Russia needs to send 10,000 law students to the United States fortraining so the country can develop the rule of law.

American patent attorney, 1998

Showdowns with tax cheats and kicking in doors of deadbeat businessesare the best things I get to do in this job.

Chief of Russia's State Tax Service, 1998

I seldom spend a week in Moscow without witnessing acrimonious debates —at meetings, in private discussions, and in the press—about ownership of Russian discoveries or pirating of western inventions. Uncertainty abounds as to whether western financiers, Russian research and development organizations, or individual inventors are the rightful beneficiaries of anticipated profits from products developed in Russian laboratories. As Russian enterprises attempt to reverse engineer items developed in the West for the Russian market, they show little concern over patents that may be attached to the original items. Should Russian industry begin to revive, the conflicts over protection of patents, copyrights, and trademarks—the three aspects of intellectual property—will surely intensify.

Russian diplomats, lawyers, and research managers haggle frequently with western partners in international projects over ownership of innovations that may generate commercial products. They are relentless in their complaints that American companies providing funds for cooperative activities carried out in Russia do not let Russian part-

ners have the opportunity to share in profits from sales or licenses based on “Russian” technologies. The Americans argue that their money supports the work and therefore they are the rightful owners of all discoveries. The Russians counter that their brain power fuels the discoveries, hence they are entitled to reap some of the benefits of their own know-how.

International sharing of intellectual property rights was one of the most contentious issues during the establishment of an international institution in Moscow to provide research grants to Russian scientists and engineers—the International Science and Technology Center. The negotiations dragged on for 18 months, with marathon arguments between western and Russian diplomats bolstered by lawyers, economists, and scientists. Who has commercial rights to the results of joint high-tech projects, rights in Russia, in Europe, in the United States, and in the rest of the world? Must the scientific results of projects that will not have commercial payoff in the foreseeable future be made available to the general public, or can researchers keep this information locked up for their own personal use? If the party entitled to patent rights for a new device won't risk its money to obtain a patent that in the West may require paying lawyers $15,000, can the other participating party then claim the rights and buy patent protection for itself, lest bystanders take over the discovery?

During this extended dialogue, it was clear that Russian legal provisions are not precise and their interpretation depends in large measure on the views of the Russian officials overseeing their implementation. Every time western diplomats thought they had achieved an accord, a new Russian lawyer would enter the fray with a different edict that, he would argue, must be observed. It was not unusual for an expert from a Russian ministry to show up at negotiations with an overriding document conveniently authorized just the preceding day.

In the end, a consensus was reached concerning intellectual property resulting from the international program that had been the center of this attention. When a western government finances a project, that government should have exclusive rights for selling the products in its own country, Russian researchers should have exclusive rights in their country, and the rights in other countries should be shared. But an

escape clause was included. This clause stated that, regardless of the provisions of the agreement on division of rights that had just been so painstakingly negotiated, the participants in projects retain the option to adopt any arrangements that are mutually acceptable. ¹

Had the negotiators wasted all that time? Probably not. Even if other arrangements are considered under the escape clause, the agreed-upon formula for sharing provides a point of departure for negotiations on the new arrangements. Also, agreed-upon provisions negotiated by government representatives help Russian entities develop agreements with western companies. They can use the intergovernmental formula as an opening gambit in bargaining, whereas western companies inevitably start from the position that they should own all rights everywhere.

For almost a decade, the Russian government has experimented with modifications of long-standing laws and traditions in an attempt to improve the environment for Russian and foreign entrepreneurs interested in drawing on Russia's extensive technological resources. In recent years, the Duma has enacted special laws to help clarify situations involving patents, although uncertainties remain. The government has also taken steps to facilitate trouble-free international cooperation in research and development. They urge Russian institutions to include clear provisions concerning intellectual property in international contracts so as to avoid conflicts after the projects are under way.

All the while, Russian managers spend 24 months or longer obtaining protection of their discoveries from the Russian patent office. They are then surprised to learn that Russian patent certificates mean little overseas. Even more importantly, if no customers at home or abroad are interested in their inventions, they have simply wasted their time and money, both in the laboratory and in the offices of bureaucrats reluctant to expedite requests without special compensation. With the collapse of the economy in 1998, many managers found they indeed had wasted their time and money. They declared bankruptcy, as concerns over patents, copyrights, and trademarks soon paled in comparison with the financial realities of Russia.

A vivid example of the inadequate concern of the Russian government over intellectual property rights is its reluctance—or at least its

lack of priority—to crack down on copyright theft. The U.S. and other governments repeatedly protest the expanding Russian piracy of video cassettes and complain loudly about fraudulently acquired computer software. If such pirated goods were purchased rather than stolen, western organizations would have received hundreds of millions of dollars in payments since 1992. Meanwhile, this never-to-be-collected debt continues to mount.²

Russian officials shrug, pointing out they are at the mercy of the omnipresent Russian mafia, which controls the entertainment and software industries. To help stem contraband trade in cassettes, the U.S. Motion Picture Association has financed a Russian Anti-Piracy Organization (RAPO) within the Russian government. In 1998, RAPO officials—typically recruited from the intelligence services and from special police units—seized 825,000 video cassettes from the pirated-products market, booming in the wake of the financial crisis that made legitimately imported products prohibitively expensive.³ As for the sale of computer software, in June 1999 the Russian police made a statement about their determination to enforce applicable copyright law. They provided the international press with photo opportunities to document the crushing of 500,000 illegal disks by a bulldozer. ⁴Despite the increase in seizures of cassettes and disks, however, fines for piracy are rarely collected.

