms) 3.4 3.0 3.3 4.1 4.3 3.6 Total PIT Tax Gap (in % of paid PIT) 26.0% 25.4% 26.5% 26.4% 25.8% 26.0% PIT efficiency gap (in % of paid PIT) 10.3% 10.3% 11.1% 13.1% 12.9% 11.5% PIT tax expenditure gap (in % of paid PIT) 15.7% 15.1% 15.3% 13.3% 13.0% 14.5% Total PIT Tax Gap (in % of GDP) 1.0% 0.8% 0.9% 1.0% 0.9% 0.9% PIT efficiency gap (in % of GDP) 0.4% 0.3% 0.4% 0.5% 0.4% 0.4% PIT tax expenditure gap (in % of GDP) 0.6% 0.5% 0.5% 0.5% 0.4% 0.5% Memo: GDP in billion soms 569 654 640 783 971 Source: State Tax Service, Kyrgyz Republic CIT TAX GAP 106. In relative terms, CIT tax gap (as a share of potential CIT tax) declined from close to 64 percent in 2018 to 42 percent. Declared gross operating profits grew very fast during the analyzed period (45.6 percent p/a) and actual CIT taxes paid grew even faster (63.6 percent). Expressed as percent of GDP, CIT tax gap generated a revenue loss which averaged 0.4 percent of GDP annually (i.e. 0.3 percent of GDP losses during 2018-2020, 0.5 percent loss in 2021 and 0.6 percent loss in 2022). In short, CIT tax gap assessment indicates that favorable developments in reducing relative CIT Tax Gap expressed as a percent of potential CIT tax need to be continued to collect more CIT taxes and stop further increases in CIT tax losses relative to GDP. Table 12: CIT Tax Gap, 2018-2022 2018 2019 2020 2021 2022 Average Gross operating profits (mn soms) 29.7 33.4 31.5 58.9 133.6 57.4 CIT rate 10% 10% 10% 10% 10% 10.0% Potential CIT tax (bn soms) 3.0 3.3 3.2 5.9 13.4 5.7 Actual CIT taxes paid (bn soms) 1.1 1.3 1.2 2.4 7.7 2.8 CIT tax gap (bn soms) 1.9 2.0 2.0 3.5 5.6 3.0 CIT tax gap as % of potenial CIT 63.7% 60.1% 62.4% 58.8% 42.1% 57.4% CIT tax gap as % of GDP 0.3% 0.3% 0.3% 0.4% 0.6% 0.4% Memo: GDP in billion soms 569 654 640 783 971 Source: State Tax Service, Kyrgyz Republic MINING TAX GAP 107. Total revenues from mining recorded a very strong (34 percent p/a) growth during the past five years. Actual average tax rate on mining increased from 1.8 percent to 12.9 percent during the same period driven by differential price dynamics and changes in tax rates. During the 2018-2020 period 37 potential and actual mining taxes were almost equal, yielding a close to zero tax gap. In 2021 and 2022 the tax gap increased because prices and actual taxes paid on “gold concentrateâ€? production and sales increased much faster. This affected the level of potential mining taxes (from 3 to 9 and 11 bn soms in 2020, 2021 and 2022 respectively) and, hence, increased substantially the mining tax gap from zero to 0.4 percent of GDP in 2021-2022. Table 13: Mining Tax Gap, 2018-2022 2018 2019 2020 2021 2022 Average Total revenue from mining (bn soms) 17.3 26.2 32.1 47.6 56.0 35.8 Total tax paid from mining (mn soms) 0.3 1.1 3.7 6.1 7.2 3.7 Actual tax rate on mining 1.8% 4.1% 11.5% 12.9% 12.9% 8.6% Potential max tax rate on mining 1.9% 4.9% 11.5% 18.9% 19.6% 11.3% Potential max tax on mining (mn soms) 0.3 1.3 3.7 9.0 11.0 5.0 Mining tax gap (mn soms) 0.0 0.2 0.0 2.8 3.8 1.4 Mining tax gap as % of potenial 8.4% 16.6% 0.2% 31.7% 34.4% 18.3% Mining tax gap as % of GDP 0.0% 0.0% 0.0% 0.4% 0.4% 0.2% Memo: GDP in billion soms 569 654 640 783 971 Source: State Tax Service, Kyrgyz Republic VAT TAX GAP 108. VAT is by far the largest source of tax revenue in Kyrgyz Republic . VAT contributes a large 45 percent share to total tax revenues and amounts to 9.2 percent of official GDP. This relatively large share is explained by: • the heavy reliance on VAT revenues assessed mainly on imports (almost 80 percent of VAT revenues), • exceptionally large size of final consumption relative to GDP (see box table below), • large shares of “VAT free and exemptâ€? (34 percent) and “zero rateâ€? goods (10 percent) which: directly cause sizeable efficiency and expenditure gaps (on average 5.1 and 4.4 percent of GDP respectively - see Table 15), and generate a strong asymmetric impact of companies operating under special tax regimes causing low VAT refunds and higher effective VAT rate based on official numbers, and by • relatively large informal and underground economy and sizeable recorded and unrecorded remittances. 