Consulate General of the Russian Federation in Mumbai (Bombay), India

COMMERCIAL AND BUSINESS INFORMATION\REPORT: "THE ENABLING
ENVIRONMENT FOR FOREIGN INVESTMENT IN THE RUSSIAN FEDERATION

     THE ENABLING ENVIRONMENT FOR FOREIGN INVESTMENT IN THE RUSSIAN FEDERATION
     Legal Framework and Policies
     at Federal and Regional Level

     Table of contents
     Introduction 7

Part I.

     The Legal And Regulatory Framework
     For Foreign Investment
     A. Federal Laws And Policies 15
     1. General Legislation On Investment Activity 15
     2. Restricted Areas And Natural Monopolies 19
     3. Special Rules For Mineral Resource Extraction 26
     4. Foreign Exchange Regulation 28
     5. Customs Regulations 31
     6. Investment Promotion And Institutional Arrangements 34
     B. Regional Policies And Practice 36
     1. Administrative Practices 36
     2. Regional Incentives And Tax Free Zones 36

Part II.
     Key Policy Issues for Creating an Enabling
     Environment for Investment

     Overview Of Major Obstacles To Business Development
     Protection Of Property Rights 39
     The Regional Dimension: Investment Policies At Sub-Federal Level 64
     Tax System 76
     Privatisation Policies 114
     Financial Infrastructure And Intermediation 130

Part III.
     Investment Policies And Institutional Framework:
     Challenges and Future Directions

     Policy Conclusions And Recommendations
     1. Legal Framework, Protection And Enforcement
     of Property Rights 158
     2. Governance Problems and Corruption
     in the Public And Private Sectors 168
     3. Regional Policies 170
     4. Tax Policy 171
     5. Privatisation Policy 174
     6. Financial Sector Development 177
      Annex I. Bilateral Investment Treaties 181
      Annex II. Tax Treaties 183
      Annex III. Regional Economic Indicators 185

introduction

     PART I.

     THE LEGAL AND REGULATORY FRAMEWORK
     FOR FOREIGN INVESTMENT

     Introduction

     In terms of the country's size, economic potential and natural resources, Russia has attracted relatively insignificant levels of FDI since the break-up of the Soviet Union. Cumulative FDI since 1992 represents only US$ 96 per capita (compared to Hungary: US$ 1,528 or Estonia US$ 863) [check - update]. FDI inflows peaked in 1997 at around US $5 billion compared to US $ 2.5 billion in 1996, dropping to under US $ 3.4 billion in 1998. This poor performance in attracting FDI was accompanied by significant capital flight which was estimated to account for about 3 per cent of GDP in the period 1995-96.[verify estimate] Interestingly, the somewhat larger FDI inflows in 1999 are boosted by an increasing share originating from Cyprus, possibly indicating a growing return of flight capital in this guise (see Table XX). By the end of 1999 Russia had attracted US $ 21.6 billion in cumulative gross inflows of FDI and recorded some US $8.3 billion in outward FDI.

     The hesitant development of inward FDI should be seen against the background of nearly a decade of economic decline in the Russian Federation. Although GDP growth was marginally positive in 1997, and the 1998 rouble devaluation coupled with strong export prices have helped to produce an upturn from late 1999, the fact remains that the estimated level of real GDP in 1998 only represented 53 per cent of its 1989 level. During the whole period of transition, fixed capital investment declined every year until 1999, since when an upward trend has been recorded. Data for 1999 and the first half of 2000 show a rising trend in fixed capital investment which seems to be strengthening as revised data are coming on stream. To some extent this rebound is brought more sharply in focus by the sharp decline in economic activity during the 1998 crisis year. In January- June 2000 investment in fixed capital grew by 6.3 [correct] per cent compared to the first half of 1999.

Table 1. GDP, industrial and agricultural output
and fixed capital investment
(previous year equals 100)

	1993	1994	1995	1996	1997	1998	1999
GDP	91.3	87.3	95.9	95.0	100.4	95.1	103.2
Industrial output	86	79.1	96.6	96	101.9	94.8	108.1
Agricultural output	96	88	92	93	100.1	86.8	102.4
Fixed capital investment	88	76	90	82	94.5	93.3	101.0
Source: Goskomstat

     Although this encouraging trend is being confirmed monthly by new data, it still looks very fragile. Russia needs very large amounts of investment over the coming decades to replace its obsolete capital stock and assure even a modest level of annual economic growth. Since internal sources of investment growth are limited, the expectation that a substantial portion of this required investment should take the form of inward FDI hinges on completion of critical structural reform.

     The task of creating a positive investment climate is probably the most important facing Russia at the present time, where the poor environment for entrepreneurship and fixed capital investment should not be allowed to prevent the economy from deriving full benefit from the currently very favourable external economic conditions. The strengthening balance of payments situation provides the best background so far into the Russian transition experience for policies to radically tackle the long-standing structural deficiencies in the tax system, financial markets, institutions of bankruptcy, regional/federal relations and competition.

     The importance of foreign investment to Russia is also illustrated by the fact that, even in difficult economic situation of the past few years, firms with foreign ownership have performed significantly better than wholly Russian-owned enterprises. Measured in terms of output per employee, their efficiency is twice the average Russian level.

     A study conducted by McKinsey at the end of 1999 indicates that about two-thirds of Russian enterprises are still viable and investment in new capital stock and modern management methods could bring their productivity up to 65% of the United States level. One of the quickest ways to do this would be to attract foreign investment and management techniques into these firms.

     According to Goskomstat data, investment activity carried out by enterprises with foreign capital participation in 1999 constituted slightly more than 10% of the total volume of fixed capital investment in Russia, indicating that foreign capital already has some tangible influence on the domestic economy. Even in the climate of general economic decline during the crisis period in 1998, the output of enterprises with foreign ownership grew by 20% in current prices. The share of enterprises with foreign ownership in Russian GDP is rather small, but during the past five years has grown steadily (from 2.2 per cent in 1994 to 4.7 per cent in 1998) [update]. The main countries of origin of cumulative FDI in the Russian Federation have been Germany, the United States, the United Kingdom and other European Union countries such as the Netherlands, France Austria and Sweden - in addition to Cyprus, as mentioned above.

     Structural trends in foreign investment

     Tables 2 to 5 below show trends and volumes of foreign investment over the past five years as well as its sectoral and regional distribution. When interpreting the data, it should be borne in mind that Russian investment statistics still rely on some residual Soviet-era methodology, when all investment was made by the state. As a result, many investment activities, especially those of smaller enterprises, fail to be recorded. Thus, available data must be interpreted as an approximation, on the basis of which the true investment picture can be assessed.

     [Statistics to be updated]

Table 2.Foreign investment in the Russian Federation
(Million $)

	1995	1996	1997	1998	1999
Type of investment	SCS	BP	SCS	BP	SCSBPSCSBPSCSBP
Direct	2020	2016	2440	2479	533366393361276142602890
Portfolio*	39	-738	128	4583	68145963191 847631-815
Other**	924		4402		628182215269
Total	2983		6970		12295117739560 SCS - data of the State Committee for Statistics (Goskomstat)

     BP - balance of payments data calculated by the Central Bank of Russia

     * Goskomstat calculates the volume of portfolio investment excluding operations of Central and commercial banks.

     ** Other investment, according to Goskomstat methodology, includes mainly long and medium term loans.

     Footnote: The influx of foreign capital in Russia is officially monitored by two agencies: the State Committee for Statistics (Goskomstat) and the Central Bank of Russia (CBR). The former publishes special statistics on foreign investment flows and on the performance of enterprises with foreign capital participation. The latter incorporates data on FDI in the balance of payments. They use different sources for this purpose: Goskomstat relies on customs statistics and special questionnaires. CBR, taking into account Goskomstat data, also uses it's own system of monitoring capital operations of banks, which require permits from the CBR according to currency control legislation. Therefore, the data of the two agencies may differ, but generally are of the same magnitude. To show trends in foreign investment we will refer to the more detailed data of Goskomstat.

Table 3. Foreign investment in the Russian Federation by sectors
(Per cent)

Sector	1997	1998	1999
Finance, banking, insurance, trade, marketing services, management consulting	58.4	40.9	20.0*
Industry	31.8	39.9	49.4
Fuel	15.8	16.0	17.8
	6.2	12.5	14.8
Food
Ferrous and non-ferrous metallurgy	4.4	4.5	9.7
Mechanical engineering and metal-cutting	1.9	2.6	3.0
Wood-processing, pulp and paper	1.3	2.0	4.1
Retail trade and catering	4.8	10.2	17.0
Transportation and communications	1.7	5.0	9.5
Construction	0.2	2.0	0.1
Source: Goskomstat, Ministry of Economy of the Russian
Federation * estimates

     Foreign investment began to decline in the second quarter of 1998 and peaked in the third quarter at the climax of the country's financial and political crisis. Inflows rose again in 1999, marked by a high share of inflows from Cyprus (8 per cent in the first half of the year), and reached their highest level since the start of the Russian economic transition.

     The structural trends of 1998 and 1999 show a growing shift of foreign investors' attention from the financial to the real sector. The overall share of foreign investment (portfolio and FDI) in industrial enterprises grew at the same time as the FDI share in the total amount of foreign investment in the industrial sector. For instance while in 1998 this share was about 42 per cent, in 1999 it increased to 54 per cent. It is also worth mentioning that the 1999 increase in foreign investment was mainly generated by FDI rather than portfolio investment, as in the recent past.

     There has also been a shift in the sectoral breakdown of FDI in Russia. The fuel industry seems to be losing its former position as the leading recipient of foreign capital, as larger volumes of foreign investment have recently been directed to the food industry. While this redirection can be interpreted as driven by the improved competitive situation of domestically produced consumer goods after the crisis and devaluation, it may also reflect the fact that the full potential for foreign investment in the Russian fuel industry has not been realised due to weaknesses in the legislative basis and implementation of production sharing agreements (PSAs - see Chapter XX).

     According to Goskomstat data, as of 1 July 2000 (update), the accumulated volume of foreign direct investment in Russia totalled US$ 14.5 billion, while on the basis of balance of payments data…….[CBR data?]

Table 4. Accumulated foreign investment as of 1 July 2000
(update to October 2000 ??)

Investment Type	Billion $	% of total
Direct	14.5
Portfolio	0.3
Others (definition ??)	15.8
Source: SCS, Ministry of Economy of the Russian Federation The largest amounts of FDI were concentrated in the food industry ($ 2568.6 million), fuel industry ($ 2210.3 million), telecommunications ($ 2243.4 million) and retail trade and catering ($ 1312.9). The amounts directed to other sectors are of a significantly smaller magnitude.[update]

Table 5. The 10 regions of Russia receiving the largest amount of foreign investment
(Cumulative as of 1 January 2000)

Region (city/oblast)	Foreign investment	FDI
	($ million)	(% of total)($ million)(% of total)
Moscow	14314,8	48,94459,835,0
Sakhalin oblast	1481,9	5,11474,711,6
St Petersburg	1259,2	4,3900,17,1
Moscow oblast	1250,7	4,31106,68,7
Republic of Tatarstan	1060,0	3,688,60,7
Tiumen oblast	1037,1	3,5355,22,8
Krasnodarsky krai	902,9	3,1717,15,6
Republic of Komi	481,3	1,6310,02,4
Nizhny Novgorod oblast	441,6	1,5134,91,1
Irkutsk oblast	375,6	1,371,80,6
Source: ??

     In terms of geographic distribution, FDI tends to be concentrated around urban and resource-rich areas, dictated by access to infrastructure and markets and the investment policies pursued by individual regions.
     A. Federal Laws and Policies

     1. General Legislation on Investment Activity

     Background

     Since the beginning of the 90s far-reaching reforms have taken place in the Russian Federation which has seen the creation of a private sector, the liberalisation of prices and distribution channels and the development of completely new trade and investment links with OECD member countries. Institutionally, Russia today is a profoundly different country to what it was nine years ago. While some aspects of the institution-building process have been delayed or met with more political resistance, the improved macroeconomic performance is providing the needed opportunity for the authorities to move strongly to fill these remaining gaps in the legislative and regulatory environment for business activity.

     Since the early years of the transition period, legislative reforms have proceeded at a rapid pace and largely without accompanying efforts to co-ordinate those that affected the same or related areas of economic activity or to ensure a logical sequence of change.

     In many cases of reform old state institutions were dismantled without the provision of a fully developed new regulatory and institutional framework to ensure the implementation of market-oriented legislation. This lack of a concerted, comprehensive transition in legislative terms from the centralised Soviet rule to a market economy has created a high-risk, uncertain business and investment climate with widespread opportunism and corruption, misuse and misappropriation of state assets and conflicting information flows. This situation has been accompanied by social problems and at times been exacerbated by adverse economic developments or extreme situations such as the August 1998 financial crisis.

     The first period of reforms took place against a background of confusion emanating from conflicting Soviet and Russian Federal legislation and presidential decrees. The Constitution was changed in 1994 and provides for equal rights and obligations for foreign and Russian citizens. Basic principles affecting the interests of foreign investors are also upheld in the Constitution, including the protection of property rights and freedom to engage in entrepreneurial activity. The Constitution was, however, introduced after the major privatisation drive during which constitutional order by default had to refer to the 1977 Russian Federation Constitution. Although extensively amended, this document did not adequately accommodate the economic and social changes underway and their implications.

     The 1994 Constitution , the first two parts of the Civil Code adopted in 1995 and 1996 and new legislation on joint-stock and limited liability companies and insolvency in the years which followed constitute the legal framework for trade and investment in Russia. These are supplemented by other sector or activity-specific laws on property, natural resources, banking, insurance, and other specialised areas. Some provisions regulating investment are also included in the laws on competition and environment protection. Nonetheless, certain important legislative issues remain unresolved, namely the adoption of the Land Code, the lack of adequate registry procedures for non-possessory pledges in line with the provisions of the Civil Code and outstanding work on the finalisation of the Tax Code (Part II), to mention a few.

     General investment issues are addressed by a federal law enacted in 1998 and amended in 2000 on "Investment Activity in the Russian Federation implemented in the Form of Fixed Capital Investment". Article 5 of the law is specially dedicated to the activities of foreign investors on the territory of the Russian Federation. It provides for the supremacy of international treaties and agreements over the law concerned. In general the law does not bring about any concrete guarantees or restrictions for investors, different from those already included in the Civil Code and other legislative acts pertaining to business activities. Another law, on "Foreign Investment in the Russian Federation" was enacted in 1999 to specifically confirm national treatment for foreign investors and to set out certain provisions for special incentives and restrictions, as well as, importantly, to introduce a much disputed grandfather clause (see Box XX). Beyond a recent amendment to the first law above, to incorporate a similar grandfather clause, neither law offers much more in terms of security for or restrictions on (foreign) investors than the Civil Code and are more declarative in nature reflecting the government's commitment to existing investor rights.

     Box 1. Grandfather Clause

     The Grandfather Clause is formulated in Article 9 of the law entitled "Guarantees to Foreign Investors and Companies with Foreign Investment against Unfavourable Changes in the Legislation of the Russian Federation. This stipulates that if certain unfavourable developments in legislation lead to an increase in the cumulative tax burden, a foreign investor remains subject to the same legislative conditions as at the start of implementation of the project. The unfavourable developments in question are listed in the law and include changes in customs duties and fees, taxes, other mandatory payments to the federal budget and extra-budgetary funds and alterations in restrictions for foreign investors.

     The introduction of the grandfather clause was controversial among Russian legislators and is in itself a significant step towards stabilising the foreign investment climate in the country. It is, however, in its scope reminiscent of the Soviet-era approach to investment with the focus on large-scale "priority projects" and a high degree of discretionary power allocated to government agencies.

     Such projects are defined as those involving "… a total amount of foreign investment of at least 1 billion roubles (or the equivalent amount in the currency of a foreign investor at the rate established by the Central Bank of the Russian Federation on the effective date of this Federal Law) or a foreign participation) in the charter (joint-stock) capital of a company with foreign investment of at least 100 million roubles (or the equivalent amount in the currency of a foreign investor)". Projects must also be included in the special priority list adopted by the Russian Government" (Article 2 of the above-mentioned law).

     The clause discriminates against present and future investors in small and medium-sized projects- in July 1999 when the law was enacted 1 billion roubles was equivalent to US $41 million - and defers to unspecified government agencies the seemingly arbitrary power compile the priority project list. Neither the nature and scope of the list nor the listing criteria and procedures are specified or published. Foreign investors may thus in principle and at any time be declared by an official agency to be in violation of the unspecified obligations related to Article 9 and deprived of the remissions granted to them in accordance with the grandfather clause. In this case "… monetary amounts which were not paid because of the use of those remissions are to be refunded in the manner provided for by the legislation of the Russian Federation."

     Moreover, the grandfather clause as formulated in the law seems to contain internal contradictions. For instance, according to Paragraph 2, Section 1 of Article 9, the grandfather clause provision is applied to a company with foreign participation of over 25 per cent of the charter (joint-stock) capital and to a company with foreign participation implementing a priority investment project regardless of the level of foreign participation in the charter (joint-stock) capital of such company. This contradicts the requirement for ALL projects to be on the official priority list and is misleading as it gives the impression that an investment project with considerable foreign participation can acquire protection against unfavourable changes in legislation regardless of its total volume. The lack of clarity surrounding the question of "priority projects" falling under the grandfather clause is one of its major weaknesses and several draft government decrees are being worked on by the Ministry of Economic Development and Trade and different government agencies to eliminate the contradictions and discrepancies.

     As an illustration of how the concept of national treatment and promotion of investment activity is gradually influencing the domestic investment climate, a grandfather clause provision has been included in Article 15 of the 1998 Federal Law on Investment activity Implemented in the Form of Fixed Capital Investment as from 2 January 2000. This provision, which was added as a result of pressure from the Council of the Federation, applies to both domestic and foreign investors alike and there are no quantitative limitations on the size of priority investment projects or on the level of foreign participation.

     The controversy surrounding the grandfather clause makes it increasingly apparent that the framework legislation on foreign investment incorporates obsolete and contradictory approaches which make it ineffective or inapplicable in practice. There is a need for clearer formulation of investment incentives and their extension to domestic investors either through an amended framework law on investment activity or through accommodating provisions in the Tax and Customs Codes and in the laws regulating payments to extra-budgetary funds.

     · poor co-ordination of legislative acts which leads to mutually exclusive provisions

     · frequent amendments to resolve short-term problems which undermine legislation

     · unclear balance of jurisdiction at federal and regional levels which are not conducive to uniform implementation

     · non-existent or ineffective penalties for violation of laws

     Investors' lack of protection against non-compliance with laws is partly a consequence of the failure of the existing Russian judicial system to keep pace with change. There is no special procedure for handling petty disputes and no special courts with different areas of specialisation to develop the necessary expertise for more complex issues. Investors are in fact often deterred from taking cases to court by the lack of independence of judicial procedure and long delays due to court workloads. Judges, bailiffs and other court officials tend to be too inadequately remunerated to ensure their commitment to protecting the rights and interests of plaintiffs or enforcing court rulings (See further Chapter I, Part II).

     2. Restricted Areas and Natural Monopolies

     Restricted areas
     Practically all transition economies apply certain restrictions on foreign investment in "strategic companies" and natural monopolies for a number of economic and political reasons. Present Russian legislation exhibits a lack of clarity as to he extent of such restrictions and the time span over which they are to be enforced.
     Draft law on areas and territories restricted for foreign investment.
     At the present time there exists no comprehensive specification of areas restricted to foreign investment. However, a draft law entitled "On the list of sectors, and territories with prohibitions or restrictions for foreign investment" had passed the first reading in the previous Duma and is now ..???. The list itself is in the process of being drafted and is initially to include areas of importance to national security and defence and state monopolies such as distilleries, export and processing of precious metals and other export-oriented industries.
     In October 2000, a draft list of restricted areas, including over 1000 enterprises ranging from airlines to bakeries where foreign capital share is limited to a maximum of 25 per cent, was being circulated to a number of government agencies. Fears have been expressed by the foreign investor community that the final bill will contain a very wide list of restricted sectors and territories or provisions giving government bodies power to alter or extend the list at any moment. To avoid the very fact of its adoption being seen as a negative signal to foreign investors, the provisions in the proposed law should set out a clear and limited list of restrictions, superceding and invalidating the multitude of restrictions on foreign investment and activities of firms with foreign capital previously existing in other acts and regulations, at all levels of government.

     Financial sector

     Banking

     Restrictions on the activities of foreign banks in Russia were imposed in 1993 by a decision of the Board of Directors of the Central Bank. The Board established a 12 per cent limit on the share of foreign capital in the total capital of the banking sector. Although this limit remained well above actual levels of foreign participation for a number of years, it was exceeded after the financial crisis of 1998 when Russian banking capital contracted dramatically. In the first quarter of 1999, the share of foreign capital in the charter capital of banks registered in Russia reached almost 20 per cent. As of 1 January 2000, this share had declined to about 10 per cent due to the growing capitalisation of the banking system (especially of banks with CBR participation). More changes including bankruptcies, mergers and acquisitions are expected as the restructuring of the Russian banking system proceeds. Many analysts believe that that about 1000 of the 1300 banks in Russia have little chance of surviving. Investment opportunities should emerge for foreign banks with access to resources and wishing to establish or increase their presence in the Russian banking sector.
     A further complications is that the above-mentioned decision of the CBR Board of Directors restricting foreign ownership in the banking sector became void in 1996 through the enactment of the Federal Law on Banks and Banking Activity which states that "… the size (quota) of the participation of foreign capital in the banking system is established by a federal law according to a proposal of the government in consultation with the Central Bank of Russia.". As no such law has ever been enacted, the restriction has no legal basis. However the Central Bank still issues administrative acts referring to the 12 per cent limit and could potentially refuse the granting of licenses to banks with foreign capital if the quota is depleted. For the time being, there are no cases reported where a non-resident bank has appealed to a court to dispute a decision of the Central Bank not to grant it a license on such grounds.
     Here is no doubt that the Russian banking sector would benefit significantly from increased foreign participation. This fact is acknowledged by the Ministry of Economic Development and Trade which is in favour of encouraging foreign capital into the Russian banking system to attract skills and technology, promote competition and improve banking services. It plans to draft a special law governing levels of foreign shareholdings and curb the discretionary control of the Central Bank over the sector. The Central Bank takes a more protectionist view, lobbying for the interests of local banks such as Sberbank which monopolise retail operations in Russia and is, for its part, working on amendments to the Federal Law on Banks and Banking Activities which could broaden its powers to regulate the shareholdings of foreign banks
     At present, as the share of foreign banking capital in Russia is quite low and the number of foreign banks seeking to expand operations in Russia quite limited, the negative impact of the restriction is marginal. However, in the future, its existence could seriously hamper the inflow of investment resources and overall development of an efficient domestic banking system.

     Insurance

     The Russian insurance sector is relatively underdeveloped, with total premiums written by local firms much lower than that of a single large international company. Just over 1,500 insurance companies were registered in Russia at the beginning of 2000, 60 (4 per cent) of which have foreign participation . The number of insurers had been increasing steadily in the preceding years on account of tighter control of the insurance supervisory body of compliance with legislation and increasing competition on the market. Local insurers offer far fewer services than foreign companies and only a small minority of Russians have basic life or property insurance policies.
     In 1994 Russia signed and agreement with the European Union obliging it to open up the Russian market to foreign insurers by the end of 1999. Before that foreign insurers could only act through subsidiaries where their stake did not exceed 49 per cent. Their intermediary activities are restricted by the allocation of insurance risks exclusively with Russian and reinsurance with foreign companies.
     In 1999 a bill entitled "Amendments to the Law on the Organisation of Insurance Business in Russia" was passed by the Duma and the Federation Council after considerable controversy and enshrines a procedure for the activities of affiliated companies of foreign insurers on the Russian markets. In summer 1999 the President of Russia had vetoed the bill, but it was ultimately passed due to the strong lobbying efforts of the local insurance and banking community. This has effectively limited foreign insurers' capital to 15 per cent of the overall capital of insurance companies operating in Russia, cancelling the previous 49 per cent limit foreigners were allowed to hold in the capital of an individual company. At the same time companies with more than 49 per cent foreign capital and subsidiaries of foreign companies were banned from selling life insurance, all forms of mandatory insurance or insurance services to organisations in which the state holds a stake. The bill requires foreign insurers wishing to gain control of more than 49 per cent of an insurance company to have a 15-year record in their home country and at least two years previous experience in the insurance sector in Russia (through subsidiaries).
     This law puts major constraints on the development of the insurance market in Russia. Moreover, according to the law, the minimum charter capital set for foreign insurers - at approximately 20 million rubles or slightly more than US$ 700.000 - is ten times higher than that set for Russian entities. This degree of discriminatory treatment is unlikely to attract further foreign capital to the sector.
     The insurance market is regulated under the terms of the above-mentioned law by a federal executive supervisory body, the Department of Insurance Supervision, under the jurisdiction of the Ministry of Finance. Its functions are to oversee the licensing of insurers, set conditions for insurance and reinsurance, rates, standards, supervise management of insurance reserves and insurance liabilities and accounting procedures.
     As a result of consultations between domestic insurers in Russia and the international insurance community the following necessary steps of liberalisation of the market were identified :
     · Adoption of Federal Law on Insurance Supervision;
     · Introduction of controls over insurance companies' solvency;
     · Application of international accounting standards for the insurance industry;
     · New sector-specific taxation schemes.

     Natural monopolies

     Natural monopolies in Russia are defined in the 1995 Federal Law No. 147-FZ. The law governs relations on the Russian market between entities engaged in exploiting natural monopolies, consumers, federal and regional executive authorities and local agencies. The following activities are covered by the legislation:
     · - transmission and transport of oil, oil products and gas through pipeline systems;
     · - services for the provision of electricity and heating;
     · - rail transport;
     · - transportation terminal, port and airport services
     The law empowers specific natural monopoly agencies for all the areas listed above to regulate prices and the provision and distributions of commodities to consumers in terms of the rights and interests of citizens, national security and heritage considerations. These agencies oversee government policy in respect of monopolies and monitor transactions involving the right of ownership or use of fixed assets, their capital investments or the sale or lease of their fixed assets in excess of 10 per cent of the value of their latest balance-sheet equity.
     No specific provisions for or restrictions on foreign investment in areas classified as natural monopolies are incorporated into this law. Currently foreign participation in several, single-unit natural monopolies considered as "strategic enterprises" is regulated by a number of legislative acts.

     Energy and Gas Sectors

     Of the natural monopolies, the energy and gas sectors are of major strategic importance for the Russian economy, accounting for some 45 per cent of Russian exports, 60 per cent of foreign exchange revenue and 20 per cent of GDP (update ?). Russia's resources represent about five per cent of total world oil reserves and approximately one-third of gas reserves.
     The future successful exploitation of these reserves will require considerable foreign capital and technology inputs and to date the level of foreign investment in these sectors has been limited (confirm total amount up to 1999 if possible). Output of oil and gas declined by 50 per cent over the ten-year period 1989-1998 and only a major inflow of investment can have a significant impact on this negative trend. Due largely to the unattractive and unstable general and sector-specific investment regime on account of lack of comprehensive legislation, property and physical access rights, an over-complicated revenue rather than profit-based tax regime and market access and price controls, much of the profits of companies in these sectors have been taken out of the country in recent years (see paragraphs XX on capital flight) instead of reinvested. Whilst there has recently been a slight reversal in this trend, it is vital that the legislative position of production sharing agreements become clear and financing through shares, bonds and loans become possible to also attract capital to and retain capital in these sectors.
     A general legal framework for the exploitation of natural resources, and most specifically the extraction of minerals, was established with the enactment of the Subsoil Law in 1992 and its amendment in 1995, although an accompanying Oil and Gas Law is still pending, as are a number of necessary normative acts and amendments concerning the Law on Production Sharing Agreements (see below).
     Conditions of access to oil and gas export pipelines must also be improved, as must investment conditions for private providers of pipelines systems who are currently deterred by the proposed legislation on "Trunk Pipeline Transport" which leaves the control of tariffs and access to the state. Other barriers to investment include the complicated, mainly revenue-oriented environmental legislation which needs to be aligned with international standards.
     Licensing of foreign investment projects in energy resources is regulated on a case-by-case basis under the terms of the 1994 government Decree No. 1418 "On the Licensing of Separate Kinds of Activities"and falls under the jurisdiction of different federal entities. Licences are required in respect of the storage of oil and gas and derived products, the generation and distribution of electricity and fuel energy, the erection and repair of energy facilities and equipment. The licensing process is carried out by a number of federal authorities, ministries and local government agencies.

     Power supply

     The foreign share to be allowed in the capital of the Unified Energy Systems of Russia (RAO UES) is defined by a federal law No.74-FZ of May 1998,"On the Particulars of the Management of Stocks of the Russian Joint-Stock Society of Energy and Electrification" and the maximum is currently set at 25 per cent. Paradoxically, this share was exceeded several years ago, before the law in question had been passed, and now it appears that there is no legal way to reduce it. Therefore the aforementioned law not only constitutes an infringement of the rights of existing investors, but has no legal basis for implementation. In April 2000 the new management of the Federal Commission for Securities Markets proposed increasing the government stake and decreasing the foreign shareholders' stake through diluting the share capital of the UES. Predictably, this proposal provoked sharp criticism from the investor community and reflected very poorly on the investment climate in Russia.

     Gas industry

     Admission of foreign equity to GAZPROM, the Russian state gas monopoly, is defined by presidential decrees. The most recent decree of this kind #1316 of October 1998 made it possible to sell off an additional 5 per cent of the government's share in the equity of GAZPROM (which was subsequently purchased by RUHRGAS) and brought the maximum foreign participation level to 14 per cent. Gazprom, which controls 25 per cent of the world's natural gas reserves and is Russia's biggest export earner and energy supplier, is in need of substantial reform and restructuring . President Putin has declared his intention to increase government influence over the company and has already taken steps to block the transfer of Gazprom's assets to other subsidiaries or affiliated entities or the dilution of its holdings without board approval. His objective is to transform Gazprom into an efficient and transparent company, restore production levels and profits in line with its access to gas reserves. By putting an end to the present suspected asset-stripping activities of the company and imposing standards of corporate governance, Putin hopes send a positive signal to investors regarding his commitment to improving the business and investment climate. With the appropriate regulatory and legislative environment in place, this sector would offer considerable opportunities for foreign investors and their capital is also much need to realise the full potential of Gazprom resources.

     Defense-related industries

     Aviation industry

     The law regulating the aviation and space industry includes some restrictions on foreign investment activities in the sector. It sets a maximum limit of 25 per cent on the stake of foreign companies in Russian aviation firms and requires that Russian nationals occupy all top management positions in any company. The law has been sharply criticised for a number of years by foreign companies (in particular United Technologies) co-operating with the major Russian aircraft manufacturers.

     3. Special Rules for Mineral Resource Extraction

     Production Sharing Agreements (PSAs) are used in the Russian Federation to provide a special legal framework for foreign investors in mining, oil, gas and other sectors requiring substantial long-term investment. Such agreements are based on the Federal Law on Production Sharing Agreements which was adopted in 1996. They govern relations between federal and local government bodies and foreign investors and have been vital to attracting foreign investment to Russia's natural resource sectors. The main objective of the PSA legislation is to provide a higher degree of stability to long-term investors in these sectors than what is generally available in the current economic and political environment in Russia.
     Oil production has almost halved during the past decade and may fall further without serious capital injections. The problem of lack of capital is also very evident in the gas industry and Gazprom (see above) recently announced its inability to supply enough fuel to the domestic economy due to lack of investment. The short-term benefits of high oil prices should not be allowed to mask the long-term investment crisis in the Russian energy sector.
     Foreign fuel companies have reduced their activities in Russia over the past number of years due to the unfavorable investment climate. The general legislative framework cannot ensure the stability, transparency and predictability necessary for large-scale and long-term investment projects. PSAs create a tax regime which enables investors to recoup investments before the government take increases and provide a stable basis for the long-term nature of natural resource-based projects. According to estimates of the Petroleum Advisory Forum [explain], PSAs can give Russia a chance to attract several billions of dollars of FDI into the energy sector in the coming decade. Such large-scale investments can have a multiplier effect generating local employment and contracts for local industry and services send a positive signal to foreign investors in other sectors.
     PSA legislation is acknowledged internationally to be a very complex and sensitive area giving rise even in some highly developed economies to conflicts of interest relating to local and national development priorities, ownership and access rights and environmental and financial issues. Similarly the passage of PSA legislation in Russia was a long and controversial process, with problems still to be resolved. It has not proved effective to date in Russia and fails to compete with the legislative cover provided in this area in other resource-rich countries such as Azerbaijan and Kazakhstan. Under the legislation it was envisaged originally that the Subjects of the Federation and the Federal Government would prepare a list of 250 licences covering 32 regions to be approved by the Duma. As of February 1999 (update??) only 10 licences had been approved . The lack of progress was largely due to the delay in passing the necessary enabling legislation to harmonise the PSA law with existing customs and tax regulations,as well as laws on foreign investment and the subsoil and continental shelf.
     A total of 12 laws were amended in 1999 to accommodate PSA legislation. According the these amendments imported purchased or leased goods and services for PSA implementation are exempt from duty and VAT, investors working under PSAs are exempt from road tax and goods or financial assets transferred free of charge from the investor to the operator are exempt from VAT. Dividends paid by the investor from profits deriving from the PSA are tax-exempt. Amendments likewise introduced in 1999 to the Law on Subsoil Resources provide that users of such resources under PSA are exempt from royalty payments and instead compensate for the state share of exploration costs [explain]. A number of sub-laws are, however, still required to implement the aforementioned amendments; there are, for example, still disputes regarding the basis for calculation of the government's exploration costs as opposed to the operator's exploration, development and production costs.
     According to Russian PSA legislation every oilfield or other site for natural resource extraction is to be endorsed by a special law. The first law of this type On the Subsoil Sites Eligible to Development on Production Sharing Conditions was passed on in June 2000 and contained a list of 7 mineral resource fields. At present there are several draft laws covering oil and gas fields and gold mines being reveiwed by the Duma. One of the drawbacks is that such laws do not provide for clear selection criteria for the new mineral resource sites eligible for inclusion in the PSA scheme and this seriously hampers potential investors' strategic planning.
     Yet another issue which requires clarification is the fact that the PSA law contradicts the newly adopted parts of the tax code stipulating that taxes should be paid only in monetary form. Therefore a special PSA chapter should be introduced and adopted in the framework of Part II of the Tax Code. It then must be decided what institution will be authorised to sell the government share of PSA output and at what prices (and will the book prices be applied)? It is clearly more difficult to control export earnings of oil companies than to control monetary tax payments and there is already competition between Russian oil firms for an exclusive right to sell PSA oil which has the potential to lead to the unorthodox practices associated with in-kind payments.
     The main areas where Russian PSA legislation could be made more effective are a) reconciliation with other legislative acts, which currently hamper its implementation and b) elimination of discriminatory amendments to the Law On Production Sharing Agreements such as the requirement that 90 per cent of project sub-contractors should be Russian.
     According to a government act of August 2000, the main initiative to guide and form the legal and institutional framework for PSAs is to establish a clear distribution of powers and responsibilities among the different authorities such as the Ministry of Economic Development and Trade, the Ministry of Energy, the Ministry of Natural Resources, the Ministry of Taxes and Collections and other involved government agencies. There is a proposal to adopt a "one-window" principle in negotiating, registering, implementing and managing PSAs. Plans for this approach are being drafted by the Ministry of Economic Development and Trade.

     4. Foreign Exchange Regulation

     section on general situation to be inserted….