Intellectual property rights are but one aspect of the murky legal framework surrounding business dealings in Russia. In the long run, they must be a critical factor if Russia is to have an economic future that meshes with technological achievements the world over. For the present, the Russian government is likely to continue complaining that western business partners cherry-pick the best Russian technologies while failing to provide adequate compensation for Russian inventors.

Of more immediate concern to most Russian firms and institutes than intellectual property rights, however, is the uncertain tax code and the constant threat of property confiscation should the tax police discover irregularities and pursue payment on behalf of the tax service. As demonstrated in the preceding chapter, the multiplicity of taxes and high tax rates have fueled the centuries-old Russian tradition to avoid taxes through both legal and illegal evasion schemes. To many

well-connected organizations and individuals, tax collection is a concept and not a reality. But, at many research and development institutions, taxes take a heavy toll on the limited funds available for exploring the future.

Reliable patent protection and tax relief are important keys to a viable business climate. Western investors, accustomed to meaningful patents and to tax exemptions for research and development in their own countries, want to see immediate action on both fronts. From the perspective of most Russians—who live from payday to payday—tax relief is the dominant issue. Patents represent an investment in the future. As such, they are often ignored, even though the future consequences from lost claims on technologies may be great.

There are a few tax breaks for some research institutions, particularly those emphasizing basic research. Tax relief for expenditures on research should mean more funds to uncover technologies that lead to patents. These patents in turn can increase market shares and entrepreneurial earnings. The taxes from these earnings should then strengthen the government's capabilities to enforce the law, although more effective patent protection is not a current priority.

Why bother developing a new device or a new manufacturing process if someone else will steal your idea and undercut you in the marketplace? This has been the mantra of Russian government officials frustrated by their inability to hold western technology hunters at bay. Looking to the distant day when Russian technologies worthy of patents are commonplace, they certainly have a point.

Western businesses argue that they are playing by the rules. They add that it is not their fault that the Russian patent system is not fully developed and is poorly enforced by the embryonic Russian court system. Also, if Russian entities are eager to trade long-term rights to technologies for immediate financial income, why shouldn 't foreign businesses be willing partners?

Few people, from Russia or the West, fully comprehend the workings of Russian law as it applies to intellectual property. Some regula-

tions interpreting these laws are known only to a limited few. Provisions in the most widely disseminated documents are sometimes vague. Even when regulations are clear and a Russian inventor carefully follows procedures, with all required documents in order, redress from an infringement on the rights of the inventor is almost unknown. From time to time, court rulings in Russia recognize the misuse of property rights. But, for the aggrieved party to actually receive remuneration for economic losses due to patent infringement is indeed a rare occurrence. Once a decision is rendered, the case is filed away.⁵ With no system in place to retrieve funds—and no penalty for nonpayment—it's up to the individual to collect.

Many Russian entrepreneurs simply walk away from the procedures necessary to obtain patent protection. They are convinced that any lawyers they might engage will charge large fees and deliver little in return. Occasionally, such entrepreneurs become shocked to learn that someone else had taken the trouble to patent “their” inventions.

What is so mysterious about patent protection in Russia? After all, in 1992 and 1993 the Russian government enacted intellectual property rights legislation that closely resembles similar western laws. The legislation's purpose is to promote research by ensuring that successful inventors are rewarded, to prevent duplication of research, and to clarify ownership rights.⁶The soundness of the 1992-93 legislation is reflected in the likely acceptance of Russia into the World Trade Organization. Membership requires that national legislation on intellectual property rights meets an international standard of acceptability. ⁷

But, despite international acceptance of the patent law, there is a weakness in the Russian approach. The legislation does not adequately address ownership of technologies that are developed with the use of government funds—and for decades the government has financed the bulk of innovative work at Russian institutions. Correcting this weakness is central to stimulating technology development in a country where the government has a long history of financing almost all research activities. What's more, many technological innovations of commercial significance will only emerge in the marketplace if government funding is involved, at least to a limited extent. Thus, ownership of the

results of government-funded projects is an issue that needs to be resolved.

The 1992-93 legislative flurry ceded all rights for results of government-funded activities to the institutions where the work is conducted. They were to decide whether individual inventors deserve a share of the proceeds. Despite protests from entrenched government officials that their ministries should be the rightful owners of discoveries they finance, under the law ownership rights could be assigned only to legal entities—research institutes, manufacturing enterprises, and innovative firms—that make discoveries. Nevertheless, the ministries kept trying to obtain pieces of financial pies that occasionally were cooked up—and divided up—within these organizations, threatening to withhold future funds unless pieces are delivered to their doorsteps.

In 1998, a Russian expert on technological development and intellectual property law, Yuri Lebedev, summarized the situation thus:

The government has declined to control the use of scientific-technical results obtained using government funds. The consequence has been chaotic redistribution of rights to such results, ineffective use of research results, development of many undefined and contentious relationships, and violation of the legal rights of patent and copyright owners.⁸

This statement could be misinterpreted as advocacy of a return to the Soviet system of governmental shepherding of innovations from the workbench to the consumer. The government would then control all associated financial dealings. This expert, however, advocates reducing the chaos within the new market economy without turning back to the ways of the past. He is on target with his suggestions.

The framework Lebedev proposes would help ensure more equitable sharing of the rights to products resulting from government-funded projects. Underlying his solution would be legislation that assigns intellectual property rights to enterprises and institutes that develop new technologies, as was the case. In addition, however, he recommends clear legislative language specifying that individual inventors receive significant portions of any profits from patented technologies. Also, to respond to at least some concerns of government ministries, the framework calls for the government to receive the right

to use patented technologies for noncommercial purposes, such as use in space exploration, through nonexclusive, no-cost licenses.