109. During the same period transactions excluded from VAT tax (due to zero VAT rate, granted VAT free status or based on legal or discretionary policy decisions) amounted on average to around 447 bn soms compared to VAT taxed transactions amounting on average to almost 610 bn soms. This opened up a VAT tax gap which increased from around 38.4 bn soms in 2018 to 95 bn soms in 2022 (with 59.3 bn soms annual average). During the same period transactions excluded from VAT tax (due to zero VAT rate, granted VAT free status or based on legal or discretionary policy decisions) amounted on average to around 447 bn soms compared to VAT taxed transactions amounting on average to almost 610 bn soms. This opened up a VAT tax gap which increased from around 38.4 bn soms in 2018 to 95 bn soms in 2022 (with 59.3 bn soms annual average). 38 Table 14: VAT revenues by source – 2018-2023 (as percent of GDP) Increase in VAT 2018 2019 2020 2021 2022 2023e 2023/2021 bn soms share in % Share of actual VAT in GDP 9.3% 7.8% 6.2% 8.1% 11.1% 12.7% 80.1 100.0% of which: Domestic VAT 2.1% 1.8% 1.7% 2.0% 2.1% 2.5% 13.3 16.6% VAT on Imports 7.2% 5.9% 4.5% 6.2% 9.0% 10.1% 66.7 83.4% from EAES 3.1% 2.7% 2.7% 3.2% 3.1% 2.8% 6.7 8.4% Other countries 4.0% 3.2% 1.8% 3.0% 5.8% 7.2% 57.7 72.1% Sales tax 0.8% 0.6% 0.6% 0.6% 0.7% 1.7% 14.1 Memo items: VAT (% of Final Consumption) 9.3% 8.9% 6.9% 8.4% n.a. n.a. Final Consumption (% of GDP) 99.7% 87.8% 88.9% 96.7% n.a. n.a. Final Consumption (bn soms) 567.4 574.3 568.4 757.0 n.a. n.a. GDP (bn soms) 569.4 654.0 639.7 782.9 971.0 1,134.0 Source: Staff calculations based onoffiial data presented in text and annex tables. e) Estimate based on January-October 110. Expressed in relative terms, VAT tax gap averaged almost 50 percent of potential VAT tax, with growing GDP share of lost VAT revenue: from 6.7 percent of GDP in 2018 to 9.8 percent in 2022. The huge VAT revenue loss in 2022 is due to an “efficiency gapâ€? (5.1 percent of GDP), a “tax expenditure gapâ€? (4.4 percent of GDP), and a “compliance gapâ€? (0.3 percent of GDP). 39 Table 15: VAT Tax Gap, 2018-2022 2018 2019 2020 2021 2022 Average Potential VAT base (bn soms) excl Gold 705.6 759.1 765.8 1,074.8 1,702.6 1,001.6 of which Taxed VAT 453.3 493.6 452.1 660.8 988.9 609.7 Zero VAT rate 84.9 75.4 63.8 117.7 180.6 104.5 VAT free and exempt 217.4 247.2 305.9 351.3 589.1 342.2 Potential VAT 84.7 91.1 91.9 129.0 204.3 120.2 Potential VAT on taxed goods 54.4 59.2 54.2 79.3 118.7 73.2 Potential VAT on zero rate goods 10.2 9.0 7.7 14.1 21.7 12.5 Potential VAT on free and exempt goods 26.1 29.7 36.7 42.2 70.7 41.1 Actual VAT paid 52.3 51.6 47.0 70.1 114.3 67.1 Actual VAT on domestic goods 22.0 22.8 20.2 29.2 40.2 26.9 Actual VAT on imported goods 30.3 28.9 26.8 41.0 74.2 40.2 VAT tax due 2.1 7.6 7.1 8.8 2.6 5.7 VAT GAP 38.4 46.3 51.5 65.1 95.0 59.3 VAT GAP % of potential VAT 45.4% 50.8% 56.0% 50.5% 46.5% 49.8% VAT GAP % of GDP 6.7% 7.1% 8.0% 8.3% 9.8% 8.0% VAT Efficiency GAP 20.6 20.9 22.3 31.0 49.9 29.0 VAT Efficiency GAP % of potential VAT 24.4% 23.0% 24.3% 24.0% 24.4% 24.0% VAT Efficiency GAP % of GDP 3.6% 3.2% 3.5% 4.0% 5.1% 3.9% VAT Tax expenditure GAP 15.7 17.8 22.0 25.3 42.4 24.6 VAT Tax expenditure GAP % of potential VAT 18.5% 19.5% 24.0% 19.6% 20.8% 20.5% VAT Tax expenditure GAP % of GDP 2.7% 2.7% 3.4% 3.2% 4.4% 3.3% VAT tax Compliance GAP 2.1 7.6 7.1 8.8 2.6 5.7 VAT Tax Compliance GAP % of VAT 2.5% 8.4% 7.8% 6.9% 1.3% 5.3% VAT Tax Compliance GAP % of GDP 0.4% 1.2% 1.1% 1.1% 0.3% 0.8% Memo: GDP in bn soms 569 654 640 783 971 Source: State Tax Service, Kyrgyz Republic 111. Although much smaller in size of taxable transactions and tax gap, VAT and Excise taxes assessed on imports caused an average combined tax gap revenue loss of 0.9 percent of GDP. Of this among, 0.7 percent is attributable to import VAT tax gap and 0.2 percent to the import Excise tax gap. Table 16: Import VAT Tax Gap, 2018-2022 2018 2019 2020 2021 2022 Average Potential M subject to VAT 181.1 181.4 183.5 275.4 315.3 227.3 Potential VAT on M 21.7 21.8 22.0 33.1 37.8 27.3 Actual VAT on M 17.6 17.6 18.2 25.8 29.7 21.8 M VAT gap 4.1 4.2 3.9 7.2 8.1 5.5 M VAT gap in % of potential 19.0% 19.3% 17.5% 21.8% 21.5% 19.8% M VAT gap in % of GDP 0.7% 0.6% 0.6% 0.9% 0.8% 0.7% Memo: GDP in bn soms 569 654 640 783 971 Source: State Tax Service, Kyrgyz Republic 40 Table 17: Import Excise Tax Gap, 2018-2022 2018 2019 2020 2021 2022 Average Potential M subject to Excise tax 33.9 33.4 30.3 41.1 42.5 36.3 M exempt from Excise tax 5.5 4.5 3.6 6.9 9.9 6.1 M subject to excise tax 28.4 28.9 26.7 34.2 32.6 30.2 Excise tax rate (tbd) 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% Actual