     The current exchange rate arrangement is based on a floating rate since September 1998, prior to which a managed exchange rate "corridor" was operated for a number of years. The exchange rate is determined in the interbank foreign exchange market, which was unified in June 1999, after a short period during which a dual exchange rate mechanism had been in operation subsequent to the 1998 financial crisis. The interbank market links exchanges electronically across the country. The official rate of the rouble is set equal to the previous day's weighted average rate in the interbank market. The CBR at times intervenes in the market to give direction to movements in the exchange rate and has since mid-1999 made recurrent large purchases of foreign exchange to stem the tendency of appreciation of the rouble.
     The Russian Federation accepted the obligations of Article VIII of the IMF's articles of agreement with effect from I June 1996, confirming the absence of foreign exchange restrictions on current account operations. Most capital account operations remain subject to licensing by the CBR……complete]
     In recent years, capital flight has been an endemic feature of the Russian economy, prompting the authorities to fine-tune their use of the artillery of foreign exchange regulations to stem the exodus. Many estimates of capital flight exist, but even on the more modest scale of equating it to part of the net errors and omissions item in the balance of payments, an average level of US $ 11 billion per annum is attained during the period 1994-1999.
     The channels of capital flight are well established and recognised, including 1) underreporting of export earnings, 2) overstatement of import payments (including fake contracts), 3) fake advance import payments and 4) a panoply of capital account transactions effected through correspondent accounts of non-resident banks with Russian banks.
     Since the August 1998 crisis, the authorities have been seeking to stem capital flight through a number of additional restrictions on both current and capital account regulations, with some of the former in contravention of the obligations assumed under Article VIII, thus requiring special approval from the IMF.
     Among these, the restrictions imposed on advance import payments have given rise to considerable protest in the foreign investor community, as advance payments required under valid import contracts are not freely permitted. The CBR policy to tighten control over current operations particularly relating to trade in services is reflected in a number of newly introduced regulations aimed mainly to reduce capital flight generated by fictitious imports of services. Such regulations (CBR ¹ 500-ó of 12.02.99 and ¹721-ó of 30.12.99) confer additional powers to CBR and the Service of Currency Control and in fact introduce a permit rather than a registration regime for current operations arising from the imports of services.
     For portfolio investors, the restrictions imposed on the repatriation of proceeds on non-residents transactions in the GKO/OFZ market (suspension of conversion operations through non-residents' S-accounts) have been particularly contentious. Other measures of more " general nuisance" nature have taken the form of increased regulation on cash transfers by non-residents. Consensus seems now to be forming in the CBR that the best, most efficient route to follow in combating capital flight is intensifying the licensing and scrutiny of compliance by authorised foreign exchange banks of their obligations - such as regulation of reporting requirements by banks on foreign exchange transactions, increasing their possibilities to detect and refuse suspicious foreign exchange transactions, enhanced regulations of correspondent accounts. [rewrite] In addition, amendments of the Civil and Criminal Codes to establish more severe penalties for violations of exchange control are being contemplated.

     Other, non-crisis induced problems of longer standing….[rewrite paras below]

     The regulations governing the transfer of profits out of Russia pose major difficulties for foreign investors operating in Russia. The existing hard currency regulations and, more specifically, their ambiguity and technicalities make some transactions administratively impossible and others economically unviable. This is particularly true of foreign trade contracts in which it is extremely difficult for parties to change price conditions, payment procedures and deadlines and to assign claims. These restrictions hamper the parties' flexibility and efficiency in their contractual relations and provoke disputes. This situation is due to the requirement to prepare the so-called export-import transaction record [passport] for purposes of currency control. The said passport must be officially updated in a rather cumbersome procedure each time the parties introduce changes to their agreement.
     Numerous problems are created by the sub-division of hard currency operations into current and those involving the movement of capital, in accordance with the Law "On Currency Regulation and Currency Control". The ambiguity in the wording makes it difficult in practice to classify transactions under the different categories and renders many currency payments risky unless a license has been obtained from the Central Bank, which tends to be a rather laborious process in itself.
     The handling of hard currency royalty payments for the use of objects of intellectual property can be used as an illustration: by their very nature, these currency operations are obviously not related to the movement of capital, however, they are not to be found in the exhaustive list of current transactions, which serves as the basis for obtaining a Central Bank license for each payment. This provision, due to the expense (legal fees) and time consideration for the procedure, makes international licensing agreements undesirable.
     The imposition of surrender requirements (mandatory sale of currency export earnings) to the level of 75% leads to the situation where foreign investors with Russian subsidiary companies are forced to incur considerable expenses (including the exchange rate difference) in connection with the sale and the subsequent purchase of hard currency in order to transfer profits (dividends) out of Russia. A recent proposal by the CBR to raise the currency surrender requirements for exporters to 100 per cent seems to have been abandoned.

     5. Customs Regulations [section to be reviewed and updated]

     Russian customs legislation imposes duties on both imports and exports and their collection is regulated by the Customs Code and other legislative acts. The State Customs Committee, which is also a federal agency, is responsible for monitoring and ensuring compliance with such legislation.
     Frequent and unpredictable changes in Russian customs legislation and arbitrary action by customs authorities have generally created problems over the years for foreign investors who will undoubtedly be heartened by the recent announcement by President Putin that a system of simplified customs tariffs will be introduced in Russia in early 2001. Russian customspolicy and legislation is now undergoing significant changes in respect both of the tariff schedules and administration on account of negotiations with the WTO on Russia's accession. Considerable reductions in import duties are being considered together with a major simplification of the trade system. In addition, the elimination of numerous individual privileges and exemptions is envisaged. A proposal recently submitted by the State Customs Committee to the government would affect more than 4500 commodity positions, reducing the number of tariffs from seven to four and the average tariff from about 13.5 per cent to 11 per cent. In addition the negotiations with WTO are focusing on tariffs as well as services and agricultural issues.

     Imports

     At present, a wide range of imported goods are subject to customs duties, which are mainly calculated on an ad valorem basis. Rates range from 0 to 30 per cent and average out between 20 and 25 per cent. Per unit duty rates are also applied in some cases and fixed in Euros. Rates are doubled for goods from countries without "most favoured nation" status, whilst reduced rates are operated for goods from developing or least developed countries. All customs duty rates are set by the Russian Government. Some customs tariffs were revised in 1999 such as those imposed on inputs for the electronics and furniture industries, whilst others were significantly increased (e.g. pharmaceuticals). The previous Ministry of Trade, supported by the State Customs Committee, had proposed the reduction of some of the higher tariffs in Russia which, up to now, the government has been reluctant to approve as they have been an importance source of federal revenue .

     Exports

     Since early 1999 temporary customs duties on exports of certain commodities (e.g. oil, iron, nickel, aluminium, coal and certain agricultural products) have been introduced to appropriate some of the windfall revenue gains to exporters due to the substantial increase in world prices of these commodities as well as to the devaluation of the rouble. It is estimated that the reintroduction of export taxes on energy exports alone have led to an improvement in general government revenues of some 2 per cent of GDP since the pre-crisis period.

     Procedures and special incentives of relevance to foreign investors

     The Foreign Investment Advisory Council (FIAC) [see page??below] has been working with the authorities on measures to standardize customs clearance and procedures in general and those affecting investors in particular. A new Customs Code and legislation on customs tariffs have been drafted and will be submitted to the government for consideration. Some new procedures and methods of settling customs duties have been introduced recently which it is hoped will speed up clearance times and save costs for investors. These changes were formalised this year in the "Statute Concerning the Acceptance of Temporary, Partial and Periodic Customs Declarations" which was approved by the State Customs Committee. The new simplified and standardized procedures have, however, not yet been reflected in the Committee's regulatory instruments which tighten customs control of imports entering Russia. A draft statute on bonded warehouses is also being prepared and will distinguish between warehouses intended for trading and those solely for production purposes.
     There are several basic groups of customs issues directly relevant to foreign investment: a) import duties on goods and services imported as part of the fixed capital of an enterprise with foreign investment; b) import duties on goods imported by a foreign investor who sets up a manufacturing line of similar goods on Russian soil; c) import duties on parts imported for the manufacturing of a final product by an enterprise with foreign investment.
     Initially it was planned that the new law on foreign investment would contain a provision on customs benefits and exemptions for goods imported as a contribution to the charter capital of enterprises with foreign investment. In the final version of the 1999 law there is only one article stipulating that a customs tariff exemption could be given to a priority investment project according to customs legislation of the Russian Federation. In the interim customs Code there is a provision for such exemptions but no concrete procedure. A draft decree of the government "On the procedure of the extension of exemptions applied to goods imported as contribution to the charter capital of enterprises with foreign investment" has been prepared and circulated to various government agencies. This document has not yet been adopted and some additional changes to it are under discussion. One current proposal is to extend import duty exemptions to any goods imported by the owners of an enterprise engaged in a priority investment project as part of its fixed (not only charter) capital.
     The law on foreign investment also does not directly provide for any special customs regime for parts imported by manufacturing enterprises partly owned by foreigners. Up to now such incentives were introduced mainly by decrees of the President and acts of the government on a case-by-case basis. For example, Presidential decree No 73 of January, 1995 and Government act No 751 of July, 1995 prescribed additional incentives for large-scale FDI in the manufacturing industry. The main incentive is lower tariffs on imported goods if the importer makes a substantial investment to develop production of similar goods in Russia. As a rule such incentives are granted according to special investment agreements signed between large investors and an authorised government agency. Initially this was the responsibility of the Ministry of Economy and, after its dissolution, this function was transferred to the Ministry of Economic Development and Trade.
     The Presidential decree No U-135 of February 1996 was specially tailored to support foreign investment in the Russian automotive industry. The support was extended to large-scale projects meeting special requirements. The importation of parts connected with a project were to be treated by the customs as supplies from a spare parts depot, meaning that, within quotas annually established by the government for each project, these supplies when coming from the territory of the spare parts depot to the rest of the territory of Russia will be considered as originating from Russia (which means no customs duties are charged). Such preferential treatment was limited to a maximum period of 7 years.
     However these case-by-case incentives proved to be relatively ineffective. The implementation of this type of special decree is usually complicated by the fact that it a priori runs into conflict with several other federal laws and regulations and requires a lengthy and difficult period of bargaining with various federal government and regional authorities. It is quite understandable that such processes can promote corrupt practices. In any case incentives based on exemptions from basic legal acts can be considered only as a temporary measure. The liberalisation of the customs regime, simplification of procedures and general lowering of import tariffs generated by the rapprochement with the WTO could become a strong incentive for investing in Russia.

     6. Investment Promotion and Institutional Arrangements

     There are several public sector entities in Russia assigned to develop foreign investment policy and legislation.
     At government level, the Ministry of Economic Development and Trade and - specifically - its Department of Investment Policy is responsible for developing investment strategy, drafting legislation on investment issues, selecting priority investment projects eligible for tax and customs exemptions and other incentives and negotiating special investment agreements with large-scale investors. There are also units in several other ministries and agencies responsible for investment issues relevant to their sectors. Bilateral investment treaties with other countries …..?
     Investment promotion functions at the federal level are given to a quasi-government agency - the Russian Foreign Investment Promotion Centre.which is directly dependent on presidential administration (or else under what?] It has three main functions: a.) to promote an attractive image of Russia as an investment base among potential investors; b.) to attract investors for specific projects; c.) to provide information services to investors. The Centre tries to inform potential investors about existing investment opportunities through promotional campaigns in the mass media, organisation of exhibitions, presentations and workshops and special investment missions by Russian entrepreneurs and federal and regional officials to foreign countries. The Centre however suffers from a lack of government input (??) and financing.
     As a private sector initiative with active co-operation from the former Ministry of Economy, the Foreign Investment Advisory Council (FIAC) was designed as a feedback institution to record and communicate investor needs and concerns to the Russian government. It was set up in 1995 with the membership of 25 major companies operating in Russia and the EBRD. The Council drafts recommendations addressed to the Russian government on investment policies and the legislative framework affecting the business and investment climate. Its work has been instrumental in promoting improvements to the Russian tax system, amendments to several pieces of investment legislation and the gradual introduction of international standards of accounting and auditing. However, the frequent changes in Russian government in recent year have rendered FIAC's work less effective, as it is by design relying on close ties between major companies and high officials. Its limited impact on the general investment situation in Russia is limited by its very nature: in fact FIAC serves a lobby for large companies which were very well placed in Russia even in the Soviet era and are, in general, more concerned with resolving specific issues and problems via direct access to high-level government officials than in developing a level playing field and competitive environment for business in the country.
     There are also several other private sector organisations representing geographical or sectoral investor communities such as the European Business Club, German Economic Union, American Chamber of Commerce and the Petroleum Advisory Forum. These, however, mainly act as local discussion clubs and generate little information for external use.
     One recent idea, widely discussed and promoted primarily by FIAC members was to establish an Ombudsman responsible for investment dispute resolution in the Russian government. This idea received no support at government level on the grounds that there is no legal basis for the institution of an ombudsman in Russia. Instead the government proposes to organise special hearings on investment conflicts in the Duma and to devote special attention to improving the effectiveness of the court system.

     B. Regional Policies and Practice

     1. Administrative Practices
     2. Regional Incentives and Tax Free Zones

     PART II.
     KEY POLICY ISSUES FOR CREATING AN ENABLING
     ENVIRONMENT FOR INVESTMENT
     Chapter I. PROTECTION OF PROPERTY RIGHTS
     Legislative, Enforcement and Governance Issues
     Contents

     Introduction
     Contents and coverage of basic areas of law
     - Protection of shareholder rights
     - Balancing interests of debtors/ creditors
     - Pledges, mortgages and liens
     - Trust management
     - Land and real estate ownership
     - Transfer of property
     - Protection of Intellectual Property Rights
     - Law Enforcement
     - The judiciary
     - Execution of court judgements

     3. Public and private sector governance
     4. Policy recommendations

     1. Introduction

     In this chapter we will discuss the degree to which investors fail to benefit from full protection of property rights in the Russian Federation and the different avenues for possible improvements to this fundamental aspect of the investment climate. Property rights are here interpreted in a wider sense, to encompass not only rights relating directly to physical property, but also contractual rights and obligations as well as to dispute resolution regarding their fulfilment.

     In order to discuss the perceived insecurity of property rights it is necessary to look both at the content of the law, its implementation via the court system and the practices in public and private sector governance which at times lead to violations or infringements of investor rights.
     Following the many decades under a system geared towards state ownership, which mainly relied on legal sanctions to protect the property rights of the state, impressive results have been achieved within the space of a few years in the legislative affirmation of individual ownership rights. Property rights as well as the collected legal norms that regulate benefits of ownership such as possession, use and disposal are clearly spelled out in contemporary Russian legislation, fully in accordance with the accepted principles in the civilised world. Even though some white areas and lack of clearly defined frontiers between individual and state property remain to be addressed, the basic legal framework provides for protection of ownership rights in practically all possible spheres, both as concerns direct violations of physical property, as well as indirectly, via infringements of contractual rights.
     Considering the short space of time during which a wealth of legislation has been developed in Russia to regulate market-based relationships and transactions, (Civil Code, Joint-stock company Law, Law on limited liability companies, Law on securities, Law on the protection of investor rights and legal interests in the securities market, Law on bankruptcy, the acts on privatisation, on antimonopoly regulation, on land, on real estate, on patent rights, etc) it is not surprising that certain aspects of the existing normative base still need completion. Below we will point to certain areas where white spots continue to exist or the legislation remains insufficiently developed. Another fundamental problem, not discussed further here, is the fragmentation of legislation and the lack of internal consistency following from the sheer magnitude of the task confronting legislators during the 1990's as well as the recurring need for amendments during the transition period. This underlying constraint is also part of the reason for the lack of correspondence sometimes found between the tasks set for state regulation and the powers designed for the state to implement this regulation.
     Having indicated the remaining weaknesses and lack of development in a number of areas of legislation, we will discuss the major aspect of investor insecurity with respect to property rights - the enforcement practices for the existing legislation. As we have noted above, legal reform can proceed rapidly, and foreign investors have in the past few years been able to voice their recommendations for improvements in the law through channels such as the FIAC. However, it is the tension between the written law and its application which is at the heart of present institutional bottlenecks and these are not as readily influenced by investor complaints. To assess the problems existing in the area of enforcement, a short overview of the judiciary in the Russian Federation and the procedure for execution of court judgements is required.
     In the transition context one also needs to take into account that new legislation, however sound and effective from a formal, drafting perspective, often is undermined by behavioural attitudes on the part of officials and market participants, so that its intended functions cannot be effectively implemented. In a final section we will discuss public sector governance and the incidence of corruption as well as the current efforts to improve corporate governance in Russian enterprises and banking institutions.

     2. Contents and coverage of basic areas of law

     A review of the legal aspects of the investment climate should also include specific contents and coverage of basic areas of law. The objective would not be a fully comprehensive review but merely to identify and comment on significant deficiencies of relevance to investors in areas such as pledge law, bankruptcy law and company law - to capture significant problems investors could face in commercial transactions such as secured lending, project finance, debt restructuring etc. There is also a need to identify and discuss failures in the legal framework for banking and financial market institutions in general, although problems in these area derive more from weaknesses in implementation mechanisms rather that actual missing elements in the laws (with the important exception of the legislation on the Central Bank of Russia). In the EBRD legal indicators for transition countries, Russia consistently comes up with high scores on content - or extensiveness - of the laws and low on enforcement - or effectiveness.
     Other matters for consideration which are of importance to foreign as well as domestic investors which are only mentioned here in passing are:
     · the lack of stability of laws;
     · inconsistency of laws resulting from successive tinkering and amendments driven by short-term objectives;
     · inadequacy and ineffectiveness of penalties for non-compliance, coupled with a distinct imbalance between the severity of penalties and infringements in many instances where penalties are specified.

     Protection of shareholder rights

     The protection of shareholder/investor rights and the need to strengthen regulation and oversight by the authorities in this domain is a very topical subject in today's Russia. A detailed analysis of the more prevalent types of corporate conflicts occurring and the means of regulating them is needed. On the basis of such analysis, the necessary adaptations of existing legislation can be carried out and the appropriate response from the regulatory and supervisory powers be designed. There is a significant role to be played in this domain by the self-regulatory organisations and private business through the development of codes of conduct for securities market participants. [See page?? for comments on the work on developing corporate governance principles for Russian firms involving a substantial number of market participants as well as advice from international organisations such as EBRD, IFC , OECD and the World Bank]
     In the domain of corporate law, attention should be given to:
     · Widening the monitoring capabilities exercised by the board of directors and minority shareholders of the executive organs of companies and majority shareholders
     · Prohibiting insider dealing[check status??]
     · Qualifying deals among affiliated entities, widening the concept of an affiliated party and strengthening the power of regulatory authorities to prohibit such deals when required[status??]
     · Extending disclosure requirements as well as the responsibility for the content of such information disclosure
     · Regulating the dilution of share capital
     · Limiting cross-ownership of share capital
     · Strengthening the requirements for independent audits
     · Protecting good faith shareholders from effects of invalid share transactions
     · Introducing personal liability and responsibility for officers, directors and controlling shareholders for the damages inflicted on the own company , or on its shareholders (with outright dismissal for breaking corporate governance norms and imprisonment in graver cases)
     There are pressing needs for amendment to the law on joint stock companies on the following points: (1) the introduction of pre-emptive rights for all shareholders to participate in new issues of shares irrespective of any stipulations regarding such a right in the company's articles of association; (2) decisions regarding issuance of additional shares or obligations convertible into shares through closed subscription should be the exclusive prerogative of the general shareholders'meeting; (3) prohibiting the conversion of an open underwriting into an effectively closed one through a requirement that the shares should be paid for with specified property; (4) strengthening the powers of the board of directors to control the executive organs of the company; (5) clarifying of the procedures for calling a general meeting of shareholders; etc. A law project introducing these amendments was adopted by the Duma in the third reading on 2 June 2000, but the Federal Council later blocked the draft changes, reportedly due to pressure from certain major companies.[check reasons given for blockage and status ]
     Such amendments are not intended to signify exclusive concern with legal protection of minority shareholders' rights from infringements by major shareholders. They aim to establish a balance of interests of different groups of investors or participants in the corporation. Upholding that balance also requires protection of issuers from bad faith action or blackmail on the part of minority shareholders. From the legal standpoint it is necessary to find a sensible compromise between the necessity to provide minority shareholders and foreign investors the protection they require from infringements of property rights and at the same time avoid blocking up the legal system with unfounded claims made by minority shareholders on the basis of private agendas.
     The most important aspects of the protection of ownership rights of shareholders and portfolio investors in general have been linked with the reorganisation of enterprises or joint stock companies. As the experience of the period 1997 - 2000 shows, it is the in the reorganisation of juridical persons that the infringements of property rights have been most widespread. Above all, attempts have been directed towards pushing out individual minority shareholders into new companies in a troubled financial situation or transferring valuable assets into new entities leaving only impaired assets in the original shareholding structure.
     Attempts to combat these abuses through strengthened regulation and oversight are clearly insufficient, and proposals have been made to amend the legal basis covering reorganisations (notably, through changes to the joint-stock company law and introduction of new federal legislation "On the reorganisation of juridical persons"; "On reorganisation and liquidation of commercial enterprises; as well as via a federal law on the introduction of changes to the Civil Code, chapter 4 on juridical persons).
     Lack of compliance with disclosure requirements must be addressed both in the joint stock company law, in the law on protection of rights and legal interests of investors, the law on securities and also through the introduction of international accounting standards and criminal liability for non-compliance. It is also necessary to strengthen legislation regarding the possibility for shareholders or groups of shareholders to request compulsory audits of issuers' commercial and financial activity (at the expense of issuer).
     As concerns small and medium-sized issuing companies certain of the more elaborate requirements for information disclosures are excessive and standardised procedures for registering their share issues would be sufficient.
     An important task for supervisory authorities is the introduction of a system for monitoring who participates in the share capital of companies and the establishment of clear rules concerning mergers and acquisitions. This is extremely important for preventing insider dealing. A mechanical extension of the concept of affiliated party is not enough, since the establishment of transparency of ownership relations in a company or a bank requires penetration into the dynamics of real owners/decisionmakers. In order to provide outsiders with real information about who the major principals of a corporation are and to bring the latter to take responsibility for any infringements or direct damage inflicted on shareholders it is necessary to expose flows of capital between entities to identify group holding relationships.

     Balancing interests of debtors/creditors

     The protection of creditor rights is of crucial importance for the further development of investment activity in Russia. Deficiencies in the present situation have to be addressed via a balancing of protection and enforcement of contractual rights, corporate law, bankruptcy procedure, tax legislation and execution of court judgements.
     The threat of bankruptcy and the transfer of property to creditors normally constitute an important incentive for debtors to honour their debt obligations. Nevertheless, the huge arrears existing in the Russian economy, the tradition of soft budget constraints and the socio-psychological barriers to the imposition of real bankruptcy processes for loss-making companies (especially large ones who provide employment and social benefits to whole communities), the many technical problems involved in a realistic and objective assessment of the true financial situation of a debtor company and corruption have reduced the effectiveness of existing legislation.
     The new law on bankruptcy which entered into force on 1 March 1998 is progressive in terms of world standards, and attempts to strike a correct balance of incentives both to debtors to honour their contractual obligations and to creditors not to abuse the institution of bankruptcy. It also provides for the appointment of external management during the bankruptcy process. As the number of insolvency cases has more than doubled following the introduction of the new law, it could be claimed that courts have only been able to test the new procedures while in a situation of great pressure on resources. Amendments are still considered necessary, to refine the trigger mechanism so that it is not pulled to early on still solvent companies and also to improve the rights of certain interest groups, including the state. A frequent complaint in Russia has been that minority shareholders are not heard or not even able to vote in negotiations concerning reorganisation plans proposed as alternatives to liquidation. It is also claimed that the office of administrator during the insolvency process should be reserved to professionals with adequate training and calls have been made for strengthening the existing certification requirements for persons holding such office and introducing a licensing procedure.
     However, the long-standing problem remains that the institution of bankruptcy in Russia is widely utilised as a means of appropriation and redistribution of property by seizure, retention or privatisation, mostly in cases initiated by competitors of the firms exposed but also by entities affiliated to insiders in the companies. In fact, the paradoxical situation has ensued that companies with sufficient degree of transparency and robustness have been pushed into the bankruptcy process (as there have been conditions present allowing competitors to take control over their assets) while companies in worse financial conditions have escaped the process for want of attractive assets identified by creditors or the competition. Initiation of or interference in insolvency procedures by political authorities at different levels has also been used as a very selective means to exercise economic influence on companies.
     Another major issue in Russia concerns the priority claims of creditors. Priority order for the payment of claims from the assets of a bankruptcy estate places debts to employees and the state (all tax arrears, including to social funds) above debts contracted in the normal course of business. Although not a matter for commercial dispute, it is clear that the priority order has tended to undermine lenders confidence in obtaining satisfaction in execution procedures as arrears on taxes and salaries tend to be very high in many Russian companies. To resolve this issue it would be necessary to develop consensus on a radical solution to the lingering tax debt of a large number Russian enterprises - possibly through restructuring of accumulated tax debts by way introducing some form of amnesty scheme. Such consensus could probably only be reached if the scheme also would ensure absolute impartiality in the legal procedures for assessing the extent of such debts and objective verification of facts regarding the type of tax delinquency. Also, certain cases of delinquency of more systemic importance would need to be isolated and pursued so as to set useful examples regarding incentives for tax compliance.
     Thus, on the one hand it is necessary to offer better protection of creditor rights in general while on the other hand there is still a pressing need to shield debtor companies from attempts to seize their assets through unjustified or invalid petitions for bankruptcy.
     Policy direction in this area should be:
     · Refining the criteria for triggering the commencement of insolvency procedure in order to avoid invalid petitions for bankruptcy of actually solvent companies
     · Developing clear criteria for choosing between liquidation and reorganisation and establishing the conditions for rejecting competitive execution in favour of prolonging the period of external management
     · Strengthening compulsory qualification requirements for arbitration managers as well as introducing some form of control of their activity and liability for action taken in the exclusive interest of certain groups of creditors
     · Encouraging the formation of professional management companies involving trained professionals (liquidators, trustees, accountants, lawyers) specialising in the insolvency process
     · Introducing liability for intentional misuse of the insolvency process through fictitious bankruptcy petitions
     · Developing principles and procedures for the state to participate in all stages of bankruptcy proceedings (amongst the number of parties having the right to vote as part of groups of creditors)
     · Removal of legal limitations on wider adoption of out of court agreements between debtors and creditors, including those involving restructuring of debtor obligations
     In the interest of protecting the rights of companies from unfair attempts to seize control of their assets through bankruptcy procedure it is necessary to increase the ability of court institutions to refuse the use of bankruptcy procedures as a standard means to extinguish debt (possibly by referral to bad faith use of the rights established in Article 10 of the Civil Code). In order to initiate bankruptcy proceedings, creditors should be forced to establish clearly that no other means exist to pay off the debt in question.
     Within the framework of corporate law it is necessary to prevent the establishment of the type of "overnight" shell companies without proper capitalisation, which are used in operations diluting the authorised share capital of another company, in order to protect creditors and assist them in the recovery of losses incurred through this route.

     Pledges, mortgages and liens

     The legal basis for pledge law was initially formulated in the law On Pledges of May 1992, which established the right for a creditor/pledgeholder to satisfy his claims on a debtor through the disposition of the pledged property in advance of other creditors of the debtor in question.
     With the entry into force of the first part of the Civil Code in 1995, the legal basis for the fulfilment of contractual obligations (including pledges) was widened and a number of amendments introduced. The result is that Russian law now provides for a wide range of means to enforce contractual obligations including but not restricted to forfeit, liens, bank guarantees, downpayments and seizure of debtor property.
     The special character of pledge law resides in the fact that it has connections with estate law while the pledging of goods in production or inventories does not have such linkage. State-owned companies likewise have the right to pledge assets, within the framework of agreements for full economic control and operational management. In view of the wide range of possibilities this opened up for spontaneous privatisation, a special Letter on agreements for mortgaging of state property was issued already in 1992 by the Agency for State Property.
     The order of priority of satisfaction of creditor claims in bankruptcy proceedings is also of importance to the use of pledges. Credits secured by pledged assets in fact only rank in third place, after full satisfaction of claims of higher priority, with the result that there is no unconditional priority for secured creditors. This together with other unregulated aspects of property rights undermines confidence in security as a means of accessing external finance. In assessing the value of security offered as pledge, Russian banks usually attach the highest rank to bank guarantees from foreign or first class Russian banks, above government securities and easily realisable goods and real estate.
     On the other hand, companies may themselves hesitate to use the pledge mechanism in fund raising operations, being loath to offer a means for competitors to take control of the company or its assets. There are also certain purely technical improvements required in the giving and accepting of pledges, such as the need to develop procedures for avoiding the repeat pledging of assets already securing previous obligations, or elimination of notarial or other fees charged which can make pledging prohibitively expensive.
     For these various reasons, the use of pledged security seems to be the prerogative of large companies and banks able to defend their own interests. Controversies still abound, as is illustrated by the many highly publicised fights which have ensued in the post-crisis context over the blocks of shares pledged prior to the crisis by the large private Russian companies as security for foreign currency credits. It is estimated that the 17 largest private Russian companies had total such foreign currency debt outstanding of more than US $ 1 billion in August 1998. Acquiring these blocks of shares has become the object of many schemes and manipulations involving competitor groups and banks.

Trust management [section to be revised]

     The regulation of trust activities in Russian law is characterised by a certain duality - on the one hand it follows the Anglo-Saxon tradition relying on as entrusted property or estate law, on the other hand it has aspects of Romano-Germanic law as entrusted management.
     The sphere of trust activities is in fact quite widely developed in Russia, with the following examples that could be mentioned:
     · Management of investment funds and investment companies;
     · management of blocks of corporate securities;
     · private management of state-owned (federally or regionally) blocks of shares;
     · management of client deposits of equities and other assets by trust departments of commercial banks
     · asset management carried out by PIFs (investment funds) or OBUFs (bank-run investment funds);
     · management of creditor loan portfolios [factoring?] and budgetary payments (trusts in the sphere of discount, accounting and budgetary instruments)[??];
      restructuring of debt undertaken by special departments of trust companies.
     The incomplete and contradictory status of legislation relating to trusteeships (including the lack of definition of the concept of trust) has led to the widespread use of trust schemes to hide true ownership control, withdrawal and export of assets and tax evasion.
     The scheme by which directors or real principals of a Russian joint stock company transfer this company into management by an affiliated or dummy entity created for this purpose is well known. Similarly widespread is the establishment of an "impersonal" trust company abroad - offshore, either directly or via a chain of dummy trustees - through which a Russian joint-stock company or blocks of its shares and other assets are managed. The real beneficiaries or principals, be they the actual owners, the founders of the trust or the trust managers, can thus evade responsibility and control by the authorities.
     In the trust management of state-owned blocks of shares there is no guarantee that the assets under management are not plundered or diluted in some form, despite the very strict stipulations in the Civil Code regarding trustee responsibility for the managed object.
     For the further development of trust management in Russia it is necessary to address the directly contradictory regulations in joint stock company law (e.g. the prohibition of voting by prior agreement) in the tax code, in the insolvency legislation, etc. It is also necessary to stop the use of trusts for avoidance of antimonopoly legislation, for creating sham transactions and for fraudulent property transfers.
     To these problems can be added the existence of white spots and incomplete enforcement of legislation German joint stock law e.g. establishes full economic liability for a principal hiding behind dummy juridical persons.
     Thus, in order to develop a more satisfactory legal basis for trust relationships from the perspective of protection of property rights, the concept of split ownership [check terminology] must be developed and the mutual obligations of trustee and trust giver must be analysed for every concrete situation which arises through such relationships. This would require further borrowings from Anglo-Saxon legal tradition and is more a question of creating legally effective, clearly formulated, non-contradictory trust mechanisms rather than attacking the potential for criminal use of the trust concept within the overall weak institutional framework.

     Land and Real Estate Ownership

     In accordance with article 36 of the Russian Constitution, citizens as well as companies have the right to own land and are free to use and dispose of land and other natural resources as they see fit, unless this has any harmful effects on the surrounding environment or on other citizens. However, it is necessary to strengthen the legislative basis for market operations with real estate both by developing and adopting new laws or facilitating the practical implementation of existing ones such as the Land Code of the Russian Federation, Chapter 17 of the Civil Code "the Law on property and other estate laws relating to land" the legislation relating to land registry (cadastre), the laws on registration of ownership rights to real estate and transactions with such, on mortgages, on appraisal and valuation, on licensing of real estate agencies , on mortgaging state and municipal real estate, and others.
     Other areas where policy direction would be important are:
     · Development of a state system for registering real estate property and transactions therewith and to strengthen rights to land plots occupied by buildings;
     · Development of a system for real estate valuation;
     · Establishment of procedures for auctioning state and municipal real estate with land plots, including vacant plots;
     · Development of legal basis for insurance of property rights to real estate, including titles;
     · assessment of tax liability for real estate based on its market value and removing incentives in current legislation for artificial lowering of prices in real estate transactions;
     · raising standards and licensing requirement for real estate operators;
     · Introduction of administrative and criminal liability for illegal or unauthorised activities on the real estate market.
     An important element for further development of the real estate market would be the strengthening of property rights of privatised companies to the land on which they stand. Such rights would give them the possibility to devise more effective management schemes for the land in question and bring into existence the principle of "one company - on unified property complex ", giving the company full freedom of action over its property.
     Of special importance is the adoption of a full-fledged land code in the Federation. The legislation does not separate the rights to purchase and sale of land from the regulation of land use where concerns regarding the transfer of agricultural land into other uses has blocked progress on the land code. The present situation presents the problem that a number of regions (such as Tartarstan and Saratov) have introduced their own regional acts which already legalise unimpeded purchase and sale of land while the current Federal Land Code does not allow fully free transactions with land. Land is in fact divided into different categories : agricultural land, where sale and purchase are restricted so that e.g. transfer to private hands is allowed but without the right to further sale, gift or mortgage; land for personal use, where sale and purchase are fully free at the discretion of the owner; and land which cannot be sold or purchased (parks, reservations etc) . It has also been proposed that as a compromise, a sort of "long-term certificates allowing the possession of land" should be developed which could be sold and transferred as inheritance. Another compromise version which does not provide any real solution could be amendments to the Law on Mortgages which would allow for mortgaging agricultural land. In essence this would represent an interim solution to the freeing of land transactions.

     Transfer of property rights

     It is very important to develop a better system for securing the transfer of property rights, with respect to immediate notification and registry to avoid fraudulence. Procedures must be rendered transparent and technically standardised to avoid possibilities and opportunities for corruption as well as imposition of regional and local restrictions on transfer. In addition to a significant improvement in the general climate for business transactions, this would probably result in a substantial increase in the tax base. In the field of land and real estate, a new law came into force in 1998 concerning registry of rights to property and transfer thereof. More complete harmonisation of federal and regional legislation and practices in this area is still required, including the necessary documentation. Weaknesses in the pledge laws concerning immovable property represent a major problem in this area and the federal law on mortgages does not pay much attention to the protection of rights in the conclusion of such transactions.
     As concerns transfer of securities, the weaknesses in the registry dating from the initial development of the securities markets are well known. Following the improvements in legislation and regulation governing the activities of registrars, the following problems and infringements are still common:
     [to be inserted]
     The providers of depository services in the Russian securities markets have also been placed under stricter regulation in recent years, but a number of infringements of investor rights are still common, such as:
     [to be inserted]
     There are also a number of other infringements or lack of proper observance of regulations relating to the issuance, information disclosure, registration and distribution of securities which put investor at risk of having a purchase or sale invalidated. Similar concerns can arise in connection with clearing and settlement activities, for the finalisation of property transfers, and proposals have been raised for developing better regulation of such activities.

     Protection of Intellectual Property Rights [section to be revised]

     The protection of intellectual property rights is of obvious importance to the process of innovation in the real sector. The need to strike a balance between the individual rights of creators/inventors and the right of society in general to benefit from advances achieved in the arts or in science is normally addressed via patent law, as a means to protect ownership rights through the registry of inventions, authorship, industrial creations and product logos.
     The adoption of the draft third part of the Civil Code (section V on the exclusive right to intellectual property) should first of all codify into Russian legislation the various separate rights in this respect which are currently enshrined in a number of individual laws.
     Greater importance should be attached to the prosecution of counterfeiting production, pirating of software and other violations of intellectual property in the areas of art, literature and science. Amendments should be made to the law on product logos and much stricter protection would be needed of copyrights in the field of audiovisuals.

