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June 13, 2006

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Reference ID Created Released Classification Origin
06KIEV2293 2006-06-13 14:55 2011-08-30 01:44 CONFIDENTIAL Embassy Kyiv

DE RUEHKV #2293/01 1641455
R 131455Z JUN 06


C O N F I D E N T I A L KIEV 002293 




E.O. 12958: DECL: 06/13/2016 

REF: A. KIEV 1370 
     B. KIEV 1941 

Classified By: Deputy Chief of Mission. Reasons 1.4 B) and D) 

1. (U) This message contains a guidance request, see 
paragraph 9. 

2. (C) Summary.  In a June 6 meeting with DCM, Minister of 
Finance Viktor Pynzenyk discussed his concerns about budget 
performance and energy supplies.  He denied the Ministry of 
Finance had asked the State Tax Administration to delay 
payment of VAT refunds to companies such as Cargill, which is 
owed over $40 million. Although Ukraine would be able to 
address its 2006 budget problems, he said, uncertainty over 
gas prices and their impact made prospects for the 2007 
budget worrisome.  Ukraine needed tax and budget reforms that 
would be difficult to pass in a Rada filled with wealthy 
deputies.  One measure, for which he sought U.S. support, 
would be to renounce Ukraine's double taxation agreement with 
Cyprus.  Pynzenyk said Russia's energy maneuvers constituted 
a threat to Ukraine's sovereignty.  He feared that 
UkrHazEnergo would usurp the role of state gas and oil 
company NaftoHaz, and was acting in the interests of the 
Russians.  End Summary. 

VAT Refunds: Not My Responsibility 

3. (SBU) We requested the meeting specifically to discuss the 
State Tax Administration's (STA) failure to refund to Cargill 
over $40 billion of VAT the company had paid for inputs for 
the exports it ships from Ukraine.  While the STA had 
promised significant refunds in April and May, and had paid 
as much as $150 million in refunds to other firms, it had 
made only a token payment to Cargill.  DCM noted that in an 
earlier conversation with Ambassador (ref A), Pynzenyk had 
suggested that delaying VAT repayments was a deliberate 
tactic to keep the budget deficit from expanding beyond 
planned parameters.  Pynzenyk responded that he had no 
authority over the STA, but could write a letter on the 
matter.  He said he had encouraged the STA to stay up to date 
on VAT refunds, but could not order the STA to repay a 
specific firm. 

4. (SBU) He acknowledged that some oblast tax authorities who 
had fallen behind in their tax collections may be "saving 
face" by delaying VAT refunds.  Budget performance for 2006 
was staying within planned parameters (i.e. a deficit below 
2.5% o GDP) despite lower revenues in part, Pynzenyk said, 
because VAT refund claims were two billion UAH lower than 
expected.  He then acknowledged that local STA authorities 
had failed to submit reports of VAT refunds claimed, making 
it impossible for the Treasury to disburse the funds. 
(Comment:  Pynzenyk thus indirectly admitted that VAT refunds 
were suffering in order to meet budget goals, but implied his 
own Ministry bore no responsibility. End comment.) 

2006 Budget in Some Trouble... 

5. (SBU) Pynzenyk reiterated that the GOU was collecting less 
tax revenue in 2006 than in 2005.  VAT receipts were 350 
million below plan, but the real problem was lower corporate 
income tax receipts.  Rather than increase collections, tax 
authorities wanted to revise the plan's monthly revenue 
projections downward.  This would make it appear that 
revenues had met the plan for the first 11 months of the 
year, but in the 12th month there would suddenly emerge a 
huge shortfall.  He denied anecdotal reports we had heard 
from some companies that the STA was asking firms to pay 
taxes in advance as a way of keeping the books close to 
balanced.  He said that the problem was not that oblast tax 
authorities were failing to turn over their tax receipts to 
the Treasury; tax receipts automatically went to the 

6. (SBU) Customs offices, however, often delayed turning 
their tariff revenues over to the Treasury in order to 
collect interest on the float, Pynzenyk said.  The GOU was 
transferring all Customs accounts to the State Treasury in 
order to address this problem.  To date, the accounts of 
seven of 50 customs offices were already transferred; the 
rest would be by the end of the year, he said. 

