TAX REFORM IN AZERBAIJAN THE NEXT STEP USAID Trade and Investment Reform Support Program In Azerbaijan Baku April 2008

VAT REVENUE COLLECTION - In 2007, VAT generated total revenue of AZN 1,176 million; 22.2% of total tax revenue & 4.7% of GDP. - Revenue performance remains low in comparison to that of other CIS countries CountryVAT RateIn 2005, VAT revenue as % of Total tax revenueGDP Armenia Azerbaijan Total GDP: 4.8 Non-Oil GDP 8.6 Belarus18 (RR10) Georgia Kazakhstan1536.8*5.0* Kyrgyzstan Moldova20 (RR 5 & 8) Russia18 (RR10) Tajikistan2053.5**6.8 Turkmenistan20NA Ukraine Uzbekistan20 (RR15) Average Note: RR = Reduced Rate, * 2003, ** internal taxes on goods and services, NA = Not Available

VAT PERFORMANCE Performance MeasuresYear VAT Growth rate VAT/GDP Ratio Potential VAT collection as % of GDP VAT Compliance Rate Buoyancy Efficiency Ratio C-efficiency Ratio VAT Productivity

VAT REGISTRATION THRESHOLD VAT registration threshold AZN 22,500/quarter (annual AZN 90,000) High compared to the corresponding figures of many countries CountryThreshold National CurrencyUS$ UKGBP 55,000108,000 AzerbaijanAZN 90,000 (annual)106,000 PakistanPKR 5 Million79,000 AustraliaAUD 75,00070,000 IndonesiaIDR 600 Million65,000 UkraineUAH 300,00059,000 ThailandTHB 1.8 million56,000 South KoreaKRW 48 Million49,000 New ZealandNZD 40,00032,000 BangladeshBDT 2 Million31,000 CanadaCAD 30,00027,000 Sri LankaLKR 1.8 million18,000 LuxemburgEUR 10,50017,000 NepalNPR 1 Million14,000 FinlandEUR 8,50013,000 DenmarkDKK 50,00011,000

VAT REGISTRANTS Total number of VAT registrants - approximately 10,500. Much lower than number of VAT registrants in other countries CountryTotal PopulationPer Capita Income (USD)Number of VAT Registrant Azerbaijan8,532,7002,53710,504 Montenegro684,7003,80015,275 Estonia1,340,60019,73160,603 Latvia2,300,00016,16366,340 Croatia4,500,00014,495153,149 Slovakia5,400,00018,454159,106 Czech Republic10,200,00023,076626,970 Austria8,200,00037,431784,329 Hungary10,100,00018,9711,165,886 UK60,200,00034,6531,868,000  Threshold should be revised downward and fixed on an annual basis.

TAX PERIOD Monthly tax period for all types of taxpayers Results in high compliance and administrative costs Consider adopting two tax return periods: monthly for large taxpayers and quarterly for others

TAX CREDIT IN CASE OF MIXED TRANSACTIONS In case of mixed supply, the input tax can be deducted only in the ratio of goods and services used in taxable transactions Does not seem to be adequate Following provisions may be introduced: - Inputs directly and wholly attributable to taxable supplies: full credit - Inputs directly and wholly attributable to exempt supplies: no credit - Inputs that cannot be wholly attributed to either taxable or tax exempt supplies: input tax to the proportion of taxable sales to total sales

No credit is allowed for tax paid on stock at the time of VAT registration Results in double taxation and makes the new taxpayer less competitive Consider providing credit for the tax paid on stock at registration INPUT TAX CREDIT ON STOCK

Refunds processed within 45 days of receipt of application for refund Long period, particularly for exporters Waiting period for refund processing needs to be reduced REFUND

CREDIT/DEBIT NOTES No provision of debit/credit notes Necessary to adjust VAT amount stated in tax invoice due to cancellation of supply, alteration in previously agreed consideration for supply, change in tax rates and return of goods or part of goods to supplier Introduce provision of debit/credit notes to reflect change in value of supply or tax thereon.

BASIC ALLOWANCE UNDER PIT Every single AZN is subject to PIT when monthly income exceeds AZN 200 Almost 4 million PIT payers, rather high (population 8.5 million) PIT payers are: 508,446 in Estonia (population 1.3 million); 161,570 in Montenegro (population 0.7 million) and 2,157,211 in Slovakia (population 5.4 million) High compliance and administrative cost Consider establishing a reasonable level of basic allowance for all types of income earners by amalgamating some of the existing exemptions

INCOME TAX RATES PIT rate highest in the CIS countries (35% in Azerbaijan as compared to 10% in Turkmenistan, 12% in Georgia and 13% in Russia, Tajikstan and Ukraine, and to the average CIS rate of 19%). Social security tax at 25% (3% for employees and 22% for employers). The combined rates are very high, which discourages taxpayers to work more, save more and invest more The profit tax rate of 22% is also on high side when compared with other CIS countries, where the average profit tax rate is 20%. Top marginal rate for PIT and profit tax rate be reduced and aligned.

DIVIDEND TAX Dividends subject to a withholding tax of 10% at shareholder level, resulting in: –Economic double taxation of dividends –Encouraging loan financing rather than equity financing –Providing possible tax advantage for those who can keep their savings in the form of retained profit in the company. –Encouraging enterprises to pay shareholders in forms other than dividends. Abolish dividend tax

EXEMPTIONS/INCENTIVES Various exemptions and incentives under different taxes Erode tax base, complicate tax administration and bring distortions Minimize exemptions at least in a graduated manner.

EXCISE DUTIES Excise rates on imports and domestic products fixed separately, violating WTO principles Excise tariff unnecessarily complex Equalize the rates of excise duties on both imports and domestic products Wherever possible, convert specific rates into ad valorem rates to make the excise system more transparent, equitable, and elastic Classify goods on the basis of the Harmonized Classification System

PROPERTY TAXES Property tax and land use tax levied separately Different filing and processing requirements Many exemptions Low rate Integrate property tax and land use tax Minimize exemptions Increase tax rate

SIMPLIFIED TAX Simplified tax regime applies to enterprises and physical persons with below AZN 22,500 quarterly turnover Simplified tax in lieu of the VAT, profit tax, and property tax in the case of legal entities while in lieu of VAT and profit tax in case of physical persons High threshold Complicated rate structure Lack of anti avoidance rule Lower threshold Simplify rate structure Introduce anti avoidance rule