Illegal fuel market in Ukraine: Can it be subdued in five steps?

Illegal fuel market in Ukraine: Can it be subdued in five steps?

And why taxes alone don't solve everything

Illegal fuel market in Ukraine: Can it be subdued in five steps?

The Verkhovna Rada reintroduces pre-war tax rates and excise duties on petrol, diesel fuel, and liquefied gas from July 1. Specifically, the VAT will increase from 7% to 20%. The losses to the state budget from unpaid excise duties and VAT amount currently to approximately 400 million UAH per month, and with the reintroduction of pre-war tax rates from July 1, taxation will increase by more than twice. This illegal sector not only creates significant losses for the Ukrainian economy but also hinders the development of the legal oil and gas industry.

Yesterday, on June 27, a meeting of the Temporary Investigative Commission on the illegal fuel trade took place. Four components of the problem were discussed: illegal retail sales, illegal production, legal retail sales with tax evasion, and the necessary legislative changes.

The Ukrainian oil and gas market is struggling with a constant issue – the dominance of the illegal fuel market. During a year and a half of war, the aggressor bombed over 30 major oil depots and a number of oil refineries, including semi-legal ones. Today, participants in the oil market and petroleum retail in Ukraine are trying to restore and build new positions and opportunities for civilised existence. After all, the country's economic survival depends on solving this issue in the near future.

Mind reached out to the Ukrainian Oil & Gas Association to comment on why the counterfeit market still exists, what hinders its containment, and what to do to ensure that taxes actually go to the budget, not into the pockets of “shadow players”. Yaroslav Starovoytenko, the new head of the Ukrainian Oil & Gas Association, agreed to answer our questions. The Association proposes to take at least five steps to achieve economic stability.

What is happening in the market right now?

Unfortunately, despite all the efforts of the government, the illegal fuel market in Ukraine has not only persisted but has also been gaining momentum. Recently, the Finance, Taxation, and Customs Policy Committee of the Verkhovna Rada reported an increase in the 'shadow' market to 10-15%. The committee estimates the budget losses at 5-10 billion UAH per year. This colossal amount could have been allocated to the army, the restoration of destroyed infrastructure, and social benefits.

The schemes used by the illicit traders remain the same: manufacturing counterfeit fuel in mini-refineries, selling fuel at petrol stations for cash without providing fiscal receipts or providing fictitious receipts, that is, 'off the books', and fraudulent VAT schemes.

Furthermore, the number of facilities producing substandard and low-quality fuel is increasing within the country. Currently, around 20 such mini oil refineries are operating, employing primitive methods and outdated equipment, polluting the environment, and violating labour protection, ecological, and fire safety standards. On these facilities, gas condensate is transformed into poor-quality motor fuel, which is then primarily sold to Ukrainian vehicle owners for cash.

To make this substandard fuel resemble regular petrol, it is mixed with approximately 30% oxygen-containing solvents, which increase its octane rating. Then, this explosive mixture, both literally and metaphorically, finds its way into Ukrainian vehicles through unregulated grey and black petrol stations. It is likely that the “unfortunate owners” of such places also pay their employees “under the table”. Therefore, this subpar and illegal fuel has a significant price advantage in the market.

The situation is further complicated by the fact that solvents, diluents, and gas condensate used in fuel production are not subject to excise taxation. Consequently, their storage, transportation, and sale largely remain uncontrolled by the government. Additionally, the lack of state control over the raw materials supplied to illegal mini-refineries allows the sale of counterfeit documents to legitimate enterprises in various sectors of the economy. These organisations falsely claim to use gas condensate as fuel for boilers, furnaces, and dryers.

As of April 2023, there are over 450 retail fuel trading locations operating in the controlled territory of Ukraine with signs of violating existing legislation. We observe a trend of increasing such locations compared to 2021 and 2022. The prevalence of the illegal fuel market encompasses the entire country, with noticeable concentrations in the Lviv and Kyiv oblasts.

What will be the consequences of reintroducing a 20% VAT?

After the reduction of value-added tax (VAT) to 7% in May 2022, the volume of tax evasion significantly decreased. By the way, it was precisely VAT evasion that led to the largest budget losses in the country.