     3. Law Enforcement (Judicial system, dispute resolution, court procedures and execution)

     Introduction

     Numerous and sometimes widely publicised complaints have been raised by foreign investors in the Russian Federation concerning their experience with law enforcement. In order to discuss where the problems have been encountered and priorities for improvements to the system of implementing and enforcing the law in Russia, it is necessary to give a short overview of the system for dispute resolution within which investors currently operate. It is not the task of this study to assess or make recommendations regarding the structure and organisation of the judiciary in the Russian Federation. The more modest objective is to briefly explain the structure and to point to the problem areas where investors frequently have been left dissatisfied with the administration of justice.
     A certain historical perspective is indispensable to comprehend the current situation of the judiciary in contemporary Russia. During the Soviet era, the judiciary was not a separate branch of power but rather a subordinate state body. This lower status was not conducive to developing Party respect for the judiciary, which consequently was attributed a poor standing in terms of resource allocation, suffering from inadequate funding and training facilities for its staff. As the judiciary had not had the role of controlling the behaviour of higher state bodies in the past, it could not be expected to act as countervailing force to sanction the visible demonstrations of greed and appropriation of state assets which occurred when the process of perestroika was initiated, followed by the first wave of mass privatisation. Incumbent officials and managers could thus unhindered capitalise on previous positions and relationships within government institutions and regulatory bodies to further their own economic and political interests. This schematic background picture provides some explanation both of the lingering weakness of a resource-starved judiciary in current Russian society as well as of the strong distrust in the rule of law on the part of the general population. After all, the core element of the rule of law is that law applies in equal measure to the powerful and the non-powerful and that legal institutions have sufficient authority and independence to make meaningful the remedies imposed against the powerful.. Kathryn Hendley, "Trying to make law matter: Legal reform and Labour Law in the Soviet Union" (18-19) 1996.
     In addition to the lack of confidence in and respect for the rule of law in Russia and the continuing lack of accountability of the ruling political elite there are also several institutional barriers to effective implementation of legislation, which, in a more concrete sense, have been the subject of controversy for foreign investors. These are connected to the lack of independence of the judiciary from local political authorities and serious deficiencies in Russia's law enforcement system, in turn related to the continuing low status of the judicial system mentioned above.
     Many problems for investors arise from the limited approach of the courts with regard to the interpretation of legal norms. This is directly related to the limited opportunities of Russian judges to become fully trained in the law, and to fully understand new economic concepts embodied in legislation.
     Staffing is a serious problem in the judicial branch of power, due to under-funding. It is encouraging to note the statement by acting President Putin in December 1999, advocating "a larger role and greater authority for the judiciary." Increasing the prestige of judicial power, attracting qualified specialists, training currently working staff, guaranteeing real independence of the judges - these are all necessary steps in this direction. Special attention must be paid to the system of enforcement of legal rulings and other decisions. There have been numerous cases where court decisions have not been carried out because of undue influence on enforcement officers or the absence of effective enforcement mechanisms.
      should be emphasised that a general problem with law enforcement in Russia relates to the lack of institutions and markets developed to a level where execution of court orders can be facilitated. In the previous system, with its limited degree of property ownership and other economic freedoms, such as e.g. the use of bank accounts for funds transfer, there was no need to develop systems and mechanisms to register, trace or freeze various categories of assets. Such mechanisms and supporting information disclosure is only gradually being built out, in line with growing requirements of business transactions and relationships. As systems registering ownership claims are normally developed on the very basis of commercial requirements rather than being created specially for legal enforcement purposes, it would probably be too costly and possibly counterproductive to implant such services ahead of the needs of general commercial activity.

     The judiciary

     The administration of justice is the exclusive function of the judiciary in accordance with article 118 of the Constitution of the Russian Federation and article 1 of the Law on the Judiciary System in the Russian Federation.
     · - Arbitrazh courts
     · - Courts of General Jurisdiction
     · - Arbitration (third-party) tribunals
     · - Procuracy
     · - Specialised bodies
     While the first four can issue binding resolutions in some form or other, the two latter serve different functions: the procuracy is the public prosecutor who has the authority to bring cases to represent the interest of the public or the state and to appeal some judgements or awards whether or not initiated by a procurator. The specialised bodies are responsible for the enforcement of the law in any particular domain (customs, tax or competition policy) with the aid of special procedures and may have powers to issue mandatory orders, fines and otherwise intervene in cases within their respective competencies. In certain cases they (viz. the Antimonopoly Ministry) may serve as a forum for resolving disputes between parties concerned by a dispute in the relevant area. Any specialised body empowered to act in matters concerning commercial activity may become involved in legal disputes following appeals by one or more of the parties in the dispute on grounds of violation or misapplication of procedural legislation.
     The courts are organised in three tiers, territorial courts, an additional tier of ten courts assigned broad districts serving as review instance of cases of legal error etc and the Supreme Arbitrazh Court, which is the highest instance. It is charged with administration of the system, review of its practices and to summarize practice, providing information and guidance to the lower courts.
     The general jurisdictional rules of arbitrazh courts do not distinguish between the parties on the basis of resident or non-resident status of legal entities or the citizenship of individual entrepreneurs. Exceptions are if an international agreement of the Russian Federation contains provisions affecting the rules of the case, or if it concerns immovable property located outside the Federation or if it concerns transportation where the transport agency is located outside Russia.
     The courts of general jurisdiction consider all criminal cases, civil disputes concerning citizens who are not individual entrepreneurs and appeals of administrative and other action which does not fall within the jurisdiction of other courts.
     Although the arbitrazh courts cover most standard types of business activity, there are a few cases of relevance to commercial activity which currently fall within the courts of general jurisdiction rather than the arbitrazh courts. These relate to:
     appeals against normative acts (rules or regulations with binding force) as being inconsistent with a law or with legal rules of superior force. Examples may be the application of tax or customs rules, in complaints filed by a legal entity against a state body.
     cases where an individual who is not registered as an individual entrepreneur is a party. Disputes in a simple partnership where one or more of the founders is an individual would be an example. Disputes arising from the conduct of a company's management or employees may also fall into this category, if the suit is brought by an individual shareholders e.g. - only if the shareholder were a legal entity would the case be heard in an arbitrazh court.
     Like the arbitrazh courts, the courts of general jurisdiction are organised in three tiers, headed by the Supreme court of the Russian Federation, with the second tier being the courts of the subjects of the Russian Federation and the lower tier constituted by the district courts. In some regions there are also peace courts established for minor criminal, administrative and civil cases. There is still uncertainty as to the status and subordination of the regional courts to the Supreme Court - in principle the law now considers all courts to be Federal courts and the Supreme Court to be the directly superior court of the respective supreme courts of the constituent regions of the Federation.
     The Constitutional court does not have involvement in commercial disputes unless there has been a challenge to the constitutionality of laws or another legal acts applicable to commercial matters. This court has in recent years issued a number of important decisions on such matters as the confiscation of property by customs authorities, liability for late tax payments, imposition of fines etc. The decisions of the Constitutional Court are binding on all courts, whether arbitrazh or of general jurisdiction and on all other officials and bodies of the Russian Federation.
     Arbitration tribunals (not to be confused with the arbitrazh courts) existed in Russia in the 19th century and had a fairly wide use for commercial disputes until the Revolution, after which they gradually ceased to function. The possibility of resort to arbitration reappeared in the 1990s and by 1997 there were some 250 permanent arbitration tribunals in operation, mainly handling dispute resolution in very narrowly defined specialty areas. Only a small number have broad general jurisdictions.
     The Soviet Union was a participant in the New York convention on the Recognition and Enforcement of Foreign Arbitral Awards and the Russian federation succeeded it as a participant in 1993. A law on international commercial arbitration was passed in the same year, applying the requirements of the New York Convention and establishing a similar regime for the decisions of arbitration tribunals in Russia with respect to international commercial matters. Some of the domestic arbitration tribunals also accept commercial cases with international character, such as e.g. those under the Moscow City Chamber of Commerce - and, for specific areas, the MICEX facilities for arbitration and those of the national association of stock exchanges. A major problem exists in the lack of coherence amongst different laws regarding domestic arbitration and its applicability to cases involving foreign elements, which must be resolved in line with the growing presence of foreign investments in Russia….. [rewrite para…also mention the Russian ICAC ]
     It should be noted that the transfer of any dispute from the arbitrazh or general court jurisdiction to arbitration requires a specific clause or agreement between commercial parties, as there is no general assignation by law of cases to arbitration tribunals.

     4. Problem areas and current reform proposals

     Some critics of the existing duality of the court system are of the opinion that it could have a negative effect on the development of jurisprudence. As the arbitrazh courts and the courts of general jurisdiction are called upon to apply many of the same legislative provisions in resolving disputes, there is an unavoidable overlap in development of court practice. There is also the problem for plaintiffs that cases may arise where there is some degree of uncertainty as to which system it belongs in, although the two systems of courts do make an effort to coordinate their approach to questions of jurisdiction and sometimes are willing to hear a case close to the line of division. Proposals have been made in the reform programme of the Putin administration to eliminate this duality of the court system by unifying the arbitrazh courts and the courts of general jurisdiction. Similarly it has been suggested that the three Supreme Courts should be unified into one. The opposing point of view is that this would jeopardise the administration of justice as the courts of general jurisdiction have little experience in handling commercial cases.
     Another major problem concerns the lack of independence of the territorial courts from the political authorities in the different subjects of the Federation. As a shareholder or investor plaintiff can only bring a suit against a juridical person - a company having infringed his rights - in that company's own geographical locality, foreign investors are particularly exposed to the potential interference of authorities in support of local entrepreneurs. In the overwhelming majority of cases (70 per cent according to certain estimates) such disputes are decided in favour of the respondents. It seems to be the general opinion in Russian business circles that the arbitrazh court system is used in the regions as an effective means to thwart the interests of outside firms which may be considered persona non grata by local authorities.
     This is again an inherited weakness for the Soviet period, when theories of separation of power were not accepted. The courts were not seen as a third branch of government with corresponding authority and independence, but rather as subordinate to the higher bodies of the state. No court could invalidate a legislative or regulatory act. Judges were appointed for short periods by government bodies of the same territorial level as the relevant court and usually were dependent on these authorities for reappointment and also for some part of their material support. In the beginning of transition attempts were made to reduce regional or local interference in judicial decision making by having judges appointed at higher level of state administration than that at which the court functioned. Attempts continue to prevent influencing by regional and local governments and to increase financing and provision for court officials while at the same time making them independent of the sources of support at local or regional level. More radical proposals have also been made for the establishment of full extraterritoriality of lower courts to remove them from influences of regional administrations .
     Despite the extraordinary actuality of judiciary reforms for the protection of property rights, the key texts of the Presidential-governmental reform programme for the year 2000 say very little about this subject. In the missive sent by the President to the Federal Assembly, there is talk about the "downgrading" of courts through the fact that their decisions and judgements have often been ignored by regional and local authorities. The list of priority tasks for the reform programme does not bring this problem up.
     Nevertheless, such separate problems as financial resources, qualifications of judges, corruption in the administration of justice in the whole or through puppet federal or regional courts and officials are very pressing. The latter problem directly infringes the constitutional rights of citizens and juridical persons, as the dominus litis in actual fact becomes the implementing organs of the judiciary.

     Execution of Court Judgements

     The 1997 Law on execution proceedings regulates the details of the enforcement process, while the service responsible for execution of judgements - the court bailiff service - was established by a special law, also adopted in 1997. This service is organised as an executive body attached to the Ministry of Justice. It is principally funded by the federal budget, but also relies to some extent on additional regional contributions as well as an element of self-finance through retention of part of execution fees imposed on respondents in cases of non- voluntary compliance. There are also some incentive payments provided for the court bailiffs.
     A feature of the Russian system of law enforcement is that the receipt of a court decision containing a judgement is usually not sufficient for execution, but the plaintiff has to take additional action to ensure that the decision in his favour is executed. The award of a sum of money or a performance or the transfer of property by a court decision requires an accompanying execution order from the court, valid for a specified time period.
     It is important to note that execution orders can only be issued by a Russian court which means that all arbitral awards and decisions of foreign courts must be recognised by a Russian court and an execution order issued by this court on the basis of the foreign award or decision.
     Limitation periods of these orders are usually set as six months in arbitrazh courts while for execution of foreign judgements or arbitration tribunals, the limitation period is three years.
     A number of practical problems have been encountered by foreign investors in the execution of court judgements, of which most are linked to the general deficiencies in funding, staffing, training and/or degrees of corruption plaguing the judiciary noted above.
     One problem area relates to the fact that the court bailiff is not obliged to conduct a search for a debtors assets - and the lack of comprehensive registry mechanisms may in fact make such searches pointless. The cost for any searches undertaken must be met by the creditor.
     A debtor has right to indicate which assets should be executed against first if existing monetary assets are not sufficient. However, the final determination of the order of priority is set by the court executioner and this power has engendered a large field of opportunities for corruption.
     As in the insolvency process (see page?) the order of priority of claims in case funds are insufficient to cover claims of all judgement creditors may reduce the incentives for a claimant to complete the execution process if higher priority claimants are present. Claims arising out of the normal conduct of business take the lowest priority following debts to employees, to state pension, employment and insurance funds and to the budgets of any level of state authority.
     A general difficulty concerns the conduct of auctions of property seized in cases where monetary assets are lacking. Apart from the problems of valuation and disposal of physical assets in situations of non-existent or underdeveloped markets this field again has given rise to many corrupt practices with respect to valuation, selection, hiding and retention of assets.
     An unresolved problem linked to the balance of debtor/creditor regimes discussed in section ??? concerns the requirement for the court enforcer to inform the Federal Bankruptcy Agency regarding execution proceedings involving the basic productive assets of an enterprise. The Bankruptcy Agency may in turn feel compelled to inform other creditors. If any other creditor or the Agency itself opts to initiate an insolvency procedure, the execution order will be suspended.
     Another problem which at times has received attention in the international press concerns the lack of execution of the decisions of international arbitration courts. As Russia is a signatory of the New York Convention regarding recognition and implementation of international arbitration awards, Russian courts should rightly only be concerned with the possible contraventions of procedure for the administration of the decisions in question - which could contain infringements of the rights of either party - and not examine their content. The actual situation here is complex , since the lack of due procedure for administration of justice is often invoked by the local coutrs, on the one hand while, on the other hand Russian companies frequently claim to have been unaware of the procedures and regulations they may come into contact with through accepting international arbitration. However, the fact remains that there are numerous cases where international arbitration awards and decisions are directly ignored by local courts on spurious or trumped-up grounds.

     Public Sector Governance

     Corruption of public officials is not a phenomenon unique to the authorities at federal, regional and local level in the Russian Federation, as it is a common social and political problem in both developing and economically advanced countries around the world. In the context of transition countries, of which Russia can be considered part, the massive undertakings of wealth redistribution in combination with a fragile institutional framework, recently erected or still under construction and fragmented social cohesion, a high degree of corruption is to be expected. Why Russia has frequently been ranked among the most corrupt countries in the world has much to do with the scale and scope of the initial privatisation as well as the fact that its public administration was largely left in place, with the grafting of new management and units onto existing Ministries and agencies failing to remove the "control" culture of the previous era.
     As to the impact of privatisation on criminalisation, estimates by the Ministry of the Interior indicate that some 40 thousand businesses were controlled or created by criminal entities, as elements and groups linked with the "shadow" economy came to the forefront of economic life in this process. Further estimates show some 70-80 per cent of privatised firms as well as banks paying various forms of tribute to criminal groups, racketeers and public officials. Commercial companies are said to allocate 30-50 per cent of profits to ensure "special relations" with representatives of the authorities.
     Although there have been additional legislation as well as concerted campaigns to crack down of this form of corruption, the resort to mere policing is made difficult by the scale of potential remuneration compared to average salaries in public administration. A presidential address dating a few years back regretfully stated that "the risk of being persecuted is totally out of proportion to the profits to be gained from criminal activity".
     The lack of fundamental reform of public administration can be illustrated both by the strong growth in central government through proliferation of new, additional structures with supporting territorial arms and by the fact that middle management levels inherited from the former system were at least until recently left relatively undisturbed. As a result, competing and overlapping structures limited possibilities for effective horizontal co-ordination, while the retention of large numbers of officials from the former system perpetuated the mentality of "state control" with bureaucrats vested with licensing and other powers on a discretionary basis.
      petitioning culture that persists, with many tens of thousands of appeals received by the government apparatus annually indicates that too many decisions rise to higher levels in the hierarchy, preventing the proper exercise of strategic management functions at the top echelons. Too much discretionary authority in a system that still relies heavily on permission-based procedures rather than notification requirements is a good breeding ground for corruption. The concept of conflict of interest is also underdeveloped.
     The combination of complex laws, government control over key assets and low level of remuneration of government agents, weak enforcement and control mechanisms provides a breeding ground for corrupt practices. Furthermore, given the sheer number of sometimes conflicting regulation in tax and other areas, most businesses are in violation of some regulation or other and can thus be free game for pressures for bribes by officials. Regulatory reform and simplification of procedures are key steps to reduce opportunities for corruption. Increase in salary levels, introduction of laws against conflicts of interest, strong independent controls, credible enforcement and penalties are also to be recommended.
     Although the present government has included among its objectives the transformation of the public administration into a merit-based, transparent and accountable civil service, it is a long process given the scale of the problems and the resources required. Nevertheless, the fundamental goals of improving service delivery, strengthening accountability and developing a performance driven culture with a focus on cost-effectiveness are clearly incorporated in the programme. For the immediate future it would seem that significant results could already be obtained by raising wages and salaries to the level needed for weakening the motivation for corruption, while at the same time liberalising and eliminating discretionary procedures through the removal wherever possible of quotas, ceilings, permissions, licences etc.

     Private sector governance issues

     [to be inserted]

     CHAPTER II. THE REGIONAL DIMENSION:
     INVESTMENT POLICIES AT SUB-FEDERAL LEVEL

     1. Introduction

     The Russian Federation consists of 89 federal "subjects" or regional administrative units largely reflecting ethnic divisions of Soviet times. The largest units (21) are classified as republics (ethnic homelands with elected presidents), others (49) known as oblasts (provinces run by elected governors), krais (6 territories also under elected governors) or okrugs (11 ethnic sub-divisions of oblasts or krais) - all designations for national autonomous areas. The cities of Moscow and St. Petersburg are independent federal entities or subjects with elected mayors. Each of the 89 federal entities has its own administration and foreign investment policy or regime.
     Russia is also divided up into 11 economic regions without administrative status and, loosely based on these, eight interregional economic associations which group together federal subjects with common economic interests. In some cases these associations exercise strong lobbying power in Moscow.
     Under Boris Yeltsin, there was considerable devolution of power to the regional governors and authorities, encouraging the evolution or continuation of regional legislation and practices and weakening central institutions. This followed on a period of almost three years between 1988 and 1991 when over forty of the former Soviet republics declared themselves to be sovereign in what is now referred to as "the parade of sovereignties". While some republics ultimately became independent states in their own right, other republics - namely the former Autonomous Soviet Socialist Republics (ASSRs) - now largely constitute the 21 republics of the Russian Federation. Their varying claims and aspirations towards self-rule, sometimes strengthened by the prospect or threat of eventual secession, were accommodated in individual bilateral treaties regulating their relationships with central government. In addition, many oblasts, krays and autonomous okrugs also negotiated special privileges sanctioned by treaty. Forty-six of the eighty-nine subjects of the Federation have bilateral treaties with the federal government, starting with Tartarstan in February 1994 and including, most recently, the City of Moscow in June 1998. Thus this period saw the creation of a complex and difficult - sometimes termed asymmetric - basis for the evolution of healthy federal structures.
     The resulting inconsistencies in the application of central government policy and legislation by the regional administrative units stem from their different levels of economic and political power which up to now has influenced the level of autonomy which they have been able to assume unilaterally or been accorded in the framework of special agreements. The climate for investment and business activity in general has suffered accordingly through frequent and unpredictable changes in rules, regulations and practices and lack of transparency, with considerable costs and insecurity for entrepreneurs.
     A prominent example of unilateral regional assertion of power was the initiative taken by some governors to introduce their own emergency measures in the aftermath of the August 1998 financial crisis. These were largely unconstitutional measures such as price controls and customs duties imposed at regional level as well as the withholding of taxes due to the federal centre. Thus, during the period in question, the central government was unable to effectively exercise authority at regional level.
     Since assuming power, President Putin has evidenced his intention to claim back and strengthen power at the federal centre at the expense of regional autonomy as a matter of priority. By the late summer of 2000 his programme of administrative reform had already resulted in amendments of laws defining the legislative and executive powers of the federal subjects and the introduction of a new law reconstituting the Federal Council (upper Chamber of the Federal Assembly). With the stated objective of creating what the President termed "a unified legal and economic space in Russia", the programme and supporting legal amendments provide for the following important elements of reform
     · the removal of governors and heads of regional legislative bodies from the Federation Council. A State Council without legislative powers is to be created which will include direct representation by regional governors;
     · the powers for the President to dismiss governors who repeatedly violate federal law by enacting regional laws in contravention of federal legislation, and powers for regional governors to similarly remove the heads of local administrations
     · the reassignment of regional representatives of the federal government entrusted with monitoring the compliance with federal law to seven major supra-regional districts.
     The new federal supra-regional districts (Central, Far East, North Caucasus, North-west, Siberia, Urals and Volga) do not readily correspond to the existing interregional associations of federal subjects with shared economic interests, but rather to the regional break-down of the military administration. They vary greatly in size, accounting individually from 5 to over 25 per cent of the Russian population. The responsibility for the economic development of the new districts is being entrusted to newly appointed Presidential Representatives who have been selected mainly from a military background and are largely unfamiliar with the federal districts to which they have been assigned. The Presidential Representatives are empowered to ensure that the central government's policies are implemented consistently throughout Russia and report directly to President Putin. Given the structural differences in the new supra-regional districts, their administration will present specific economic and political challenges in each case. The ultimate challenge shared by all new Presidential Representatives will be the successful implementation of new structures and systems in the regions following the dismantling of existing ones. Although the more popular interpretation of these measures in the media attribute them to the need of exercising stricter control of any potential anti-constitutional activity by the Governors, experts attach more significance to the objective of extricating territorial offices of the federal organs from influence of regional and local political authorities. It has been announced that other federal bodies will now be represented at this new district level rather than in each region. Such bodies include the Ministry for Taxes and Collections and the State Customs Committee. The intention is clearly to break up former alliances between the territorial offices of federal organs and regional administrations which have served to undermine federal power. (Update as situation evolves)

     Legal Basis for Division of Competences

     The Constitution of the Russian Federation is the main instrument through which powers and areas of jurisdiction are devolved to different levels of government. It makes provision in principle for legislative measures taken by federal subjects or regions to comply with those laid down in the Constitution.
     The Constitution specifies that major issues of economic and foreign policy and international treaties and relations fall within the jurisdiction of central government. Jurisdiction is shared with the regions for matters such as co-ordination of Russia's international and external economic relations and treaty obligations, ownership and use of land and all natural resources and state property, environmental protection, public health and taxation. Areas not specifically addressed in the Constitution are considered to be the domain of the regions and both the regions and the central government may assign authority in any matter to each other. Equal treatment of all regional administrative entities is also provided for in the Constitution.
     The conclusion of a number of bilateral treaties and agreements between the central government and over half of the regions which continued up to 1998 has provided "quasi legal" cover for the independent and differing regional legislative practices and their (frequent) lack of conformity with the provisions of the Russian Constitution in areas affecting investment, among others. These agreements generally reflected the status and bargaining power of the local politicians or particular (unique) characteristics of the regions and resulted in widely differing powers and responsibilities in terms of area and scope. Frequently they provide for regional responsibility for areas such as borrowing on international capital markets with the backing of the local government, investment promotion and the creation of regional free economic zones. They and the Constitution are, however, left open to broad or narrow interpretation by local officials and politicians which may result in policies and decisions that are, in a strict sense, in conflict with federal law.
     Whilst much of the legislation at regional level appears to conform with the Russian Constitution or with formal arrangements with the central government, there are definite contradictions and inconsistencies in its implementation in some regions which affect key areas such as land ownership and foreign investment policy and practice. Samara and two other regions, Saratov and Tartarstan, have, for example, already passed regional legislation to adopt a market-oriented land code which still remains an unresolved problem at federal level. (see Chapter I above). This means that, in practice, investors holding legal title to land in these regions could still have their ownership rights contested in a federal court.
     It should also be pointed out that deficiencies and contradictions in the legislative framework are felt also at central government level in struggles among ministries and other institutions for dominance over segments of the economy, leading to duplication of activities, administrative hurdles for investors and corruption within the public sector. An example of such a situation is the conflict between the Ministry of Finance, Central Bank and the Federal Commission for the Securities Market regarding regulatory control and oversight of the Russian financial markets.
     Both at regional and central government level this unsettled and unclear situation favours the development or maintenance of power bases by individual officials within institutions. This is characterised by a tendency to monopolise both functions and powers which results in the concentration of authority in the hands of such - often senior - officials. This background is very conducive to administrative barriers, corruption and other obstacles and costs which particularly affect the investment and business climate in Russia.
     The new administration has focussed its attention on these problems and their effect on business activity and competition. In a recent statement following a review of the status of legislation in the regional districts, President Putin referred to 6000 local laws which were found to be in contravention of federal legislation. The programme of strategic development for Russia for the period 2000-2010 is specially oriented towards the creation of a favourable investment climate with particular emphasis on the reduction of administrative barriers for investors.
     FDI issues and policies fall under the jurisdiction of the Department for International Investment Co-operation at the Ministry of Economic Development and Trade which is also responsible for co-ordinating these activities at both federal and regional level. A new Law on Foreign Investment in the Russian Federation was approved in 1999, replacing a former Foreign Investment Law of 1991 which was amended in 1993, 1995 and 1997. It covers all forms of foreign investment permitted in the Russian Federation with the exception of investment in banks, other credit institutions and insurance companies which are catered for by different legislation. (see Part I, Section XX)

     . Diverging Regional Investment Policies

     The profiles of the Russian regions differ greatly in terms of economic prosperity, industrialisation, infrastructure and financial independence vis-à-vis central government. Their commitment to attracting foreign investment also varies considerably. Such factors inevitably influence their links with central institutions and approach to economic policy in general and to investment policy specifically. Consequently, the levels of international investment and business activity in the regions present substantial variations. Whilst natural resources have attracted many foreign investors in some regions, those with an overall positive approach to business development also increasingly have a degree of success despite structural and other disadvantages. Big urban centres have also proved more attractive to investors to date and generally trade and investment activities are very concentrated on a regional basis : only 20 regions in Russia account for approx. 80 per cent of the country's exports, 20 regions accounted for approx. 85 per cent of total FDI in Russia between 1993 and 1998. About 30 per cent of the country's exports and over 50 per cent of FDI in Russia is concentrated in Moscow and the surrounding region. (update as available).
     An analysis of the investment climate of selected regions clearly highlighted typical characteristics of regions which different approaches to and a varying degree of success in attracting foreign investment. In terms of attractiveness for FDI, regions in Russia can be broadly characterised as being conducive, unconducive or neutral. The regions of Leningrad and Novgorod are examples of investment bases without notable natural resources, but with favourable business climates which, in addition to basic attractions (geographic location, labour pool, infrastructure), also have relatively clear and consistent regulatory and administrative environments to facilitate foreign investment. On the other hand, investors encounter an inhospitable environment for their business activities in Pskov despite its excellent location for foreign and domestic markets. Problems here as indeed elsewhere in Russia include an inefficient regional administration which is inflexible in accommodating foreign investors who face the major barrier of being "forced" into joint ventures where possible. The resource-rich Komi Republic offers considerable potential for investors, but has done little to create a favourable investment climate. Local investment promotion policy is unclear and incentives are limited - in some cases investors have been required to sponsor local services (e.g. school) to gain access to the region. For some investors, however, these problems, the unfavourable location, infrastructure and business environment are offset by the availability of natural resources - a situation also found in many other resource-rich regions of the Russian Federation.
     It is clear therefore that the regional administrations follow very individual and diverse economic policies, from liberal to interventionist with varying degrees of subsidisation, regulation and use of taxation to protect (vested) interests or achieve other specific economic or social objectives. Attempts have been made to categorise the regions in terms liberal or interventionist regimes - one study describes an "internal border" separating the "Red Belt"(southern Russian regions with pro-Communist electorates) from the rest of Russia. In this "Red Belt" area economic reforms have been less liberal and slower in pace than elsewhere in Russia and show signs of interventionism. In reality, however, it is difficult to accurately depict a rapidly changing situation as economic policies in some regions shift frequently
     As mentioned above, very different legal environments have evolved on the basis of treaties and agreements with the central government . In addition it is difficult to address the many discrepancies which arise between written laws and informal arrangements which prevail in many regions and have a crucial influence on trade and investment policy, particularly in terms of regulatory procedures.
     The central government cannot keep pace with diverging interpretations and infringements of federal legislation affecting the investment climate in the regions. Some regional governments simply lack the expertise to implement international business standards and practices, information flows in both directions are inadequate and co-ordination lacking in many economic policy areas.

     4. Concrete Barriers and Obstacles faced by Investors

     Although most regions acknowledge the importance of investment for their economic development and future prosperity and do address this question in their own legislative practices, particularly in the areas of registration formalities and incentives, the major concern for the business and investment community is the complex set of administrative barriers which are created or aggravated by the situation described above.
     These barriers occur mostly at regional, but partly also at central government level, despite the fact that the Russian Constitution provides for freedom of economic activity, free movement of goods, services and financial assets and open competition. Though not necessarily consistent or constant in their structure or over time, these barriers can take the following forms:
      restrictions on the creation of new business entities or on the activities of existing ones (e.g. procurement and renewal of licences and arbitrary changes in licensing procedures and requirements in violation of federal laws);
     · imposition of specific suppliers of goods and services on business entities;
     · anti-competitive privileged treatment of certain business entities over others;
     · combination of functions of business entities and official institutions (i.e. combined business and regulatory activities in one entity);
     · over-complex administrative procedures and requirements, state control and regulatory structures for businesses, unauthorised interference with business management;
     · unfair or incompetent performance of duties by officials; breach of contractual obligations;
     · unstable legislation, inadequate access to information.
     The prevalence of these barriers at regional level is attributed to the above described lack of a unified legal space in the Federation. According to data from the Russian Office of the General Procurator, the regional authorities passed over 1,700 legislative acts in 1999, one-third of which fail to comply with the provisions of the Constitution. Since governors have enjoyed parliamentary immunity as members of the Federation Council, the use of their powers as head of subjects of the Russian Federation for the advancement of particular regional interests or even personal enrichment - particularly in business-related areas - has been without direction sanction.
      following are some examples of administrative barriers which occur only at regional level:
     · sale bans on goods or services from one Russian region in another or restrictions on business activities from one region to another; price-fixing; handling of licence applications and fees;
     · tolerance of legislation in contravention of federal legislative provisions;
     · impediments to debt collection among enterprises.
     In particular foreign investors have noted a proliferation of bureaucratic barriers at regional level involving additional licensing and product certification requirements. These also apply to domestic investors, but complaints have not been as forceful - it is suggested - either because the problems are so widespread as to be trivial or simply because they do not perceive themselves as being singled out for harsh treatment.
     There is no comprehensive incentives programme for investors in Russia and this in itself is sometimes perceived as a barrier to foreign investment. Legislation on foreign investment in the Russian Federation provides a basis for the introduction of incentives at federal level by presidential decree and government acts. There is, for example, a general federal provision for an investment tax allowance for expenditure on depreciable productive assets. In fact those incentives on offer are primarily of a fiscal nature and target small enterprises (max. 150 employees), employers of handicapped persons and R & D expenditure or specific sectors such as banking, film production and distribution, mineral resource industries or automobiles. Other special incentives are directed at large-scale FDI in the manufacturing industry and mainly involve reduced tariffs on imported goods under specific conditions laid down in individual investment agreements with large investors (min. USD 10 million in equity capital). Exemptions from foreign exchange regulations are also sometimes granted. These exceptional and occasional incentives have, however, proved cumbersome to implement and conflicted with existing legislation in part as well as encountering resistance at regional level. The new Law on Foreign Investment in the Russian Federation attempts to address this problem and legalise special incentive packages by formally defining so-called "priority investment projects" and requiring their inclusion on a list of such projects with government endorsement. (see Part I, Section XX)
     The new investment law also empowers Russian regions and municipal authorities to provide incentives to investors from their own budgetary resources and this is now widely practised within the limits of the share of federal tax revenues allocated to the regions, with certain incentives and exemptions being restricted to foreign investors. It is estimated that in the first half of 2000 that the value of investment incentives granted in the regions represented the sum of 70 billion roubles of their federal tax revenue allocations.
     Certain types of incentives tend to be preferred by regions with industrial structures or economic problems in common: incentives based on excise on alcohol production in regions where this sector is concentrated and VAT-based incentives (which specifically contravene federal legislation !) and exemptions from local taxes in economically depressed areas.
     The regional incentives offered are generally tax-based. Given the serious budget deficits in many regions, it is more likely that the loss of revenue through fiscal incentives will constitute an additional burden on the regions and maintaining them possibly at the expense of investing in a sound and fair tax system, legislative framework and good general infrastructure is likely to be the least cost-effective and viable approach to investment promotion in the long-term.
     There is also evidence that the unsystematic use of fiscal incentives in Russia distorts competition, has given rise to monopolies and discrimination, and is conducive to corruption. The potentially counterproductive nature of such inducements is already evident in some regions where the high level of incentives offered is attracting investors solely to avail themselves of the lower tax liabilities without conducting any business or investment activity whatsoever. A similar situation was found in the so-called "closed autonomous territories" - former military centres - where substantial fiscal privileges were offered to companies in the past. These powers have been considerably reduced in the budgetary legislation for 2000.
     While the international policy debate on whether and which investment incentives are actually cost-effective has not reached any conclusion, it is acknowledged that low tax burdens through fiscal incentives do not generally by themselves attract FDI. Here the limited amount of investment in the many low-tax regimes in Sub-Saharan Africa can be taken as an example, suggesting that a difficult business environment is not offset by generous fiscal - or indeed other incentives. A reasonable and transparent taxation system and administration coupled with underlying stability for economic activity, including confidence in the rule of law, are considered to form the basis for most investment decisions - rather than low or even no taxes. Internationally, many of the governments most successful in attracting FDI are also among those that best meet the requirements for good governance, which in turn lends credibility to the particular incentive programmes operated. In this context, it would seem particularly important for Russia and its regions to stress the need of moving away from discretionary incentives towards reliance on rules-based means of attracting FDI.
     Aside from the relatively widespread fiscal incentives, Russia has had the ambition of promoting foreign investment through free economic zones and two federal laws also provide for their creation in different parts of the country offering tax, duty and VAT exemptions under certain conditions. The first of these were established in the second half of the 1980s and several more were created in 1990-91 by government resolution. Examples of these are found in Kaliningrad in the Baltic region and in north-east Russia. These free zones had little obvious impact on investment inflows initially and failed to thrive or expand for economic and political reasons and against an unclear and constantly changing legal background.
     Further legislation passed in 1997 envisaged two different types of free economic zones - those designated for export production and others for industrial production and trade. Both categories allow for duty-free zones and exemption from the obligation to surrender foreign exchange earnings as well as the right to settle accounts in foreign currencies. Here again the incentives offered are tax-based, ranging from profit tax exemption to tax deductions for expansion or modernisation projects and reduced or zero VAT rates under certain conditions. Additional incentives may also be offered by the regional authorities in accordance with their areas of jurisdiction. The specific conditions for investment projects to qualify vary from location to location and are stipulated by regulatory basis for the individual zones.
     The approval process for the creation of free economic zones is relatively simple - the central government takes the decision on the basis of a feasibility study for the proposed zones. In practice, however, many zones still fail to materialise or remain confined to existing enterprises. The continuing lack of success of the zones as FDI bases in recent years has been attributed largely to inadequate accompanying investment in, or poor quality of, the surrounding infrastructure.
     The free economic zone in the Kaliningrad region is a typical example of one with a troubled history: it was created in 1991 but failed to function initially for legal and regulatory reasons. Over time the list of incentives on offer in the zone constantly changed with the cancellation of certain types of incentives.
     Although the regulatory basis for the zone was strengthened, it has had no significant success in attracting foreign investors. Furthermore the particular duty-based incentives offered led to loss of duty revenue and smuggling whilst the lower import duties for goods handled through the zone discouraged local investments in the agricultural industry. Duty-free import quotas have been introduced successively to combat this problem.(update)

     5. Investment promotion

     In addition to the Department for International Investment Co-operation, the Ministry of Economic Development and Trade has a Foreign Investment Promotion Centre (FIPC) with the task of attracting and facilitating investment in the Russian Federation. Its investment promotion methodology is based on practices of established European agencies (IDA Ireland) and other institutions such as the Foreign Investment Advisory Service and the Multilateral Investment Guarantee Agency. A private sector initiative which has benefited from the active support of the former Ministry of Economy. The Foreign Investment Advisory Council (FIAC), was created in 1995 with representation by major international corporations. Its role is to develop concrete recommendations for the government on improvements to the investment climate in the country.
     The Ministry of Finance, the State Property Committee (GKI), the Fund for Federal Property (see also section on Privatisation), other state services, the Russian Central Bank and a number of other associations and chambers of commerce also provide different forms of support for incoming investors. (???)
      is also a growing understanding among many individual regions of the Russian Federation that it is of crucial importance for their economic development to actively promote and compete for foreign investment. In addition to regional legislation permitting special local incentive packages, efforts are being made in some regions to establish competent promotion agencies ("one-stop shops") to handle incoming foreign investment proposals. In some regions, interagency committees have been created for this purpose. (more info needed here).