Excise tax on M 8.5 8.7 8.0 10.3 9.8 9.1 Potential excise tax on M 10.2 10.0 9.1 12.3 12.8 10.9 M Excise tax gap 1.7 1.3 1.1 2.1 3.0 1.8 M Excse tax gap in % of potential 16.2% 13.4% 11.8% 16.8% 23.3% 16.3% M Excise tax gap in % of GDP 0.3% 0.2% 0.2% 0.3% 0.3% 0.2% Memo: GDP in bn soms 569 654 640 783 971 Source: State Tax Service, Kyrgyz Republic 112. In combination with the above discussed VAT tax gap, all VAT and Excise tax related gaps cause an average annual revenue loss of 8.9 percent (ranging from 7.7 percent of GDP in 2018 to as much as 10.9 percent in 2022). This squarely puts the highest priority on addressing all elements of the VAT system and identifying the causes of revenue loss of such magnitude. The main focus should be on the sources of discretionary decisions in the broad tax expenditure area with such high public revenue losses, ways of scaling down or removing key discretionary decision leading to such adverse outcomes, and exploring other policy and structural reform options for achieving the same or similar legitimate goals through less distortionary measures. PROPERTY TAX GAP 113. At present, property tax gap analysis is assessed on a heavily undervalued tax base. The valuation of immovable property and transport vehicles in STA tax base appears to be significantly below market value, with reduced coverage resulting from multiple often arbitrary exemptions and exclusions. Even after properly allowing for social equity and poverty considerations, property taxes hold a great potential for future revenue increase based on more realistic valuations and tax assessment, especially in the longer run when real incomes measurably increase. 114. Potential property tax presented in Table 14 is computed based on an incomplete set of data provided by STS and our estimates. based on actual property taxes paid, and data on taxes and non- taxed area in years 2020-2021. Tax gap numbers declined from 0.5 percent in 2018 and then stabilized at around 0.3 percent of GDP in 2022. This can be explained by the declining share of non-taxed areas in houses and apartments, and by the erosion of the tax base value due to inflation and market trends. Table 18: Property Tax Gap, 2018-2022 2018 2019 2020 2021 2022 Average Actual property tax (bn soms) 2.8 3.0 2.8 3.1 3.0 2.9 Potential property tax 5.9 5.0 5.2 5.7 5.4 5.4 Property tax gap 3.1 2.1 2.4 2.6 2.5 2.5 Property tax gap in % of potential prop tax 52.4% 41.1% 45.8% 45.8% 45.6% 46.1% Property tax gap in % of GDP 0.5% 0.3% 0.4% 0.3% 0.3% 0.4% Memo: GDP in bn soms 569 654 640 783 971 Source: State Tax Service, Kyrgyz Republic 41 TAX ADMINISTRATION CONTRAINTS 115. A 2016 tax administration assessment (TADAT) showed mixed results in performance for the STS. The STS performed well in taxpayer services and tax audit planning, but had limited capability to manage tax compliance as well as issues in accuracy of the taxpayer registration database. Outdated tax administration business processes coupled with a lack of full automation of core tax administration undermined performance further. 116. Recognizing these problems, the STS has implemented reforms to improve the accuracy of the taxpayer registration database by developing criteria for inactive taxpayers; roll out of e-filing and broad scale up of digital services for taxpayers. The STS has undertaken a number of digitalization measures—e-invoice, e-filing, goods e-tracking system, and introduction of online cash machines. However, compliance management is not based on risks and corruption continues to be widespread, as reflected in the survey results (Enterprise Survey 2019). 117. The findings of the recent 2022 Tax Compliance Cost Survey of 1,100 businesses funded by the World Bank show recent reversals in some of the early gains in terms of compliance cost. Figure 4 shows that while tax reforms initiated in 2012 initially reduced tax compliance cost for all legal entities by almost half in the first four years, sometime after 2016 the course was reversed, and by 2021 companies were spending more time on tax compliance than in 2014. For VAT payers, the situation has worsened the most. Ten years after reforms were initiated, companies spent more time complying with the VAT obligations than at the beginning of the reform process. These rising compliance costs in the face of reforms that aimed at reducing such costs do not enhance trust in government fairness