Lebedev advocated other modifications to patent practice. State-owned manufacturing enterprises had the right to appropriate research results from government-funded projects for their own use if such action is “in the interest of the industrial sector.” Lebedev believes that such use should be based on licensing arrangements between the enterprises and the research laboratories. However, his proposals became mute when in 1999 new government regulations —contradicting the 1992-93 laws—vested ownership of results of government-funded activities in the ministries.⁹

An important aspect of Russian intellectual property law that directly affects individual Russian scientists and engineers is traced to a Soviet system that provided for each inventor to receive limited compensation for use of his or her discoveries based on author's certificates. In an economy that was not driven by profit, the level of compensation was usually small. Still, prestige associated with author's certificates was high, and such certificates covered approximately 80 percent of the most important Soviet technological achievements. The other 20 percent of Soviet-era discoveries were attributed exclusively to manufacturing enterprises and research institutes, particularly those discoveries with direct military applications.

Following enactment of the 1992-93 laws, owners of author's certificates were given a 20-year window within which to exchange them for patents. Some entrepreneurs have taken advantage of this no-cost exchange while others simply have not been motivated to go to the trouble of exchanging the documents. They hold on to their author's certificates, delaying action until the day when they have real value.

Even when the owner of a certificate has a claim to a technology, it is seldom clear how the claim can be exercised so the owner profits. In a rare case, a government agency may actively support an owner 's protest that his or her technology is being misused. The likely response of the organization that has taken over the technology will be to pay the original inventor a token amount or simply to halt production plans, in which case no one benefits.

The roots of much technology of current interest date to the Soviet era. Controversy abounds as to ownership of the technology that is now available, including the scope of any given author's certificate. In cases where contemporary technology combines old inventions with new ones, the confusion mounts. For a specific, recently-developed technology, the ownership struggle may involve claimants from a government agency, former employees of a now-defunct institute where the work was performed, management of the new replacement institute, and members of the original scientific team who cling to their yellowing author 's certificates.

Meanwhile, many technology-oriented organizations have been privatized. If privatization procedures were not followed meticulously, as is often the case, the new entities now have difficulty laying claim to the technological developments of the predecessor organizations. Then confusion as to who owns a specific technology that originated in the predecessor organization increases even more.¹⁰

Potential investors interested in commercializing old technology, or hybrids of old and new technologies, are rightfully wary about risking funds in uncertain investments. If they are successful in developing salable technologies and profits start flowing, they can be reasonably sure that someone else will lay claim to the technologies underlying their products.

My repeated suggestion to Moscow officials that the Ministry of Science and Technology establish a commission to address the blurs in ownership of technology has fallen on deaf ears. Such an entity, at the request of a Russian or foreign organization interested in commercializing a specific technology, would rule on the ownership aspects. The commission would identify all legitimate claimants, if any, and the extent of their claims. The technological entrepreneur with eyes on a potential market could attempt to make financial arrangements with the claimants. If unsuccessful in efforts to compensate the claimants or to develop appropriate licensing arrangements, the entrepreneur could walk away from the technology. No one would benefit or lose. If the entrepreneur decided to proceed with his or her project, there would be no surprises after he or she had spent funds.

This suggestion to establish yet another bureaucracy when there are not enough funds to pay salaries within existing offices was a non-starter. Entrenched bureaucrats claimed they were already empowered to make such judgments, although they had yet to consider a single case. They argued that they also needed supplementary pay to compensate their involvement in such complicated matters.

The suggestion, nevertheless, is sound if entrepreneurs are expected to invest in existing technologies. Granted, such a commission—probably with a small staff and an uncertain payroll—might not be very efficient. Still, it would be a start in the long process of resolving thousands of conflicting claims on technologies that might some day have real value. If the applicants pay modest fees for determinations by the commission, the mechanism for resolving uncertainties would be energized.

To further explore the impact of patent uncertainties on technology development, in the spring of 1998 Russian colleagues assisted me in determining whether uncertainty over intellectual property rights was stifling applied research activities at Russian institutes. We conducted a survey of 28 applied research institutes—from the Russian Academy of Sciences, the university sector, and the industrial sector —and then followed up with more in-depth discussions. While each institute had a differing view on intellectual property, a general consensus emerged on a number of key points.

First, the framework for intellectual property rights was important but usually not the critical factor influencing research and development in the late 1990s. Given economic difficulties, there was limited opportunity to find markets for products that would be protected by patents; and copyrights and trademarks were almost unknown to the institutes. Nevertheless, there was an occasional opportunity to lay claim to technologies that might have commercial value in the future. Clearly, according to the respondents, the situation would have been much worse had the 1992-93 laws not been in place.

Also at the institute level, protection of new discoveries was more important than resolving uncertainties in exploiting old technologies. Unlike industrial enterprises interested in selling off-the-shelf technolo-

gies developed in the 1980s and earlier, the institutes were concerned primarily about the fruits of current research activities. Uncertainty over ownership of old technologies was of less interest.

