The Ukrainian information technology (IT) industry is the world’s fifth largest and the fastest growing IT outsourcing services market. The listing of EPAM Systems, Inc. on the New York Stock Exchange in February 2012, raising US$ 72 million, focused a spotlight on the IT industry in Ukraine. However, the sector is still underinvested in many areas. With the worldwide demand for innovative technology showing no sign of diminishing and with support from the Ukrainian government, the IT industry has a high potential for further growth and should continue to attract foreign investors.
In 2011, the revenues of Ukrainian IT companies reached US$ 3.3 billion. It is estimated that Ukraine has more than 25,000 IT specialists working with over a thousand IT outsourcing companies on development of programs and applications, making Ukraine one of the most attractive “nearshoring” destinations for businesses based in Eastern and Western Europe. Another 20,000-25,000 IT specialists work in other segments of the IT industry. Ukraine’s IT strength is based on a strong tradition in cybernetics, mathematics and computer science, a legacy of the former Soviet Union’s educational system, which creates a talented labor pool that has relatively low wage expectations. While Ukraine’s unfortunate reputation as a hackers’ paradise is also testimony to the excellence of its programming skills base, the convenience of Ukraine’s geographic location coupled with a well-trained and creative IT specialists willing to work at lower wages has won Ukraine the nomination for “Outsourcing Destination of the Year” in Europe in 2011 and enhanced Ukrainian attractiveness to western investors. In the last two years, the Ukrainian IT market experienced a 40% increase in 2010 and a 35% increase in 2011, recovering strongly after a sharp decline in 2009, and it is expected that the IT market will continue to record double digit growth rates in 2012 and 2013.
Structuring an IT business in Ukraine
To date one of the major segments of Ukraine’s IT business — outsourcing and software development — has been particularly attractive to foreign investors seeking to benefit from Ukrainian IT specialists’ ability to solve complicated problems creatively at a reasonable price. The variety of outsourcing and software development assignments to Ukrainian programmers runs the industry gamut from support, for example, to certain industries such as warehousing/logistics, aviation, telecommunications, accounting, training services, engineering and architectural drafting via CAD and CAM to plant automation, game design, graphic design, 3D imaging, illustration, biometric access control and identification, GPS control and navigation and linguistic and multilingual machine translation to name a few. Such a broad range of IT capability has attracted foreign investment which has followed several well-established models.
As with any other business, an IT business in Ukraine can be established through acquisition or investment in an existing company or by setting up a local subsidiary or representative office. Many global and specialist IT companies, such as Microsoft, Sun, IBM, Dell, SAP and Cisco, have established business units in Ukraine. Given that many IT professionals prefer the flexibility of not working in a corporate environment, some Ukrainian and foreign IT companies have established businesses by employing or contracting for services with Ukrainian individuals. Other foreign companies have started out by outsourcing software development to a Ukrainian company or individuals but eventually took the Ukrainian operation in-house as a subsidiary.
Risks associated with acquisitions and investments in an existing business can be avoided by starting a business from scratch, but reaching critical mass will take longer without a strong local base from which to begin. As discussed further below, employment and intellectual property rights issues will apply to both acquisitions and start-ups.
Given the existing strength of the Ukrainian IT industry, many American, Canadian, German, French, Israeli and Russian companies prefer to outsource their IT needs to a Ukrainian company and let that business provide the local workforce. Ciklum, in which the leading Ukrainian private equity company, Horizon Capital, recently invested, has built a highly successful business on providing IT project teams and the necessary infrastructure for customers in more than nine countries.
Transfer of Intellectual Property Rights
The work performed by IT specialists under an outsourcing contract or as employees of a foreign-owned company will in most cases involve creation of intellectual property (“IP”). Under Ukrainian IP laws, copyright protection is available for computer programs and databases created in Ukraine. A copyright can be transferred and licensed as in other countries, and the author retains his moral rights (e.g., the right to be recognized as the author and the right to object to derogatory acts prejudicial to the author’s honor and reputation).
Where IP is created as part of an employment agreement, special attention should be paid to the issue of ownership and transfer of IP rights. Under the Civil Code of Ukraine, property rights in the IP (e.g., the right to use the creation, the exclusive right to allow use of the creation and the exclusive right to prevent unlawful use of the creation) are jointly owned by employee and employer, unless otherwise specified in an agreement between the parties. It is important that the relevant provision in the employment agreement is carefully drafted to address the issue of creation of IP in the course of employment, transfer of property rights in the IP to the employer and remuneration of the employee for the transfer of his joint ownership rights to the employer. As a matter of best practice, an employment agreement should be accompanied by documented instructions from the employer on creation of a specific product and an “act of transfer” under which the parties acknowledge transfer of the employee’s property rights in those specific products to the employer.