or in long-term business development plans. Figure 4. Dynamics of legal entities' time costs on tax accounting by tax regime, working days per year VAT payers Non-VAT payers Single tax 81.8 73.3 65.6 48.1 36.7 29.4 29.5 19.3 18.5 15.2 16.3 10.6 2012 2014 2016 2021 2012 2014 2016 2021 2012 2014 2016 2021 118. One of the key issues in improved compliance management is weak capability of the STS to obtain and use third party information, including automatic exchange with all relevant government entities and financial institutions. The STS has already accumulated significant amount of data through VAT e-invoices, e-filing and other changes, but capabilities to use data in compliance management should also be improved. This includes further strengthening of use of data analytics in audit case selection and VAT refunds; predictive modelling in debt management to identify high risk debtors; and improvement in 42 taxpayer services by developing tailored channels of communication for different taxpayers. Many administration measures that are tax-instrument specific are also listed in the Key Tax Instrument section. 119. Modern tax administrations make extensive use of data analytics. Based on 2016 OECD survey, Australia, Ireland, New Zealand, Singapore, and the United Kingdom used analytics across a full range of activities, but many other countries started using data analytics to improve compliance. Table 19. Breadth of use of analytics across functions in 15 countries Audit case Filing and Debt Taxpayer Policy selection payment management services Australia compliance Ireland New Zealand Singapore United Kingdom Canada Norway Finland China Mexico Sweden Malaysia Netherlands Switzerland France 43 CONCLUSIONS AND RECOMMENDATIONS 120. While nominal tax revenues increased at an average annual rate of almost 40 percent between 2020 and 2023 (from KGS 107 billion in 2020 to an estimated almost KGS 290 billion in 2023), a significant share of the increase came from one off events. Direct taxes contributed about 22 percent to this increase, but the main driver was indirect taxes with VAT revenues contributing 74 percent. VAT on imports contributed almost 83 percent of the increase in VAT revenues, with about 4/5 of this increase coming from VAT on imports from non-EAEU countries. Imports from non-EAEU countries, Kumtor taxes, and late CIT collections contributed to increases in revenues but these were one-off events and so should be excluded from the longer term tax revenue projections and related tax sustainability analysis. 121. The recommendations below are organized around how to mobilize revenues sustainably by reducing tax gaps originating from informal economy, tax exemptions and remaining weaknesses in tax administration. INFORMAL ECONOMY 122. The share of informal economy ranges from about 21 percent to over 35 percent of GDP, leading to estimated tax gap of 5 to 8.7 percent of GDP. The informal economy in the Kyrgyz Republic is influenced by a wide range of factors: non-registered business activities, especially in rural areas; unregistered production of otherwise legal goods and services; under-reporting or not reporting income; and an enterprises in the formal economy that engage in tax evasion due to high tax compliance costs. An important contributing factor are huge remittances (estimated at over USD 3 billion in 2022, or close to 30 percent of GDP) which create a permanent inflow of unreported income and fuel shadow economy transactions. 123. Cutting the share of informal economy in half (i.e. increasing formal tax-paying economy by 10 percent in low case and 18 percent in high case scenario) could increase tax revenues by 2.5 – 4.3 percent of GDP. To achieve the objective of reducing tax gap caused by the informal economy, a coordinated policy action is needed to: • step-up awareness and advocacy efforts; • organize training in tax reporting skills, • provide a range of fiscal incentives on the positive side, and • step-up tax discipline and introduce penalties. TAX EXPENDITURE GAP 124. Total tax expenditure gap is estimated at 7.2 percent of GDP in 2022. Almost three quarters of the gap (or 5.2 percent of GDP) is due to the VAT tax expenditure gap. The second largest contributor (13 percent of the gap) is tax expenditure gap associated with CIT and mining taxes (1 percent of GDP). PIT and property taxes explain another 10 percent of the overall tax expenditure gap (equal to 0.7 percent of GDP). 