With this focus on current activities, the institutes viewed Russian patent laws as reasonably clear. As expected, they considered costs of Russian patents high, delays in issuing patents excessive, and penalties for not respecting patent rights nonexistent. Some gave much higher priority to obtaining patents abroad than to wasting time and energy in Russia—assuming they could find a foreign partner to pay the high registration and related fees.¹¹

In summary, the importance of protecting intellectual property rights is widely acknowledged throughout the Russian government and the research and development community. For most enterprises and institutes, patent, trademark, and copyright protection will bring benefits only in the distant future, however, and will not relieve the pressing problem of meeting current payrolls. Foreign investors who are encouraging large Russian manufacturing enterprises to dust off older technologies seem to be the most eager to sort out intellectual property issues as soon as possible. In one area—namely intellectual property rights associated with international projects—Russian entities feel that immediate action is needed so they will no longer be at a disadvantage in working with foreign partners.

In 1998, patent experts at the Ministry of Science and Technology confronted me with the following assertion:

During the past two years, not a single patent application has resulted from the 450 research projects financed by the U.S. Department of Energy in Russia. The Americans insist on taking possession of all patent rights that might flow from the projects. Therefore, Russian researchers have no incentive to search for market applications of their work. If they cannot share in the profits from their research, why should they try to make Americans richer?¹²

Total U.S. ownership of intellectual property rights resulting from activities supported in whole or in part with U.S. funds is the position most commonly taken by U.S. government agencies as well as by

American companies. There has been an important exception, however.

A ground-breaking model for the division of rights for western-financed projects at Russian institutes was adopted in 1994 by the International Science and Technology Center (ISTC), established in Moscow by the United States, the European Union, Japan, and Russia. Box 5.1 sets forth the division of rights in the ISTC model for a project financed by the U.S. government. In this case, the U.S. government

passes on its rights to an appropriate U.S. institution that has demonstrated special interest in the project. This approach diverges from the more common formula whereby the western provider of funds receives all rights. The ISTC model calls for a genuine sharing of rights between the funder and the Russian institute that carries out a project. (This formula is the result of the 18-month negotiation cited at the beginning of this chapter.)

For the first few years after these ground rules were adopted, few research results were patented in Russia or abroad. Beginning in 1997, however, the ISTC undertook a concerted effort to both fund projects with commercial potential and pay more attention to the patent aspects of project results. By 1999, commercialization of technology had become a major concern of the ISTC, and the need to protect technological developments took on a high priority. It seems likely that, in the not too distant future, financial returns will be flowing both to Russian institutes and U.S. collaborators from some projects.¹³

The position of almost all western companies doing business in Russia is quite firm. They are not prepared to share intellectual property rights with anyone, even rights for marketing made-in-Russia products in Russia. In many cases, western firms reward individual Russian researchers responsible for important discoveries—most often with bonuses and trips abroad rather than with a percentage of profits from sales of products.

To date, western companies have been operating in a buyers market, with Russian institutes and researchers so desperate for funds they will not object to any arrangements concerning patents. At the same time, the position of the companies has not gone unnoticed by the Russian government. Some Russian officials resent what they consider to be exploitation of “their” talent, and politicians continuously threaten to block western access to Russian technologies rather than to continue tolerating technology bazaars that benefit western firms. Neither the concerned politicians nor the resentful officials have been able to muster enough support in Moscow to be able to change western habits. However, one-sided patent arrangements certainly do not encourage assistance from these officials when companies encounter administrative problems that hamper operations in Russia.¹⁴

That said, western firms intending to establish a permanent presence in Russia should reconsider their extreme positions on intellectual property. In the long run, a western company's recognition of the entitlement of Russian entities to share in the fruits of Russian knowhow may help pave the way to new discoveries with financial returns for the company. But, whatever the commercial agreements that are reached on intellectual property rights, both foreign firms and Russian partners should insist on written contracts that include provisions to fill in blanks not addressed in Russian legislation and regulations.

The intransigence of western companies with regard to intellectual property rights sometimes motivates Russian organizations to seek access to intellectual property through whatever channels they can uncover. In response, western high-tech firms with substantial investments in Russia are well advised to have a continuing presence in the country to resolve problems that inevitably arise over infringement on property rights. Also, western companies should hesitate in taking proprietary products to Russia for demonstration or other purposes lest they be compromised. Finally, western companies cannot rely only on legislation and contracts to adequately protect their technologies, and they should develop networks of officials both in Moscow and at the municipal level whom they can call upon when controversies arise.¹⁵

Sharing of intellectual property rights is an investment in the future of Russia. While western governments cannot be expected to interfere in commercial arrangements of western companies, they should set an example by acknowledging that international projects are only truly international when there is an equitable division of profits from innovation. An adoption of the ISTC model by western governments in their bilateral programs would go a long way toward supporting the struggling research and development sector. Also, the approach would improve the political climate for continued western engagement with important Russian institutions.

For years, every Russian manager has been waiting for legislation that will take some of the tax burden off his or her back and simplify

accounting procedures. There are more than 200 different types of federal, regional, and local taxes in Russia. Most firms involved in innovation must cope with at least several dozen. These firms, hopeful of earning income from their innovations well into the future, are obliged to pay their taxes now.¹⁶

Several tax breaks are bestowed on some scientific institutions, in recognition of the fact that in the long run scientific research benefits society as a whole. They are exempt from paying value added tax (VAT) on goods and services, federal profit tax on income from research contracts, and regional property tax. Smaller, but still significant, local taxes that can be avoided by an institute engaged in scientific research include land, forestry, animal, and water taxes if natural resources are the object of scientific study.¹⁷

Several categories of scientific institutions have special tax exemption status: the State Scientific Centers and the institutes of the Academy of Sciences, the Academy of Medical Sciences, and the Academy of Agricultural Sciences. In addition, tax exemptions may be granted to other institutions demonstrating that at least 70 percent of their total income is derived from research and development activities. This usually means that most of an institute's income must come from government research funds. At the beginning of 1999, certification of scientific institutions meeting the 70 percent criteria was well underway, indicating a governmental intention to verify the legitimacy of claimed exemptions. At the same time, a few research institutes that are heavily engaged in commercial activities have spun off daughter companies where they concentrate their commercial income so the entire institute will not be subject to all of the taxes levied on commercial organizations.¹⁸

