On December 29, 2022, the Revenue Service of Georgia published the new Methodical Instruction on requirements for acquiring and maintaining the Virtual Zone status. This document introduces material changes to the corporate taxation rules provided in the previous edition of the Instruction that was published earlier last year.
In this article, we will be briefly going over the most important changes from the Instruction that may affect your business if you are currently running a Virtual Zone entity or planning on creating one for your IT activity. We are also going to be referencing some of the old rules and comparing them to the recent ones.
There’s been a slight change to the procedure for acquiring the Virtual Zone status. The Instruction requires the applicants to submit the list of IT projects they have worked on in the past 3 years (if any).
The guideline does not specify whether this requirement only applies to a legal entity seeking the VZ status, or if the work experience of the founders also has to be demonstrated in cases where the entity itself does not possess any relevant experience.
Despite its current lack of clarity, the overall purpose of this added requirement is to demonstrate that the purpose of the legal entity applying for a Virtual Zone is to operate in the IT field, and to show that there is proof supporting this intention.
The definition of “software”
As many readers of this article are probably aware, the general Virtual Zone profit tax exemption applies to sale of software by a VZ entity to clients abroad.
The problem with the wording of the exemption used to be the lack of statutory definition of “software”, which made it difficult for IT companies to determine whether their activities actually qualified for the Virtual Zone status.
One of the more intriguing aspects of the Instruction is exactly the fact that it now contains the definition of “software”.
The Instruction makes a reference to the Law of Georgia on “Copyright and Related Rights”, which defines the term “computer program” as a set of instructions expressed in words, codes, schemes or any other machine-readable form, that allows a computer to operate in order to achieve a certain result. This term also includes preparatory material for computer program design. According to the Instruction, the definition of a “computer program” shall be used for “software” as well.
Furthermore, if legal entities seeking the Virtual Zone status still cannot figure out if their activity qualifies as development of software, the Instruction states that the main criterion for granting the profit tax exemption shall be the purpose of the activity itself. This means that if the activity in the IT field is for the ultimate purpose of creating IT products, then such activity shall be considered as eligible for the corporate tax benefit.
Taxation of Single-member Virtual Zone Companies
The origins of the Virtual Zone concept can be traced back to the early 2010s when the government was carrying out various reforms with the intention of developing the emerging IT field in the country. The entire purpose of Virtual Zones was exactly that – to promote the creation of IT businesses, to encourage investors to set up IT companies, and to hire local staff.
Eventually, the tax authorities decided that having local staff for VZ entities was sort of mandatory, as it legitimized a company’s claim to being a local IT operation. As a result, when it came to VZ companies that were owned and operated by the same people (in many cases just one person), the tax benefit was either given partially, or not granted at all, depending on the exact circumstances of the case.
With the new Instruction, the Revenue Service has decided to change all of that. Now even an entity that operates without any IT staff in Georgia is entitled to the full profit tax exemption, as long as the shareholder of the company is a Georgian tax resident.
At present, this guideline remains vague towards the issue of whether the shareholder has to still be physically in Georgia while developing software, or if it is sufficient that they maintain tax residence for the year in which the software is created. This might present a major issue, considering the fact that Georgian tax residence can be obtained by spending 183 non-consecutive days in the country in any 12-month period, as opposed to spending the whole year, not to mention the special program for high net-worth individuals allowing them to obtain tax residence without even spending a day in Georgia.
Regardless, if the founder of a Virtual Zone entity is granted the tax residence of Georgia, they would be able to spend significant time of the year outside the country while developing IT products for their own company. In this way, they would meet the requirement imposed by the new guideline, while going against the very purpose of the tax benefit: to develop the IT field in the territory of Georgia.
This is an obvious oversight in the new regulations, and we expect this issue to be addressed in subsequent releases of the Revenue Service or future tax disputes.
Another significant change that the Instruction introduces is the ability of the Virtual Zone company to utilize the work of independent contractors in the territory of Georgia. Previously, it was not clear whether doing that would be sufficient for getting the profit tax exemption, since all the requirements pointed to the necessity of having full-time employees in Georgia.
By contrast, the new guideline discusses an example of a Virtual Zone entity that has both employees and independent contractors that create IT products in the territory of Georgia. It is evidenced by this example that having independent contractors who create IT products in Georgia contributes to proving that these products were indeed created in the territory of the country for the purpose of the specific tax benefit.
The new guideline also sheds some light on the issue of the licensing of software by the Virtual Zone entities. Previous regulations were unclear about the possibility of applying profit tax exemption to provision of software under a license of use. Our understanding was that this would be covered under the profit tax exemption only if the licensed software was created by a company after getting the Virtual Zone status.
However, the new guideline addresses a scenario where a licensed software was created before the software company obtained Virtual Zone status and states that in such cases the corporate tax benefit still applies.
The reasoning behind this regulation is that the development of IT products often involves other activities than the initial development phase, such as the essential maintenance, updates and subsequent services that product developers usually provide. Without these activities, it would be impossible to maintain the functioning of the IT product that is licensed to a client. Accordingly, the new guideline establishes that the licensing of programs – even ones created before obtaining the Virtual Zone status – is perfectly eligible for the corporate tax exemption.
If you want to learn about the new regulations in greater detail, you can take a look at the translated version of the Instruction here, or book a consultation with us.