44 125. Policy recommendations that could help gradually and sustainably reduce the VAT tax expenditure gap should recognize the main sources59 of the gap and the legal bases60 for exclusions, as well as connected tax instruments (sales tax) and intended policy objectives (consumer/food subsidies). • Reexamine the rationale for VAT exemptions. The exemptions include zero VAT rates, VAT free and exempt goods and services as stipulated by the recent procedures approved by the Parliament. Consider eliminating exemptions that are an inefficient use of fiscal resources and those whose objectives can be achieved more efficiently by other means. • Compensate for impacts on food and basic goods. The Government can compensate for the impact of resulting price increases of food and basic goods by introducing targeted means- tested subsidies to broadly defined lower income groups. • Eliminate the sales tax and increase the VAT rate. The sales tax can be eliminated or merged with VAT and the VAT rate increased with neutral fiscal revenue impact. Combine this change with improved VAT refund mechanisms that would provide automatic or faster refunds by relying on recent improvements in invoicing and payments. • Prepare stakeholders for changes in tax policy. Address political economy issues beforehand to secure majority political support for changes that require a different mind-set (of the public, politicians and media) and break from the rules inherited from Soviet times (subsidized food and energy prices, no income and property taxes etc.). • Broaden the base of PIT, CIT and property taxes. Increase tax coverage and progressivity in order to gradually broaden the direct tax base and approach a compliance-based tax system with more equitable distribution of tax burden. • Reexamine, simplify and rationalize special tax regimes (patent and single tax regime). TAX EFFICIENCY GAP 126. To reduce efficiency gap, the Kyrgyz Republic should review the laws that exempt taxable activities. The Government will need to define a path to phase out and/or change the laws that attempt to achieve legitimate objectives (of greater equality and poverty elimination) through inefficient tax exemptions. These include unrealistically high physical thresholds for untaxed real estate property. 127. Change in public and business perceptions and building awareness that state/public provision of critical services and social assistance is not possible with the existing erosion of tax base through tax exemptions and exclusions firmly set in laws. TAX COMPLIANCE GAP 128. The compliance gap is only partially captured in the top-down and bottom-up instrument based analysis. Based on the methodology described in Annex I, the compliance gap is made of the assessment gap (which includes but is not limited to the informal economy), and the collection gap captured in the PIT and VAT tax gap assessments. The results, summarized in Table 20 below, show that the compliance 59 VAT exemptions defined in the tax code include: agricultural inputs (incl. fertilizers), water, electricity, heating energy, cooking gas, medicines, financial services, transport services, educational inputs, technology increasing energy efficiency, electric vehicles, import of natural gas, imported military equipment and goods. 60 If the exclusions are based on laws approved by the parliament or on international treaties, the exclusions are classified as part of the Efficiency gap. Else, if exclusions are based on discretionary decisions of the government they are treated as Tax Expenditure gap. 45 gap for the 2018-2022 period ranges on average between 3.2 and 3.6 percent of GDP in the low and high informal economy case, respectively. Table 20: True compliance gap 2018 2019 2020 2021 2022 Average Assesment gap Informal economy (low case) 4.8 4.4 3.5 4.0 5.0 4.3 Informal economy (high case) 7.3 6.9 6.2 7.0 8.7 7.2 Collection gap PIT compliance gap (PIT tax due) 8.9 9.7 10.1 19.0 16.5 12.8 VAT compliance gap (VAT tax due) 2.1 7.6 7.1 8.8 2.6 5.7 Total compliance gap (high case) In bn soms 15.8 21.7 20.7 31.8 24.1 22.8 As % of GDP 2.8% 3.3% 3.2% 4.1% 2.5% 3.2% Total compliance gap (high case) In bn soms 18.3 24.2 23.4 34.8 27.8 25.7 As % of GDP 3.2% 3.7% 3.7% 4.5% 2.9% 3.6% Source: Own calculations based on data presented in tables 4, 7 and 11. 