Armenia has heralded the IT sector as a priority industry since the year 2000. Unfortunately, that stance is not reflected in public policy. Two decades on, industry and trade remain the main driving forces of Armenia’s economy.
There have been attempts to encourage the sector. We have seen various government programs, legislation and regulations, international memoranda, even a few large investments. However, the sector mostly provides outsourcing services to foreign organizations.
On the bright side, there have been a few developments that have radically changed the direction of the industry. In 2000, the Union of Information Technology Enterprises was established. The Enterprise Incubator Foundation (EIF) was established in 2002 as the result of a partnership between the Government of Armenia and the World Bank. EIF is one of the largest technology business incubators and consulting companies in the region, Synopsys established operations in Armenia in 2004. In 2004-2008 alone, it invested $1.3 billion in manufacturing and educational technology in Armenia. Synopsys cooperates with a number of universities and also provides scholarships to students in the field of electrical engineering. Since 2008, its educational program has been attended by 300 students annually.
If You Tax Less, They Will Come
By 2015, the Government had finally clued in to the great value that the sector was generating. They introduced legislation to formalize regulation and simultaneously offer tax incentives to IT companies operating in Armenia. It was called the Law on State Support to the Information Technology Sector.
The law foresaw a 0% profit tax rate (instead of 20% of net income), and a 10% income tax rate for employees in the sector (compared to the current 21% flat tax).
In 2014, the year before the law was introduced, 16 IT companies had been established in Armenia. With the law coming into force the following year, 2015 saw 59 IT companies registered for tax privileges. The positive trend continued with 98 in 2016 and 272 in 2017. About 2400 new jobs were created at these startup companies, with an average annual salary of 3.0-3.4 million AMD ($6,000-$6,800).
In the month following the 2019 amendments, 100 companies applied for the tax benefit, of which 41 were approved.
In 2019, the law was amended by Bill G-027, which fundamentally changed the criteria for which companies would be eligible, in order to mitigate corruption risks. There had been instances where one large company was divided into several small companies in order to meet the eligibility criteria, because there was no clear prohibition of this practice in the previous version of the law. The new version disqualifies companies that "were created as a result of the reorganization of another [company]."
Out of the Shadows
It is necessary to understand to what extent these benefits contribute to the establishment of the IT ecosystem, and whether they are sufficient for solving the problems the sector faces, to save it from an inevitable stagnation.
Make no mistake. The tax benefits are a real incentive for the further development of some companies in the sector. Some startups that have been leaning on them since the beginning, such as RenderForest and HexDivision, have today become established businesses. However, the benefits are most useful to companies that have already transitioned from the Early Stage and entered the Commercial Stage.
Early Stage startups have just turned a new idea into more material value. Often such startups do not even have an initial investment, and any money earned is reinvested in the project until the first major investment.
It is mainly after this stage that startups begin to register as an actual company, which is a prerequisite for receiving investments. However, not only does the law not facilitate the registration process, in some cases it even hinders it.
The main purpose of both the original 2015 and the revised 2019 versions of the law is to bring startups “out of the shadows” and get them to start reporting their transactions to the tax authority. There is no clear strategy, study or calculation as to what problems exist in the sector, what problems the law will solve, the costs to the state in lost tax revenue and what results those funds are producing. A few very high-level documents briefly touch upon a few goals, but they are so broad in nature that they read more like a poetic toast than a clear strategy.
In general, any such intervention—be it a law or an incentive—is an instrument of public policy. Economist Hovhannes Avetisyan explains the phenomenon: “In such cases, the state tries to intervene to solve a problem in the sector. Questions arise: what are the problems to be solved, what assessment was given to them, what solutions are being proposed, and why is the given solution the most optimal at that moment?”
Other than encouraging companies to enter the formal economy, there are simply no answers to the remaining questions. Especially since the shadow economy is the least of the problems daunting Armenia’s IT sector.
According to Amalya Yeghoyan, former Deputy Minister of Transport, Communications and IT, the law greatly encouraged companies that used to work as informal teams to become registered as companies and appear in the tax system. Registering as a company first and foremost benefits the startups themselves. It is the first step to attract the attention of foreign capital and break into the market.
According to Yeghoyan, however, these tax incentives only provide results in Yerevan. They are not sufficient to start a tech business outside the capital. Issues such as access to human resources and additional risk factors like border tensions negatively impact the attraction of investment beyond Yerevan and the law is not able to counterbalance those forces.