     CHAPTER III. TAX SYSTEM

     Ongoing reforms and policy options for improving the investment climate

     1. Executive Summary (move to Final Policy Recommendations Chapter?)

     Complaints from foreign investors about the excessive tax burden imposed on their operations in the Russian Federation have, in the main, originated from the multitude of different taxes levied and, importantly, from the methods of determination of the actual tax base. Statutory tax rates in Russia prevailing during the transition period have in fact not been very high by world standards, except in the case of payroll taxes.
     Many studies and reports have pointed to the fact that the Russian tax system consistently discourages investment, both through its structure and the manner it has been implemented. This fact remains true for domestic as well as foreign investors, whether we discuss start-ups of new business or the restructuring of existing firms. The frequent changes in rules and regulations have created a degree of uncertainty, which impacts negatively on business development as a whole.
      this situation has prevailed throughout the transition period cannot be ascribed to a lack of understanding of the importance of a fair and equitable, stable and efficient tax system for furthering investment and output growth. Russian policymakers and experts drafted a new tax code based on such principles as early as 1993. For many years, this and subsequent reform initiatives have been mired in political controversy, both at federal and regional level, often becoming hostage to other political bargains. The comprehensive tax reform now being implemented in Russia has two main objectives: it addresses both the lack of an efficient system for inter-budgetary allocations of revenues and expenditures - fiscal federalism - and the need for improving the structure and calculation of taxes to enhance neutrality, fairness and thus the degree of compliance.
     Due to substantial restrictions on the deductibility of many business expenses, the tax base for the Russian profits tax is larger than the comparable corporate tax base in industrialised countries, thus often resulting in a higher - sometimes - much higher, effective profits tax rate than the nominal statutory rate. As many of the major expenses subject to restricted deductibility are those incurred by businesses in the restructuring and modernisation of capital assets acquired in the privatisation process, this has had a significant negative effect on investment aiming to raise capital productivity. When added to the fact that personnel training expenses have generally not been deductible at all, it is clear that the manner of determination of the profit tax base has consistently provided investors with the wrong incentive from the point of view of transforming productive resources so as to unlock economic growth.
     A somewhat similar problem still remains with respect to VAT, as businesses in Russia are faced with restricted ability to credit fully VAT on all purchases. The result is that the effective VAT rate is usually greater than the statutory VAT rate and becomes a cost to the business. Thus, even though value added tax is intended to be a tax on final consumers rather than on businesses, the Russian VAT more often than not is also a tax on production.
     The high tax cost of labour prevailing during the transition period in Russia, which results from the combination of many taxes and charges imposed on employers' payrolls added to the personal income taxes has discouraged the hiring of additional labour and given rise to tax evasions schemes. The latest tax reform package brings in a unified tax on wages at a highly regressive rate in order to reduce the incentives for businesses to understate the size of their payrolls and thus bring more employees out of the shadow economy.
     The many unresolved issues in the field of inter-budgetary relations and arrangements for revenue sharing between the federal and regional governments have brought added uncertainty and changeability to the tax environment faced by investors through multiplication of seemingly irrational and incoherent taxes.
     In the first years following the dissolution of the Soviet Union, inter-budgetary relations were quite chaotic. Despite the passage of framework laws on the fundamental principles of the budgetary process and the tax system, setting out the structure and division of responsibilities, actual division of tax authority amongst federal, regional and local governments mostly followed individual bilateral negotiations.
     Although the current policies aim to claim back and reaffirm federal authority, relying on closed lists of taxes allowed at the different budgetary levels, many regions and local governments continue to introduce taxes that are not provided for in the federal legislation.
     It also belongs to this picture that local officials enjoy a number of tools other than formal fiscal authority which can be used in their relations with investors to circumvent restricted tax autonomy. The regional and local authorities control licensing of various forms of activity and are often partners in local commercial enterprises and financial institutions. Their leverage is substantial and every investor in Russia has become keenly aware of the need to maintain good relations with the local administration. In addition, there exist funds at regional and local level, to which local businesses are often encouraged to make "voluntary" contributions.
     As a general criticism of the system it has been argued that the combination of strict limits on tax authority at lower levels of government, mandatory expenditure obligations and a plethora of regulations and other instructions make orderly budgetary execution extremely difficult for regional and local officials. These conditions do not provide incentives for responsible budgetary execution policies, but can serve as partial explanation for the rent-seeking activities by these officials, when coupled with the low pay available to civil servants. Sanctions for such irresponsible activities are in addition not easily imposed, given the size of the Federation and the information and other advantages enjoyed at local level.
     Thus, while strong federal presence seems likely to remain necessary in near future, it should not simply take the form of increasingly rigid federal regulation which could risk backfiring as sub-national authorities continue to seek loopholes for every restriction. A workable revenue-sharing system clearly requires consensus about its fairness in order to be genuinely effective.

     2. Basic Parameters of the Russian Tax System

     Legal Elements

     The legal basis of the Russian tax system consists of three principal building blocks:
     (a) Part One of the Tax Code, which defines the basic principles of the Russian tax system and tax administration rules;
     (b) Part Two of the Tax Code, passed by the Federal Assembly in July 2000, which initially (when it enters into force from January 2001) will contain personal income tax, VAT, excise and social taxes, and eventually replace the series of separate laws that currently define other individual taxes; and
     (c) Relevant tax provisions in the Customs Code and Criminal Code.
     Each legislative element has its is supplementary implementing regulation, such as instructions, regulations, tax declarations and other forms issued by the tax administration and other governmental bodies.
     Part One of the Tax Code is the 'tax constitution' of Russia and contains 142 articles that address such issues as definitions of tax terms, rights and responsibilities of taxpayers, powers and obligations of the tax authorities, tax audit and appeals procedures, assessment of penalties, and tax offsets and refunds. Most of Part One came into force on 1 January 1999 and replaced a number of federal laws, Presidential decrees, governmental decrees, and instructions and other explanatory documents issued by the tax administration bodies.
     Part Two of the Tax Code which amends and codifies previous separate laws defining individual taxes will enter into force on 1 January 2001. Most of the earlier, separate laws were introduced in 1992, establishing and defining value added tax ('VAT'), profits tax (not yet included in Part Two), personal income tax, property taxes (not yet included in Part Two), and excise taxes. While the 1992 separate laws have each been amended several times, their basic structure has remained the same until the major revisions to be introduced via the adoption of Part Two of the Tax Code.
     Thus, during most of the 1990's approximately 54 federal, regional and local taxes and social fund payments have applied in Russia. Once Part Two of the Tax Code comes into effect, the number of taxes will be reduced to 28. ( check ) However, the bulk of the total tax liability of a typical business has generally been attributable to 6 categories of taxes - profits tax, VAT, customs duties, labour taxes, property taxes, and turnover taxes. Certain types of businesses, such as those involved in natural resources or production and sale of alcohol and tobacco, are subject to additional taxes such as excise taxes and royalties. As set out in Table (Insert), the major changes in the tax burden for business firms via the recent reform will come from simplification and lowering of labour taxes, reducing the tax basis for calculations of profit tax and elimination of virtually all turnover taxes.

     Tax administration

     Federal organs are responsible for the collection of all taxes, whether federal, regional or local in nature. They also control the division of revenues between these different budgetary levels. With the exception of Tartarstan, regional and local administrations do not have separate tax services or treasuries. The formal federal subordination is, however, not upheld in practice, as regional administrations often have a considerable say in the appointment of local officials to the federal offices. The main extra-budgetary funds (other than the Pension and Social Insurance Funds) are likewise informally dependent on local authorities, while technically controlled at federal level.
     On the federal level, there are several tax administration bodies that are involved in monitoring and ensuring taxpayers' compliance with tax legislation.
     The main tax administration body is the Ministry of Taxes and Collections (known as the State Tax Service prior to December 1998). Part One of the Tax Code authorises regions and local governments to establish their own separate tax administration bodies for the collection of regional and local taxes. However, to date no such regional and local tax administration bodies have been established. (check)
     The Ministry of Taxes and Collections has approximately 180,000 employees across Russia and is vertically organised, with a federal headquarters, a regional office in each of the 89 regions, and local offices (or 'inspectorates'). The local tax inspectorates handle the actual day-to-day collection of taxes and monitoring of taxpayers' compliance with tax legislation. A local tax inspectorate has responsibility for those businesses that are registered (or required to be registered) within the jurisdiction of the inspectorate and those individuals who reside within that jurisdiction. (The Ministry of Taxes and Collections is separate from the Ministry of Finance, which retains responsibility for macro-economic and budgetary policy, as well as accounting, tax treaties and certain tax policy issues.)
     Another tax administration body is the Federal Tax Police, which is also a federal agency. The Federal Tax Police is a criminal investigation agency that is responsible for the prevention, discovery, and termination of criminal and administrative violations of tax legislation. At the request of the Ministry of Taxes and Fees, Tax Police officials also participate in tax audits and provide protection to officials of the Ministry of Taxes and Collections.
     Each of the four extra-budgetary funds mentioned above also has its own independent tax administration body that monitors and ensures compliance with payments required under the social fund legislation. From 2001, with the implementation of Part Two of the Tax Code, the new, unified Wage Fund will be administered by the Ministry of Taxes and Collections. Apart from the simultaneous lowering of the overall tax burden on wages, this reform, which eliminates four collection systems, is in itself a major improvement for business firms.
     There are no specialised tax courts in Russia. Tax disputes involving legal entities and individual entrepreneurs are resolved in arbitration (commercial) courts, while tax disputes involving individuals other than individual entrepreneurs are resolved in courts of general jurisdiction.

     Tax Treaties

     As of 1 July 1999, 40 tax treaties between Russia and various foreign countries are in force (update). This figure includes treaties entered into directly by Russia and those USSR treaties to which Russia is a successor. Under Article 15 of the Constitution, the provisions of properly ratified international treaties to which Russia is a party prevail over provisions of domestic Russian law. This principle is reflected in Part One of the Tax Code.

     3. The Power to Tax and Inter-budgetary Relations

     Tax Authority

     The formal fiscal system in the Russian Federation consists of three levels, federal, regional and local, but as the local budgets tend to be closely dependent on regional budgets, the system is usually referred to as a two-level hierarchy of federal and regional budgets. Nevertheless, a degree of ambiguity exists in the status and authority of local budgets (generally larger cities or former administrative districts) which at times has contributed to the level of uncertainty encountered by investors on the fiscal front.

     While the Russian Constitution in principle empowers each level of government to impose its own taxes, it simultaneously grants the Federal Assembly significant control over the taxes imposed at all three levels of government. First, all federal taxes must be established by federal legislation (not, for example, by the executive branch). Secondly, the 'general principles' of regional and local taxes are determined by federal legislation, including the types of regional and local taxes that may be established. The 1992 federal law 'On the Fundamentals of the Taxation System in Russia' setsforth a closed list of 22 federal, 5 regional and 23 local taxes (a total of 50) that could be imposed in Russia. As noted above, these will be reduced to 28 through the introduction of Part Two of the Tax Code. In addition, the 'quasi-tax' payments that are made to the four social funds in Russia (i.e., Pension Fund, Medical Insurance Fund, Social Insurance Fund, and Employment Fund) will be collapsed into one single tax on wages.
     Federal taxes are established directly by federal laws enacted by the federal Parliament and are payable throughout the Russian territory. Regional taxes are established by regional legislative bodies in accordance with Part One of the Tax Code and the parameters defined in the list of regional taxes to be included in Part Two of the Tax Code. The new Tax Code also defines the object of taxation, tax base and the maximum tax rate with respect to each regional tax. Similarly, local taxes are established by local authorities in accordance with the new Tax Code.
     In Russia, the basic rule is that tax exemptions or reductions may only be established by legislation [cite Law]. This means, for instance, that the president or government cannot grant tax exemptions or reductions on their own. In addition, legislation of a particular level of government may only provide tax exemptions or reductions for taxes payable into the budget of that level. For example, this means that federal legislation cannot grant an exemption for taxes payable into regional and local budgets. Tax exemptions or reductions cannot be of an individual character, except in 'exceptional cases' (which are not defined).

     Budgetary allocations of tax revenues and expenditures

     The allocation of tax revenues among the three levels of government in Russia is based on a complex combination of 'tax sharing' and 'tax assignment'. In other words, the revenues from a particular tax do not necessarily flow entirely to the budget of the level of government that enacted the tax. For example, the profits tax is classified as a federal tax, but profits tax revenues are shared between the federal budget and the regional budgets, with 11 percentage points of the profits tax base allocated to the federal budget and generally 19 per cent allocated to the regional budget of source. Similarly, even though VAT is labelled a federal tax, in fact 85 per cent of VAT revenues from domestic transactions generally are transferred to the federal budget and 15 per cent of the revenues are transferred to the budget of the region in which the revenues are collected. In Part Two of the Tax Code it is proposed to direct 100 per cent of VAT revenues to the Federal budget However, 100 per cent of the revenues from certain other taxes are transferred directly to the budget of the level of government that enacted them.

     These inter-budgetary relations are currently going through a reform process, of which the first major step was the implementation of Part One of the Tax Code from January 1999 which codified existing tax legislation and served, among other things, to clarify the relative tax authority of federal, regional and local organs. It is soon to be followed by the implementation of Part Two (see above) and a revision of the Budget Code, to provide clearer delineation of expenditure responsibilities as well as a shift towards a larger federal share in the general government budget.
     In the first years following the dissolution of the Soviet Union, interbudgetary relations and arrangements for revenue sharing between the federal and regional governments were quite chaotic. Despite the passage of framework laws on the fundamental principles of the budgetary process and the tax system, setting out the structure and division of responsibilities, actual division of tax authority amongst federal, regional and local governments mostly followed individual bilateral negotiations. The new constitution of 1993 opened up the way for a formalisation of budgetary authority of the Subjects of the Federation as well as the creation of a system for redistribution via transfers of federal revenue to regions with insufficient revenue bases. Although a number of Presidential decrees temporarily granted regional and local governments the right to introduce their own taxes, such privileges had generally been rescinded by 1996. Earlier bilateral agreements between the federal authorities and individual national republics granting special retention proportions of federal revenue were allowed to lapse, legislation allowing regions to grant companies tax privileges so as to create local tax havens was changed and tax collection and redistribution amongst different budgets was made the exclusive responsibility of federal organs, eliminating possibilities for regional interference. However, despite the trend towards reaffirmed federal authority, and the closed list of taxes established by the Tax Fundamentals Law (and confirmed by the Constitutional Court and Part One of the Tax Code) many regions and local governments continue to introduce taxes that are not provided for in the federal legislation.

     Problems in inter-budgetary relations affecting the overall tax environment for investors

     The evolution of revenue and expenditure division between federal and regional budgets gives evidence of an increase in decentralisation during the course of the 1990's, with revenue to the federal budget falling from 16 to 11 per cent of GDP from 1992 to 1998, while revenues to the consolidated regional budgets remained stable around the level of 12-13 per cent of GDP. A similar pattern can be seen on the expenditure side. As noted above, the trend towards a more equal division of revenue is not reflected in the division of powers to tax, as the majority of revenue to regional and local budgets derives from taxes which are determined at federal level. Such is still? the case e.g with the primary sources of regional revenue VAT, excise taxes and profit tax, while income tax ….While the new Tax Code has marginally increased fiscal authority at regional level, it has not brought any significant increase in the sphere of tax autonomy for the sub-federal levels of government. The reluctance to decentralise is understandable seen against the background of the situation that ensued in the mid-1990s when the lower levels of government were temporarily allowed greater scope for introducing new regional and local taxes. At that time domestic and foreign investors were faced with a confusing proliferation of sometimes irrational taxes with consequent negative effects on entrepreneurial activity. However, the present tendency to centralise tax authority could in practice backfire, as lower levels of government would continue to seek loopholes for every restriction. A workable revenue-sharing system clearly requires consensus about its fairness in order to be genuinely effective. On the expenditure side a persistent problem has been both to clarify the sharing of expenditure obligations between the different levels of government and to ensure the balance between these obligations and the capacity to raise revenue. The practice of issuing unfunded federal mandates for regional and local governments expenditure, which were in
     terpreted as obligatory rather than recommended if funding resources allowed is to be eliminated in the current revision of the Budget Code.

     [Transfers are now operated via the Fund for Financial Support of Subjects of the Federation (FFSSF) established in 1994, supplanting the previous chaos of grants, special agreements, changes in tax-sharing norms and offsets which were highly politicised and often totally by-passed the budgetary process altogether. Its underlying methodology is more formalised, but there is still too much political horse trading according to critics. rewrite]
     As a general criticism of the system it has been argued that the combination of strict limits on tax authority at lower levels of government, mandatory expenditure obligations and plethora of regulations and other instructions make orderly budgetary execution extremely difficult for regional and local officials. These conditions do not provide incentives for responsible budgetary execution policies, but can serve as partial explanation for the rent-seeking activities by these officials, when coupled with the low pay available to civil servants. Sanctions for such irresponsible activities are in addition not easily imposed, given the size of the Federation and the information and other advantages enjoyed at local level.
     It should also be mentioned that local officials enjoy a number of tools other than formal fiscal authority which can be used in their relations with investors to circumvent restricted tax autonomy. The regional and local officials control licensing of various forms of activity, water supply, access to privileges for settling taxes and energy payments, offsets, protection from bankruptcy, inspections and even guarantees for commercial loans. Sub-national authorities are not infrequently partners in local commercial enterprises and financial institutions. The leverage is substantial and every investor in Russia has become keenly aware of the need to maintain good relations with the local administration. Extra-budgetary funds represent an additional tool through which local administrations can exert pressure on investors. While the territorial subdivisions of the Federal extra-budgetary funds are formally under federal authority and soon will be unified as a Wage Fund under the Ministry of Taxes and Collections, there exist funds at regional and local level, to which local businesses are often encouraged to make "voluntary" contributions.

     4. Investor Concern with Specific Forms of Tax Liability

     Experience to date

     Although many foreign investors have complained about the excessive tax burden they have had to carry on their operations in the Russian Federation, their problems have not originated so much from the statutory level of the taxes imposed at federal, regional or local level. Statutory tax rates in Russia were in fact not very high by world standards - other than in the case of wage taxes - even before the recent tax reform. Marginal tax rates appear higher in international comparisons, because of the sharing of tax bases between different authorities and because of different definitions of the base itself. It has more been a question of the multitude of different taxes levied and, primarily, the methods of determination of the actual tax base.
     Many studies and reports have pointed to the fact that the Russian tax system consistently discourages investment, both through its structure and the manner it has been implemented. This fact remains true for domestic as well as foreign investors, whether we discuss start-ups of new business or the restructuring of existing firms. A powerful driving force for the recent reform measures was that the sheer number of particular taxes and exemptions as well as the frequent changes in rules and regulations have created a degree of uncertainty which impacts negatively on business development as a whole.
     That this situation has prevailed throughout the transition period cannot be ascribed to a lack of understanding of the importance of a fair and equitable, stable and efficient tax system for furthering investment and output growth. Russian policymakers and experts drafted a new tax code based on such principles as early as 1993, but this and subsequent reform initiatives have for many years been mired in political controversy, both at federal and regional level, often becoming hostage to other political bargains. It is often pointed out that the primary reason for failure of comprehensive tax reform in Russia is the relationship between federal and sub-federal authorities and the lack of an efficient system of fiscal federalism.
     As described in section ? above, the situation improved substantially after the general part of the new tax code was finally passed by the Duma in 1998 and became law as of 1 January 1999. In addition to clarifying the rights and obligations of tax-payers, it brought in a cap on the number and type of taxes which can be imposed at federal, regional and local level. In addition, the whole spirit of interpretation of tax legislation was rendered more favourable for tax-payers. A further amendment later in 1999 strengthened the tax authorities' ability to enforce tax compliance and collection.
     Progress with the reform of other, specific parts of the tax code, which addresses the problems of determining actual tax rates imposable at federal, regional and local level, as well as the rules for the sharing of revenues raised by these various taxes has now been confirmed through the passage of Part II of the Tax Code in the Summer of 2000. However, the particular reform changes which will significantly reduce the profits tax base for enterprises are not yet passed and can probably only enter into force in the year 2002 or beyond This seems also to be the case with the abolition of the majority of turnover taxes [check].
     From discussions with major foreign investors in Russia within the framework of the FIAC (Foreign Investor Advisory Council) one might conclude that, despite this tangible progress, not all of the previous specific grievances have been eliminated. Many rates and exemptions still remain unstable, being frequently altered with the objective of increasing short-term tax collection. The existence of numerous so-called nuisance taxes at all levels which are not producing significant revenue to the authorities (but rather serve to perpetuate rent-seeking and corruption by individual officials) is still a fact although the practice is being discouraged in the tax reform package. The enforcement of the new, stricter regulation as to which taxes may be introduced by constituent entities within the Federation, and by local authorities still must be strengthened. Investors also request further rationalisation of personal income tax, pay-roll taxes and profits tax, with full recognition of exchange rate differences in order to reduce incentives to conceal revenue. Although Part II of the Tax Code brought profit tax base calculations significantly closer to standard international practice, further room for deductibility of expenses for the determination of profit tax is still demanded, particularly with regard to professional training expenses, entertainment expenses and interest payments.
     A short overview of the major types of taxes that apply to businesses in Russia is necessary to explain where problems have most frequently occurred and/or are likely to persist:
     Although quite similar to the major taxes that apply to businesses in more advanced economies, the Russian versions of these taxes often do not apply mechanically or economically in the manner that their counterpart versions do. The result is that the total liability of a Russian business for the taxes is usually higher than a simple comparison of statutory tax rates with a modern Western economy would seem to imply.

     Table 1 summarises the major Russian taxes, the tax bases for the taxes, and the generally applicable tax rates, followed by an indication of the reforms intended over the short and medium term. More detailed description of individual taxes and their imposition will only be given regarding profit tax and VAT, where the majority of investor complaints have been focused. [The sections below on individual taxes must be updated to distinguish between current and proposed or already enacted new law]

     Profits tax

     Taxpayers of the profits tax are:
     (a) Russian legal entities (i.e., legal entities formed under legislation of Russia);
     (b) foreign legal entities (i.e., legal entities formed under legislation of foreign countries) that have a 'permanent establishment' in Russia; and
     (c) foreign legal entities that do not have a permanent establishment in Russia.
     A Russian legal entity is subject to profits tax on its worldwide income on a net basis. A foreign legal entity with a permanent establishment in Russia is subject to profits tax on a net basis on its income attributable to the permanent establishment. If its Russian source income is not attributable to a permanent establishment, a foreign legal entity in Russia tax is generally withheld at source on a gross basis.
     A 'permanent establishment' of a foreign legal entity is defined generally to be any branch, bureau, office, agency or other place through which business activities are carried out, as well as a dependent agent used in Russia by the foreign legal entity. However, many of the tax treaties currently in force establish a higher threshold for the existence of a permanent establishment for their respective resident legal entities.
     From 1 January 1999, a Russian legal entity and all of its branches are treated as a single taxpayer. The net profit or loss of a Russian legal entity is apportioned among the entity's head office and branches based on the relative book value of production assets and number of employees (or payroll) of the head office and branches. Previously commonly owned Russian legal entities were not allowed to 'consolidate' their net income or loss and be treated as a single taxpayer for profits tax purposes. A foreign legal entity with multiple permanent establishments in Russia located in different jurisdictions is not permitted to consolidate the permanent establishments' net income or loss. Instead, each permanent establishment is treated as a separate taxpayer for profits tax purposes. Table 1. Russian Taxes, Tax Bases, Tax Rates and Reforms
(table title???)

*Type of tax*	*Tax base*	*Tax rate*	*Reforms 2000-2001 and beyond*
Profits tax	Net income of Russian companies and permanent establishments of foreign companies	30% maximum for most companies, 38% maximum for banks, brokers, insurance companies and intermediaries	Introduction of local profit tax of 5 % for a limited period of years to compensate for removal of a number of social fund contributions, removal of part of exemptions, widening allowable deductions from tax base, new depreciation rules
Value added tax	Turnover from domestic sales of goods and services and value of imported goods	20% for most goods and services, 10% for certain food and children's goods, 0% for exports outside the CIS	Transition to 100% allocation to federal budget, removal of exemptions, introduction of principle of country of destination, long-term reduction of rates to 16-18% level
Customs duties	Value or unit of imported goods and limited number of exported goods	Ad valorem rates range from 0% to30%, with average of 20-25% . Various per unit rates	Transition to a more unified system of rates with a limited number of higher rates applying for certain homogeneous categories of products
Personal income tax	Worldwide income of Russian residents and Russian source income of Russian non-residents	6 brackets from 12% to 45%, with top rate applicable to annual income over 300,000 rubles ($10,700)	Transition to flat rate of 13 % and full allocation of revenues to regional budgets, removal of exemptions
Social (payroll) taxes	Wages paid by Russian companies and foreign companies doing business in Russia	38.5% (employer portion)1% (employee portion)	Lowering to 35.6 % (and to 22.8% for self-employed)
Property tax	Book value of assets	2%
Road users tax	Gross receipts	2.5%	Reduction to
Housing fund tax	Gross receipts	1.5%
Excise taxes	Turnover from or units of domestic sales of excisable goods by producers and value or unit of imported excisable goods	Various per unit and ad valorem rates on alcohol products, wine, beer, tobacco, gasoline, jewellery, Automobiles, crude oil, and natural gas	Transition to a system of specific rates, with increased rates on petrol, luxury cars, jewellery
Advertising tax	Cost of advertising service	5%
Sales tax	Cash and credit card sales	5%	Rates

     The profits tax rate that normally applies to most Russian legal entities and foreign legal entities with permanent establishments in Russia is 30 per cent. However, a rate of 38 per cent generally applies to banks, brokers, insurance companies and profits from intermediary activities. These rates are in line with, or even lower than, corporate tax rates applied in industrialised countries. The overall rate is split into separate federal and regional portions - 11 per cent is the fixed federal rate and the balance represents the regional rate. Each region may choose its own tax rate, up to 19 per cent for most companies and up to 27 per cent for banks, brokers, insurance companies and profits from intermediary activities. Most regions have chosen the maximum rates, although a notable few have lowered or even eliminated the regional rate in order to attract investment.
     Foreign legal entities without permanent establishments in Russia are subject to withholding taxes on their Russian source income at 15 per cent for dividends and interest, 6 per cent for freight income, and 20 per cent for all other types of income, although these rates may be reduced or eliminated by an applicable tax treaty.

     Tax base

     Like corporate income taxes in industrialised countries, the tax base for the Russian profits tax is generally defined as gross revenue minus expenses, but the manner in which deductible expenses are determined is where the Russian profits tax departs from corporate income taxes in more developed economies. Because of substantial restrictions on the deductibility of many business expenses, the tax base for the Russian profits tax is larger than the comparable corporate tax base in industrialised countries, thus often resulting in a higher, and sometimes much higher, effective profits tax rate than the nominal statutory rate. As many of the expenses subject to restricted deductibility represent the major costs incurred by businesses in the restructuring and modernisation of capital assets acquired in the privatisation process, this has had a significant negative effect on investment to increase capital productivity. When added to the fact that training expenses have generally not been deductible at all, it is clear that the manner of determination of the profit tax base has consistently provided investors with the wrong incentive from the point of view of transforming productive resources so as to unlock economic growth.
      are some of the major aspects of the determination of the Russian profits tax base that increase the effective profits tax rate. The degree to which a business is affected by any particular aspect depends on the type of business (e.g., capital intensive or services, equity or debt financing, retail trade or manufacturing, etc.). Also, some of the expense deduction limitations may be relaxed or eliminated under tax treaties.
     (a) Closed list of deductible expenses. In most tax systems in industrialised countries, the general rule is that all business-related expenses of an enterprise are deductible, except for those whose deductibility is specifically limited or prohibited by law or regulation. In contrast, under the Russian profits tax only those expenses that are included in a list prescribed by the government are deductible. Although the list is fairly long and detailed (but with a Soviet era emphasis on production-oriented businesses), there are some business expenses, for example, many employee benefits.
     (b) Interest expense. In general, the only types of deductible interest are:
     (i) interest on loans from Russian banks used to finance working capital;
     (ii) interest on trade credits;
     (iii) interest on loans from Russian banks used to acquire production assets that qualify for the 'capital investment' exemption discussed below; and
     (iv) interest on loans used in financial leasing.
     Thus, for example, interest on shareholder loans is not deductible. With regard to bank loans, interest is only deductible up to the Central Bank refinancing rate plus 3 per cent for ruble denominated loans and up to 15 per cent for foreign currency denominated loans. In general, interest on a bank loan used to purchase fixed assets and intangible assets is not deductible (unless the assets are production assets that qualify for the capital investment exemption).
     (c) Training expense. In general, internal training expenses are not deductible. Tuition payments to licensed educational institutions are deductible only up to 2 per cent of annual labour costs.
     (d) Advertising expense. Advertising expense may be deducted only up to a specified percentage of annual sales of a business. The greater the amount of annual sales, the lower the percentage of deductible advertising expense. The limitation begins at 2 per cent of annual sales up to 2 million rubles ($80,000), goes down to 1 per cent of annual sales between 2 million rubles and 50 million rubles ($2,000,000), and then bottoms out at 0.5 per cent for annual sales over 50 million rubles.
     (e) Research and development expense. In general, research and development expenses are not deductible except in limited circumstances.
     (f) Insurance premiums. In general, only premiums for 'mandatory' insurance, as required by law, are fully deductible. For example, a minimum level of insurance is required to be purchased for goods that are transported. However, voluntary insurance of property and other defined risks is deductible only up to 1 per cent of annual sales.
     (g) Business trips. The deductibility of business trip cost are subject to low caps. For domestic trips, out-of-pocket expenses in excess of 167 rubles ($6.60) per day are not deductible. Similar restrictions apply to foreign business trips depending on the place.
     (h) Depreciation. Tax depreciation in Russia is significantly lower than economic depreciation. One reason is that the statutory depreciation periods are longer, sometimes much longer, than the economic lives of the assets. For example, buildings generally have statutory useful lives of 80 to 250 years. In addition, the straight-line method of depreciation must be used in most cases. From 1998, Russian companies are allowed to revalue their fixed assets for tax purposes on the basis of independent appraisals. This should help to mitigate the effect of inflation on the value of depreciation deductions, although property tax liability will increase to the extent the book values of assets are increased.
     (i) Losses from sales of fixed assets. Losses from sales of fixed assets are not deductible.
     (j) Net operating losses. A net operating loss of a business for a particular tax year can be carried forward for five years. However, only 20 per cent of the loss for such year can be used during each of the five years. If the 20 per cent amount cannot be fully used in a given year, then the unused portion of the 20 per cent amount is lost. There is no inflation adjustment.
     (k) Dividends. Dividends are subject to taxation when declared. Individual shareholders are fully subject to personal income tax on dividends. Dividends received by corporate shareholders are subject to a 15 per cent final withholding tax at source. The 15 per cent tax applies regardless of the percentage shareholding of the corporate shareholder. This means that a dividend received by a parent company from its 100 per cent-owned subsidiary is subject to a 15 per cent tax. Thus, holding company structures in Russia have a high tax cost if profits are distributed in the form of dividends.
     Despite the many limitations on deductibility of expenses As harsh as the restrictions on deductions may seem now, the situation was once worse. For example, during 1992-1994 wages above a low threshold could not be deducted. This deduction limitation transmogrified into the ignominious 'excess wages tax' in 1994, which imposed a 38 per cent tax on wages paid in excess of a low threshold. The excess wages tax was finally repealed effective from 1 January 1996. In addition, until 1 January 1999 it was generally difficult for a business to recognise a tax loss if the business sold its inventory below cost. However, from 1 January 1999 the 'sale below cost' rule is repealed and such tax losses from sales of inventory are deductible., the Russian profits tax also includes some investment incentives that may in part contract the profits tax base for certain categories of taxpayers. Perhaps the most widely used is the 'production investment' incentive. In brief, this incentive allows a company that makes a capital investment to deduct fully the cost of the investment to the extent that the investment exceeds the taxpayer's depreciation for the year in which the investment is made. If the capital investment is a depreciable asset, then the taxpayer may also depreciate the asset.
     Foreign investors use several techniques to minimise their Russian profits tax liability. One of the most common techniques is the use of various Russian tax treaties that permit qualifying Russian companies and permanent establishments of foreign legal entities to deduct fully certain expenses, such as interest and advertising, despite the domestic law limitations discussed above. In order to qualify for the expense deduction benefits under the treaties, a Russian company must be owned in whole or in part by a shareholder resident in one of the respective treaty partner countries. The minimum ownership percentage varies from treaty to treaty. A permanent establishment of a foreign legal entity qualifies for the benefits if the foreign legal entity is resident in one of the respective treaty partner countries.
     There are special rules that apply to the determination of the tax base of permanent establishments of foreign legal entities. In general, a permanent establishment is subject to profits tax on its Russian source income less its expenses (subject to the deduction limitations under Russian legislation discussed above). However, a certain type of income received by foreign legal entities is specifically defined in the profits tax legislation as not considered to be connected with activities in Russia. That type of income is a foreign legal entity's income from sales of goods from outside Russia pursuant to a foreign trade contract where title passes to the Russian buyer before the goods cross the Russian border. This generous exemption from Russian profits tax is claimed by many foreign businesses that manufacture their goods abroad and then sell the goods directly to Russian distributors.
     Foreign investors may also minimise their Russian profits tax liability by exploiting the liberal transfer pricing rules in Russia. The Russian transfer pricing rules include a 'safe harbour' under which a selling price used by related parties that is within 20 per cent, above or below, of the fair market value of the item sold is respected for tax purposes. Although the rules have only been in effect since 1 January 1999 and are thus untested, in principle this safe harbour may permit rather generous shifting of the profits tax base from Russia on both imports and exports. (However, for purposes of calculating applicable customs duties and import VAT, the valuation rules in the Customs Code will apply.)
     It is also important to note that the Russian tax authorities have the power to impute taxable profit to a permanent establishment. In particular, if the Russian tax authorities find it impossible to determine the actual taxable profit attributable to a permanent establishment, they are authorised to impose profits tax on the 'deemed' profit of the permanent establishment. 'Deemed' profit is computed as 20 per cent of the gross Russian source income of the permanent establishment. If gross Russian source income cannot be ascertained, 'deemed' profit is computed as 20 per cent of the Russian portion of the foreign entity's worldwide gross income, allocated on the basis of relative numbers of employees. If such calculation is equally impossible, deemed profit is equal to 25 per cent of the expenses of the permanent establishment. Although technically the use of these methods to deem profits is at the discretion of the tax authorities, some taxpayers in effect choose the application of the last method (based on expenses) by not disclosing sufficient information to the tax authorities for them to apply the other methods.