129. Improvements in tax administration can also contribute to lowering the tax compliance gap . Tax administration complements recommendations aimed at reducing informal economy, which would substantially reduce the assessment part of the compliance gap (see para 125-6 above), and recommendations on expanding the PIT tax base and reforming VAT system (para 128) targeting the collection gap. In terms of specific tax administration measures, the following areas should be priorities: • Develop and implement comprehensive compliance risk management across registration, filing, payment and audit. • Building on e-services and third-party information, ensure better use of the data already available to the STS, the data analytics could be powerful tool to improve compliance. • Review business processes and reporting requirement to lower compliance costs, investments in IT infrastructure are essential to improve taxpayer experience. • Continue efforts to clean taxpayer database. 46 ANNEX 1. TAX GAP FRAMEWORK Tax gap analysis attempts to measure tax evasion and tax base erosion, which can undermine fairness and integrity of our tax systems. The tax gap consists of the compliance gap, which could be defined as a difference between taxes paid and all taxes that should be paid based on the current legislation, and policy gap, which consists mainly of tax exemptions and non-taxable transactions. Figure 1 describes the essence of the tax gap analysis. Figure 1.1: Tax Gap Analysis Framework ABCD = Full Potential Tax Collections EBHF = Compliance Gap GHCD = Policy Gap B H K C Full Compliance LBHM = Assessment Gap JKCD = Efficiency Gap / Non-Taxable Partial L M GHKJ = Tax Expenditure Gap Compliance ELMF = Collection Gap Current E F Compliance AEFG = Actual Collections A G J D Tax Policy Structure e nce ativ t ren ere rm Cur Ref No Source: IMF (2016): The Revenue Administration— Tax Gap Analysis Program: Eric Hutton OECD (2017): The Measurement of Tax Gaps, M. Whicker The analysis presented in this study focuses on tax revenue performance, including performance of different revenues in the presence of external and other shocks. We will first analyze actual tax collections (data) by main tax instruments over the 2018-2022 period under the current tax policy structure, i.e. actual tax laws and practices implemented by the STA. This provides a starting estimate of the actual collections (area AEFG in Figure 1). The analysis looks at variance in performance of different tax instruments over time an in the presence of external and internal negative and positive shocks. The analysis also shows what are inherent limits to increasing revenue contributions under present legal system, discretionary policy interventions, compliance and other behavioral characteristics of the taxpayers (individuals, households, SMEs and large businesses), organizational and structural setup of the STA and policy making bodies (MoF, Government, Parliament). 47 In short, the analysis presented in the study provides a framework to systematically (albeit provisionally at this stage due to the lack of data and policy information) evaluate the key elements of the tax gap framework: • The Tax Compliance gap (square EBHF) which has two elements: Tax Collection and Tax Assessment gap. • The Tax Collection Gap (ELMF square) i.e. the difference between assessed and actually collected taxes due to weaknesses in tax administration and enforcement; and • The Tax Assessment Gap (LBHM square) i.e. the difference between full and actual tax assessment under current (i.e.(imperfect) tax policy structure. • We will also be able to use information on tax exemptions (or tax expenditures) and special provisions in tax and other legislation to better understand the Tax Policy Gap which captures the difference between an ideal (Reference, optimal or comprehensive) tax policy structure and the current, actual tax policy structure that prevails in the country. Again, the Tax Policy Gap (square GHCD) will be broken down into two homogenous elements: • The Tax Policy Efficiency Gap (square JKCD) due to Non-Taxable activities excluded by law or policy; and • The Tax Expenditure Gap (square GHKJ) due to discretionary tax exemptions / tax expenditures. Where appropriate, the study will discuss the key sources of present tax gaps and possible policy actions to reduce the gaps and increase tax revenues. 