Some research institutes believe the 70 percent rule to be unfair. Their core research budgets from government are very small, and they must raise funds from a variety of sources. They argue that if such income, whatever its sources (e.g., property rental to commercial organizations), is reinvested in research programs it should be considered within the 70 percent rule. Otherwise, they will simply be discouraged from raising private funds.¹⁹Then, in 1997, Russian officials opposed to any types of exemptions from taxes took aim at the universities and

attempted to levy taxes on research grants and graduate student stipends, but they were overruled by the Duma.²⁰

In 1999, the Russian government and the Duma took steps to lighten the tax burden on all sectors of the economy. These measures were important for research and development institutions and researchers with little cash flow. The maximum personal income tax rate was reduced from 45 percent to 35 percent. The required contributions to the pension and other social funds by employers was reduced from 39 to 33 percent of the employee payroll.²¹The national VAT is being reduced from 20 to 15 percent, although a small comprehensive sales tax has been introduced to compensate for loss of some income from this primary revenue generator. Taxes on company profits were reduced from 35 to 30 percent. Finally, emerging businesses (fewer than 200 employees) producing consumer goods or engaged in public works projects have a two-year start-up holiday from federal taxes. To help ensure that tax revenues remain steady, additional regulations were designed to reduce tax evasion and improve tax collection.²²

New spotlights have focused on more limited tax exemptions that would benefit technology-oriented firms. Local officials, for example, have persuaded the Duma of the need for 30 tax havens established as either (a) special economic zones to attract foreign investment through tax holidays and import/export privileges or (b) administrative territories encompassing nuclear and other defense towns that permit local jurisdictions to reduce the share of tax collections sent to Moscow, as we shall see in Chapter 8. With each such exemption, financial officials in Moscow deplore the loss of tax revenues while they watch favored businesses prosper. In the nuclear cities, scientists also derive direct benefits. Most tax havens have became money laundering enclaves, however, with only a few cities achieving their intended objective of stimulating local industrial and technological development.²³

Another type of tax exemption came into public focus in the summer of 1999 when banners appeared in several Russian cities and in the press. “Ban Tolling: Stop Robbing Russia,” the banners proclaimed. Unknown parties, and perhaps the tax service itself, protested the practice of trading companies acting as tollers—bringing into Russia the inexpensive mineral alumina to be processed into aluminum at Sibe-

rian smelters and then exported to customers in the West. The alumina is imported at $120 per ton, a fee of $250 per ton is paid to the smelters, and the aluminum is sold on the London metals exchange at $1,400 per ton. The tax code exempts well-heeled toilers from import duties, export tariffs, and VAT.²⁴

At the same time, under a presidential decree internal tolling is also exempted from VAT. Alumina mined in Russia is processed along with imported alumina in the Siberia smelters. Altogether, 90 percent of Russian aluminum is linked to tolling. Without tolling, Russian officials have estimated there would be a drop of 30 percent in Russian processing of alumina and a loss of tens of thousands of jobs.

It is not surprising that shady companies have gained substantial control over activities at Russian smelters. Politicians attempting to change the generosity of the law may be subjected to blackmail and death threats. In principle, nevertheless, the concept of tax breaks to encourage industrial activities in Russia that add value to natural resources is a sound policy in moving away from a Russia that simply exports raw materials. Better legislation is needed to regulate tolling, but more transparent accounting practices of the enterprises would also reduce temptations to bilk shareholders of their rightful earnings. Then in a surprise move in early 2000, several Russian aluminum producers abandoned tolling, allegedly in response to public criticisms of the practice.²⁵

Tax credits for investments to encourage innovation are also a lively topic within government circles. In 1999, after lengthy debate, the Duma rejected a proposal to exempt from federal taxes industrial profits that are reinvested in research and development or in modernization of facilities. Debate on the length of the amortization period for expenditures on new industrial equipment was also intense. These discussions will undoubtedly be revived in the months and years ahead. ²⁶At the regional and local levels, investments in improving manufacturing acilities—particularly high-tech facilities—are often deductible from regional and local taxes, usually at 50 percent of the total investment.²⁷

Russian companies, including many technology-oriented companies, probably owe more than $50 billion in back taxes. According to

tax authorities, only 25 percent of taxable personal income is declared. One report noted that, of 24,000 firms in Moscow subjected to audits in 1997-1998, 16,000 were fined for tax evasion.²⁸Lower estimates were presented in late 1999 by the minister responsible for tax collection, who claimed that only one of six firms cheat on their taxes and that the arrears were only $8.7 billion. The first estimate seems more reliable, given the well-known history of tax evasion. The minister also stated that one-half of income earners —including many of the wealthiest Russians—cheat on their personal income tax. This number is also probably low.²⁹

Against this background, in 1998 the tax service promised the:

• arrests of 10 major tax offenders within a few months;

• 700,000 audits by the end of 1999;

• increased tax collections from companies that are able to pay;

• crackdowns on the gray economy, especially informal traders who have not paid taxes; and

• aggressive collections of VAT.