     Value added tax

     Like the profits tax, the Russian VAT appears to be very similar to VAT laws in industrialised countries. For example, the Russian VAT is collected in stages by businesses; credits are allowed for VAT on purchases; the standard tax rate is 20 per cent, with a 10 per cent rate applicable to a limited number of items (food and children's goods) and an effective 0 per cent rate applicable to most exports; and VAT is generally imposed on imports. Despite its superficial similarity to other VAT laws, however, the Russian VAT does not function in a manner consistent with a traditional VAT. The result is that rather than being a tax only on final domestic consumption (as is the purpose of a VAT), the Russian VAT is sometimes a tax on businesses as well as on final consumers.

     Taxpayers

     Under the Russian VAT legislation, taxpayers are defined as those businesses that are required to collect VAT on their taxable sales (not the businesses that pay VAT on their purchases, although such businesses may receive a credit for VAT paid on their purchases). Specifically, taxpayers of the Russian VAT are:
     (a) Russian legal entities carrying out production and other commercial activities;
     (b) foreign legal entities carrying out production and commercial activities in Russia; and
     (c) importers of goods into Russia.
     The standard of 'carrying out production and other commercial activities in Russia' applied to foreign legal entities is different from the 'permanent establishment' standard used for profits tax purposes as discussed above. Because the VAT standard is lower than the profits tax standard, and no Russian tax treaties apply for VAT purposes, a foreign legal entity may be liable for the collection of VAT on its sales in Russia even though it is not liable for profits tax.
     A foreign legal entity that is not registered in Russia for tax purposes may nevertheless sell a good or service the 'place of supply' of which is Russia. In such case, the Russian purchaser of the good or service is required to withhold VAT under a procedure similar to the 'reverse charge' mechanism used in the European Union.
     Although, a Russian legal entity and all of its branches are treated as a single taxpayer for VAT purposes since 1 January 1999. However, even though a Russian legal entity's liability for all other taxes is calculated on a consolidated basis and apportioned among the entity's head office and branches, the entity is required to calculate its VAT liability separately for each branch that "independently realises" goods or services. Commonly owned Russian legal entities are not allowed to 'consolidate' their sales subject to VAT (and credits on purchases) and be treated as a single taxpayer for VAT purposes. Finally, it is interesting to note that individuals (including individual entrepreneurs) who engage in production and other commercial activities are not considered VAT taxpayers and thus do not charge and collect VAT on their sales or recover VAT on their purchases.

     Tax rates

     The standard VAT rate for domestic sales is 20 per cent, which applies to most goods and services. A reduced rate of 10 per cent applies to certain food and children's goods. Imports are subject to a standard rate of 20 per cent, with a 10 per cent rate applicable to certain food and children's goods.
     Exports of goods and services are exempt from VAT, and the exporter is entitled to recover VAT paid on purchases relating to the export. This mechanism is the equivalent of 'zero rated' exports in the European Union.
     Imports from, and exports to, countries that are members of the Commonwealth of Independent States (CIS) are subject to special VAT rules. Generally speaking, imports from CIS countries are not subject to Russian VAT, and exports to CIS countries are subject to VAT. However, the exact application of these rules to trade between Russia and a particular CIS country is often unclear and variable. It is proposed that CIS trade will eventually move to pure 'destination' basis of taxation rather than the current 'origin' basis.

     Tax base

     Generally speaking, a VAT taxpayer in Russia calculates its net VAT liability using the 'credit method'. This means that the taxpayer calculates its VAT liability on its taxable sales and then subtracts the VAT on its purchases for which it is entitled to a credit. (However, retailers in Russia use the so-called 'mark-up' method to calculate their VAT liability under which they are liable for VAT on their profit on the sale of their goods.)
     In determining its VAT liability on its sales, a taxpayer is liable for VAT on sales the 'place of supply' of which is Russia. Although there are no clearly defined sourcing rules for sales of goods, the generally accepted standard is that the place of supply of goods is Russia if title to the goods passes in Russia (unless the good is exported in the process). The sourcing rules for services are very similar to those used in the European Union Sixth Directive on VAT. Thus, for example, services relating to real estate are treated as supplied at the place of the real estate, services relating to movable property are treated as supplied where performed, advertising, consulting and similar services are treated as supplied where the beneficiary has its place of economic activity, and most other services are treated as supplied where the supplier has its place of economic activity.
     Even if the place of supply of goods or services is Russia, there is a long list of goods and services that are exempt from VAT. These include postal services, banking services, pharmaceuticals, medical services, public transport, and the mass media. As discussed in section ? below, of particular interest to foreign investors with AROs in Russia is the exemption from VAT on office leases of AROs of companies resident in countries that grant a reciprocal exemption to representative offices of Russian companies in that country. The exemption is especially important for AROs that do not carry out any taxable sales in Russia, as the tax authorities would likely deny a refund of VAT paid by such AROs.
     As mentioned above, a VAT taxpayer that uses the credit method reduces its VAT liability on its sales by the VAT on its qualifying purchases. The major VAT problem facing businesses in Russia is the restriction on the ability to credit fully VAT on all purchases. The result is that the effective VAT rate is usually greater than the statutory VAT rate. If the excess over the statutory rate cannot be passed on through the production chain or to consumers, such excess becomes a cost to the business. Thus, even though a VAT is intended to be a tax on final consumers rather than on businesses, the Russian VAT more often than not is also a tax on production.
     There are two main restrictions on a VAT taxpayer's ability to credit VAT on purchases. First, only VAT on expenditures that are chargeable to 'production and selling' costs for profits tax purposes are creditable. As discussed above, there are restrictions on the deductibility of many major businesses expenses, each of which normally attracts VAT as well. Thus, for example, a business that purchases advertising not only cannot deduct the expense in excess of a low threshold, but also cannot credit the VAT that is paid on the non-deductible portion. Secondly, VAT on inputs used in capital construction are not creditable, but instead are added to the depreciable base of the construction and amortised under the profits tax. This can add a significant cost to the self-construction of buildings.
     As in other VAT systems, businesses that sell goods or services that are exempt from VAT are generally not entitled to a credit for VAT on purchases relating to the exempt goods or services. (As discussed above, there is an exception for exports outside the CIS.) A business that sells services that would normally be taxable but are non-taxable because the place of supply of the services is outside Russia (i.e., 'outside the scope', such as advertising services purchased by a foreign legal entity) is treated as selling an exempt service and is not entitled to a credit for VAT on purchases. When a business sells both taxable and exempt goods or services, the VAT on its purchases is apportioned between the taxable and exempt sales.
     Another VAT-related problem arises when a business is in a VAT-refund position. This may occur during a start-up phase of a new business, or following the acquisition of the assets of an existing business (there is no exemption for acquisitions of entire businesses, except in the context of a reorganisation), or when a business is predominantly engaged in export activities. Given the current and recent budgetary problems in Russia, tax refunds have been paid, if at all, only after long delays. Until 1 January 1999, no interest accrued on the refund amounts and taxpayers were not unilaterally allowed to offset the refund amounts against liabilities for other taxes. This resulted in an additional VAT cost for businesses in a VAT refund position. However, from 1 January 1999 interest accrues on refund amounts and taxpayers are entitled to offset overpaid taxes against liabilities for other taxes. Although these interest and offset rules are new and untested, in principle they should reduce or eliminate the VAT cost to businesses of being in a VAT refund position.

     Payroll taxes

     [This section needs update]

     The tax cost of labour is an important cost for any business. As discussed below, the tax cost of labour in Russia is relatively high. A plethora of taxes and charges are imposed on the payroll of employers. The major four social programmes are funded from payroll taxes - the Pension Fund, the Social Insurance Fund, the Medical Insurance Fund, and the Employment Fund. A regional Educational Needs Tax is the other payroll tax. The generally applicable tax rates and tax base for the payroll taxes are as follows. The typical cumulative payroll tax rate in Russia is therefore 38.5 per cent, which is high by international standards but in line with the rates currently applicable in most post-socialist countries in Central and Eastern Europe. Some regions also impose an educational needs tax equal to 1% tax of payroll.
     The combined Russian personal income taxes and payroll taxes result in a relatively high tax cost of labour, which both discourages the hiring of additional labour and encourages tax evasion schemes. One measure of the tax cost of labour is the percentage of taxes payable on compensation paid to an employee. For an employee subject to personal income tax at the top marginal rate of 45 per cent (from 1 January 2000) the tax cost of labour is 61 per cent.
     Because most foreign-owned businesses operating in Russia employ expatriates in addition to Russian citizens, it is useful to discuss the special Russian taxation rules applicable to expatriates. For expatriates living and working in Russia, their status as a 'tax resident' or 'non-tax resident' of Russia determines their Russian personal income tax liability. The basic rule is that an individual who spends more than 182 days in Russia during a calendar year is considered a tax resident of Russia for that calendar year. Domicile and citizenship are irrelevant to the determination. A tax resident of Russia is subject to Russian personal income tax on his worldwide income, while a non-resident taxpayer is subject to Russian tax only on his Russian source income. If an individual is a tax resident of both Russia and a country which Russia has entered into a tax treaty (which is always the case for US citizens), then the treaty usually contains a 'tie-breaker' test that determines the individual's country of tax residency.
     Given the residency definition, one common strategy used to minimise the Russian personal income tax of expatriates is for an individual to move to Russia after 2 July in order to avoid satisfying the more-than-182-day test during his first year of assignment. Similarly, the individual can fail the more-than-182-day test in his last year of assignment by leaving Russia before 2 July. Because the personal income tax sourcing rules are somewhat unclear, some adventurous foreign firms take the position that the source of income earned by an individual who fails the more-than-182-day test is the place of payment. Under this view, even though the services are performed in Russia, the individual is not subject to Russian personal income tax so long as payment is made offshore by a foreign legal entity.
     Even if an expatriate is a Russian tax resident, he is (apparently) exempt from personal income tax on employer-provided housing and car allowances. In addition, wages paid to foreign nationals are (apparently) not subject to the Pension Fund or Social Insurance Fund charges. This reduces the typical social charges on wages of a foreign national to 6.1 per cent.
     Because many expatriates working in Russia are still reluctant to be direct employees of a Russian company, the typical expatriate working for a multinational company is employed by a non-Russian company in the group and then 'seconded' to the Russian company in the group. The Russian company usually reimburses the non-Russian company employer for the individual's compensation plus a mark-up. This structure has become dangerous of late, however, as the Russian tax authorities have begun to treat the foreign employer as having a permanent establishment in Russia for profits tax purposes by virtue of the activities of the seconded employee.
     Another structure that is gaining in popularity is the use of 'dual employment contracts' under which the expatriate has an employment contract with a Russian subsidiary for services performed in Russia and another employment contract with a foreign member of the group for services performed outside Russia. It may be possible to minimise the Russian portion of the expatriate's compensation depending on the time he spends in Russia and whether the non-Russian services can reasonably be valued higher than the Russian services.

     Property tax

     There are several types of property taxes in Russia. The major one is the enterprise property tax, which applies to property that a company owns or leases with an option to buy. In general, the tax is imposed on the book value (even if different from fair market value) of a company's assets. Most of a company's assets are subject to the tax, with cash and securities being notable exceptions. Each region selects the rate applicable to property located in that region, up to a maximum of 2 per cent.
     As discussed above, companies may re-value their assets for tax purposes based on independent appraisals. While such re-valuations increase the depreciable base for profits tax purposes and thus increase deductions, they also increase the taxable base for property tax purposes and thus increase property tax liability.
     A foreign company that owns property in Russia that is subject to property tax is required to register and pay property tax, even if the foreign company does not have a permanent establishment for profits tax purposes. Certain tax treaties exempt foreign companies from Russian property tax on their property located in Russia.

     Turnover taxes

     [This section needs update]

     There are two principal taxes paid by most businesses based on their gross sales revenues - the road users tax and the tax for support of the housing fund and of facilities of the socio-cultural sphere (commonly abbreviated as the 'housing fund tax').
     The road users tax is an earmarked tax the revenues from which are used to construct and maintain highways in Russia. The maximum rate of the road users tax is 3.75 per cent - 0.5 per cent of which goes to the federal road fund and up to 3.25 per cent of which goes to the relevant regional road fund. As most regions have chosen 2 per cent as the regional rate, the normally applicable road users tax rate is 2.5 per cent. Incidentally, businesses engaged in 'trading' of goods pay the road users tax based on the difference between the selling price and the purchase price of their goods, not gross sales revenues. Only revenues from a company's 'main activity' are subject to the road users tax, and not revenues such as dividends and interest from non-sales activities.
     The housing fund tax is a local tax that is earmarked for the indicated programmes. The maximum rate that may be imposed by local governments is 1.5 per cent. Most of the local governments in Russia have enacted the tax. The tax base is the same as for the road use tax; i.e., traders pay on their gross margin and most other businesses pay on gross sales revenues.
     In combination, these two taxes often represent 4 per cent of a business's revenue, a rather substantial amount especially for businesses such as start-ups, loss makers, and low profit margin operations. The taxes are sharply criticised as epitomising the Russian tax system's revenue-based rather than profit-based approach to taxation.
     Natural gas 15% (domestic sales and sales to Belarus)
     30% (all other exports)
     Crude oil 55 rubles ($2.20)/tonne (average)
     Gasoline 350 rubles ($14) or 450 rubles ($18)/tonne
     The general rule is that imports of excisable goods are subject to excise tax and exports of excisable goods are not subject to excise tax (although all exports of oil and natural gas are subject to excise tax). As in the case of VAT, imports from, and exports to, countries that are members of the CIS are subject to special excise tax rules. Generally speaking, imports of excisable goods from CIS countries are not subject to Russian excise tax, and exports to CIS countries are subject to Russian excise tax. However, the exact application of these rules to trade between Russia and a particular CIS country is often unclear and variable. It is proposed that CIS trade will eventually move to a pure 'destination' basis of taxation rather than the current "origin" basis.
     Unlike all other major Russian taxes, producers of excisable goods are generally required to calculate their excise tax liability using the accrual method (as opposed to having a choice between accrual and cash). The one exception to this rule is the excise tax on natural gas, which is calculated using the cash method.

     Advertising tax

     Some local governments, including Moscow City, have established a tax on advertising. The tax is usually equal to 5 per cent of the cost of advertising services and is imposed on the buyer of the advertising. Given the strict limitation on deductibility of advertising expense discussed above, the after-tax cost of advertising in Russia can be quite high.

     Sales tax

     Many regions in Russia have also enacted sales taxes, usually at a rate of 5 per cent. The sales tax applies in addition to VAT. Although the sales tax may apply at the wholesale and retail levels, the tax is only collected on cash and credit card sales. In order words, the sales tax is intended to apply only to sales to consumers and not to inter-business sales.

     The role of tax treaties

     Russia is a party to 40 tax treaties that are in effect as of 1 July 1999. Of these, 9 were inherited from the Soviet Union and 31 have been entered into directly by Russia since the break-up of the Soviet Union.
     As discussed above, tax treaties often strongly influence the choice of the form of investment, financing the investment, and the taxation of investment operations. Similarly, tax treaties are widely used to lower or eliminate the Russian tax cost of repatriation of profits and investment.
     Many investors from Europe and the US invest in Russia thorough companies incorporated in their home countries. Russia's treaties with the UK, Germany, Ireland, France and the US were all entered into in the 1990s and are consistent with the OECD Model Treaty. However, by far the most popular treaty among foreign investors in Russia is that with Cyprus. The combination of Cyprus' tax haven rates (approximately 4.25 per cent) and secrecy laws, as well as 0 per cent withholding rates on dividends, interest and royalties and no anti-treaty shopping article in the Treaty, have made Cyprus companies the investment vehicle of choice for many foreign investors. Despite threats by the Russian Government to terminate the Cyprus Treaty, in late 1998 the Cyprus and Russian Governments signed a new treaty that is generally as beneficial as the current version. The new treaty will come into effect only after ratification by the parliaments of Cyprus and Russia.(check)
     Below is a summary of the withholding rates on dividends, interest and royalties in several of the major Russia tax treaties.

*Country*	*Dividends (%)*	*Interest (%)*	*Royalties (%)*
Cyprus (current)	0	0	0
Cyprus (proposed)	5/10	0	0
Austria	0	0	0
US	5/10	0	0
Canada	10/15	10	10
United Kingdom	10	0	0
Germany	5/15	0	0
Ireland	10	0	0
France (from 1 January 2000)	5/10/15	0	0
Netherlands	5/15	0	0

     Because refunds of Russian taxes are paid, if at all, after long delays, most foreign investors have attempted to obtain an advance exemption whenever possible. The basic rule is that advance exemptions are granted only for income that is 'regular and homogeneous'. This generally includes interest, dividends, royalties, capital gains if paid in instalments, and management fees.
     Certain of the newer Russian tax treaties contain anti-treaty shopping articles (e.g., the US-Russia Treaty) or require that the 'beneficial' owners of certain types of Russian income payments be treaty country residents (such as the Germany-Russia Treaty). However, the USSR treaties that have been assumed by Russia, particularly the popular Cyprus-Russia tax Treaty, do not contain anti-treaty shopping articles or beneficial ownership requirements. The proposed Cyprus-Russia tax Treaty also does not contain an anti-treaty shopping article.
     Finally, it should be noted that despite the large number of Russian tax treaties, tax inspectors outside the major cities of Moscow and St. Petersburg often have little experience in applying treaty provisions. Thus, many foreign investors have encountered difficulties in claiming tax treaty benefits in the Russian provinces.

     Dividends

     Dividends paid by a Russian company to a foreign legal entity shareholder are subject to a 15 per cent withholding tax. Dividends paid to a non-resident individual shareholder are subject to a 20 per cent withholding tax. Dividends are not deductible by the Russian company. Most Russian tax treaties provide for reduction or elimination of the withholding tax on dividends. Because dividends are 'regular and homogenous', it is usually possible to obtain an advance exemption from the withholding tax.

     Repayment of debt

     Repayment of debt by a Russian company to a foreign shareholder or affiliate is not subject to Russian tax. Similarly, repayment of debt by a Russian company to a Russian bank subsidiary of a Western bank, along with release of an offshore deposit or guarantee, are not subject to Russian tax.
     Some multinational foreign investors in Russia have preferred to fund their Russian subsidiaries primarily with debt because repatriation of a debt investment is easier than repatriation of an equity investment (see next section). However, as discussed above, there are issues that may discourage the use of debt. First, a significant amount of debt may cause the Russian company's net asset value to fall below its charter capital or minimum charter capital and result in the attendant consequences discussed above. Secondly, if the Russian company is expected to generate taxable losses before deductions for interest expense, it may be more tax-efficient for the foreign investor's worldwide group to place the borrowing for the investment in the Russian subsidiary in a jurisdiction in which a deduction for interest expense may be utilised currently.

     Redemption of shares

     Although the Russian rules for sourcing income are unclear, the redemption of a foreign shareholder's shares in a Russian company is normally treated as giving rise to Russian source income. The foreign shareholder's gain on the redemption of shares (or the entire redemption proceeds if the amount of gain cannot be established) is subject to a 20 per cent withholding tax, unless reduced or eliminated under a tax treaty.
     There are two main tax issues connected with the redemption of shares held by foreign shareholders. First, in calculating a foreign shareholder's cost basis in its shares, the historical ruble acquisition price is used. However, it is unclear whether cost basis includes only contributions to charter capital (as reflected in the nominal value of the shares held by the foreign shareholder) or also include share premium paid in connection with the acquisition of the shares. Secondly, as discussed above, advance treaty exemptions are available only for 'regular and homogeneous' income. While a lump sum redemption payment would not be considered as 'regular and homogeneous', some foreign investors have been able to obtain advance exemptions for share redemptions by dividing the redemption proceeds into two or more instalment payments.

     Sale of shares

     Like a redemption, the sale of shares of a Russian company by a foreign shareholder is normally treated as giving rise to Russian source income. This is true regardless of whether the sale is attributable to a permanent establishment in Russia of the seller. The foreign shareholder's gain on the sale of the shares (or the entire sale proceeds if the amount of gain cannot be established) is subject to a 20 per cent withholding tax, unless reduced or eliminated under a tax treaty. If a foreign legal entity sells the shares to another foreign legal entity and neither has a taxable presence in Russia, there is currently no mechanism for enforcement or even payment of the tax.
     The two issues discussed above with respect to redemptions also apply to sales of shares. In the case of a sale, however, the issue regarding calculation of cost basis is more complex where the foreign seller acquired the shares in foreign currency from another foreign legal entity. It is unclear whether the cost basis is calculated in rubles at the exchange rate on the date of purchase or on the date of sale.

     Tax disputes

     A complaint frequently heard from investors prior to the introduction of Part One of the Tax Code has been arbitrary decisions and uncivil treatment meted out by the tax authorities in situations of disputes with individual tax payers. It was stated that the tax authorities constantly violated existing rules and taxpayers did not have effective mechanisms to protect their rights. Moreover, the balance of rights between the tax authorities and taxpayers was tipped in favour of the tax authorities. In particular, the tax authorities could audit a taxpayer for any tax period and the audit could last for an unlimited period of time. Many investors found that the tax authorities often used their broad audit powers to harass taxpayers.
     The new Code deals with such past criticism through setting forth certain basic principles of the Russian tax system. These basic principles include the following:
     (a) Taxes may not have a discriminatory character or be applied differently depending on political, ideological, ethical, confessional or other differences among taxpayers.
     (b) Taxes must have an economic basis and may not be arbitrary.
     (c) In the establishment of taxes, consideration shall be given to the actual ability of a taxpayer to pay a tax, proceeding from the principle of fairness.
     (d) Taxes may not hinder citizens' realisation of their constitutional rights.
     (e) A tax shall be considered as established only if properly defined in terms of all aspect of its application and calculation
     (f) Taxes shall not violate the unitary economic space of Russia, directly or indirectly limit free movement of goods or monetary means within the boundaries of Russia, or in any other way limit or create obstacles to the legal activities of taxpayers.
     (g) Tax laws that establish new taxes, increase tax rates, establish or aggravate liability for tax violations, establish new obligations, or in any manner worsen the position of taxpayers may not be retroactive. Tax laws that remove or mitigate liability for tax violations or establish additional guarantees for the protection of rights of taxpayers shall be retroactive.
     (h) All irremovable doubts, contradictions and ambiguities of tax laws shall be interpreted in favour of taxpayers.(check)
     (i) Each taxpayer shall be considered innocent in the commission of a tax law violation, until his guilt is proven by court in the established procedure.
     Part One of the Tax Code establishes a relatively clear set of rules and procedures for the conduct of tax audits and provides taxpayers with greater protections against abuses by the tax authorities than under the prior audit rules which were governed primarily by internal instructions and regulations of the Ministry, of a non-binding nature.
     Part One of the Tax Code also imposes certain obligations on the tax authorities. These include, in particular, obligations to comply with tax legislation and other federal laws, to behave properly and considerately towards taxpayers and their representatives and not humiliate their honour and dignity, to perform refunds and credits of excessively paid and excessively recovered taxes, late payment interest and penalties, and not to disclose 'tax secrets'.

     Tax law penalties

     Prior to the coming into force of Part One of the Tax Code on 1 January 1999, tax law penalties were criticised by taxpayers on two main grounds - overall penalty levels were excessive and the culpability of taxpayers was not taken into account. The Tax Code significantly reduces the level of most tax law penalties under prior law (although the overall number of categories of penalties is more than doubled), and also takes into consideration whether the taxpayer was 'negligent' or had a reasonable excuse for the violation.
     In order for a person to be liable for committing a tax violation under the Tax Code, the following three basic elements must be present.
     (a) The tax authorities prove that the taxpayer is guilty of committing the tax violation. The tax authorities have the burden of proving that the taxpayer acted either 'negligently' in the case of most violations, or 'intentionally' in the case of a few violations. All irremovable doubts as to the guilt of the taxpayer are interpreted in favour of the taxpayer.
     (b) None of the circumstances ruling out the guilt of the taxpayer are present. Even if a taxpayer committed a tax violation either 'negligently' or 'intentionally', the Tax Code lists certain circumstances under which the taxpayer will not be treated as guilty of committing the tax violation. These include commission of a tax violation because of natural calamity or other extraordinary or insurmountable circumstances, commission of a tax violation by an individual who could not be aware of, or control, his actions because of his sickly state, or commission of a tax violation in reliance on written instructions or explanations given by the tax authorities or other governmental body within the scope of their authority.
     (c) The statute of limitations has not expired. In general, a taxpayer cannot be liable for a tax violation if more than three years have passed since the violation was committed However, if the taxpayer commits another tax violation, of any kind, during the three-year period, the three-year statute of limitations for the first violation starts again from the day the second violation was committed.
     Part One of the Tax Code contains 29 tax law penalties, which are generally in line with standard practice in other countries on the most common violations. (check)
     Criminal law penalties for tax violations were introduced in the Criminal Code that went into effect at the beginning of 1997, for evasion of tax obligations of individuals and of companies. For a taxpayer to be guilty of criminal tax evasion, the prosecutor is required to prove wilful intent. The penalties include monetary fines and imrisonment - up to seven years for very large, repeated evasion.

     Appeals procedures

     Taxpayers who disagree with a decision of the tax authorities, such as a tax assessment following a tax audit, have two choices for appealing the decision: an administrative appeal or a judicial appeal.
     In an administrative appeal the taxpayer files an appeal either with a higher level of the Ministry of Taxes and Collections or a higher level official within the Ministry. For example, a decision of a local tax inspectorate would normally be appealed to the relevant regional tax inspectorate, while a decision of a local tax inspector would normally be appealed to the head of the local tax inspectorate. A taxpayer is required to file an administrative appeal within three months from the day on which he learned or should have learned of the violation of his rights, although this period may be extended. The tax authorities must consider an administrative appeal within one month of receipt of the appeal. Filing an administrative appeal does not foreclose the taxpayer from filing a simultaneous or subsequent appeal with a court.
     It is important to note that filing an administrative appeal does not automatically suspend the execution of the appealed decision. However, the tax authorities with which an administrative appeal is filed are authorised to refrain from collecting the assessed tax from the taxpayer following an appeal if they expect that it may be inconsistent with Russian legislation.
     With regard to judicial appeal, one of the most positive trends for taxpayers is the success that they have been having in Russian courts with their appeals against decisions of the tax authorities. Although precise statistics are not available, it is estimated that taxpayers win over 50 per cent of cases involving disputes with the tax authorities.
     A company or individual entrepreneur files a judicial appeal in an arbitration (commercial) court, while an individual other than an individual entrepreneur files his appeal with a court of general jurisdiction
     The general statute of limitations for filing judicial appeals is three years. In general, an arbitration court is required to render a decision within two months after acceptance of the appeal. The arbitration court's decision may be appealed at least twice by either the taxpayer or the tax authorities.
     At the request of the taxpayer, an arbitration court has the discretionary right to apply injunctive measures prior to issuing its decision. That is, the court may effectively suspend the tax authorities' execution of the decision that is being appealed. Taxpayers usually request such injunctive relief when the tax authorities have assessed a large amount of tax in order to prevent the tax authorities from collecting the assessed tax from the taxpayers' bank accounts or other property until the court has taken a decision. Courts sometimes, but not always, grant injunctive relief.
     Tax consequences of different forms of establishment
     Foreign investors in Russia have either established themselves directly via an accredited representative office or branch or indirectly through a Russian a company (joint stock or with limited liability) or partnership. As the tax consequences of the various forms of establishment open to foreign investors differ, it is worth giving a brief overview of relevant considerations.
     Accredited Representative Office (ARO) is the oldest form, available already in Soviet times. It has long been popular with investors because of the substantial benefits enjoyed in terms of tax, customs and currency operations. In recent years, however, many of these benefits and privileges have been removed, so that the only important benefits now only apply with respect to certain VAT payments and the non-resident status for foreign exchange regulation.
     Branches can technically engage in business operations which are prohibited to ARO's (although the restriction that AROs should not engage directly in commercial activities are not always enforced). They enjoy the same non-resident status for foreign exchange operations as AROs. Although branches in the past have been hampered by many practical constraints due to a lack of familiarity on the part of many officials with this form of legal status, it is expected that investors may increasingly prefer this form as ARO tax privileges have been cut back. In banking, branch status is in principle allowed but entails the same capitalisation requirement as for subsidiaries.
     Joint stock companies, whether open or closed, must comply with the governance structures established by the Joint-stock Company Law (very bureaucratic rules) as well as the Civil Code and are subject to capitalisation rules that generally discriminate against foreign investors (100 x minimum wage compared to 1000 x minimum wage)…They must also register share issues with Federal Securities Commission (very bureaucratic) and must pay tax (0.8 per cent) on each issuance.
     Limited liability companies does not issue shares or stock and thus do not need to comply with security regulations as do joint stock companies, although the capitalisation rules are the same as for joint stock companies. Also advantage that corporate governance formalities less cumbersome. A participant in a limited liability company has the unilateral right to withdraw from the company at any time and demand redemption of the participant's participatory interest in exchange for the net asset value of the interest.
     Thus investors have generally preferred this version of establishment over the joint-stock form except in cases where the right for partners to withdraw unilaterally has been seen as a potential risk.
     Both joint stock and limited liability companies have the same tax obligations as... (check)
     A general partnership is a legal entity established by two or more general partners on the basis of a partnership agreement. The general partners engage in business activity in the name of the partnership and are jointly and severally liable for the debts of the partnership. A person may be a general partner in only one general partnership.
     A limited partnership is a legal entity established by one or more general partners and one or more limited partners on the basis of a partnership agreement. The general partners engage in business activity in the name of the partnership and are jointly and severally liable for the debts of the partnership. The limited partners do not engage in business activity in the name of the partnership (except by power of attorney) and their liability for the debts of the partnership is limited to the amount of their investment.
     The same rules apply to tax payments in that both general and limited partnerships are separate tax payers for all major taxes. Under the Civil Code, the respective partners also enjoy substantial flexibility in determining rules for governance of their partnership.
     A simple partnership (also referred to as a 'joint activity') is an arrangement under which two or more partners combine their property or services, without the formation of a legal entity, in pursuit of a defined joint business activity. Like a general partnership, the partners in a simple partnership are jointly and severally liable for all debts of the simple partnership. A simple partnership is a reasonably well-known form of activity, with antecedents in the Soviet era in the form of 'co-operation agreements'. For this reason and the favourable taxation regime discussed further below, simple partnerships are the most popular of the partnership forms in Russia.
     The partners in a simple partnership have broad discretion in defining the terms of their relationship, including management responsibilities, expense sharing, and profit distribution. Unless otherwise provided by the partnership agreement, property and property rights made available for joint use by the partners become the common property of the partners, as well as the property that results from the activities of the partnership.
     The taxation of simple partnerships is considered to be quite favourable, although somewhat unclear. (In fact, simple partnerships are often used for tax minimisation or tax avoidance purposes.) Neither contributions of property to, nor distributions of property from, a simple partnership are treated as taxable dispositions of the property. Since a simple partnership is not a legal entity, it is not treated as a separate taxpayer of any tax, including profits tax. Thus, partners in a simple partnership are liable for profits tax on their respective distributed shares of profits of the partnership, although losses are not deductible by the partners. VAT on the turnover of a simple partnership is usually paid by the partner that maintains the partnership's accounts or by the partner that executed the relevant sales contract. Property tax is paid by the partners based on the assets they contributed and their respective shares of property resulting from the activities of the partnership.
     The taxation of a foreign partner in a simple partnership is uncertain. The prevailing view is that whether a foreign partner's share of profits from a simple partnership is attributable to a permanent establishment in Russia is based solely on the foreign partner's activities in Russia, i.e., the activities of the simple partnership are not imputed to the foreign partner. Although this treatment presents interesting opportunities for foreign investors, caution should be exercised until the tax authorities formally clarify their position. (check on this)

     Chapter IV. Privatisation POLICIES

     1. Executive Summary

     The Russian Federation completed its small-scale and mass privatisation programme by 1994, succeeding in transferring ownership of 40 per cent of state-owned enterprises to some 40 million citizens largely by voucher distribution, either directly or via the intermediation of investment funds. Over 75 per cent of the Russian workforce is now estimated to be employed in privately owned companies.
     This massive privatisation undertaking endowed the Russian economy with a basic corporate sector, a corporate securities market and its first network of institutional investors. The use of vouchers led, however, to dispersed ownership structures and widespread insider (management) control (up to 65 per cent on average) of privatised companies. The state retained up to 20 per cent of many companies, with little cash investment taking place at this time. The question of enterprise reform was largely ignored on the assumption that this would be the object of a further phase of redistribution of ownership rights involving the disposal of the residual state shareholdings. Mass privatisation was regrettably not accompanied by the necessary land reform, one of the many difficult political dimensions of privatisation in the Russian Federation. Altogether, the highly politicised context contributed to unstable and inconsistent legislative practices resulting in uncertainty and discriminatory treatment for many investors which are still perceived to be part of the Russian investment climate to this very day.
     Against this background, the second - "cash" - privatisation phase failed both in its prime objective to generate revenue for the state and - for want of a comprehensive plan based on strategic investment and enterprise reform needs - to attract enough outside foreign or domestic investors to tackle the corporate restructuring problems. Investors were critical of the lack of transparency of this privatisation initiative during which many shareholdings were sold below their real value to insiders and the well-connected dominant financial-industrial groups (FIGs). As the failure of "cash" privatisation rapidly became apparent, a controversial "loans for shares" scheme was introduced, whereby shares in selected important state-owned companies were auctioned to a consortium of major banks (mostly with links to the FIGs) in return for loans. These auctions were conducted without transparency, fair competition and open access for foreign investors. The scheme proved highly controversial, the loans provided were mostly not commensurate with the market value of the shares and the FIGs were able to consolidate their control of substantial shareholdings in the companies involved in the scheme. This left a legacy of disputes and unresolved issues which dogged the privatisation process in the years that followed.
     Legislative provisions were made in 1997 to complete case-by-case privatisations and compile lists of assets and shareholdings to be privatised or retained in state ownership for strategic reasons. Commercial valuation of assets and market-oriented tender procedures were announced. With the exception of a few significant sales, there was little interest in the residual state shareholdings as other unresolved issues such as land and property rights, comprehensive enterprise reform and administrative barriers increasingly preoccupied investors. In the difficult period leading up to the financial crisis in 1998, privatisation potential was further limited by conditions affecting international investment activity in the oil sector.
     Further legislation and a detailed policy statement in late 1999 are expected to shape the future privatisation strategy of the Russian Federation during the present decade. New approaches involving more clearly defined priorities for the sale of the remaining state assets, new privatisation methods and increased emphasis on professional, commercial and transparent deal structures and procedures have been announced.
     The necessary further legislative changes and clear evidence of the government's commitment to practical implementation of the new approaches are, however, still lacking as investors have been getting mixed messages from recent privatisation transactions.
     All Russian privatisation legislation enshrines, in principle, free access and national treatment for foreign investors in all areas exception those of importance for national security or where there are moral or ethical concerns. This has not, however, protected foreign investors against discriminatory and unfair treatment as a result of changing requirements, legislation and procedures at different levels of investment projects and before and after their implementation. There is still no clear indication of the Russian government's intentions concerning non-residents' access to natural monopolies and some major companies in the oil, energy and aerospace industries. In practice foreign entrepreneurs have mostly opted for joint ventures, direct acquisition of companies from management or share purchases on the primary or secondary markets to establish an investment base in the Russian Federation.
     Investors' concerns still revolve around the continuing absence of a clear long-term privatisation programme, unresolved ownership, corporate governance and other (legal) problems dating back to the cash privatisation and "loans-for-shares" scheme, poor management of residual state shareholdings and the lack of institutional and procedural transparency for the handling of future transactions.
     With the transfer of ownership from public hands now largely completed in the Russian Federation, there is no call for a new privatisation model. Rather it seems clear that resources should now be devoted to restructuring and resolving ownership and governance deficiencies in privatised companies. Underlying issues such as the rule of law, the fiscal regime, administrative barriers and lack of financing resources affecting the overall business environment must also be addressed. (cf. chapters 1- 3;5). Priorities for the completion of privatisation should be the resort to direct and competitive sales to strategic investors for the more marketable stakes, appropriate organisational and administrative procedures for the full privatisation of minor shareholdings and state assets requiring extensive restructuring and the introduction of sound management structures for property remaining in state ownership to eliminate malpractices.