48 ANNEX 2. DATA TABLES Table A.1: KR: Tax revenues 2018-2022 (billion soms) 2018 2019 2020 2021 2022 2023e Total tax revenues 116.6 121.5 106.9 149.2 231.0 288.8 Direct taxes 29.5 32.8 35.2 43.1 83.1 75.3 PIT TAX 11.5 12.9 12.2 15.3 20.3 24.1 PIT - KR residents 10.0 10.6 10.5 12.7 17.2 20.8 PIT on non-residents 1.5 2.2 1.6 2.6 3.1 3.3 CIT 4.5 5.8 4.9 7.8 18.0 14.7 Interest income tax 0.5 -0.1 0.0 0.0 0.0 0.0 Tax on gold producing companies 0.5 0.8 3.4 5.8 7.2 10.6 Special regime taxes 2.8 2.9 2.2 3.0 5.0 10.4 Single tax on SMEs 0.2 0.3 0.2 0.4 2.4 7.9 Tax on patents 2.5 2.7 2.0 2.6 2.5 2.3 Other taxes (Kumtor) 7.0 7.5 9.6 8.0 29.4 11.6 Tax on Kumtor revenue 7.0 7.5 9.6 8.0 10.6 11.5 Tax for development of mineral base 0.0 0.0 0.0 0.0 18.8 0.1 Property taxes 2.8 3.0 2.8 3.1 3.2 4.0 Real estate taxes 0.8 0.9 0.9 1.0 1.2 1.5 On businesses 0.8 0.9 0.9 1.0 0.1 0.0 On living space 0.0 0.0 0.0 0.0 1.1 1.5 Tax on mobile property 0.8 0.8 0.8 0.8 0.9 1.1 of which: Private cars 0.7 0.7 0.7 0.7 0.8 1.0 Land tax 1.1 1.2 1.1 1.2 1.1 1.4 Agricultural use 0.5 0.5 0.5 0.6 0.3 0.3 Urban areas 0.6 0.7 0.6 0.7 0.8 1.0 Indirect taxes 87.1 88.7 71.8 106.1 148.0 213.5 VAT 52.8 50.9 39.5 63.6 107.6 143.7 Domestic VAT 11.9 12.1 10.7 15.4 20.4 28.7 VAT on Imports 40.9 38.8 28.8 48.3 87.2 115.0 from EAES 17.9 18.0 17.4 24.7 30.5 31.5 Other countries 22.9 20.9 11.4 23.6 55.9 81.3 VAT on IT services by foreign co. 0.0 0.0 0.0 0.0 0.1 0.8 Sales tax 4.3 4.2 3.8 4.9 6.4 19.0 Road tax 0.0 0.0 0.0 0.0 0.0 0.0 Excise taxes 10.3 9.9 9.0 11.4 11.7 17.4 on domestic 1.8 1.3 1.0 1.1 2.0 4.0 on imports 8.5 8.7 8.0 10.3 9.8 13.4 Natural resource tax (incl. Royalty) 1.4 1.7 2.2 3.3 4.2 4.6 Foreign trade taxes (customs atc.) 18.3 22.0 17.3 22.9 17.9 28.0 Source: Kyrgyz National Statistical Committee (NSC) e) Estimate based on January-October actual data. 49 Table A.2: Kyrgyz Republic - Top-down Tax gap estimate, Low informal economy scenario 2018 2019 2020 2021 2022 Actual GDP (bn soms) 569.4 654.0 639.7 782.9 971.0 Total tax revenue (bn soms) 116.6 121.5 106.9 149.2 231.0 Direct taxes Actual Direct tax base (GNI) 552.1 564.7 581.8 687.2 852.3 Actual Direct tax revenues 29.5 32.8 35.2 43.1 83.1 Effective direct tax rate 5.3% 5.8% 6.0% 6.3% 9.7% Potential Direct tax base (with shadow) 681.3 697.4 702.8 831.5 1,031.3 Theoretical Direct tax liability (with shadow) 36.4 40.5 42.5 52.1 100.5 Top-down Direct tax gap (with shadow) in billions of soms 6.9 7.7 7.3 9.0 17.4 as percent of net indirect taxes 23.4% 23.5% 20.8% 21.0% 21.0% as percent of actual GDP 1.2% 1.2% 1.1% 1.2% 1.8% Indirect taxes Actual Indirect tax base 567.4 574.3 568.4 757.0 939.0 Actual Indirect tax revenues 87.1 88.7 71.8 106.1 148.0 Effective indirect tax rate 15.4% 15.5% 12.6% 14.0% 15.8% Potential Indirect tax base (with shadow) 700.2 709.2 686.7 916.0 1136.2 Theoretical Indirect liability (with shadow) 107.5 109.6 86.7 128.4 179.0 Top-down indirect tax gap (with shadow) in billions of soms 20.4 20.8 14.9 22.3 31.1 as percent of net indirect taxes 23.4% 23.5% 20.8% 21.0% 21.0% as percent of actual GDP 3.6% 3.2% 2.3% 2.8% 3.2% Memo: Informal & underground ec. as % of GDP 23.4% 23.5% 20.8% 21.0% 21.0% Source: Kyrgyz National Statistical Office, data and estimates 50 Table A.3: Kyrgyz Republic - Top-down Tax gap estimate, High informal economy scenario 2018 2019 2020 2021 2022 Actual GDP (bn soms) 569.4 654.0 639.7 782.9 971.0 Total tax revenue (bn soms) 116.6 121.5 106.9 149.2 231.0 Direct taxes Actual Direct tax base (GNI) 552.1 564.7 581.8 687.2 852.3 Actual Direct tax revenues 29.5 32.8 35.2 43.1 83.1 Effective direct tax rate 5.3% 5.8% 6.0% 6.3% 9.7% Potential Direct tax base (with shadow) 748.3 773.6 796.4 939.9 1,164.9 Theoretical Direct tax liability (with shadow) 40.0 44.9 48.1 58.9 113.5 Top-down Direct tax gap (with shadow) in billions of soms 10.5 12.1 13.0 15.8 30.5 as percent of net indirect taxes 35.5% 37.0% 36.9% 36.8% 36.7% as percent of actual GDP 1.8% 1.9% 2.0% 2.0% 3.1% Indirect taxes Actual Indirect tax base 567.4 574.3 568.4 757.0 939.0 Actual Indirect tax revenues 87.1 88.7 71.8 106.1 148.0 Effective indirect tax rate 15.4% 15.5% 12.6% 14.0% 15.8% Potential Indirect tax base (with shadow) 769.1 786.7 778.1 1035.4 1283.3 Theoretical Indirect liability (with shadow) 118.1 121.5 98.2 145.2 202.2 Top-down indirect tax gap (with shadow) in billions of soms 31.0 32.8 26.5 39.0 54.3 as percent of net indirect taxes 35.5% 37.0% 36.9% 36.8% 36.7% as percent of actual