From July 1, 2023, the government is reinstating the full 20% VAT rate and full excise rates on fuel. Everyone understands why this is happening – the country's budget needs to be replenished not only by external donors. However, reintroducing a 20% VAT on fuel without strengthening its administration by the government can exacerbate the problem of illegal trade, as the financial attractiveness of tax evasion will increase in an arithmetic progression, resulting in an overall increase in its volume.

Recently, the A-95 Consulting Group published calculations demonstrating that the price of petrol may increase by 11.2 UAH/litre, diesel fuel by 7.7 UAH/litre, and gas by 2.6 UAH/litre if fuel taxes are returned to the level of February 2022. Therefore, in order to save money, fuel buyers will increasingly turn to “grey” or even “black” sources, stimulating the growth of the shadow market.

Five steps to clean the market from fuel illegal activities

The issue of illegal fuel trade poses significant challenges that require constant and comprehensive measures. At Ukrainian Oil & Gas Association, we propose a range of actions that can be taken to effectively and comprehensively address the problem and protect the budget of Ukraine, legitimate businesses, consumers, and the environment.

Introduction of excise duties on solvents and gas condensate. Mini-refineries purchase tens of thousands of tons of raw materials and components that are not subject to excise duties for the production of counterfeit fuel. Therefore, by even introducing a zero excise duty on gas condensate, the state will be able to control the movement of these goods throughout the entire chain, from production to the final consumer. Moreover, implementing a high excise rate for oxygen-containing solvents and diluents will make the production of adulterated petrol economically unattractive.

Transparency in tax payments. Public disclosure of the tax amounts paid by each participant in the fuel market can be an effective measure in promoting transparency. Comparing the tax amounts paid by companies per petrol station network or per litre of fuel sold vividly demonstrates the tax burden and level of social responsibility of a particular company or network. Discrepancies in tax burdens of 10 or even 100 times should at least raise questions among relevant regulatory authorities.

Utilisation of electronic administration systems and flow metres. The full utilisation of existing electronic administration systems for fuel sales and level gauges and flow metres on fuel tanks allows for real-time visibility of all fuel transactions. These systems are located in the tax authority, and market participants provide data according to various terms and conditions. The association proposes granting access to this system to law enforcement agencies, especially those units combating illegal circulation of excisable goods. This way, they could utilise this analytics, identify “anomalies” and promptly submit requests and respond accordingly.

Strengthening control over cash discipline. There are various options for enhancing control over compliance with cash discipline at petrol stations. These range from the physical presence of tax officials at retail fuel trading locations (the so-called timekeeping) to increasing accountability for tampering with cash registers and developing software that allows such interference and manipulation of tax reporting data.

Raising public awareness and vigilance of executive authorities. The demand for cheap fuel among vehicle owners gives rise to the supply of illegal gas stations. Therefore, we consider it necessary to inform vehicle owners about the consequences of their interaction with the shadow fuel market, as well as other citizens, that due to the operations of 'grey' and 'black' petrol stations, they are deprived of social benefits, the state loses tax revenue, and the armed forces lack weapons and ammunition.

Simultaneously, the objects that are located in violation of urban planning legislation disregard fire safety norms and rules of retail fuel trade, requiring increased attention and appropriate response from regulatory authorities.

Recently, we have restored the functionality of the perevirAZS map, through which consumers themselves can provide information about the presence of locations where petrol stations with signs of violation are situated.

The map includes a section titled "Indications of Illegality," which provides consumers with tips on how to distinguish an illegal petrol station and information regarding the documents that a legal petrol station must have according to the law. The map also includes a questionnaire that any citizen can fill out to submit a petrol station for inspection if it exhibits signs of violating current legislation, such as refusing to issue a receipt, lacking customer facilities, firefighting equipment, and so on.

The crisis associated with illegal fuel trade requires urgent measures to protect the state budget, legal businesses, and the environment. Reforming tax policies and implementing comprehensive control measures can become a powerful deterrent to the production and sale of substandard fuel. By removing financial incentives and improving regulatory oversight, Ukraine can effectively overcome the challenges associated with illegal fuel trade and promote a more reliable and transparent fuel market.

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