     2. Introduction

     The privatisation process in the Russian Federation has progressed at a relatively rapid pace, although the choice of strategies has been severely conditioned by the need to build support for reforms, sometimes at the expense of improving enterprise performance. While not burdened with the complex restitution issues experienced in many transition economies, other particular problems marked the evolution of privatisation is the Russian Federation. These involved the early and spontaneous transfer of state assets into micro entities with varying (legal) forms (quasi-private, quasi-collective) and the prevalence of large-scale, locally or even regionally dominant industrial complexes requiring far-reaching restructuring with potentially serious social implications. The issue of ownership reform within the context of privatisation also proved highly problematic and subject to considerable political and populist pressure. The strong political aspects of privatisation policy in Russia contributed to the inconsistency and instability of evolving legislation, giving rise to contradictory legislative acts, frequent changes in tactics and procedures and discriminatory treatment of certain groups of investors. Nonetheless, ownership of thousands of state-owned entities was transferred to private hands and over 75 per cent (verify -update) of the Russian workforce is now estimated to be employed in private companies.
     Voucher privatisation was the predominant method in the initial phase with the objective of first-time distribution of private ownership. This objective was achieved, albeit with the result of dispersed ownership structures, leaving many companies in the control of existing management, more often than not without any underlying restructuring plan. In a second phase the focus was on concentrating ownership and generating revenue for the state, although lack of strategic consideration of investment and enterprise reform needs and transparency resulted in valuable shares being sold below their real value to insiders and large financial-industrial groups (FIGs). By 1997 the strong competition among powerful groups for the remaining desirable state assets created scandals and controversies around major privatisation transactions throughout the period leading up to the financial crisis in 1998. Since then the pattern of below-value sales of state assets to politically well-connected companies has continued. It now remains to be seen whether, under the Putin administration, the new ideas formulated in the recent privatisation policy statement by the government will be realised and the remaining transactions concluded in a less political, more transparent and equitable manner in line with best international practices. (monitor progress)
     Evolution of the Privatisation Process 1992-1999

     Legislation and Policies

     The first legislative acts governing privatisation in the Russian Federation were enacted in the Summer of 1991 by the RSFSR Supreme Council even before the dissolution of the USSR. However, their practical implementation began only in 1992, with the Decree On Acceleration of the Privatisation of State and Municipal Enterprises, followed by the approval of the Fundamental Provisions of the Programme for the Privatisation of State and Municipal Enterprises for 1992 which outlined the procedures to be implemented. These Fundamental Provisions had been drafted on the basis of the draft State Privatisation Programme for 1992 and became the first document regulating the privatisation process, initiating the programmed (as opposed to spontaneous) privatisation in Russia.
     The first Privatisation Programme of 1992 embodied the political compromise made between, on the one hand, paid for (by the active part of the population) and free (vouchers to everyone) privatisation and, on the other hand, between the privatisation model for every citizen and special privileges for the enterprises' employees. It also set the stage for the further large-scale privatisation in 1992-1994. Many of the major flaws of the programme, which subsequently have been heavily criticised, can be attributed to these initial compromises, considered necessary for the programme to get off the ground at all.
     The small-scale (mainly service establishments) and mass privatisation (medium-sized and large companies) programme of the Russian Federation was completed between 1992 and 1994. Vouchers were widely distributed to all Russian citizens, both minors and adults. 144 million Russians, representing 79% of the population had claimed their vouchers by end-January 1992, and voucher investment funds were created to serve an intermediary function. This first privatisation initiative had the prime objective of widely distributing private ownership rights with minimal negative social implications and on the assumption that enterprise restructuring would take place in a subsequent phase of redistribution of these rights.
     On completion of the mass privatisation in 1994 the ownership of over 40 per cent of 240,000 state-owned enterprises had been transferred to private hands. More than half of the small enterprises had been privatised (about 75,000 entities) and over 20,000 (verify figures) -joint-stock companies created from the medium-sized and large enterprises in state ownership. Shares of 16,500 of them were disposed of at voucher auctions and acquired by some 40 million Russians either directly or through investment funds of which over 600 were created during this period.
     The process involved, firstly, a closed share subscription reserved for employees, followed by open public auctions mainly at regional level. Shares in some larger companies were sold at interregional auctions, whilst the state retained a block of up to 20 per cent of shares in many enterprises. The groundwork had been laid for the development of new ownership rights, a corporate sector of the economy, corporate securities market and a network of institutional investors.
     Despite the basic achievements of the mass privatisation in terms of establishing a corporate sector, most companies emerged with an ownership structure involving considerable insider control - on average 65 per cent (Pistor & Spicer) - and external ownership distributed among investment funds, banks, other outsiders (collectively up to 22 per cent on average) and the state (17 per cent on average). Little or no direct investment was generated and the ownership structure prevented enterprise restructuring as managers were, in some cases, guaranteed their jobs in return for not selling their shares. Under these circumstances funds interested in reforming companies were thwarted in their efforts to increase their shareholding and effectively influence corporate governance and most groups of shareholders were unable to constitute a stable majority.
     A further problem arose from the fact that companies' real estate holdings were not privatised with their other assets, leaving certain property rights completely unaccounted for in the transactions
     The next phase of the process was governed by the Fundamental Provisions of the State Programme for the Privatisation of State and Municipal Enterprises in the Russian Federation after July 1st 1994.
     The main challenge of this phase in 1995 was to sell off the residual state holdings either by free transfer or sale of shares to employees in a closed subscription, sale of equity by investment or commercial tenders or by auction or sale of remaining shares at interregional or nationwide auctions. Some restrictions were introduced in respect of certain sectors of industry and in the structuring of federal shareholdings and golden shares. This particular privatisation initiative was, however predominantly driven by the need to raise revenue for the federal budget and little emphasis was given to the strategic sale of blocks of controlling shares or capital market sales to attract foreign investors. The Federal Property Fund was responsible for the programme and it was implemented at municipal and regional level by local property funds.
     The process of cash privatisation advanced very slowly and yielded only 1.1 trillion roubles for the Russian government instead of the total revenue of 8.7 trillion roubles, which had been projected for the year. The transactions and tender processes were frequently non-transparent and based on undertakings by buyers to invest in the companies whose shares they acquired. Apart from generating little revenue, the main result was that inside management control was increased in the companies and major banks acquired large blocks of shares in valuable companies. It is suggested that the widespread insider dominance in companies following mass privatisation was a deterrent to potential new outside investors during the cash privatisation phase.
     A loans-for-shares auction scheme was adopted in an attempt to offset the failure of the cash privatisation to mobilise funds for the government. It was first proposed by a bank consortium in mid-1995 (ONEXIM, Menatep, Stolichny, Bank Imperial) and involved the transfer of shares in some of the largest Russian companies (e.g YUKOS, LUKoil, Sufgutneftegas, Novolietsk Iron and Steel) to a consortium of banks as trustees. In return for the shares, the banks provided loans and partly paid off the transferred companies' debts. It was decided to implement the scheme through (carefully controlled) competitive tenders with bids from at least two participants, for "contracts" to provide loans to the federal budget. The blocks of state shares handed over to the banks served as collateral for the loans which the state was to repay at the beginning of 1996. Failure to repay the loans would entitle the banks to sell the shares under certain conditions. This ultimately enabled the lenders to keep the shares by selling them to themselves. 12 rigged auctions took place with little transparency, restricted competition and the frequent exclusion of foreign investors and even many consortium members. The loans provided did not cover the market value of the companies, the transactions being manipulated to accommodate the limited resources of Russian banks. Some companies even challenged the scheme in the courts and, after considerable controversy and criticism, it was abandoned after a short period, although not before many of the financial-industrial groupings involved had assumed substantial blocks of shares in the companies targeted by the scheme. The loans-for-shares scheme ultimately became a source of disruptive (legal) disputes, slowing down privatisation in the years that followed.
     A third component of the 1995 privatisation initiative, the sale of property and plots of land, never advanced for lack of planning and consensus. Another missed opportunity during this period was the Russian government's first attempt at a classic privatisation transaction in the telecommunications sector. Despite the interest of two major international bidders, the transaction never reached a conclusion as a result of inadequate preparation and lack of advance regulatory reform of the sector to shape its future and protect public as well as investor interests.
     The general lack of progress with privatisation in Russia in this period was in part attributed to the weak and contentious institutional framework with none of the authorities involved (see Box XX) capable of demonstrating clear policy or leadership at this critical time.
     Investment activity slowed down further in 1996 following the shares-for-loans scheme and the government proposal to transfer federal shares to the regions in payment of debts. This had had a dampening effect on privatisation as regional authorities speculated on the extent of final share packages they would receive, although ultimately only a few such transfers are reported to have taken place.
     A new law became effective in 1997: On the Privatisation of State Property and on the Basic Principles of the Privatisation of Municipal Property in the Russian Federation. The new features of this law included a focus on the actual state shareholding in enterprises rather than the enterprises themselves, provision for the compilation of a list of objects to be privatised within a year and a list of strategic objects to remain in state ownership. It also stipulated the employees' privileges in the privatisation transactions (discount on share prices). Provision was made for objective valuation of assets on the basis of book and market value. Commercial tenders with investment conditions were introduced and the possibility of a lease with option to purchase was reintroduced under market value conditions.
     A 1997 Resolution On the Procedure for Implementing Individual Projects of the Federal Property Privatisation provided the formal framework for preparing key privatisation projects on a case-by-case basis as a priority for the country, a specific region or sector of industry. This was to provide for the special support of these projects, but coincided with a general deceleration of the privatisation process as the major state shareholdings released for privatisation had already been disposed of and the residual shareholdings failed to arouse interest. Investor activity was also influenced by other still unresolved issues such as the need for enterprise reform and consolidation, unclear land and property rights and other barriers at regional level where federal privatisation decisions were not always respected, nor control over local enterprises easily relinquished, even if they, in a strict sense, were part of federal property. The situation was further exacerbated by ongoing disputes dating back to the loans-for-shares scheme, these difficulties culminating in the financial crisis of August 1998.
     In 1997 there was, however, a number a number of significant sales including stakes in United Energy Systems (8.5 per cent), Svyiazinvest (25 per cent) and some oil companies. A new reverse trend in privatisation also coincided with this period - notably the transfer of shares back to the state by privatised companies in financial difficulties. The shares served as collateral against grace periods for tax payments. (UPDATE)
     The situation in general deteriorated as the financial crisis gathered momentum in 1998 and privatisation prospects were further limited by the lack of appeal of the oil sector due to unfavourable world market conditions up to mid-1999.
     A new law On the State Property Privatisation and on the Basic Principles of Privatisation of Municipal Property in the Russian Federation also failed to promote privatisation transactions, although three lists of potential objects for sale came out in 1999. The first list included stakes in the major joint-stock companies (JSCs) such as LUKoil, Gazprom, Aeroflot - some of these transactions were subsequently postponed and may take place in 2000. (check status) The second list targeted 60 enterprises mainly in the oil and metallurgy sectors with the potential to yield substantial revenue for the state and the third list, some 1,200 residual shareholdings in small and medium-sized enterprises to be sold off by the regional offices of the Russian Federal Property Fund. (update)
     Some results of privatisation in the period 1995-1999 are summarised in Table ??. (table to be updated and clarified)

Table ?? Privatisation in the period 1995-1999

	1995	1996	1997	1998	1999	2000
Number of privatised enterprises	6000	5000	3000	2583	595	-
Approved budget	4,991 trln.à	12,3 trln.	6,525 trln.	8,125 bln.c d	15 bln.c f (in total 18.5)	18 bln.c (in total 23.7)
Actual revenue	7,319 trln.	1,532 trln.	18, 654 trln.b	14,005 bln.e	8,3 blnc (in total 17.3)	-
Dividends on the federally-owned stocks	115 bln.	118 bln.	270,7 bln.	574,6 ìëí.	6,15 bln.	Plan 3,5 bln.

     a. The approved budget has been adjusted in December 1995, actual income has been secured by pledge auctions for 70,8 %.
     b. including 1,875 bln. dollars from the sale of shares of "Svyazinvest" holding.
     c. only from the sale of property.
     d. adjusted up to 15 bln. rbl. In April 1998 (at the Governmental level).
     e. including 12,5 bln. rbl. From the sale of 2,5 % of shares of RAO "Gazprom".
     f. not included into the budgetary revenues.

     Rights of foreign investors

     All privatisation legislation in the Russian Federation provides in principle for free access and national treatment for foreign investors with the exception of areas of importance for national security or where there are moral or ethical concerns. Additional authorisation requirements have nonetheless been arbitrarily imposed on foreign investors at regional level in small-scale privatisation transactions and investors have also been confronted with changes in legislation on foreign ownership levels following the formal conclusion of transactions (United Energy Systems - put in footnote with details update). There is as yet no clear government strategy concerning foreign investors' access to the natural monopolies and former military facilities and restrictions on foreign investment in certain major companies in the oil and energy and aerospace sectors. For want of easier and more secure access to privatisation opportunities, foreign investors have to date tended to prefer joint ventures, direct acquisition of assets from company management and purchase of new issues of shares or existing shares on the secondary market.

Box ??. Institutions Privatisation policy formulation as well as responsibilities for and practical execution of privatisation transactions are divided among different levels and institutions: a) The Russian Federal Assembly compiles, on an annual basis, a list of shares in strategic and non-strategic joint stock companies which are to be offered for sale and a preliminary list of state entities that are to be incorporated for subsequent privatisation. b) The Russian Government makes decisions on the sale of shares, on the vesting of shares in open JSCs into federal property and on exercising the special right or golden share in respect of these JSCs. It also defines the procedure for appointing/electing government representatives in management bodies of partially or wholly-owned JSCs. c) The Russian State Property Ministry makes decisions on the sale of shares, exercises the government's shareholder's rights, issues voting instructions for JSC meetings, empowers private individuals to represent government interests in JSCs and assumes responsibility for the registration of federally-owned shares and related filing procedures. d) The Russian Federal Property Fund exercises ownership and other shareholder's rights relating to shares offered for sale on behalf of the Federal government and records buyers' obligations as laid down in share purchase and sale agreements. It also issues certificates stating the right to acquire shares of open JSCs and monitors the implementation of investment and social conditions of commercial tenders. e) Separate industrial ministries and other federal executive authorities propose candidates to act as government representatives in JSC management bodies and participate in the decision-making process on the transfer, sale and disposal otherwise of federally-owned shares.

     3. The Management of State Property

     As a shareholder of more than 25 per cent in over 2500 joint stock companies (including 382 wholly-owned and 470 majority-owned) in various fields of industry, the strategies and policies of the state in exercising its ownership role naturally have a significant impact on the environment for other investors, even when not directly affected as co-shareholders. A "golden share" is currently retained in 580 companies, and the policy of the State in this respect needs to be clear and transparent to enable other investors to formulate their strategies accordingly.
     In Russia, the top management of the state-owned firms is largely in the hands of officials of federal executive authorities, as management under trust by professionals is rather the exception. It is generally recognised that management has not been very efficient, given the absence of clear contractual objectives and lack of personal accountability and financial liability for failure to adequately represent state interests or other misconduct. There have been a number of well-publicised incidents where the actions of state representatives to the board of federally owned companies - including those vested as being of strategic significance - have had direct negative impact on the net worth of the company and thus on the value of the federal asset portfolio.
     The government has resorted to a variety of methods to ensure better performance, such as personal trust agreement with management (for major strategic stakes such as the 35 per cent ownership of Gazprom), formation of holdings grouping several ownership stakes, entrusting the management of federal stakes to the management companies of major financial-industrial groups or issuing special Presidential Decrees or tailor-made legislation regarding appointments and voting instructions for significant stakes in individual enterprises or branches of industry.
     Special problems of management have been encountered with respect to the non-incorporated so-called unitary state enterprises, of which there were close to 14 000 at the end of 1999. Clear strategies and objectives for these firms have not yet been formulated and their expected reorganisation into joint stock companies has in many cases been resisted by incumbent directors currently enjoying substantial freedom of action. Apart from lack of accurate information and accounting details for these firms as well as the absence of a compulsory audit system, there are resource problems in identifying and appointing new managers, and above all, a lack of accountability and liability of incumbent managers who are, on the other hand, well protected by current labour legislation.
     Thus, a move towards increased efficiency and control of the management of state property in Russia - which in many instances continues to be subject to spontaneous, rent-seeking action by individual managers - would require the following measures:
     · Collection of accurate information for reliable inventories and audits;
     · Establishment of criteria and clear overall objectives for maintaining residual state property and adequate procedures for disposal of remainder;
     · Establishment of efficient property structures by formation of holdings or groupings of interests in accordance with identified economic and social criteria;
     · Formulation of governance criteria for the resulting structures, with clearly stated objectives with respect to private sector participation;
     · Hiring of adequately trained managers under conditions ensuring full transparency, accountability and liability.

     4. Recent Developments

     A document entitled 'Conception of State Property Management and Privatisation in the Russian Federation' was approved in September 1999 and is expected to constitute the policy document for privatisation issues for the next few years and possibly up to 2010.(any changes here, or new policy stements?) It suggests new approaches to the organisation of the sale of the remaining assets in state ownership, among them a differentiated strategy for the privatisation of high-potential companies (revenue-oriented approach) and those in need of fundamental restructuring (business plan-oriented approach). New privatisation methods are also suggested involving derivatives, sales of shares on regulated and non-regulated markets, direct negotiations with investors, instalment payments against bank guarantees. New, stronger emphasis is to be placed in privatisation decisions on professional preparation of transactions, long-term business plans, investment agreements, transparent commercial tender procedures.
     The above innovations would require legislative amendments, particularly in respect of activities on foreign stock exchanges. The unsold minority shareholdings are likely to remain a problem in terms of privatisation and management.
     Despite the soundness of the new approach heralded towards the end of 1999, evidence of its practical implementation has not been impressive to date. Investors are still getting mixed signals from privatisation practices as they await the first improvements in the investment climate promised by President Putin. No apparent changes have taken place at institutional level to reassure investors that responsibilities and functions in handling privatisation transactions are clearly allocated and observed. In fact the Ministry of State Property and the Russian Federal Property Fund both appear to be seeking additional roles and entering different areas of activity without a clear justification of purpose.(Status ??)
     A commercial tender procedure was launched for a 9 per cent shareholding in LUKoil in autumn 1999 and won by a Cyprus offshore company virtually without competition and yielding only 3 dollars per share in revenue for the state. Another major transaction last year was the sale of almost 50 per cent of TNK shares which were priced below the market rate. The conditions of the transaction suggested that, here again, the sale was structured to accommodate a particular buyer close to the holders the controlling stakes in TNK.
     More recently in September 2000, a regional oil company, Onako, was sold at double its starting price to Evrotek, a Russian investor instead of to a politically well-connected rival bidder, Profit House, in what appears to have been competitive tender with no foul play. This is being hailed as the "best privatisation in the country's history" and the first time a company was sold for its real value, despite the fact that foreigners were not allowed to bid on this occasion and some local bidders were involved in dubious alliances with each other. The results of a special auction for just under one per cent of Surgutneftegaz are now eagerly awaited in investor circles, as is the outcome of talks on workable legislation on production-sharing agreements (PSAs - see Section X) to protect foreign investors in mining, oil, gas and other industries requiring long-term investments. (ref. The Economist)
     Other recent developments are less heartening for investors: Norilsk Nickel, a mining company with foreign shareholders, has initiated a dubious share-swap scheme which dilutes outsiders' shareholdings.
     In the telecommunications sector, two mobile phone companies, MTA and Vimpelcom, have reason to believe that some of their frequencies may be confiscated by the government in favour of a new market entrant.(The Economist)
     These and other unpredictable and anti-competitive practices and remaining restrictions (limitations on foreign shareholdings in the articles of association of selected (major) companies) are still an integral part of the business and investment environment in Russia and highlight the fragility and inadequacy of the underlying legislative framework in preventing such abuses.
     Privatisation policies have had and still retain elements lacking in clarity and transparency - e.g. they are often implemented arbitrarily in an unfair and discriminatory manner. Many investors acting in good faith have been misled or defrauded. Reviews of the legality of past privatisations have become commonplace and provide are a further element of insecurity in present and future investment decisions. Much stronger evidence of a comprehensive government plan to address outstanding privatisation issues with an investment-facilitating approach is necessary to restore and sustain investor confidence.

     Main Problem Areas for Investors

     · Mid-2000: Lack of clear and reliable long-term privatisation programme or even fully developed legislative basis for publicly expressed new approaches in late 1999- Scope of restricted areas for foreign investors unclear with the exception of natural monopolies and national security, moral and ethical concerns - seemingly arbitrary limitation of foreign shareholding in certain large enterprises in oil, energy and aerospace sectors. Risk of post-investment legislative changes (e.g. United Energy Systems case) felt by investors.
     · Troubled past history of privatisation transactions with over 40% of total sales estimated to have been concluded improperly. Transparent review process required with provision for protection of minority shareholders, consistent practice in the regions and measures to safeguard the rights of good-faith investors;
     · Management strategy for residual state shareholdings unclear. Changing management practices and status of shareholdings alter outside shareholders' investment basis;
     · Confusing and unstable division of functions among authorities responsible for state assets.
     · Conduct of tender auctions lacking transparency with cases of discrimination between "outsiders" and "insiders" and selective information flows.

     Policy Recommendations

     At the present time, the privatisation process in Russia has run its course almost to the end, and disposal of the stakes remaining in state ownership hardly calls for the design of any new model or scheme. It is obvious from the review of past policies that the more acute tasks confronting policy-makers today relate to issues of restructuring and improving the governance of the privatised enterprises. To achieve results in these respects involves attacking the obstacles and barriers to the development of a healthy business climate in Russia discussed in the other chapters of this study - weaknesses in the rule of law, in public and private sector governance, in the tax area, administrative barriers particularly at regional level, and lack of financial resources for investment projects.
     In terms of dealing with the remaining problems in the area of privatisation, there are three main priorities requiring decisive and consistent policy action:
     a) Engaging in direct negotiation with strategic potential buyers - foreign and/or domestic - of stakes in major corporations remaining in state ownership (to secure adequate compensation). These negotiations must be conducted in an open and transparent manner, applying internationally accepted standards of procedure
     b) Put in place appropriate organisational structures as well as administrative procedures for carrying out the privatisation of non-strategic holdings in minor companies and entities throughout the Federation (this may require redesigning the institutional set-up and division of roles and responsibilities used for past privatisation)
     c) Drastically strengthening administrative systems for management of state property intended to remain in state ownership so as to combat malpractice and reclaim control
     The conduct of privatisation sales under point 1 above would be the most direct and visible signal to foreign investors regarding the policy approach of the present administration, where a repetition of previous non-transparent methods would have immediate repercussions on the perceived investment climate. However, policies under points 2 and 3 would also require adaptation in a positive direction for investors to recognise a more widespread improvement in the investment climate.

     CHAPTER V. FINANCIAL INFRASTRUCTURE AND INTERMEDIATION

     1. Introduction

     The provision of market-based finance to the private enterprise sector has not been developed to the level prevailing in market economies of similar size in any of the transition countries to date. In comparison with Western economies, their financial systems remain fundamentally underdeveloped. Yet the financial sector is at the core of the institution-building necessary to support sustained economic growth. Many studies and cross-country comparisons find financial depth to be the single most important factor explaining differences in growth rates among countries. There is probably close to universal acceptance of the need for developing a viable and efficient financial sector in transition countries so as to stimulate an adequate supply of savings available for real investment purposes. No policy makers would expect all savings to come from abroad in the form of direct or portfolio investment, and there seems to be agreement that the financial sector encourages domestic savings by providing attractive financial vehicles and instruments. Nor is there likely to be any controversy regarding the important role the financial sector plays in allocating savings among alternative investment uses. After all, the whole transition process represents a move away from having the state allocate scarce resources via the plan, to remove the resulting bias towards low-productivity investments in the public sector and allow scope for private sector investments with higher productivity. It is perhaps less generally understood that the financial system is supposed not only to supply and allocate funds, but also to monitor that they are used efficiently, through contractual arrangements with investors and intermediaries. These contracts must in turn be enforceable via the courts or other parties exercising a governance role, in order for an efficient and diversified financial sector to develop.
     Most transition countries have relied on the banking system to provide the crucial function of transforming savings into investment. Capital market structures and institutions take longer to create - not in terms of concrete operating systems but the corporate governance systems necessary for deep and liquid markets with widespread ownership of debt and equity. Institution-building in the financial sector is a slow process, even if, on a technical level, the infrastructure of payments systems, stock exchange trading and clearing and settlement services can be fairly rapidly created. Complex governance arrangements require acceptance of norms, development of trust in regulatory powers and expectations of enforceability of contracts and fair treatment in the courts.
     In the midst of a complex transition context, the shortage of short-term working capital and virtual unavailability of medium-term financial resources for project finance faced by the enterprise sector in Russia is in no way surprising. In addition, the collapse of the banking sector in 1998 and the slow progress in restructuring and rehabilitation of banks since that date has significantly delayed the development of market-based financial intermediation in most regions of the Russian Federation. Pyramid schemes in the early 1990's, followed by the 1998 debacle in the government securities market and repeated infringements of shareholders' rights in the corporate securities market have lowered confidence on the part of the general public in financial instruments across the board. There is also a wider issue of lack of confidence, which causes much of the populations' savings to accumulate in foreign currency, preferably not held in deposits with domestic banks, while liquid funds of the banking system currently accumulate in deposit accounts with the Central Bank of Russia (CBR), rather than being on-lent to the enterprise sector.
     Leaving the crisis and its effects aside for a moment, however, it could be said that what has been lacking in Russia is a coherent policy for the development of the financial system, clearly establishing the priorities for the transition and formulated as a constituent part of overall economic policy for macroeconomic stabilisation and return to growth. In Russia as in other transition countries, banks lie at the heart of financial intermediation function, in view of the lack of development of alternative sources of finance. The important functions to be performed by the banks in providing finance to industry during its transformation and restructuring places heavy demands in terms of soundness and safety of these institutions - in short on the supervision and regulation of banks. This is not because supervision according to high, internationally accepted standards is something desirable in itself, but because it is a tool for controlling to what extent the banks can achieve success in the supply, allocation and monitoring of funds to the enterprise sector. Apart from the much criticised slowness to effectively deal with bank rehabilitation after the 1998 crisis, there have consistently been problems for the exercise of strong and uniformly enforced supervision of banks in Russia during the first ten years of transition.
     Another important element of financial policy which has not been adequately developed in Russia is the more macroeconomic perspective of assisting other sectors of the financial system - in particular the capital markets - to take part in performing the function of intermediation described above. There have not been any coherent, consistent policies in Russia towards the development of the infrastructure and the institutional framework for deep and liquid capital markets. A number of initiatives taken in this direction at various times have foundered on controversies and in-fighting between different ministries and agencies as to whose sphere of responsibility would be concerned.
     Even though debt and equity markets can hardly be expected to play an important role in the early transition in providing new finance for investors, they are extremely important in generating information about the underlying price of assets. They would normally be particularly important in the reallocation of assets following privatisation. In deep and liquid markets, insiders would be more willing to sell and outsiders more able to build up controlling positions. Keeping in mind the perspective that liquid financial markets are closely related to the liquidity of markets for real assets brings out an important factor in the Russian context - if real assets are not easily transferred because of weak property rights and inadequate enforceability of contractual obligations, one can hardly expect that claims to these assets in a financial market would be more easily exchangeable. In addition, financial markets must offer transparency and protection of minority shareholders against insider dealings and abuse of controlling positions.
     This is not to say that direct government intervention through publicly owned institutions or specialised intermediary function would have been advisable - the classic problem of "picking winners" in other than market based settings is inherently difficult, and direct support or bail-outs engender equally classic moral hasard problems. However, both in assisting the banking sector to perform its role in providing funds for viable investment projects and in promoting the development of markets for financial assets, the government's financial policies can play an important supportive role through various policy measures.
     Sections 3 to 9 below address the situation in the Russian banking sector and the degree of development of other sectors of the domestic financial market, in order to describe the context within which investors seek to raise funds for projects and working capital.

     2. Conclusions and recommendations section (in final chapter?)…

     According to the CBR, the most important reasons for the unwillingness of banks to finance production is the lack of information about the true financial condition of borrowers, as well as the inadequate legal basis for creditor rights. Of total fixed capital formation in Russia in 1999 (659 billion roubles) only 4 per cent was financed through bank lending, 17 per cent from budgetary resources and as much as 53 per cent from enterprises' own resources. Data on working capital in the enterprise sector show more than 70 per cent financed by own resources and the remainder through supplier credits and arrears of various kinds (salaries and taxes) while bank credit plays an insignificant role. [Please provide more recent data]
     Hence it is necessary to increase the competitive pressures on banks to meet the needs of productive firms, in particular smaller clients. The authorities can and should take a lead in demonstrating that lending to start-ups and SMEs can be profitable, through introducing special support schemes and venture capital funds where conditions for banks to participate can be made suitably attractive. That access to external financing of working capital is difficult for smaller enterprises can be attributed both to limited competition among banks which relieves banks of pressure to develop lending schemes for SMEs and also high risks and transaction costs of such lending. In addition, there are problems of information and contract enforcement related to legal and regulatory frameworks that are still evolving and inadequate institutional capacities.
     To date in Russia, there do not exist any government-led project co-financing schemes involving commercial banks. A number of investment credit facilities are provided by the government directly to business firms, either financed from budgetary resources, or, as in the case of SME support, indirectly via a range of different tax incentives.
     The government can also play an important role in ensuring that the legal and regulatory framework provided for financial sector activities facilitates development of innovative financial instruments and the setting up of new types of financial institutions. It can even take a catalyst role in innovative financial engineering, by introducing new methods of financing. In the years immediately preceding the 1998 financial crisis, at least two new, important schemes were developed in Russia, which failed to materialise, reportedly for reasons of contentious turf issues between different regulatory authorities. One was the development of a commercial paper market in the Russian context, and the other was a scheme establishing a CBR rediscounting facility for banks of promissory notes (veksels), which could have brought orderly trading and considerably more depth to this unregulated market. These initiatives should be revived.
     As to other innovations, there are venture capital funds in the process of being created, leasing facilities of domestic equipment are being developed for agro-business, aviation and shipbuilding, mining, metalworking and telecommunications. However, much more could be done to facilitate the growth of such financing alternatives, for the benefit of domestic as well as foreign investors. Credit unions do not exist in Russia for want of a legal framework, but experiments with credit co-operatives have been successfully carried out in several regions. Some export credit guarantee and insurance facilities are provided to exporters by the Ministry of Finance, but no fully built-out framework for export credit guarantees exists yet.
     In Russia, it would seem particularly urgent to create and support mechanisms for working capital financing for the vigorous "trading company" sector, which includes many SMEs but also larger firms. During the late 1990's this sector experienced rapid growth, many large firms were established from scratch and managed to develop distribution networks for their products across the whole territory of the Russian Federation. Moreover, these firms have been operating in a very competitive environment, where transactions are settled in "real" funds and no barter or build-up of arrears are tolerated. The 1998 crisis and devaluation naturally constituted a significant set-back for this new industry, but the tendency has since been for these firms to identify cheaper domestic import substitutes. Faced with the need to ensure supplies on a reliable basis, some of these firms have begun to invest in local production, in may cases financed by funds repatriated from abroad. Facilitating access to finance for these companies would seem a good way of giving impetus to a budding SME sector and could at the same time bring many of the firms in question out of a less healthy dependence on mafia-linked funding.

     Suggestions for policy recommendations:

     Opening of banking sector to foreign competition - actively promoting the entry of foreign banks as important agents of innovation and prudent practices. This would include allowing branches - i.e. dropping capitalisation requirement - , removing quotas for Russian employees and other minor discrimination….
     Develop explicit scheme for deposit insurance with compulsory participation and covering fully the deposits of small and uninformed depositors. This would entail removal of the implicit scheme for savings bank - unfair competition..
     review participation in specialised institutions and schemes and concentrate on supporting areas where business activity is already beginning to thrive and additional finance could give substantial boost - viz trading companies…Develop co-financing schemes with commercial banks…
     include recommendations re debtor- creditor regime?
     Facilitate access of small, young companies to the equity market through the creation of a special tier of the market where smaller companies could raise equity finance?
     Improvements in the system for registry of claims on collateral offered as security for loans and develop more rapid and cheap enforcement procedures
     Improvements in financial accounting and disclosure by business firms to facilitate access to bank finance?
     Should the authorities encourage the setting up of special credit information and rating agencies, or do such already exist?

     3. Current situation in the Banking Sector

     Legal and institutional background

     The Russian banking sector consists of the CBR, which is responsible for the exercise of monetary policy and banking supervision, and at present some 1,325 active banks (out of a total of 2,235 registered banking institutions). The 1995 Law on the CBR confirms its status as an independent agency, accountable to the Duma, which can appoint or dismiss its chairman, who is proposed by the President. Both the Chairman and the 12-member Board of Directors are appointed for 4-year terms and make decisions based on a majority vote with a quorum of seven, including the Chairman. There are a number of state-owned banks, of which Sberbank, the large savings institution surviving from the communist era, is the largest, accounting for over three quarters of all household deposits and one quarter of all banking sector assets. Other state banks are Vneshtorgbank (the foreign trade bank) and Vneshekonombank, which handles the external debt operations of the Federal government. In addition, the CBR owns a number of commercial banks abroad. [mention current discussion regarding changes in this situation] The government-owned share of total capital in the banking sector is currently 35.7 per cent, while the share of non-resident institutions is estimated to 8.8 per cent.
     Only a minority of the 1,325 private banks have their origin in the commercial banking departments of the former Soviet state banks. The rest are institutions established since 1990, in most cases to participate in lucrative foreign exchange and trade financing operations. Initially, licensing conditions were extremely lenient and capitalisation of most banks has remained extremely low, even though requirements in this respect were gradually tightened by the CBR. In the run-up to the financial crisis a capitalisation level of 5 billion roubles was only attained by 30 per cent of the banks, and nearly 30 per cent had a capitalisation level of less than 1 billion roubles. The 10 top commercial banks had capital and reserves ranging from 10 to 25 billion roubles, while Sberbank has a capitalisation of some 120 billion roubles. Bad loan problems were substantial, although in many cases hidden by repeated roll-overs of loans with capitalisation of interest. According to CBR's estimates about one-third of all licensed banks were either experiencing serious financial difficulties or in a critical financial condition at end-1997.

     Payments System

     Due to some remaining shortcomings in telecommunications resources and software availability, the Russian payments system is not yet seen as fully developed up to international standards. The 1998 banking crisis and consequent shrinkage of inter-bank relations explain the fact that the CBR still acts as a clearing centre for many banks with underdeveloped correspondent accounts. Bank transfer is the most frequently use payments vehicle. Cheques are rarely used due to the slowness of the cheque clearing system. Modern systems for electronic settlement have been installed by the major Russian commercial banks, but payments delays still occur even in main business centres. Although banks are technically liable to compensate clients for these delays, such rights are not always enforceable.