GDP 5.4% 5.0% 4.1% 5.0% 5.6% Memo: Informal & underground ec. as % of GDP 35.5% 37.0% 36.9% 36.8% 36.7% Source: Kyrgyz NSC. Staff estimates based on World Bank shadow economy databank 51 Table A.4: Actual tax revenue 2018 2019 2020 2021 2022 Actual PIT Paid and Due (bn soms) 21.8 19.8 21.6 31.0 33.0 Actual CIT taxes paid (bn soms) 1.1 1.3 1.2 2.4 7.7 Actual mining tax paid (bn soms) 0.3 1.1 3.7 6.1 7.2 Actual property tax (bn soms) 2.8 3.0 2.8 3.1 3.0 Actual Kumtor (bn soms) 7.0 7.5 9.6 8.0 29.4 Residual (bn soms) -3.4 0.1 -3.7 -7.6 2.8 Total direct taxes (bn soms) 29.5 32.8 35.1 43.0 83.1 Total direct taxes (% of GDP) 5.2% 5.0% 5.5% 5.5% 8.6% Actual VAT paid (bn soms) 52.3 51.6 47.0 70.1 114.3 Actual VAT on M (bn soms) 17.6 17.6 18.2 25.8 29.7 Actual Excise tax on M (bn soms) 8.5 8.7 8.0 10.3 9.8 Actual excise on D (bn soms) 1.8 1.3 1.0 1.1 2.0 Actual sales tax (bn soms) 4.3 4.2 3.8 4.9 6.4 Actual nat res tax (bn soms) 1.4 1.7 2.2 3.3 4.2 Residual (bn soms) 1.2 0.0 0.0 0.0 0.0 Total indirect taxes (bn soms) 87.1 85.1 80.2 115.6 166.4 Total indirect taxes (% of GDP) 15.3% 13.0% 12.5% 14.8% 17.1% TOTAL TAX REVENUE (bn soms) 116.6 117.9 115.3 158.6 249.5 TOTAL TAX REVENUE (% of GDP) 20.5% 18.0% 18.0% 20.3% 25.7% Source: Kyrgyz State Tax Service 52 ANNEX 3.RECONCILING ALTERNATIVE TAX GAP ESTIMATES We tested three methods of VAT tax gap evaluation based on the most recent year with available data was 2019. As shown in the attached annex, the three methods yield very similar results in terms of total VAT gap expressed as percentage of potential VAT revenue (around 47% or 7.5% of GDP). More specifically, 1. IMF tax gap model based on IO tables and macro SNA data yields a VAT tax gap of 46.6% 2. World Bank final consumption model based on macro SNA data yields a VAT tax gap of 47.3% 3. Model based on agregated tax administration micro VAT data yields a VAT tax gap of 47.3% In the absence of detailed data / info on different types of VAT tax gap, we recalibrated the split between the three components of total VAT tax gap based on most recent IMF reported revenue loss of about 3.5% of GDP in 2021 due to tax exemptions (see para 13 on page 11 of 2022 Article IV report). Revised Table 11 is included in the draft report. As a result, the estimated efficiency gap (comprising the impact of zero VAT rates on goods and services granted by law and an estimated 40% of tax exemptions also granted by law) increased in 2022 to almost 24% of potential VAT revenue or 5.8% of GDP. At the same time, government discretionary tax expenditure decisions extended VAT exemptions equal to 1/5 of potential VAT revenue in 2022. The attached VAT tax gap estimates are based entirely on official sources with our estimates limited to the value of parameter r representing an average percent of registered businesses. By definition, (1-r) represents unregistered businesses for VAT purposes either because they do not meet the minimal revenue threshold or because they operate as “informalâ€? businesses. 1. VAT Gap Estimation based on IMF Methodology (based Finland Case p. 32) AR= Actual VAT Revenue (rate and amount) 9.9% 50912 50912 PV= Potential VAT revenue (see formula ) [M*(1+cst)/r]*t [(Y-X)/r]*t [(N+I)/r]*t*(1-e)n + 95256 = 72212 176698 - 153654 VAT Gap=Pot VAT - AR r= 0.65 r= 0.65 r= 0.65 44344 t= 12% t= 12% t= 12% VAT Gap in % 46.6% e= 0 n= 1 2. VAT Gap Estimation based on W. Bank Final Consumption Methodology FC=Final Consumption 574256 AR=Actual VAT Revenue 50912 FC=Final Consumption w/o VAT 523344 53 Ref VAT PV= Potential VAT revenue (FC w/o VAT) / r rate 96617 = 805145 * 12% r= 0.65 VAT Gap=Pot VAT - AR 45705 VAT Gap in % 47.3% 3. Results for VAT gap estimates based on micro data are given in Table 11 in the draft report Data sources for 1 and 2: Other Промежут HHLD consumpt State управ Inventori оч- C ion consumption ление Capital es Price Export Uses ный Ñ?проÑ? G Collect formatio change conversi fob ive C n on Kyrgyz 2019 IO table 21813 611180 1627369 T2 465664 7088 51552 49951 194770 26343 2684 6 574256 221113 N FC=Final Consumption I X Productio n Import Customs Taxes on Goods TOTAL Kyrgyz fob Excise VAT Other Subsidi Supply at 2019 taxes es market IO on prices table goods T1 1175249 369795 21355 9945 50912 4522 4409 1627369 Y M M*cst VAT VAT breakdown (Rev Serv data) 38820 12092 VAT on M from KRS data Other VAT N.B. IMF tax gap model and variables for easy reference: 54 55