Whether these objectives were met was never reported.³⁰

Tightening up on tax collection spells bad news for Russian researchers. Many large Russian enterprises, with legal advisers and easy access to Russian financial officials, will continue to find ways to limit their tax burdens—through offshore accounts, through money diversion schemes, through barter arrangements, or through bribery. Although considered small fish and therefore not singled out as targets in public statements, both research institutes and individual inventors will be under siege. They are not well equipped to fight back. Scientists and engineers have more difficulty than big business in concealing budgets. Their budgets are generally known at several levels of government since they receive most of their funds through the Russian banking system, where secrets are protected only for friends of the banks.

For the foreseeable future, the executive and legislative branches will continue to be engulfed in efforts to revise the tax code. As we saw in 1999, each proposed exemption to the tax code has its advocates. The government's general goal of eliminating exemptions will remain

but a distant thought; and, from the point of view of innovation, tax exemptions are sometimes warranted.

Tens of thousands of Russian scientists and engineers depend on foreign grants and contracts related to international projects as their primary source of income. The largest category of contributors to these projects is western governments, with most government funds dispensed through western, private-sector, intermediary organizations. The second largest category of foreign financial supporters is private industry. Both intermediary organizations and private industry depend heavily on representatives based in Russia to identify project opportunities, to monitor project implementation, and to troubleshoot administrative problems. Thus, when the tax chief targets foreigners living in Russia for special attention, many international programs designed to upgrade innovation capabilities in Russia could be in jeopardy.

Foreign residents in Russia with responsibilities related to financial transactions have repeatedly been accused by the Russian government of avoiding personal income tax obligations, primarily through receiving their salaries in off-shore transactions. In the words of the tax chief:

I think that our visitors from abroad will start paying taxes after a couple of them are arrested at the border and told that they are going to have to spend a few years in Siberia because they did not want to pay their debts to the Russian Federation.³¹

In addition to possible hits on individual employees who may not pay enough income tax, western firms worry they will be unfairly targeted by the tax service for failures to pay VAT, profit tax, or some other form of duty. Indeed, American companies usually cite taxes—both the number of taxes and the level of taxation—as the principal challenge in doing business in Russia. The tax system is far from transparent, which greatly complicates efforts to comply with the rules.

The case of Johnson & Johnson is often cited as dramatic justification for western anxieties. In 1998, the tax service confiscated 89 automobiles belonging to the firm and started criminal proceedings against

two former managers. The tax service claimed that the company owed $19 million in back taxes. The company, which has always been proud of its squeaky-clean image, cried foul. While the details of the case are still not public, different interpretations of the vague tax laws are undoubtedly at the center of the dispute. It seems likely that Johnson & Johnson will try to settle since it has no other recourse except to abandon its presence in Russia.³²

In 1998, a law was enacted that provides tax exemptions for Russian organizations that receive “technical assistance” from foreign governments, international organizations, and nonprofit foundations. According to this general legislation, Russian entities are exempt from paying VAT, import duties, and several other types of taxes on funds, services, and in-kind contributions designated for humanitarian aid and technical assistance.³³Given the vagueness of the law, it was up to the Ministry of Economics to determine which programs qualified for the tax exemption while the Customs Service determined which incoming shipments were exempt from import duties.

Then, in May 1999, a watershed law was enacted. This law provides exemptions from profit tax, VAT, the road tax, personal income tax, and contributions to pension and social funds for humanitarian assistance and technical assistance provided free of charge by governments, international organizations, and nonprofit organizations. This law also provides retroactive amnesties for unpaid taxes. It is a major breakthrough in freeing many western programs from the overhanging threat of tax collection on technical assistance activities, with all types of scientific and technological cooperation eligible for classification as technical assistance. Of course commercial transactions do not fit under this law.³⁴

There are many twists and turns in the search for legal routes to avoid payment of Russian taxes. Regardless of the provisions of laws and regulations, exemptions are only exemptions if the officials at the working level are convinced that the exemptions are legitimate. These officials often change jobs. This argues for a western provider of assistance or promoter of cooperation in order to accumulate as many officially stamped documents certifying the legitimacy of activities and the

right for tax exemptions as possible to buttress claims at the working level.

Customs charges are another tax that complicates cooperative technology activities and thus may discourage foreign investment involving imports of high-tech equipment. Since 35 percent of the Russian budget depends on collections of duties on imports and exports, the customs service has considerable political clout.³⁵In general, import duties can reach 30 percent of estimated value (although in special cases a rate of 250 percent has been applied). In any given case, the tariff depends on the type of goods, the legal status of the importer (a Russian company, an office of a western firm, a joint venture), whether the items are intended for use by the importer or by someone else, and the final destination for the goods, such as a research facility in a free economic zone.³⁶

Clearing items through customs has always been a tedious chore in Moscow and other ports of entry into Russia. Customs officials are well equipped to address general issues and to search out regulations concerning various types of charges. But, when it comes to handling items imported under programs that are supposed to have special exemptions —particularly technical assistance programs recently certified by the Ministry of Economics—the officials may be uninformed about the specific programs. That is when documentation, persuasion, and negotiation take over. Off-line payments often expedite the process.

Seemingly legitimate fees are routinely encountered at international airports and other customs clearance points. These include a customs clearance fee and a fee for storing items if they are not picked up immediately upon arrival. But every foreign program manager in Russia will probably concur that customs clearance procedures have a long way to go if international programs are to run smoothly while following the rules.