     Intermediation Role

     Despite the large number of banks still in existence, banking accounts for a small portion of economic activity by international comparisons. In mid-1998, total commercial bank assets amounted to about 30 per cent of GDP, while non-governmental deposits accounted for some 12 per cent of GDP. (This can be compared to the deposit bases of some other transition countries such as Poland, Hungary and the Czech Republic ranging between…..per cent of GDP). In mid-2000, almost two years after the banking crisis, this figure had risen to ..?? The sector is also highly concentrated, with the 200 largest banks accounting for ..?? per cent of the system's total assets as of June 2000. At the top of the pyramid, the five biggest banks with capitalisation in excess of…?? accounted for ..?? per cent of total assets, while only ..?? per cent of banks have a capitalisation in excess of $ 1 million. Concentration to Moscow ???…. Very few banks apart from Sberbank have an exstensive branch network conducting significant retail business. At the end of 1998, there were only about 4,500 branches throughout the vast regions of the Russian Federation, with Sberbank accounting for nearly half and the troubled SBS-Agro Bank for another third. At the end of June 2000, the corresponding data are..??
     Nominal deposit rates offered by banks have been substantially below lending rates since 1995, and only narrowed to an average ?? percentage points difference in 1999. This is partly explained by the low penetration of banks particularly at regional level with a lack of competition in attracting household deposits. It also belongs to the picture that Sberbank deposits are de facto government guaranteed, while for other banks there is as yet no formal deposit insurance system, although a proposal for a privately funded ?? scheme is under consideration by the Duma (What is current situation ???). On the lending side, the high rates reflect both the high yield available up to the crisis on government securities and the real risk of lending in an environment with unclear property rights, non-transparent accounting and regulations which are either seen as lax or unenforceable.
     The main activity of the commercial banks is short-term lending, as the macro-economic and political environment have generally combined to discourage medium-and long-term financing operations. Most of the large Moscow-based banks derive their client base from the financial-industrial groups to which they belong. Apart from servicing the banking needs of these clients, their activities have primarily focused on trading in government securities and equities, interbank lending, foreign exchange and forward operations, export financing, custody services, the servicing of government budget accounts, the issuance of tradeable debt instruments and investment banking activities. Under Russian banking legislation, commercial banks are able to engage in the full range of investment banking activities and in fact hold substantial portfolios of government securities and equities, although actual securities trading is still dominated by separate broker/dealer firms. Prior to the crisis, the high yields available on government securities created a classic crowding-out phenomenon, with an increasing portion of banks' assets taken up by Treasury Bills(GKOs and OFZs).

     Effects of the 1998 Financial Crisis

     In the face of growing evidence of structural fragility in the banking sector the pressures on Russian markets due to the financial crisis originating in South East Asia began to mount after the Summer of 1997. They resulted in rapid capital outflows reversing the (mainly short-term) flows of foreign investment in government securities and equities which had brought about a significant decline in yields on government paper (GKOs/OFZs), as well as a stock market boom, which saw the main RTS share price index rising by more than three times between January and August 1997. The downward pressure on the exchange rate and the CBR reserves at times reached alarming proportions and it is estimated that some US $5 billion of capital left the country during the months of October and November 1997. Although calm was temporarily reinstalled due to decisive action by the CBR, renewed acute instability starting in mid-May 1998 had to be countered with even sharper interest rate hikes. The structural fragility in the banking sector made their balance sheets increasingly vulnerable to price falls on their sizeable, short-term GKO/OFZ portfolios and substantial foreign exchange exposure. Fears of the effects of soaring interest rates and the fiscal effects of the increased cost of deficit financing brought intermittent disturbance during the Summer of 1998 as well as a downgrading of ratings and generally diminished borrowing opportunities. New fiscal and structural reform measures were announced in mid-July 1998, as well as an agreement with the IMF on a package of additional official assistance (a total of US$ 17 billion, including contributions from the World Bank and Japan). However, pressures on interest rates and reserves returned after a temporary lull, and faced with dwindling reserves, the CBR and the government announced a series of emergency measures on 17 August 1998. These included a widening of the exchange-rate band, a unilateral restructuring of GKO/OFZs maturing in the period 1
     9 August 1998 to 31 December 1999,and the imposition of a moratorium on the servicing of private sector external liabilities. Following the announcement of the emergency measures, pressures on the rouble intensified and the authorities finally decided on 2 September 1998 to abolish the exchange-rate band and let the currency float freely.
     The most immediate effect of the August 1998 measures was a virtual collapse of the banking system. Apart from the effective default declared on their large government securities portfolios, banks also suffered the effect of the devaluation on their short-term borrowings from foreign creditors, accumulated since 1997. In addition, many banks had substantial off-balance-sheet exposures in the form of forward currency contracts in favour of foreign investors in GKO/OFZs, which they were unable to square with domestic counterparties in the present circumstances. Due to acute lack of trust among banking institutions, the interbank market virtually ceased to function and the payments system was brought to a stand-still for over a month, leading to sever contractions in output and trade.

     Restructuring the Banks

     The CBR took fairly immediate action to restore the payments system, provide liquidity to paralysed banks and deal with the run on bank deposits by organising a large-scale voluntary transfer of frozen household deposits to Sberbank. However, no coherent and decisive programme for restructuring the many insolvent institutions in the banking system was launched until mid-1999. Well before the crisis the CBR had already embarked on a process of eliminating the problem of undercapitalisation in the banking system by encouraging mergers, restructurings and by outright withdrawal of licenses, but had in several instances been hampered in this work by insufficient powers to enforce closure of insolvent institutions. Legislation to enable the CBR to act in a more decisive manner was created early in 1999 through the enactment of the Law on Bankruptcy (Insolvency) of Credit Organisations, and the creation of a separately funded agency for bank restructuring, the Agency for Restructuring Credit Organisations (ARCO) in the spring of 1999. Nevertheless, it took until the summer of 1999 before the CBR announced the withdrawal of licenses of a number of large, Moscow-based banking institutions, having previously been unable to prevent "spontaneous" restructurings by some of these banks, whereby good assets and viable business was shifted to new, "mirror" banks, leaving impaired loans and liabilities in the original institutions. The adoption by the Duma of a new Law on Bank restructuring in June gives sole responsibility for bank restructuring to ARCO, with new, mandatory powers, including an equitable and transparent mechanism for share write-downs and the possibility to unwind transactions previously undertaken with the intent to defraud depositors and creditors of insolvent banks. The CBR undertook to limit any support to solvent banks or to those undergoing ARCO-approved restructuring programmes, and only offer regular facilities with full collateralisation. The following concrete steps
     in bank restructuring have been taken by ARKO after being vested with additional powers…..(please provide details)

     Improvements to supervision and oversight

     The Law on Banks and Banking Activities passed by the Duma in 1995 lays out rules for licensing bank operations and required reporting to the CBR. This law, subsequently strengthened by the Law on Bankruptcy of Credit Organisations mentioned above, provide the legal basis for the CBR to monitor banking activities and revoke licenses upon a bank's failure to meet its obligations. Since 1995, the CBR has gradually strengthened its supervisory and regulatory control of the banking system, including the formation of a special unit, the OPERU-2, to monitor the activities of the 14 largest institutions. Capital adequacy ratios have been raised, a new Chart of Acccounts was introduced from the beginning of 1998 as an important step towards internationally accepted accounting standards, [when will those be enforced?] and there has been an overall tightening of licensing procedures. In 1998, banks were also required to establish internal risk management controls and adopt new provisioning rules for non-performing loans.
     Further progress is now planned on prudential regulation. Minimum capital levels of 1-5 million ECU will be effective on ? and only those meeting the 5 million level will receive full licenses, while smaller banks will be limited as to activities and geographical scope. Mandatory capital adequacy levels were to be raised to 8 per cent from 1999 when? But due to the crisis…? Update please .

     Foreign participation in the banking sector

     The prospects for the development of the banking system from the viewpoint of its institutional structure depends on the ability of banks to adapt themselves to more severe competitive conditions in a low-inflation environment and their capacity for attracting the necessary resources for building up their capital base, meeting other CBR requirements and diversifying banking services in order to increase their competitive power. In this context, increased foreign participation would provide significant impetus for positive change.
     The Law on Banks and Banking Activities allows non-resident institutions to establish subsidiaries, branches and representative offices in Russia. However, as a matter of policy towards establishment by non-resident banks, the CBR has so far only permitted the establishment in the form of subsidiaries, not branches. The justification offered has been that the CBR wishes to exercise supervision over all resident banks, while branches would be supervised by the authorities of the home country. Statutory licensing requirements are the same for foreign-owned banks as for domestic banks, except that foreign institutions have to provide balance sheet data and audits for the most recent three years and the written consent of the supervisory authority in the home country, if required by the latter. The law also enables the CBR to impose additional requirements on foreign institutions in terms of mandatory regulations, endorsement of individuals in management positions, permitted banking operations and minimal capital requirements. At present a foreign-owned banking subsidiary is required to have a minimum capital of…?? Since January 1996, foreign-owned banks have been able to establish full service subsidiaries that provide retail and whole-sale commercial banking services to Russian clients. (A 1993 Presidential decree had previously restricted these services).
     Non-resident institutions are allowed both to set up new ventures or make acquisitions in existing banks in any proportion, except that hostile mergers and acquisitions would not be allowed and acquisitions above 1 per cent of the charter capital require separate permission from the CBR. A previous restriction limiting the share of foreign banks in total Russian banking system to 12 per cent was repealed in April 2000, which means that no legal barrier exists any longer for the share of non-resident institutions in the sector to increase substantially from its current level of below 9 per cent.
     [note that the charter of Sberbank sets limits on foreign shareholding]
     At present 16 foreign-owned banks hold full operating licenses. Since the crisis they have generally benefited from a flight to quality on the part of Russian clients, who have sought out the stability and security of service provision offered by Western banks.
     The share of foreign banks in the sector in terms of total equity capital, total assets and liabilities is set out below [please give data]

     4. The Corporate Securities Market and its Institutions

     The Russian stock market developed from the trading of the privatisation vouchers which began in 1992 and continued through the trading of shares issued in exchange for these vouchers. Some 40 million new shareholders emerged in this process, most of them having acquired shares in the companies where they were employed. Initially, the market participants were brokerage firms and voucher investment firms, which in some cases set up voucher depositiories. As the secondary market took shape in 1994 when brokers and other securities firms including foreign ones began to take positions in the newly created shares, it was mainly characterised by unregulated, chaotic practices that in several cases resulted in damaging financial scandals.
     In an effort to centralise the promotion and regulation of the Russian capital market a commission of ministerial rank, the Russian Federation Commission for Securities and the Capital Market (RFCSCM) was set up in November 1994 by presidential decree. During 1995 and the first half of 1996, this commission - now the Federal Commission for the Securities markets (FCSM) - succeeded in establishing a regulatory framework, including the licensing of securities, brokerage and investment firms, developing a capital market infrastructure, issuing new regulations and developed special legislation for the setting up of investment and pension funds. Licensed securities firms are now in excess of 3500 [please check]. Many licenses have been granted to banks' securities departments and many securities market subsidiaries have been set up by banks. The FCSM has been on the forefront in recent years to develop the legal and regulatory basis for protection of minority shareholders rights, conbat abuses of controlling positions and insider dealing (see section…)
     Although more than 50 stock exchanges were registered in Russia in mid-1996, it has been estimated that 90-95 per cent of equity transaction are carried out in electronic over the counter trading and organised stock exchanges thus play a marginal role in equity trading. [still true?] With the exception of the Far Eastern market in Vladivostok, stock exchange trading almost exclusively involved government securities. Battling against considerable central and regional resistance, promoters of a NASDAQ-based electronic trading system managed in 1995 to unify brokers and dealers associations located in Ekaterinburg, Novosibirsk, Irkutsk, Moscow and St Petersburg under the electronic Russian Trading System (RTS), which gradually have been linking other regions as well. This system now shares its dominating position with the Moscow Interbank Currency Exchange (MICEX) -originally established to trade currencies and government securities - which recently has emerged as a leading trading floor in Russia. Membership of the equity trading section at MICEX rose from 275 in 1997 to 350 in 2000, while RTS membership peaked at 626 in 1998, falling to about half due to the after-effects of the financial crisis At present RTS - which also publishes the most quoted stockmarket index - is transforming itself into a fully fledged stock exchange and introduce a DVP (delivery versus payment) system and other measures to increase security of trading. [Is this already done?]
     After initial problems and inter-agency regulatory turf disputes, registry and depository arrangements are being streamlined to provide an adequate level of service to investors. [any comments? Remaining problems?]

     Developments since the financial crisis

     Capitalisation and turnover on the equity market remain generally low in relative terms and the market is still perceived as extremely volatile. Since 1996, due primarily to strong demand from foreign investors, stocks of several firms in energy, fuels and telecommunications have become increasingly liquid. About half of capitalisation is represented by oil companies.
     The first eight months of 1997 witnessed a genuine boom in the Russian securities markets, which gained a status among foreign investors as the hottest emerging market in the world. Foreign investment both in government securities and equities rose rapidly, only to be abruptly curtailed after the Summer in consequence of investor reassessment of emerging market risk following the South East Asia crisis. Withdrawals of funds from the GKO-OFZ market drove yields up sharply and the stock market began to plummet, at one point declining by more than 20 per cent in one day. After a temporary stabilisation in early 1998, several further bouts of panic preceded the collapse following Russia's debt default and devaluation in August-September.
     During 1999, Russia's stock market again ranked among the strongest performers in the world, with the index growing by over 140 per cent from the lows experienced in 1998. In 2000, gains have been fuelled by expectations of political stability and improving macroeconomic conditions. However, volatility remains high and advancement in terms of depth and liquidity are not yet significant. The Russian equity market remains very vulnerable in periods of generalised investor apprehension about emerging market risk when there is reduced willingness on the part of investors to tolerate certain shortcomings which are less in focus during boom conditions. These shortcomings relate both to infrastructural deficiencies, particularly in clearing and settlement, and to structural weaknesses affecting the rights of minority shareholders. Several recent high-profile cases of share-holders' rights abuses have contributed to investor sensitivity to Russian risk. [Current capitalisation data - also in comparative terms with other emerging markets]
     Foreign investors have full access to the domestic market, but usually prefer to invest through ADRs and GDRs, both on account of the above-mentioned weaknesses and because of local tax regulations [size of trading in ADRs relative to onshore volumes?] Most of the ADRs are level one , over the counter traded, where no US accounting rules are not imposed, but a few major companies are developing three-year history of standardised accounts to qualify for higher level ADRs.

     Corporate bonds and notes

     Although slow to develop, the Russian corporate bond market has recently seen a surge of issues by major blue chip companies. Given the reluctance of Russian companies to see a dilution of ownership through equity issues, corporate bonds represent a preferable financing avenue. Efforts have also been made to tap into the existing pool of blocked cash proceeds from restructured GKOs held by foreign investors, although it is estimated that most of the funds invested into the recent spate of issues derive from flight capital in off-shore centres. [any estimates?] Issuers cost from offering domestic bonds are tax deductible with the exception of a 0.8 per cent stamp duty. Issues of medium term rouble denominated paper with interest and principal pegged to the US dollar have risen to ???…. Secondary markets are both MICEX and RTS.
     However, the development of a successful bond market usually requires a number of mechanisms and institutional features, of which certain key ones are still absent in Russia: there is not yet an adequate supply of high quality issues and issuers, as well as demand from institutional investors; data transparency and disclosure standards are not yet up to scratch, nor do transparent standards for rating issues to provide a sound basis for evaluating risk associated with particular issues yet exist. [Comments please]
     At the shorter end of corporate paper issuance, the surge of the promissary note or veksel market in the past few years is related to the relatively low level of development of institutions and instruments in the financial sector generally, in particular the absence of the wide range of bank lending products on offer in fully developed markets. As a means of coping with insufficient liquidity and risk assessment capabilities in the banking industry, the use of veksels has probably been beneficial in providing much needed credit in many situations, although their occasional association with fraud, tax avoidance and manipulation of balance sheets is well known.
     Promissory notes which are regulated by a 1997 federal law (recognising that Russia is part of the Geneva Convention governing such instruments) do not require prior registration. Trading is handled in an informal market by a large number of small brokerage houses. It is estimated that daily turnover in this market is many times larger than in the equity market. Plans reportedly exist to make the veksel market more transparent via new regulation, trading mechanisms and a system of rating issuers. [Any news on this??]

     5. The Government Securities Market

     The most actively traded government debt instruments are GKO (Treasury bills), OFZ (Federal Loan Bonds) and off-shore traded hard currency debt (Vnesh and Minfin bonds). Short-term Treasury Bills (GKOs) were first issued by the MOF in May 1993, while six- and twelve months maturities were introduced in 1994. Trade in GKOs is carried out at the MICEX, which also acts as a depository and clearing agent as well as organises settlements.
     While the high yields of these instruments in the period 1995 have acted to draw funds from other markets to a significant extent, creating a classic "crowding-out" phenomenon, the GKO-OFZ market has also conferred important technological benefits for the development of securities trading across the whole country. In the space of 4-5 years, it evolved from a small, experimental market into a technologically advanced nation-wide market, serving as an engine of development for the whole Russian financial sector as well as an important linkage with the international markets.
     Annualised yields on GKO-OFZs in 1995 - 1997 were generally above 100 per cent, sometimes 150 per cent, and became the object of strong foreign investor interest, in line with declining inflation in the economy and gradual removal of restrictions on non-resident access by the CBR. After the collapse of this market during the August 1998 crisis, non-residents accounted for more than 30 per cent of the US$ 40 billion of funds frozen as the government defaulted on the debt. The funds were effectively frozen in special accounts until April 1999, when the majority of foreign investors acceepted the terms of an internal debt restructuring, involving exchange for longer-term, low coupon debt and some cash which can be gradually repatriated in hard currency or dedicated to the purchase of domestic corporate securities.
     The market for GKOs was thus re-launched in 1999 for purposes of issuing the new debt which was to form part of the restructuring agreement, but has since developed beyond this framework, enabling the market to gain some volume and liquidity [what is most recent status?]

     6. Currency and derivatives markets

     [Any concrete developments here in 2000? Controversy between Antimonopoly Ministry and FCSM as to whose turf futures and forward contracts are resolved yet? I presume not a viable alternative yet for foreign investors' hedging purposes?]

     7. Institutional Investors

     The Russian insurance market has not yet got a fully developed legal basis. Licensing and supervision of insurance companies is carried out by the Ministry of Finance via its Rosstrakhnadzor department. Although some 1900 firms were registered in 1999, the size of the sector is still fairly insignificant, with total premiums written in 1998 amounting to 42 billion roubles at end 1998 (US$ 1.5 billion). The market is highly concentrated, with the five largest insuress controlling some 58 per cent of revenues. Before the financial crisis insurance companies were large investors in GKOs. According to regulation, no less than 10 per cent of reserves must be invested in government or municipal securities. However they do not play an important role in intermediation as they are prohibited from investing in publicly traded equity. Cross-holdings between insurance companies and other financial institutions is not prohibited, however. [check]
     Full legislation is not developed for pension funds either as a new law is still under consideration by the Duma (check). Registration and supervision is excercised by the Pensions Committee within the Ministry of Labour and Social Development. The Federal Commission for the Securities Markets has demanded that these funds be transferred under its supervision (check current status) . In early 2000, there were reportedly 267 licensed private pension funds in Russia with estimated combined assets of 17.5 roubles (US$ 625 million). Most corporate pension funds are managed by affiliates of the large Russian corporations and do invest in corporate securities, (any data?) although before the financial crisis they reportedly invested mainly in GKOs. According to Russian law, pension funds are allowed to invest in government-guaranteed securities, listed corporate securities, bank deposits and real estate.
     .Russian mutual funds had about 3 billion roubles under management in the beginning of 2000, and combined with the former voucher funds which reregistered as mutual funds in 1998, they manage some US$ 215 million. A new law on mutual funds was passed in early 2000 and it is replacing an earlier set of regulations and instructions issued by the FCSM. These funds represent an important new vehicle for attracting the large cash (foreign currency) savings of the domestic population which is estimated to some US$ 17 billion in 1999 (any new estimate?) This compares with approximately ??? billion kept in savings accounts in the banking system.

     8. Specialised Financial Institutions

     In 1999, the government took the decision to establish a development bank (The Russian Bank for Development) with a charter capital of US$ 500 million. Funding was allocated through the 2000 budget (is this correct?) and the bank is expected to begin operations shortly… CBR also expects to license a new state owned agricultural bank with a charter capital of US$14 million during 2000. Sources of financing for SMEs in Russia are scarce. In addition to the Federal Fund for Assistance to Small Innovative Enterprises, with a total capitalisation of ??? a number of regions have established such financing schemes…. Is this correct? Any facts available?

     9. Other Financing Vehicles [Any other avenues for raising finance that could be mentioned?]

     Venture Capital

     This sector is still small in absolute terms, although the EBRD is providing assistance through the establishment of ten regional venture capital funds in selected regions, with capital participation of other international donors. The government launched a programme to establish venture funds for technological innovation in early 2000, but the initial capital of the funds is very small. According to the Russian Venture Capital Association, the 40 venture funds currently operating in Russia have a total capitalisation of around US$ 2.5 - 3 bn. About 500m USD of this amount is committed and an estimated 350m USD is invested. [any more info?]

     Trade Finance

     Most banks in Russia fully authorised for foreign exchange operations (in March 2000 there were 700, of which 600 in Moscow) provide trade finance, although the widespread resort to export- import operations as a conduit for capital flight has prompted the CBR to introduce a number of administrative barriers for such operations (see section…)
     The government operates an export insurance guarantee scheme for large export transactions. The largest insurance company, Ingostrakh, which, having been the … is still a partly privatised institution, dominates the market for export insurance, but there are several other insurers operating in this field, including firms with minority foreign partners. Official export credit is not provided, despite the establishment of the state-owned Russian Exim Bank in 1993. Foreign agencies provide standard support for long-term import contracts for industrial and other equipment, although conditions tightened substantially after the 1998 financial crisis. Forfaiting and structured commodity and trade financing is developed mainly for mineral exports

     Financial Leasing

     The legal basis for leasing operations is fully in place, covering movable and immovable property with the exception of land and mineral resources. There is full national treatment, with lease-holding restricted to legal entities registered in Russia for tax purposes. There are nearly 1000 financial leasing companies currently operating in the Russian market, mainly operated as divisions of commercial banks or major oil and gas companies. Rapid growth in leasing business has recently been recorded in the oil, gas, aviation and other transport sectors. The major tax advantage achieved is that all payments under the lease including financial interest is fully deductible for tax purposes, and that unfavourable depereciation rules are avoided. Some foreign firms are operating leasing companies but development is hampered by the fact that leased equipment is fully liable for customs duties. In addition the lessor does not have priority right to the rental payment if the lessee cannot pay, so the sector is seen as too risky [is this right?].

     Annex or Box.
     Practical Experience of Foreign Investors in Financing Local Operations
     As resort to cost effective local finance rarely has been an option for foreign investors, most foreign firms finance their operations in Russia either directly from abroad or via a back-to-back loan through a Russian affiliate of a Western bank. In the choice between equity, debt and financial leasing to finance their investments in Russian subsidiaries, foreign investors usually take account of the following considerations….
     Equity
     Equity investment in a Russian company generally takes the form of cash or property contributions.
     In making equity investments by contributing cash to the charter capital of a Russian company in exchange for shares (in the case of a joint stock company) or participatory interests (in the case of a limited liability company) the corporate procedures are more complicated and time-consuming for joint stock companies than for limited liability companies. A Russian company is not subject to tax on amounts that it receives as a contribution to charter capital.
     As a general rule, foreign investors cannot contribute foreign currency to the charter capital of a Russian company unless the Russian company has a special Central Bank license (which is rare). Accordingly, a foreign investor normally must convert its foreign currency contribution into rubles through a special type 'I' account in a Russian bank before making the contribution.
     Under applicable corporate legislation, a Russian joint stock company may issue shares, and a limited liability company may issue participatory interests, with 'share premium', i.e., the amount contributed for the shares or participatory interests exceeds the nominal value of the shares or participatory interests issued (and thus the amount allocated to charter capital). Although applicable law is not entirely clear, the prevailing view is that a joint stock company (though not a limited liability company) is exempt from tax on share premium that it receives. However, there is a risk that the tax authorities may attempt to tax share premium, particularly if received from a minority shareholder.
     As an alternative to a charter capital contribution, a foreign investor may make a 'gratuitous transfer' of cash to a Russian company. One advantage of a gratuitous transfer is that it avoids the complexities associated with issuances of shares or participatory interests. It should be noted, however, that the Civil Code proscribes 'gifts' between commercial entities. To avoid this problem, it is necessary for the parties to provide that the transfer is governed by the law of a foreign jurisdiction that permits gifts between commercial entities. In addition, a Russian company may need to obtain a license from the Central Bank in order to receive a gratuitous transfer from a foreign investor.
     A Russian company that receives a gratuitous transfer of cash is normally subject to profits tax on the amount, unless an exemption applies. The most notable exemptions include:
     (a) amounts received by a Russian subsidiary from its parent when the parent owns more than 50 per cent of the subsidiary;
     (b) funds received from foreign investors provided that the Russian company uses the funds for financing capital investment of a production nature within one year after receipt of the funds;
     (c) funds received from a shareholder for the purpose of funding the company's 1998 accounting loss (a special exemption that was introduced after the Russian financial collapse in August 1998, as a result of which most Russian companies incurred significant losses).
     Many foreign investors have chosen to finance their Russian subsidiaries in part with in-kind contributions. This is because legislation since 1991 has provided an exemption from import duties and VAT for 'qualifying property' contributions by foreign investors to the charter capital of Russian companies. Under current legislation, qualifying property cannot be subject to excise tax (such as alcohol, tobacco, and automobiles), and must be 'basic production assets', which are defined as assets used for the manufacture of goods or other production assets, but does not include materials for the construction of facilities to be used for such manufacturing. (Thus, contributions of inventory do not qualify for the exemption.)
     Debt
     The three most commonly used forms of debt financing of a Russian subsidiary are shareholder loan, back-to-back loan through a Russian bank, and trade credit. Although non-bank loans are not prohibited under current Russian legislation (unless the frequency of lending rises to the level of a licensable banking activity), the unfavourable tax and currency control rules often make such loans unattractive as a long-term financing mechanism.
     For tax purposes, interest on a loan paid by a Russian company to another company other than a Russian bank is generally not deductible. However, as Russia is a party to several tax treaties that permit Russian companies that are partially or wholly owned by shareholders resident in those treaty countries to deduct interest regardless of whether the lender is a Russian bank .
     Interest paid by a Russian company to a foreign lender that is not attributable to a permanent establishment of the foreign lender in Russia is subject to a 15 per cent Russian withholding tax, but the tax is reduced or eliminated under most Russian tax treaties. Because interest is 'regular and homogenous', it is usually possible to obtain an advance treaty exemption from the withholding tax.
     In a departure from normal international VAT principles, interest charged by a lender other than a Russian bank is treated as a 'financial service' that is subject to Russian VAT. However, if a foreign lender has no presence in Russia, it is possible to argue that the 'place of supply' of the financial service is outside of Russia and therefore Russian VAT should not apply.
     In order to avoid the above tax problems associated with interest payments, some foreign shareholders have made 0 per cent interest loans to their Russian subsidiaries. Before the Russian transfer pricing rules came into effect on 1 January 1999, there was generally considered to be no risk of adverse Russian taxation under such an arrangement. However, it is unclear whether the Russian tax authorities will use the new transfer pricing rules to attack 0 per cent interest loans.
     The currency control aspects of a foreign shareholder loan must also be considered. As a general rule, a foreign company may provide a loan to a Russian company only in foreign currency. Furthermore, if the term of the loan exceeds 180 days, certain currency control restrictions and formalities apply.
     Because of the tax and currency control disadvantages of shareholder loans, many foreign investors debt-finance their Russian subsidiaries via back-to-back loans through a Russian affiliate of a Western bank. The loan is secured either with an offshore deposit of a member of the foreign investor's group or a guarantee.
     For tax purposes, interest paid by a Russian company to a Russian bank is generally deductible, and not subject to VAT. For currency control purposes, licensed Russian banks are free to provide loans to Russian companies in either rubles or foreign currency without special authorisation from the Central Bank.
     The main disadvantage of a back-to-back loan is the financing cost charged by the Western bank and its Russian subsidiary. The cost is usually a spread between the interest on the offshore deposit and the interest charged to the Russian company.
     Trade credit
     When the circumstances allow, foreign investors often finance their Russian subsidiaries through trade credits. That is, the foreign investor supplies goods or services to the Russian company for a deferred payment in foreign currency. There are two major benefits of this mechanism. First, payment under a trade credit may be deferred for up to 90 days (and possibly longer) without the Russian company obtaining a Central Bank license. Secondly, the Russian company may fully deduct interest on a trade credit, although such interest is subject to the 15 per cent withholding tax mentioned above (unless reduced or eliminated by treaty) and may also be subject to VAT as discussed above. If the trade credit does not provide for interest, it is possible that the Russian tax authorities may attempt to impute interest, depending on the length of deferral.
     Company law issue arising from debt financing
     Ian important consideration is that debt financing may have adverse company law consequences. A Russian company that uses significant debt financing and is generating financial losses will usually have a negative net asset value. Both joint stock companies and limited liability companies are required to compare their net asset value with their charter capital and minimum charter capital at the end of each calendar year beginning with the second year after their year of formation. If a company's net asset value is less than its charter capital on any such year-end date, the company is required to reduce its charter capital to the amount of its net asset value, a cumbersome process that requires notification of all creditors. If the company's net asset value is less than its minimum charter capital, the company is required to liquidate. If the company does not liquidate, then any of its creditors or a state agency may seek liquidation of the company in court. Russian law does not provide any mechanism for curing the net asset value problem, such as providing a shareholder guarantee or topping up net asset value after the year-end measurement date.
     Many Russian companies faced this problem at the end of 1998 because of the financial collapse in August of that year. Although it is unlikely that a state agency would force the liquidation of a Russian company that is paying its taxes regularly (as most foreign-owned Russian companies do), there is always a risk that a competitor could covertly arrange to become a creditor and then use its rights to force liquidation.
     Leasing
     Despite the enactment of a special law on leasing in late 1998 and the availability of various tax incentives, leasing remains a nascent activity in Russia for both domestic and foreign lessors. Although some foreign investors have engaged in cross-border leasing, there are still a number of legal, currency control, tax and other issues that need to be further clarified before leasing becomes a widespread financing option. Below is a brief discussion of the tax and other aspects of leasing in Russia.
     Leased assets may be depreciated at an accelerated rate of three times the normal statutory rate. The lessor and lessee can agree on which party will account for the asset on its balance sheet, and thus which party is entitled to the accelerated depreciation. Also, a lessor under a 'financial lease' can fully deduct interest on a loan used to acquire the leased asset.
     An important tax advantage to a Russian lessee is that lease payments are fully deductible, including any interest component. The current value of the lease payment deductions can significantly exceed the current value of the deductions for depreciation and interest (which would normally not be deductible) if the lessee had instead borrowed funds to purchase the leased asset.
     In the case of an inbound cross-border lease, the Russian source income of a foreign lessor that is not attributable to a permanent establishment in Russia of the lessor is equal to the lessor's margin on the lease payment, and not the gross amount of the lease payments. The 20 per cent withholding tax that applies to the margin may be reduced or eliminated under an applicable tax treaty. However, such cross-border leases can result in double VAT, as both the import of the leased asset and the lease payments are subject to VAT. In addition, it is unclear under current legislation whether a foreign lessor is required to obtain a leasing license. Finally, there are currency control issues arising from foreign currency payments made to foreign lessors.

     PART III.

     INVESTMENT POLICIES AND INSTITUTIONAL FRAMEWORK:

     CHALLENGES AND FUTURE DIRECTIONS

     Policy Conclusions and Recommendations

     Introduction

     Russia moved quickly with initial economic reforms, in particular mass privatisation and price liberalisation (despite some temporary re-imposition of price controls, mainly at regional level, following the 1998 financial crisis). Many structural reforms were, however, either incomplete or delayed, frustrating hopes for a surge in restructuring and new investment within the enterprise sector. A genuine competitive environment for business development failed to emerge, and there was no large-scale entry of new firms to receive resources freed from older, non-viable enterprises. This low investment, low restructuring trap is well described by data on economic growth and productivitydevelopments. GDP has fallen by over 40 per cent since 1992. [update figures in this paragraph] Although fixed capital formation began to show positive growth in 1999 it still remains at a level of less than a quarter of the corresponding figure for 1990. Average productivity levels are estimated to be around 24 per cent of the United States average. Soviet age assets, accounting for 70 per cent of the present industrial capital stock, were 30 per cent as productive as US assets in 1992 and are now estimated to be only 15 per cent as productive. Roughly 25 per cent of industrial capacity is in is sub-scale or obsolete assets. On a per capita level both FDI inflows and spending on research and development rank very low in international comparisons. In short, both domestic and foreign investment has been held back.
     In these circumstances it is quite clear that the factors responsible for the comparatively low level of FDI inflows are on the whole the same as those depressing domestic investment. No general solution can be found by seeking to stimulate inward FDI through special incentives or privileges to foreign investors. Seeking remedies in revisions to the legal and regulatory framework for foreign investment - as advocated in some studies - also represents an incomplete approach, as deficiencies in this respect only form a minor part of the picture. The lags in structural reform and the policy deficiencies which have combined to produce an unfavourable climate for domestic as well as foreign investment need to be analysed as a whole.
     Furthermore, studies of the performance of the domestic enterprise sectors across transition countries show evidence that the competitive pressures from foreign firms, via trade and investment, are key factors in promoting product innovation, investment in new plant and sales growth. In the case of Russia, such competitive pressures from foreign firms have generally been weak, not only because of isolation due to the geographical distances from markets, but also because of the relatively low level of FDI.
     Recent data on macroeconomic developments indicate a strong acceleration of growth, which is being reflected in concomitant growth in capital formation, and this trend is expected to continue at least into the year 2001, according to most forecasts. (In 1999 GDP growth was 3.2 per cent, while current estimates put GDP growth at 7? per cent in 2000, declining to ? per cent in 2001 - insert current estimates).
     In addition, the new administration has demonstrated a strong intent to speed up structural reforms and place heavy emphasis on measures to stimulate investment activity across the board.
     With this seemingly large window of opportunity for improving the investment climate in the Russian Federation, it is important to have a clear idea of where the most significant obstacles encountered by investors lie, as well as the most effective ways to alleviate their impact in the short term.
     One fundamental minimum condition for the existence of an attractive investment climate is certainly present in the form of an adequate resource endowment, both with respect to natural resources and a skilled and well-trained work force. Political and economic stability is also a sine qua non, and here the record has of course been variable during the past ten years of transition. However, as mentioned in the preceding paragraphs, vigorous economic growth is being registered and a prospect for medium-term stability is clearly present.
     In addition to providing a stable political environment and striving to ensure favourable macro-economic fundamentals, the government must also facilitate business development at micro level. This includes providing an adequate physical and institutional infrastructure as well as the policies which aim to promote profitable investment activity. In this study we have we have tried to identify major weaknesses in the institutional framework for and the policies towards business activity in general, including FDI.
     A multitude of impediments to the development of a healthy business climate exists in Russia, and these are often interlinked in their origin and nature. The fundamental questions we are posing can be simply stated as follows:
     · Is there an adequate, rules-based legal and regulatory environment for investment?
     · Does it apply consistently, for all, across the territory of the Russian Federation - or are there inconsistencies and regional variations?
     · Are the rules being properly implemented and enforced, or being thwarted through corrupt behaviour and rent-seeking by particular interest groups?
     The first question can, in our view, be answered affirmatively, with some caveats as to a few areas where the legislative basis itself needs to be strengthened in order to adequately protect investor rights and interests. However, the other two questions require a negative answer. There is no unified economic space, no "level playing field" for businesses in Russia, because of the multitude of administrative barriers and obstacles encountered by investors at regional level, often in contravention of federal legislation and regulation. In addition, the uncertainty of proper administration and enforcement of justice by the court system and the degree of corruption throughout the economy further undermine the confidence in the existing legal and regulatory framework.
     A further question deriving from the inventory of minimum conditions for a positive investment environment in Russia is:
     · Are there particular areas where policies could be improved either to remove disincentives for investment (whether foreign or domestic in origin) or generally to put in place missing elements of institutional infrastructure to support investment?
     In this context, we have chosen to focus on the following three issues as areas of priority:
     · The manner in which privatisation is being pursued and the policies towards participation by foreign investors
     · Developments in tax reform - in particular what should be done to address remaining negative incentives for investment
     · The situation in the financial sector and its impact on the availability of finance for investment

     1. Legal framework, protection and enforcement of property rights

     Framework laws

     The legal framework for trade and investment in Russia is established by the 1994 Constitution, the first two parts of the Civil Code adopted in 1995 and 1996 and somewhat more recent legislation on joint-stock and limited liability companies and insolvency. These laws are in turn supplemented by other sector or activity-specific laws on property, natural resources, banking, insurance, and other specialised areas. Some provisions regulating investment are also included in the laws on competition and environment protection. Two recently enacted laws, On general investment activity and On foreign investment do not introduce more security for or restrictions on investors than is already included in other legislative acts. Thus, while the existence of separate legislation on foreign investment activity had some practical significance in the beginning of transition, before the full legal basis for commercial activity was firmly embodied in other major legislative acts, it is now more declarative in nature. Beyond the specific introduction of a grandfather clause with protection against changes in legislation detrimental to investment projects (see Box XX), both laws serve more to reflect the government's commitment to existing investor rights and full national treatment for foreign investors.
     Although legislation at times has proceeded at very rapid pace, with little co-ordination of reforms affecting the same or related areas of economic activity, commercial legal rules are at present sufficiently clear, coherent and operational to support business activity in general. Unresolved legislative issues of major importance for investors remain:
     · the adoption of a universal Land Code;
     · the creation of adequate registry procedures for non-possessory pledges in line with the provisions of the Civil Code;
     · harmonisation of the Tax and Customs Codes with the provisions in investment legislation, in particular as relates to grandfather clause provisions and production-sharing agreements.
     Certain other factors impacting negatively on the legislative framework have not been discussed in depth in this document. These include mutually exclusive provisions resulting from poor co-ordination of legislative acts, and a certain degree of devaluation or undermining of legislation due to the frequency of amendments to laws aiming to resolve short-term problems. In addition there is the general problem of unclear balance of jurisdiction at federal and regional levels, preventing uniform implementation. Another deficiency is the ineffectiveness or even absence of penalties for violation of laws. In addressing these problems, it is of paramount importance that attention be given to safeguarding the stability of laws, particularly by:
     · avoiding successive tinkering and amendments to laws driven by short-term objectives
     · refraining from complete re-codification of laws unless absolutely unavoidable to eliminate inconsistencies
     For foreign investors, part of the general framework described in Part I above deserves to be singled out for immediate reform or rapid advancement of improvements already on the drawing board. This relates in particular to the foreign exchange regulations currently in force and to the area of production sharing agreements for extraction of mineral resources.
     Foreign exchange regulation in Russia provides the basic guarantees for investors as concerns repatriation of profits and dividends, as Russia has accepted the obligations of Article VIII of the IMF Articles of Agreement already since…[check]. However, current legislation requires the prior authorisation of the CBR for most capital account transfers, and the licensing system for such operations is both cumbersome to operate for the authorities and onerous and non-transparent for private sector participants. Priorities for reform are:
     · The rules for the present elaborate system for non-resident rouble accounts should be rendered clearer, more systematic and user-friendly
     · The exchange control system for both current and capital account operations should be amended to permit market participants to make freely those payments and transfers which are required under contracts that have been legally entered into (i.e. firms should not find themselves unable to perform under legally binding commercial agreements because of the foreign exchange regulatory regime or its discretionary implementation by currency control authorities)
     · The 1992 Foreign Exchange Law and its implementing rgulations should be revised to simplify the regime and bring it into line with international practice, in particular by introducing a negative list principle for capital account operations, leaving all but a specified number of items completely free of licensing requirements
     As to the legislation and regulatory regime providing the basis for production-sharing agreements, urgent improvements are needed if the full potential of this crucial area for attracting long-term foreign capital and expertise is to be realised. Beyond the already mentioned need for reconciliation with other legislation, the elimination of discriminatory requirements stipulating minimum shares (in certain cases 90 per cent) for local subcontracting is required, as well as a clearer and more transparent distribution of powers among different ministries and government agencies.