...But We Can Handle It 

7. (SBU) Pynzenyk said the GOU would probably not seek 
revision to the 2006 budget.  (Comment: Up to this point, the 
GOU had led us to believe that such a budget revision would 
be among the first orders of business for a new Rada.)  He 
said he was afraid of what the new Rada would do to the 
budget if given the chance, especially if public unrest 
followed the gas price hikes planned for July 1.  Instead, 
the GOU would muddle through by simply ignoring some 
budget-busting spending mandates such as expanded social 
benefits for survivors of World War II that the last Rada had 
passed during the election campaign.  It would delay other 
spending, and ask the Rada simply for increased spending 
uthority near the end of the year.  The new natural gas 
price structure would help the budget he said.  Rather than 
charging a single price for all consumers, and then using 
budget funds to subsidize certain categories of consumers as 
in the past, the new differentiated prices would offer a 
discount to the formerly-subsidized categories, while raising 
prices for other consumers. 

2007 Budget Could be Worse, Absent Reforms 

8. (SBU)  Prospects for the 2007 budget were more worrisome, 
Pynzenyk said, than for the 2006 budget.  The impact of any 
further rises in the gas import price was hard to predict. 
If energy costs wiped out corporate profits, the GOU would 
lose corporate income taxes.  He suggested several areas ripe 
for fiscal reforms, although he said he did not know whether 
a Rada filled with rich deputies would pass them.  His 
suggestions, some of which he had already raised with 
Ambassador (ref B), included the following: 

--  the gasoline excise tax was far below European levels and 
should be raised; 

--  the VAT exemption for agricultural producers, which made 
the Cargill VAT refunds so difficult, was an unbounded 

-- Ukraine's simplified tax option for small and medium 
businesses, like the VAT exemption for agriculture, created a 
virtual offshore sector; and, 

-- the tax exemption on income from interest on bank deposits 
not only deprived the state of revenue, but attracted money 
away from the stock markets, which would remain undeveloped 
as a consequence. 

Guidance Request: Ukraine-Cyprus Double-Taxation Agreement 
--------------------------------------------- --- 

9. (C) Pynzenyk said that a non-standard double-taxation 
agreement with Cyprus made capital flight to that country to 
evade Ukrainian taxes a serious problem.   As an example, he 
cited one company that purportedly paid 200 million UAH/year 
to a Cyprus subsidiary as a trademark license fee.  Ukraine 
had sought unsuccessfully to revise its agreement with Cyprus 
to bring it in line with international practices.  Now 
Ukraine would have to denounce the treaty.  Pynzenyk said 
Ukraine would like U.S. support for such a move.  Post would 
appreciate Department's guidance on how to respond to the 
Ukrainian request for U.S. support. 

Russia's Designs on Ukraine's Natural Gas Market 
--------------------------------------------- --- 

10. (C) Pynzenyk told DCM he did not anticipate that Ukraine 
and Russia would sign an intergovernmental protocol on 
natural gas trade, which some were predicting.  What he 
feared, he said, was that GazProm would conclude an agreement 
directly with UkrHazEnergo, leaving out Ukraine's state-owned 
NaftoHaz Ukrainy altogether.  (Note: UkrHazEnergo is the 
joint venture, half-owned by NaftoHaz and half-owned by 
RosUkrEnergo (RUE), that was set up after the January 4th 
Russian-Ukrainian agreement as the purchaser of gas imports 
from RUE.  RUE, in turn, is half-owned by Russia's GazProm, 
and, nominally half-owned by two Ukrainian investors. End 

11. (C)  Pynzenyk then suggested that UkrHazEnergo Board 
Chairman Igor Voronin represented GazProm's interests more 
than Ukraine's.  Voronin is also Deputy Chairman of NaftoHaz, 
and was reportedly a key negotiator of the January 4th 
agreement that put RUE at the center of Ukraine's gas 
imports.  Pynzenyk said "I don't understand how one person 
can sit at the negotiating table wearing three 
hats...UkrHazEnergo, NaftoHaz, and RUE, ...and perhaps a 
fourth (i.e. Gazprom)."  Asked explicitly who was behind 
Voronin, Pynzenyk said quietly, "Russia."  He concluded that 
what was at stake was not Ukraine's energy supplies, but 
Ukraine's sovereignty.  DCM reminded Pynzenyk that the U.S. 
would work with Ukraine to increase its energy independence 
and to promote greater transparency in the energy sector. 




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