As discussed in Chapter 1, a significant dimension of conducting business in Russia is reliance on barter. For some foreign companies,

barter may provide the only means to receive payment for engineering products and services. In the tax arena, barter sometimes benefits both the provider of goods and services and the recipient. Swapping goods is simply an inventory transaction not reported on a balance sheet. Barter activities cannot be detected without detailed audits, and barter strips off liability for VAT and other taxes. While finished goods go into inventory, they never show up as sales. Tax authorities then may end up looking for cash that, officially, isn't there.³⁷

For foreign companies, barter transactions are often more trouble than they are worth. Even if a firm receives products at agreed intervals without difficulty, problems with selling these products may be severe. Many companies prefer to use brokers to mediate countertrade. This practice also has risks and downsides. But, in the absence of Russian cash, it may be the only available course to take advantage of either market opportunities or unique Russian capabilities to develop products.

An important legislative action was the granting of authority to government entities at all levels—federal, regional, local—to enter into cooperative agreements with foreign organizations for economic purposes. Such agreements are to be registered in Moscow, but shortcuts around Moscow authorities have often been the rule, with complicated tax avoidance implications. ³⁸

A final tax-related issue relates to foreign equity investments in Russia. In 1987, Russia passed its first decree regarding the joint venture. Intended to pave the way for such investments, this decree has been modified many times. The idea was that if the division of rights between Russian and western investors were clarified and tax implications simplified, western companies would go to Russia.

A few joint ventures were established. However, financial squabbles among the participants and between the investors and the government prior to establishing the joint venture and then after it was in place were commonplace. Some joint ventures were simply paper creations that the Russian participants viewed as a safe channel for an influx of western dollars—funds that often failed to materialize.

Within a few years, most western firms had learned that the extensive efforts needed to put a joint venture in place before meaningful

activity could begin were not worth the effort. Therefore, straightforward contractual arrangements became far preferable for these firms. Such arrangements include licensing agreements, turn-key construction projects for which foreign companies provide engineering services, Russian manufacturing of agreed-upon quantities of product, production-sharing arrangements, and a host of other contractual approaches. Although the joint venture approach never caught on in a major way, it was an important step toward a still-evolving legal regime for foreign commercial activities in Russia.³⁹

Fair and enforceable laws and regulations that provide the framework for a safe business environment are essential if new generations of Russian technology entrepreneurs are to adopt western business standards and practices. Only then will these entrepreneurs be able to find their way in a western-style market economy. Until that time, they will need help and protection, not harassment, from the Russian government if they are to survive in a tumultuous milieu of corruption and financial deprivation.

Uncertainty over patent rights will remain a major question confronting technological progress in Russia. Few doubt that, under favorable economic conditions, some Russian technologies will be of widespread interest at home and abroad. At a less practical but still important level, Russian patent certificates that are of no interest to foreign experts looking for technologies with greater payoff can have substantial meaning for Russian inventors. They are viewed as measures of personal success and as claims, however small, on the future of the world 's progress.

Meanwhile, for a decade western voices have been cheering for the tax police to do their job. All are convinced that without tax collection Russia will never recover. An easy strategy for the tax authorities will continue to be to make pronouncements denouncing all tax deadbeats but then confronting those who put up the least resistance. This latter category includes many technology entrepreneurs.

Proposed changes in the tax code that could ease business deal-

ings will be debated for years. Some will be enacted piecemeal. For example, in 1997 the requirement to pay tax on anticipated income from a contract as soon as the contract is signed rather than when the money is received was changed. Then, in 1999, tax on sales-below-cost was eliminated. Also, the law now states that in disputes between tax authorities and the taxpayer the latter is presumed innocent until proven guilty—although recent Russian visitors to the offices of the tax service laugh when they learn about this turnabout on paper.

Whatever the laws and regulations, successful marriages of diverse interests between Russian and foreign investors will help solve many problems, including equitable arrangements to share intellectual property rights and joint efforts to minimize taxes. One American expert who has been involved in over 700 proposed and completed business marriages observes:

An extremely important predictor of success has been the quality of the Russian business partner. The ideal partner is one who has a sound understanding of western business standards and practices, can effectively navigate the labyrinthine Russian bureaucracy to obtain required approvals and registrations, is trustworthy and reliable, and is willing to learn and embrace foreign financial reporting and other business practices.⁴⁰

In short, Russia remains a country where the rule of relationships is supreme and the rule of law is still being born. Successful marriages will help convince influential politicians and seemingly intransigent bureaucrats that governmental actions to facilitate joint efforts can, in fact, pay off. Only with their leadership will the rule of law become one of the keys to technological development of Russia. ⁴¹

1. Negotiations in Moscow from November 1992 to March 1994 on the Statute of the International Science and Technology Center.

2. Vladimir Smoylenko and Ian Spence, “The Current State of Tax Reform in Russia,” Russia Business Watch, Spring 1999, pp. 38-9.

3. Nick Holdsworth, “Video Pirates To Walk the Plank,” The Moscow Times, August 14, 1999, p. 24.

4. Vladimir Merkushev, “Microsoft Sales Slump 38% in Russia, CIS,” The Russia Journal, September 27-October 3, 1999, p. 9.

5. Vladimir Meshcheryakov, “Development of Legal Regulations for

Technology Commercialization in Russia,” Technology Commercialization: Russian Challenges, American Lessons, National Academy Press, 1998, pp. 60-66. This report describes the legal basis of the protective documents issued by the patent agency while pointing out the necessity for stopping violations of exclusive rights in receiving infringement disputes, as well as mechanisms for enforcing the decisions of the courts.

6. Andrei A. Baev, “Protection of Intellectual Property Rights in Russia,” Cooperative Business Ventures between U.S. Companies and Russian Defense Enterprises, Center for International Security and Arms Control, Stanford University, 1996, pp. 267-285.