     Protection of property and contractual rights

     In practice, one of the major problems encountered by investors relates to the protection and enforcement of property rights, as discussed in some more depth in Part II, Chapter I above.
     The insecurity of property rights in Russia perceived by investors relates in particular to the protection of shareholder/investor rights, protection of secured and unsecured creditors rights and to the balance between debtor/creditor interests in bankruptcy proceedings.
     As to shareholder rights, the many well-publicised corporate scandals during the period 1997 - 2000 illustrate that it is the in the reorganisation of juridical persons that the infringements of ownership rights of shareholders and portfolio investors in general have been most widespread. Above all, attempts have been directed towards pushing out individual minority shareholders into new companies in a less favourable financial situation or transferring valuable assets to other entities leaving only impaired assets in the original shareholding structure. The need to strengthen regulation and oversight by the authorities in the domain of corporate governance to prevent these and other infringements of shareholder rights is widely debated in today's Russia. The appropriate response from the regulatory and supervisory powers is currently being designed, with a significant role to be played by the self-regulatory organisations and private business through the development of codes of conduct for securities market participants. However, unless the legal basis covering reorganisations is amended, such abuses are likely to continue.
     In the domain of corporate law, attention should be given to:
     · Widening the monitoring capabilities exercised by the board of directors and minority shareholders of the executive organs of companies and majority shareholders;
     · Prohibiting insider dealing;
     · Qualifying deals among affiliated entities, widening the concept of an affiliated party and strengthening the power of regulatory authorities to prohibit such deals when required;
     · Extending disclosure requirements as well as the responsibility for the content of such information disclosure;
     · Regulating the dilution of share capital;
     · Limiting cross-ownership of share capital;
     · Strengthening the requirements for independent audits;
     · Protecting good faith shareholders from effects of invalid share transactions;
     · Introducing personal liability and responsibility for officers, directors and controlling shareholders for the damages inflicted on the own company , or on its shareholders (with outright dismissal for breaking corporate governance norms and imprisonment in graver cases).
     There are pressing needs for amendment to the law on joint stock companies on the following points: (1) the introduction of pre-emptive rights for all shareholders to participate in new issues of shares irrespective of any stipulations regarding such a right in the company's articles of association; (2) decisions regarding issuance of additional shares or obligations convertible into shares through closed subscription should be the exclusive prerogative of the general shareholders'meeting; (3) prohibiting the conversion of an open underwriting into an effectively closed one through a requirement that the shares should be paid for with specified property; (4) strengthening the powers of the board of directors to control the executive organs of the company; (5) clarifying of the procedures for calling a general meeting of shareholders; etc. A law project introducing these amendments was adopted by the Duma in the third reading on 2 June 2000, but the Federal Council later blocked the draft changes, reportedly due to pressure from certain major companies.[latest developments?] [insert paragraph re current efforts by FCSM, OECD and other IFIs to elaborate White Paper re corporate governance code to stimulate voluntary efforts of compliance with accepted principles by market participants]
     Such amendments are not intended to signify exclusive concern with legal protection of minority shareholders' rights from infringements by major shareholders. From the legal standpoint it is necessary to find a sensible balance or compromise between the necessity to provide minority shareholders and foreign investors the protection they require from infringements of property rights and at the same time avoid blocking up the legal system with unfounded claims made by minority shareholders on the basis of private agendas.
     Lack of compliance with disclosure requirements must be addressed both in the joint stock company law, in the law on protection of rights and legal interests of investors, the law on securities and also through the introduction of international accounting standards and criminal liability for non-compliance.
      important task for supervisory authorities is the introduction of a system for monitoring who participates in the share capital of companies and the establishment of clear rules concerning mergers and acquisitions. This is extremely important for preventing insider dealing. A mechanical extension of the concept of affiliated party is not enough, since the establishment of transparency of ownership relations in a company or a bank requires penetration into the dynamics of real owners/decision makers. In order to provide outsiders with real information about who the major principals of a corporation are and to bring the latter to take responsibility for any infringements or direct damage inflicted on shareholders it is necessary to expose flows of funds between entities to identify group holding relationships. Within the framework of corporate law it is necessary to prevent the establishment of the type of "overnight" shell companies without proper capitalisation, which are used in operations diluting the authorised share capital of another company, in order to protect creditors and assist them in the recovery of losses incurred through this route.
     The protection of creditor rights is of crucial importance for the further development of investment activity in Russia. Deficiencies in the present situation have to be addressed via a balancing of protection and enforcement of contractual rights, corporate law, bankruptcy procedure, tax legislation and execution of court judgements.
     The new law on bankruptcy which entered into force on 1 March 1998 attempts to strike a correct balance of incentives both to debtors to honour their contractual obligations and to creditors not to abuse the institution of bankruptcy. It includes detailed provisions for both reorganisation and liquidation but could benefit from further refinement and clarification. There is still a pressing need to shield debtor companies from attempts to seize their assets through unjustified or invalid petitions for bankruptcy. The trigger mechanism needs to be refined so that it is not pulled to early on still solvent companies and also to improve the rights of certain interest groups, including the state. It is necessary to increase the ability of court institutions to refuse the use of bankruptcy procedures as a standard means to extinguish debt (possibly by referral to bad faith use of the rights established in Article10 of the Civil Code). In order to initiate bankruptcy proceedings, creditors should be forced to establish clearly that no other means exist to pay off the debt in question. Another major problem remains in the placing of all federal, state and local tax claims above those of secured as well as unsecured creditors in liquidation. Another frequent complaint in Russia has been that minority shareholders are not heard or not even able to vote in negotiations concerning reorganisation plans proposed as alternatives to liquidation. Further strengthening of certification and training requirements imposed on external administrators is also needed.
     Policy direction in this area should be:
     · Refining the criteria for triggering the commencement of insolvency procedure in order to avoid invalid petitions for bankruptcy of actually solvent companies, and introducing liability for intentional misuse of the insolvency process through fictitious bankruptcy petitions;
     · Developing clear criteria for choosing between liquidation and reorganisation and establishing the conditions for rejecting competitive execution in favour of prolonging the period of external management;
     · Strengthening the certification requirements for external administrators and introducing some form of control of their activity and liability for action taken in the exclusive interest of certain groups of creditors;
     · Encouraging the formation of professional management companies involving trained professionals (liquidators, trustees, accountants, lawyers) specialising in the insolvency process.
     With respect to pledge law, creditors are able to take non-possessory pledges on most types of movable assets, but the mechanisms for registration of security interests are not fully developed The order of priority of satisfaction of creditor claims in bankruptcy proceedings is also of importance to the use of pledges. Credits secured by pledged assets in fact only rank in third place, after full satisfaction of claims of higher priority, with the result that there is no unconditional priority for secured creditors. This together with other unregulated aspects of property rights undermines confidence in security as a means of accessing external finance. Thus, to widen the use of pledged security as an instrument for smaller and medium-sized companies to raise finance from banks and other creditors confident of their rights in claiming on the collateral offered the authorities should:
     · Develop dependable and effective centralised system for taking and enforcing security interests;
     · Widen the scope for enforcement of pledges via simplified court procedures or without court assistance;
     · Develop consensus on the basis for a resolution of widespread lingering tax arrears in the enterprise sector of such magnitude that creditors are dissuaded from lending against collateral, given the existing order of priority of satisfaction of claims against a debtor.
     In the area of trust management the incomplete and contradictory status of legislation relating to trusteeships (including the lack of definition of the concept of trust) has led to the widespread use of trust schemes to hide true ownership control, withdrawal and export of assets and tax evasion. For the further development of trust management in Russia it is necessary to:
     · Create legally effective, clearly formulated, non-contradictory trust mechanisms so as to eliminate the wide range for criminal use of the trust concept within the present institutional framework;
     · Address the directly contradictory regulations in joint stock company law (e.g. the prohibition of voting by prior agreement) in the tax code, in the insolvency legislation, etc.
     As mentioned above the protection and transfer of land and real estate ownership, requires the resolution of the long-standing problems regarding transfer of agricultural land which have for many years blocked the introduction of a Federal Land Code. A further, related element needed to underpin the real estate market would be the strengthening of property rights of privatised companies to the land on which they stand. Such rights would give them the possibility to devise more effective management schemes for the land in question and bring into existence the principle of "one company - on unified property complex". Other areas where policy direction would be important are:
     · Development of a state system for registering real estate property and transactions therewith and to strengthen rights to land plots occupied by buildings;
     · Development of a system for real estate valuation, including for assessment of tax liability;
     · Development of legal basis for insurance of property rights to real estate, including titles;
     · Raising standards and licensing requirement for real estate operators.
     As concerns transfer of securities, the weaknesses in the registry dating from the initial development of the securities markets are well known. Following the improvements in legislation and regulation governing the activities of registrars, the following problems and infringements are still common:
     [to be inserted]
     The providers of depository services in the Russian securities markets have also been placed under stricter regulation in recent years, but a number of infringements of investor rights are still common, such as:
     [to be inserted]
     There are also a number of other infringements or lack of proper observance of regulations relating to the issuance, information disclosure, registration and distribution of securities which put investor at risk of having a purchase or sale invalidated. Similar concerns can arise in connection with clearing and settlement activities, for the finalisation of property transfers, and proposals have been raised for developing better regulation of such activities.

     Enforcement and the judiciary

     Weak enforcement of laws is partly a consequence of the failure of the existing Russian judicial system to keep pace with change. There is no special procedure for handling petty disputes and no special courts with different areas of specialisation to develop the necessary expertise for more complex issues. Investors are in fact often deterred from taking cases to court by the lack of independence of judicial procedure and long delays due to court workloads. Judges, bailiffs and other court officials tend to be inadequately remunerated to ensure their commitment to protecting the rights and interests of plaintiffs or enforcing court rulings (See further Chapter I, Part II).
     The existing institutional barriers to effective implementation of legislation are connected to the lack of independence of the judiciary and serious deficiencies in Russia's law enforcement system, in turn related to past and present inadequacy of resource provision for the judicial system. Many problems for investors arise from the limited approach of the courts with regard to the interpretation of legal norms. This is directly related to the few opportunities of Russian judges to become fully trained in the law, and to familiarise themselves with new economic concepts embodied in legislation. Staffing in general is a serious problem in the judicial branch of power, due to under-funding. In order to create the " larger role and greater authority for the judiciary" advocated by President Putin already in a December 1999 statement, it is necessary to:
     · Increase the prestige of judicial power, attracting qualified specialists, training currently working staff, guaranteeing real independence of the judges - these are all necessary steps in this direction;
     · Special attention must be paid to the system of execution of legal rulings and other decisions. There have been numerous cases where court decisions have not been carried out because of undue influence on enforcement officers or the absence of effective enforcement mechanisms.
     A general problem with law enforcement in Russia relates to the lack of institutions and markets developed to a level where execution of court orders can be facilitated. Such mechanisms and supporting information disclosure are rarely created specially for legal enforcement purposes. Most often, they are only gradually being built out, in line with growing requirements of business transactions and relationships.
     As to the existing duality of the court system some critics are of the opinion that it could have a negative effect on the development of jurisprudence. As the arbitrazh courts and the courts of general jurisdiction are called upon to apply many of the same legislative provisions in resolving disputes, there is an unavoidable overlap in development of court practice. There is also the problem for plaintiffs that cases may arise where there is some degree of uncertainty as to which system it belongs in, although the two systems of courts do make an effort to co-ordinate their approach to questions of jurisdiction and sometimes are willing to hear a case close to the line of division. Proposals have been made in the reform programme of the Putin administration to eliminate this duality of the court system by unifying the arbitrazh courts and the courts of general jurisdiction. Similarly it has been suggested that the three Supreme Courts should be unified into one. The opposing point of view is that this would jeopardise the administration of justice as the courts of general jurisdiction have little experience in handling commercial cases.
     Another major problem concerns the lack of independence of the territorial courts from the political authorities in the different subjects of the Federation. As a shareholder or investor plaintiff can only bring a suit against a juridical person - a company having infringed his rights - in that company's own geographical locality, foreign investors are particularly exposed to the potential interference of authorities in support of local entrepreneurs. Current reform plans include measures to prevent influencing by regional and local governments and to increase financing and provision for court officials while at the same time making them independent of the sources of support at local or regional level. More radical proposals have also been made for the establishment of full extraterritoriality of lower courts.
     A feature of the Russian system of law enforcement unfamiliar to some foreign investors is that the receipt of a court decision containing a judgement is usually not sufficient for execution, but the plaintiff has to take additional action to ensure that the decision in his favour is executed. The award of a sum of money or a performance or the transfer of property by a court decision requires an accompanying execution order from the court, valid for a specified time period.
     It is important to note that execution orders can only be issued by a Russian court which means that all arbitral awards and decisions of foreign courts must be recognised by a Russian court and an execution order issued by this court on the basis of the foreign award or decision.
     A related problem which at times has received attention in the international press concerns the dismal record with respect to execution of the decisions of international arbitration courts. As Russia is a signatory of the New York Convention regarding recognition and implementation of international arbitration awards, Russian courts should rightly only be concerned with the possible contraventions of procedure for the administration of the decisions in question - which could contain infringements of the rights of either party - and not examine their content. The actual situation here is complex , since lack of due procedure for administration of justice is often invoked by the local courts while Russian companies frequently claim to have been unaware of the procedures and regulations they come into contact with as a result of accepting international arbitration. However, the fact remains that there are numerous cases of local courts failing to execute international arbitration awards on spurious or trumped-up grounds. If inclusion of clauses regarding international arbitration in commercial contracts are to be meaningful for investors, the authorities should:
     · develop means to raise the awareness within the Russian judiciary of the jurisdiction and process of international arbitration.

     2. Governance problems and corruption in the public and private sectors

     Public sector governance issues

     Corruption of public officials is not a phenomenon unique to the authorities at federal, regional and local level in the Russian Federation, as it is a common social and political problem in both developing and economically advanced countries around the world. In a transition environment such as Russia's, the massive undertakings of wealth redistribution in combination with a fragile institutional framework, recently erected or still under construction and fragmented social cohesion all contribute to provide a fertile ground for corruption.
     Although there have been additional legislation as well as concerted campaigns to crack down of this form of corruption, the resort to mere policing is made difficult by the scale of potential remuneration compared to average salaries in public administration. A presidential address dating a few years back regretfully stated that "the risk of being persecuted is totally out of proportion to the profits to be gained from criminal activity".
     The combination of complex laws, government control over key assets and low level of remuneration of government agents, weak enforcement and control mechanisms provides a breeding ground for corrupt practices. Furthermore, given the sheer number of sometimes conflicting regulation in tax and other areas, most businesses are in violation of some regulation or other and can thus be free game for pressures for bribes by officials. Key steps for reducing corruption opportunities in the medium term are:
     · Regulatory reform and simplification of procedures, reducing the scope for discretionary decisions;
     · Increase in salary levels;
     · Introduction of laws against conflicts of interest, creation of strong independent controls and credible enforcement and penalties.[mention standards laid down in the OECD Anti-bribery Convention]
     Although the present government has included among its objectives the transformation of the public administration into a merit-based, transparent and accountable civil service, it is a long process given the scale of the problems and the resources required. Nevertheless, the fundamental goals of improving service delivery, strengthening accountability and developing a performance driven culture with a focus on cost-effectiveness are clearly incorporated in the government's reform programme. For the immediate future it would seem that significant results could already be obtained in the immediate future by:
     · raising wages and salaries to the level needed for weakening the motivation for corruption, while at the same time liberalising and eliminating discretionary procedures through the removal wherever possible of quotas, ceilings, permissions, licences etc.
     As to private sector governance issues, we have already touched upon the practices in the corporate sector which have resulted in serious infringements on and abuses of minority shareholder rights. There is also of course another side to the corruption of public sector officials, in situations where business firms or other private sector parties exercise direct pressure, including threats of outright violence or sanctions putting the official at personal risk. The existence of racketeering and organised crime circles is unfortunately a fact in the Russian economic environment. The proper enforcement of existing criminal law sanctions on outright corruption, extortion of protection money and other economic crime is of course of fundamental importance for a secure investment climate. Further action by the authorities in encouraging the development of ethical standards in the corporate sector such as currently contemplated for corporate governance practices should be explored.

     3. Regional Policies

     The Russian Federation is a federal republic encompassing 89 regional administrative units. The Federal Constitutions defines the areas and scope of jurisdiction of federal and regional authorities, with shared competencies in some areas.
     Much of the latent contention between different nationalities and repressed aspirations for self-determination in the former Soviet Union found an outlet during the so-called "parade of sovereignties" between 1988 and 1991 when over 40 former Soviet Republics declared themselves sovereign. While several of these became independent states, over 20 ethnically based republics still remain within the Russian Federation. These were able to avail themselves of considerable power in the Yeltsin era, through the "parade of bilateral treaties" with the federal government. Other regions than the ethnically based also benefited from significant devolution of power from the centre during this period.
     The business climate in Russia has suffered accordingly from the absence of a unified economic space and the frequent regulatory changes, contradictory interpretation and discriminatory implementation of existing legislation resulting from unclear and contested separation of powers.
     President Putin is now giving priority to restoring authority to the central government and dismantling power bases and conflicting administrative and other structures at regional level. A programme of administrative reform has been adopted which redefines the powers of the regional authorities. Special presidential representatives in seven newly created federal (supra-regional) districts encompassing varying numbers of subjects of the Federation are to oversee compliance with federal law. This as yet untested new layer of authority will face very specific economic and political challenges.
     Whether for investors this will result in elimination of some of the differences in interpretation of laws and legislative practices (land ownership and transfer, taxation, foreign investment policy) remains to be seen. It is clear that most of the administrative barriers and other obstacles to investment and business activity in general faced by investors are found at regional level.
     While it is no doubt beneficial to encourage some spontaneous innovation and new ideas and approaches stemming from the degree of regional diversity, policy direction should ensure:
     · Harmonisation of legislation and implementation practices affecting investors at regional and federal level, including a full review of existing bilateral treaties and agreements in separate areas;
     · Transparency of regional administrative structures for remaining region-specific competencies;
     · Transparency in the role and evolution of powers of the newly created supra-regional districts
     · Formulation of region-specific investment policy and development plans to ensure best use of regional and federal programmes and resources, including budgetary transparency of incentive packages and full elimination of extra-budgetary contributions.

     4. Tax policy

     Complaints from foreign investors about the excessive tax burden imposed on their operations in the Russian Federation have, in the main, originated from the multitude of different taxes levied and, importantly, from the methods of determination of the actual tax base. Statutory tax rates in Russia prevailing during the transition period have in fact not been very high by world standards, except in the case of payroll taxes.
     Many studies and reports have pointed to the fact that the Russian tax system consistently discourages investment, both through its structure and the manner it has been implemented. This fact remains true for domestic as well as foreign investors, whether we discuss start-ups of new business or the restructuring of existing firms. The frequent changes in rules and regulations have created a degree of uncertainty, which impacts negatively on business development as a whole.
     For many years, reform initiatives have been mired in political controversy, both at federal and regional level, often becoming hostage to other political bargains. The comprehensive tax reform now being implemented in Russia has two main objectives: it addresses both the lack of an efficient system for inter-budgetary allocations of revenues and expenditures - fiscal federalism - and the need for improving the structure and calculation of taxes to enhance neutrality, fairness and thus the degree of compliance.
     During most of the 1990's approximately 54 federal, regional and local taxes and social fund payments have applied in Russia. Through the stage of tax reform coming into effect from 2001, the number of taxes will be approximately halved. However, the bulk of the total tax liability of a typical business has generally been attributable to 6 categories of taxes - profits tax, VAT, customs duties, labour taxes, property taxes, and turnover taxes. The major changes in the tax burden for business firms via the recent reform will come from simplifying and lowering of labour taxes, reducing the tax basis for calculations of profit tax and eliminating virtually all turnover taxes. Of these, perhaps the most important change - which is still to be approved by the Federal Assembly - for stimulating investment activity is the widened possibility for enterprises to deduct their business expenditure for purposes of profit tax calculations.
     Due to substantial restrictions on the deductibility of many business expenses, the tax base for the Russian profits tax has been and still is larger than the comparable corporate tax base in industrialised countries, thus often resulting in a higher - sometimes - much higher, effective profits tax rate than the nominal statutory rate. As many of the major expenses subject to restricted deductibility are those incurred by businesses in the restructuring and modernisation of capital assets acquired in the privatisation process, this has had a significant negative effect on investment aiming to raise capital productivity. When added to the fact that personnel training expenses have generally not been deductible at all, it is clear that the manner of determination of the profit tax base has consistently provided investors with the wrong incentive from the point of view of transforming productive resources so as to unlock economic growth.
     A somewhat similar problem still remains with respect to VAT, as businesses in Russia are faced with restricted ability to credit fully VAT on all purchases. The result is that the effective VAT rate is usually greater than the statutory VAT rate and becomes a cost to the business. Thus, even though value added tax is intended to be a tax on final consumers rather than on businesses, the Russian VAT more often than not is also a tax on production.
     The high tax cost of labour prevailing during the transition period in Russia, which results from the combination of many taxes and charges imposed on employers' payrolls added to the personal income taxes has discouraged the hiring of additional labour and given rise to tax evasion schemes. The latest tax reform package, coming into effect from 1 January 2001 brings in a unified tax on wages at a highly regressive rate in order to reduce the incentives for businesses to understate the size of their payrolls and thus bring more employees out of the shadow economy.
     The many unresolved issues in the field of inter-budgetary relations and arrangements for revenue sharing between the federal and regional governments have brought added uncertainty and changeability to the tax environment faced by investors through multiplication of seemingly irrational and incoherent taxes.
     Although the current policies aim to claim back and reaffirm federal authority, relying on closed lists of taxes allowed at the different budgetary levels, many regions and local governments continue to introduce taxes that are not provided for in the federal legislation.
     It also belongs to this picture that local officials enjoy a number of tools other than formal fiscal authority which can be used in their relations with investors to circumvent restricted tax autonomy. The regional and local authorities control licensing of various forms of activity and are often partners in local commercial enterprises and financial institutions. Their leverage is substantial and every investor in Russia has become keenly aware of the need to maintain good relations with the local administration. In addition, there exist funds at regional and local level, to which local businesses are often encouraged to make "voluntary" contributions.
     As a general criticism of the system it has been argued that the combination of strict limits on tax authority at lower levels of government, mandatory expenditure obligations and a plethora of regulations and other instructions make orderly budgetary execution extremely difficult for regional and local officials. These conditions do not provide incentives for responsible budgetary execution policies, but can serve as partial explanation for the rent-seeking activities by these officials, when coupled with the low pay available to civil servants. Sanctions for such irresponsible activities are in addition not easily imposed, given the size of the Federation and the information and other advantages enjoyed at local level.
     Thus, while strong federal presence seems likely to remain necessary in near future, it should not simply take the form of increasingly rigid federal regulation, which could risk backfiring as sub-national authorities continue to seek loopholes for every restriction. A workable revenue-sharing system clearly requires consensus about its fairness in order to be genuinely effective.
     · Accelerate as much as possible the recognition of deductibility of business expenses in the calculation of the profit tax base and the introduction of accounting rules which reflect the economic reality of commercial transactions, prepared in accordance with international accounting standards [Clarify status of proposals in Part II of the Tax Code for improved deductibility of expenses and improved depreciation rules for businesses];
     · [insert recommendation re transfer pricing, double taxation]
     · Provide clearer definition of taxpayers' rights and duties with possibilities for judicial and non-judicial dispute resolution
     · Higher degree of autonomy for each level of government within a clearly delineated set of revenue sources and expenditure assignments (current policy of reversing previous de facto decentralisation could backfire through reliance of increasingly rigid federal regulation and mandates, leading to accelerated search for loopholes);
     · Eliminate the conditions presently conferring substantial rent-seeking opportunities on officials subject to very limited liability

     5. Privatisation policy

     The Russian Federation completed its small-scale and mass privatisation programme by 1994, succeeding in transferring ownership of 40 per cent of state-owned enterprises to some 40 million citizens largely by voucher distribution, either directly or via the intermediation of investment funds. Over 75 per cent of the Russian workforce is now estimated to be employed in privately owned companies.
     This massive privatisation undertaking endowed the Russian economy with a basic corporate sector, a corporate securities market and its first network of institutional investors. The use of vouchers led, however, to dispersed ownership structures and widespread insider (management) control (up to 65 per cent on average) of privatised companies. The state retained up to 20 per cent of many companies, with little cash investment taking place at this time. The question of enterprise reform was largely ignored on the assumption that this would be the object of a further phase of redistribution of ownership rights involving the disposal of the residual state shareholdings. Mass privatisation was regrettably not accompanied by the necessary land reform, one of the many difficult political dimensions of privatisation in the Russian Federation. Altogether, the highly politicised context contributed to unstable and inconsistent legislative practices resulting in uncertainty and discriminatory treatment for many investors which are still perceived to be part of the Russian investment climate to this very day.
     Against this background, the second - "cash" - privatisation phase failed both in its prime objective to generate revenue for the state and - for want of a comprehensive plan based on strategic investment and enterprise reform needs - to attract enough outside foreign or domestic investors to tackle the corporate restructuring problems. Investors were critical of the lack of transparency of this privatisation initiative during which many shareholdings were sold below their real value to insiders and the well-connected dominant financial-industrial groups (FIGs). As the failure of "cash" privatisation rapidly became apparent, a controversial "loans for shares" scheme was introduced, whereby shares in selected important state-owned companies were auctioned to a consortium of major banks (mostly with links to the FIGs) in return for loans. These auctions were conducted without transparency, fair competition and open access for foreign investors. The scheme proved highly controversial, the loans provided were mostly not commensurate with the market value of the shares and the FIGs were able to consolidate their control of substantial shareholdings in the companies involved in the scheme. This left a legacy of disputes and unresolved issues which dogged the privatisation process in the years that followed.
     Legislative provisions were made in 1997 to complete case-by-case privatisations and compile lists of assets and shareholdings to be privatised or retained in state ownership for strategic reasons. Commercial valuation of assets and market-oriented tender procedures were announced. With the exception of a few significant sales, there was little interest in the residual state shareholdings as other unresolved issues such as land and property rights, comprehensive enterprise reform and administrative barriers increasingly preoccupied investors. In the difficult period leading up to the financial crisis in 1998, privatisation potential was further limited by conditions affecting international investment activity in the oil sector.
     Further legislation and a detailed policy statement issued in late 1999 are expected to shape the future privatisation strategy of the Russian Federation during the present decade. New approaches involving more clearly defined priorities for the sale of the remaining state assets, new privatisation methods and increased emphasis on professional, commercial and transparent deal structures and procedures have been announced.
     The necessary further legislative changes and clear evidence of the government's commitment to practical implementation of the new approaches are, however, still lacking as investors have been getting mixed messages from recent privatisation transactions.
     All Russian privatisation legislation enshrines, in principle, free access and national treatment for foreign investors in all areas exception those of importance for national security or where there are moral or ethical concerns. This has not, however, protected foreign investors against discriminatory and unfair treatment as a result of changing requirements, legislation and procedures at different levels of investment projects and before and after their implementation. There is still no clear indication of the Russian government's intentions concerning non-residents' possibilities to invest in natural monopolies and some major companies in the oil, energy and aerospace industries, where privatisation and deregulation programmes are being designed. In practice foreign entrepreneurs have mostly opted for joint ventures, direct acquisition of companies from management or share purchases on the primary or secondary markets to establish an investment base in the Russian Federation.
     Investors' concerns still revolve around the continuing absence of a clear long-term privatisation programme, unresolved ownership, corporate governance and other (legal) problems dating back to the cash privatisation and "loans-for-shares" scheme, poor management of residual state shareholdings and the lack of institutional and procedural transparency for the handling of future transactions.
     With the transfer of ownership from public hands now largely completed in the Russian Federation, there is no call for a new privatisation model. Rather it seems clear that resources should now be devoted to restructuring and resolving ownership and governance deficiencies in privatised companies. Underlying issues such as the rule of law, the fiscal regime, administrative barriers and lack of financing resources affecting the overall business environment must also be addressed. (see Part II, chapters 1- 3;5). Priorities for the completion of privatisation should be:
     · the resort to direct and competitive sales to strategic investors for the more marketable stakes,
     · appropriate organisational and administrative procedures for the full privatisation of minor shareholdings and state assets requiring extensive restructuring
     · the introduction of sound management structures for property remaining in state ownership to eliminate malpractices.

     6. Financial Sector Development

     According to the CBR, the most important reasons for the unwillingness of banks to finance production is the lack of information about the true financial condition of borrowers, as well as the inadequate legal basis for creditor rights. Of total fixed capital formation in Russia in 1999 (659 billion roubles) only 4 per cent was financed through bank lending, 17 per cent from budgetary resources and as much as 53 per cent from enterprises' own resources. Data on working capital in the enterprise sector show more than 70 per cent financed by own resources and the remainder through supplier credits and arrears of various kinds (salaries and taxes) while bank credit plays an insignificant role. [Please provide more recent data]
     Hence it is necessary to increase the competitive pressures on banks to meet the needs of productive firms, in particular smaller clients. The authorities can and should take a lead in demonstrating that lending to start-ups and SMEs can be profitable, through introducing special support schemes and venture capital funds where conditions for banks to participate can be made suitably attractive. That access to external financing of working capital is difficult for smaller enterprises can be attributed both to limited competition among banks which relieves banks of pressure to develop lending schemes for SMEs and also high risks and transaction costs of such lending. In addition, there are problems of information and contract enforcement related to legal and regulatory frameworks that are still evolving and inadequate institutional capacities.
     To date in Russia, government-led project co-financing schemes involving commercial banks do not exist. A number of investment credit facilities are provided by the government directly to business firms, either financed from budgetary resources, or, as in the case of SME support, indirectly via a range of different tax incentives.
     The government can also play an important role in ensuring that the legal and regulatory framework provided for financial sector activities facilitates development of innovative financial instruments and the setting up of new types of financial institutions. It can even take a catalyst role in innovative financial engineering, by introducing new methods of financing. In the years immediately preceding the 1998 financial crisis, at least two new, important schemes were developed in Russia, which failed to materialise, reportedly for reasons of contentious turf issues between different regulatory authorities. One was the development of a commercial paper market in the Russian context, and the other was a scheme establishing a CBR rediscounting facility for banks of promissory notes (veksels), which could have brought orderly trading and considerably more depth to this unregulated market. These initiatives should be revived.
     As to other innovations, there are venture capital funds in the process of being created, leasing facilities of domestic equipment are being developed for agro-business, aviation and shipbuilding, mining, metalworking and telecommunications. However, much more could be done to facilitate the growth of such financing alternatives, for the benefit of domestic as well as foreign investors. Credit unions do not exist in Russia for want of a legal framework, but experiments with credit co-operatives have been successfully carried out in several regions. Some export credit guarantee and insurance facilities are provided to exporters by the Ministry of Finance, but no fully built-out framework for export credit guarantees exists yet.
     In Russia, it would seem particularly urgent to create and support mechanisms for working capital financing for the vigorous "trading company" sector, which includes many SMEs but also larger firms. During the late 1990's this sector experienced rapid growth, many large firms were established from scratch and managed to develop distribution networks for their products across the whole territory of the Russian Federation. Moreover, these firms have been operating in a very competitive environment, where transactions are settled in "real" funds and no barter or build-up of arrears are tolerated. The 1998 crisis and devaluation naturally constituted a significant set-back for this new industry, but the tendency has since been for these firms to identify cheaper domestic import substitutes. Faced with the need to ensure supplies on a reliable basis, some of these firms have begun to invest in local production, in many cases financed by funds repatriated from abroad. Facilitating access to finance for these companies would seem a good way of giving impetus to a budding SME sector and could at the same time bring many of the firms in question out of a less healthy dependence on mafia-linked funding.
     Policy direction should be focusing on:
     · Opening of banking sector to foreign competition - actively promoting the entry of foreign banks as important agents of innovation and prudent practices. This would include allowing branches - i.e. dropping capitalisation requirement - removing quotas for Russian employees and other minor discrimination….
     · Develop explicit scheme for deposit insurance with compulsory participation and covering fully the deposits of small and uninformed depositors. (This would entail developing a solution for the continued role of Sberbank, currently benefiting from a unique competitive situation.
     · review participation in specialised institutions and schemes and concentrate on supporting areas where business activity is already beginning to thrive and additional finance could give substantial boost - viz trading companies…
     · Develop co-financing schemes with commercial banks…[more on SME financing]
     · Facilitate access of small, young companies to the equity market through the creation of a special tier of the market where smaller companies could raise equity finance
     · encourage the setting up of special credit information and rating agencies