Obviously, when contracting for services from an individual or a Ukrainian IT company, the contract should contain provisions for the transfer of IP rights to the end-customer, where appropriate. When outsourcing IT services to a Ukrainian company, or one that contracts with Ukrainian-based IT specialists, it would be advisable to check that the chain of transfer of IP rights from the individual creator to corporate owner has been addressed properly. This will reduce the risk of possible challenges to ownership of IP rights from IT specialists against both the company providing the service and the end-customer.
IP rights over creations may be registered with the State Intellectual Property Service, which provides additional protections to the owner of property rights in the IP, but since registration is not required as a prerequisite to use or transfer of IP rights and can take some time, such registration can impede the speed at which business needs to be conducted in the IT sector.
Hiring IT Specialists
Ukrainian IT companies often have a mixture of employed and contracted staff, so as to ensure flexibility of their workforces and the ability to respond to customer needs for specialist skills. Given the rather independent streak in many IT specialists and the established business relationships that these individuals may have with more than one IT company, service agreements are a prevailing feature of the industry. In most cases, such IT specialists are also registered as private entrepreneurs subject to the special tax regime that provides significant tax benefits. (Under such regime, private entrepreneurs pay a 5% unified tax with regard to the annual income of up to approximately US$ 375,000 and 15% for the exceeding amount. Also, they pay a unified social contribution in the amount of 34.7% of the statutory minimum salary. For 2012, such contribution equals up to US$ 50. They do not pay VAT.) In addition to the considerable tax advantages for parties, contracting for services offers greater flexibility in negotiating working conditions, termination, compensation and benefits and imposing fewer obligations on the company than an employment arrangement.
However, if used to disguise what is essentially an employment relationship, a service agreement may be declared to be an employment agreement by the court at the request of an interested party (e.g., an IT specialist, tax authorities). As a result, a company’s relations with the contractor will be transformed into labor relations governed by the Labor Code of Ukraine only (i.e., without the benefit of any contractual provisions). Thus, the company will be able to terminate the agreement only on grounds expressly provided by the Labor Code and will be obliged to provide to the contractor (now an employee) all benefits granted by Ukrainian labor law to employees, such as severance payments, maintaining working hours within established limits, providing paid vacation time, etc. In addition, the company may be required by court decision to pay labor-related payments (e.g., maternity, sick-leave payments and payments for unused vacation) to the contractor and may be exposed to additional tax liabilities (the additional personal income tax and unified social contributions) and penalties which can amount up to 50% of the assessed tax and contributions. The company’s officers may also be held criminally liable for tax evasion if the amount of the assessed tax or contributions exceeds the established cap.
New Legislation for IT Business
Ukraine’s IT industry was initially developed underground by IT specialists who were private entrepreneurs, suspicious of government control and possible intervention. These entrepreneurs started to surface as they formed ever larger groups providing outsourcing services to foreign companies, catching the attention of the Ukrainian government which recognized the importance of developing the IT industry in order to raise the country’s competitiveness. As a result, recently the government has begun to take steps to encourage and support the IT industry.
In recent years, several draft laws aimed at stimulating the growth of the IT industry by establishing tax incentives, have been considered by the Ukrainian parliament.
On July 5, 2012 the Ukrainian parliament adopted the long-awaited law on specifics of taxation of entities in the IT industry. The law was signed by the President of Ukraine on July 31, 2012 and will enter into force following its official publication. The law provides for the following tax benefits which will be effective from January 1, 2013 until January 1, 2023:
- exemption from VAT for the supply of software products; and
- reduction of the corporate profit tax rate to 5% for profits received by qualifying IT companies from qualifying IT activities, which include software development, IT consulting and data processing (currently, the standard corporate profits tax rate is 21%; for the year 2013 it will equal 19%; effective January 1, 2014, it will be 16%). To enjoy the tax reduction for such activities, an IT company should meet certain criteria (e.g., 70% of all income derived from the said IT activities, appropriate value of company’s assets, good tax standing, absence of bankruptcy proceedings) and obtain a status of an IT industry entity by way of registering as such with the local tax authorities.
Additional legislation benefitting the IT industry may be on its way. Draft law No. 8267 was adopted by the Ukrainian parliament on May 24, 2012. The draft law encourages IT companies to engage IT specialists on the basis of employment agreements by way of reduction in the unified social contributions from January 1, 2013 until December 31, 2022. This reduction is achieved by way of capping the taxable base amount to two minimum salaries (approximately US$ 276 while the standard cap currently amounts to approximately US $2,342). However, the President of Ukraine has vetoed the law and returned it to the Ukrainian parliament for further improvements which are expected to be addressed in the fall legislative session.