7. Meshcheryakov, “Development of Legal Regulations for Technology Commercialization in Russia.”

8. Yuri Lebedev, “Problems of Taxation and Technology Commercialization in Russia,” Technology Commercialization: Russian Challenges, American Lessons (Washington, D.C.: National Academy Press, 1998), pp. 50-54.

9. Ibid. “On the Use of Results of Scientific-Technical Activity,” Decree of the Government of the Russian Federation, No. 982, September 2, 1999. Also, “Conception of State Policy on Introducing into the Economy, the Results of Scientific-Technical Work Carried Out with Funds of the Federal Budget,” Interagency Commission, Protocol No. 6, April 7, 2000.

10. Baev, “Protection of Intellectual Property Rights in Russia.”

11. Glenn E. Schweitzer, Field notes from survey of 28 applied research institutes in Russia conducted in July and August 1997.

12. Discussions in Moscow at the Ministry of Science and Technology, July 1997.

13. Discussions in Moscow with staff members of the International Science and Technology Center, April 1998.

14. Discussion in Moscow with patent expert and foreign relations officials at the Ministry of Science and Technology, July 1997.

15. Baev, “Protection of Intellectual Property Rights in Russia.”

16. While the U.S. Department of Commerce has considerable information on the various tax requirements at the national level, there is no authoritative source of all tax requirements either at the national or local level. Both Russian and western entities are well advised to consult frequently with the authorities as to their legal obligations, as well as relying on the growing cottage industry of tax lawyers in Russia.

17. Lebedev, “Problems of Taxation and Technology Commercialization in Russia.”

18. Discussions in Moscow with a number of Russian research managers and tax specialists, November 1998.

19. Schweitzer, Field Notes.

20. “Russian Grants to Remain Duty Free,” Science, April 16, 1997, p. 1197.

21. Glenn Geffner, “Income Tax Rates Due for General Overhaul,” The Moscow Times, July 27, 1999, p. 14.

22. “Commercial Overview of Russia,” BISNIS, Department of Commerce, September 1999, pp. 16-18.

23. Igor Emenenko, “Sheltering Havens,” Business Review, September 1999. At the end of 1999, the Duma was attempting to drastically reduce the number of tax havens in connection with the need to increase tax revenues.

24. Brian Humphreys, “Campaign Targets Aluminum Firms' Tax Breaks,” The Moscow Times, September 28, 1999, p. 14.

25. Vladimir Merkushev, “Internal Tolling Likely To Be Extended One Year,” The Russia Journal, November 22-28, 1999, p. 15. Oleg Kirsanov and Sergey Padalko, “Good Changes in Russian Aluminum Sector?” The Moscow Courier, No. 1, June 2000, p. 4.

26. Smoylenko and Spence, “The Current State of Tax Reform in Russia.”

27. Alexander Chmelev, “Recent Developments in Russian Tax Legislation,” Russia Business Watch, Fall 1998, pp. 26-7.

28. “Tax Evaders Targeted,” The Moscow Tribune, November 4, 1998, p. 8.

29. “Tax Minister: A Sixth of Firms Cheat,” The Moscow Times, August 14, 1999, p. 12.

30. Karl Emerick Hanuska, “Make My Day,” Russia Review, September 11, 1998, Vol. 5, No. 16, pp. 25-28.

31. Ibid.

32. Margaret Coker, “Grab the Band-Aids, Get Ready to Fight,” Russia Review, September 11, 1998, Vol. 5, No. 16, pp. 29-30.

33. “Federal Law on Introducing Changes and Amendments in Specified Laws of the Russian Federation Concerning Taxes and Obligations in Connection with Nonreimbursable Assistance to the Russian Federation,” No. 2439-II GD, May 14, 1998.

34. Nicole N. Nelson, “MPC&A Tax Status Report,” U.S. Department of Energy, June 3, 1999, updated and corrected by spokesman for Ministry of Foreign Affairs, Monterey Institute of International Studies, Monterey, California, December 1999. For background on procedures that had been in effect until this time see “Agreement on Exclusions from Payment of Taxes in Connection with the Realization of Programs of Assistance Agreed on a Nonrepayment Basis between the Russian Federation and the Government of the United States of America,” originally signed by Minister of Finance V.G. Panskov and U.S. Ambassador Thomas R. Pickering, April 17, 1996, and subsequently extended on several occasions; and “Letter on Excluding Grants from Personal Income Tax that Are Provided by International and Foreign Institutions and International and Foreign Noncommercial and Humanitarian Organizations for Support of Russian Science,” Russian Ministry of Finance and State Tax Service (and signed by Z.A. Yakobashvili, Ministry of Science and Technology), May 21-22, 1997.

35. Discussion in Washington, D.C., with Deputy Director of Customs Service of Russia, June 1999.

36. “Russian Customs: How Much—and How—To Pay,” BISNIS Bulletin, Department of Commerce, July 1997, p. 6.

37. “Barter in Russia: How To Protect Your Investment,” BISNIS Bulletin, Department of Commerce, May 1998, p. 3.

38. “Federal Law on Coordination of International and Foreign Economic

Relations of Subjects of the Russian Federation,” adopted by Duma on December 2, 1998, and signed by President Yeltsin on January 4, 1999, No. 4-f3.

39. Jeffrey A. Burt, “Joint Ventures in Russia: The Ten-Year Lesson,” unpublished manuscript distributed by Arnold and Porter, Washington, D.C., September 1998.

40. Richard N. Dean, “The Russian Legal System: Ten Years Later,” unpublished manuscript distributed by the firm Coudert Brothers, Washington, D.C., April 1998.

41. Ibid.