If There Is No Income, There Is Also No Income Tax
Artashes Vardanyan, the former head of Microsoft Armenia, emphasizes an important point: “New startups do not need tax benefits at all because, at least initially, they work, if not at a loss, then with zero profit and income. If there is no income, there is also no income tax. The generated amount is not subject to VAT [value added tax], nor does it generate any other type of tax.”
In this case, the additional incentive for that startup should not be a tax benefit, which it cannot actually use. One area they could use help with instead is investment.
There is another problem here as well. The existence of a law is one thing, its application is another. To further illustrate this problem, and to understand it, let’s consider a typical example.
MedPoint Technologies is a medical startup that analyzes digitized data. It can predict what stage cancer has advanced to, what cells are developing, and the subsequent course of the disease with 90% accuracy. Co-founder Roza Bejanian emphasizes that, while what the law offers may be good, there is zero accessibility to it, especially for new startups.
The law is written in legalese [legal jargon]. The state bodies involved don’t have a one-window service specifically designated to provide necessary guidance. In such cases, there are two alternatives: either the new startup (which, to put it mildly, has limited resources) has to hire a lawyer or an accountant to understand how to apply and what documents are needed, or not apply at all. The same applies to the various grants announced by the ministry. Mildly put, communication between state institutions and the IT community is in a deplorable state.
Building Investor Confidence
The main problem here is that tax benefits are not of primary importance for the IT industry. There are more serious problems at hand. Tax benefits are granted at the end of the journey. But to get there, you have to be able to start.
A tax benefit is simply not a sufficient condition for a new startup to want to register its business in Armenia. The most important issue for startups is attracting investment; foreign investors are not really rushing to invest in Armenian companies. There are several reasons for this.
Bejanian says that they were turned down by investors on two separate occasions specifically because they were an Armenian startup. The investor argued that the political situation in Armenia was not stable, and expecting investment under such conditions was naive. Both cases took place before the 2020 Artsakh War.
In addition, no law in Armenia protects and guarantees a foreign investor. If the startup fails or closes down, there is no mechanism that will allow the investor to get some of their money back.
American investors do not generally enter markets where the legislation is unfamiliar and incomprehensible to them. Investors often demand that the startup be registered in the United States or a European country; otherwise, they stay away.
Hovhannes Avetisyan gives a striking example: “Belgium has the highest tax rate [among EU countries]; salaries are taxed at 40-50%. However, Amazon prefers to invest in Belgium over Armenia. The reason is the legislative field, the existence of various guarantees from the state.” This refers to state insurance funds for foreign investment that guarantees return of investment capital.
Armenia’s credit rating lags far behind those of the United States and European countries, sending a signal to investors that there is considerable risk in doing business here.
Precisely because of these factors, the co-founders of MedPoint Technologies have decided to register in France first, so that they can go through the qualification and certification stages, and then attract investment.
Artashes Vardanyan raises another issue: the lack of skilled IT specialists. This issue is the most likely to hobble the whole ecosystem’s future prospects.
Have you ever wondered why salaries in Armenia’s IT sector are so high compared to the country’s average? We are not talking about entry-level and intermediate professionals. At those levels, wages are more moderate. However, the salaries of highly-qualified specialists are stratospheric compared to the cost of living in Armenia.
The explanation is that there is a severe shortage of experienced IT specialists, compared to the demand. Vardanyan elaborates, “When they say that a big company has come to Armenia and created about 500 or 1000 jobs, how are these jobs created? Headhunting. Brain hunting. There is no other way to find highly-qualified specialists in Armenia. In Estonia, for example, specialists are brought in from abroad, at the state level, to fill the gap. We have two huge markets available that we do not utilize: Iran and India.”
In other words, when a large company opens, several small and even medium-sized companies suffer as their talent gets poached. This is not a problem that tax incentives can solve.
First, tax benefits have their niche, but startup founders need state institutions to be more customer-oriented in sharing information, even for things as simple as explaining how to apply for those benefits.
Secondly, the law on benefits mainly helps companies that are located in the capital. There is no additional incentive to take on the challenges of setting up shop outside Yerevan.
Thirdly, even if companies are exempt from all taxes, that in itself is not yet evidence that a startup will want to register its company in Armenia at all. Being based in Armenia is not conducive to attracting large investment. All the startups that have been able to attract large investments in Armenia (Picsart, Krisp, SoloLearn, RenderForest, etc.) have some type of representation, registration or subsidiary in a European country or in the U.S.
In order to solve the problem, one should not put the cart before the horse. Tax benefits are great when you are making a profit, but first you have to get there.
Armenia needs better regulation surrounding foreign investment in order to become more attractive. Former Deputy Minister Amalya Yeghoyan attests to this. According to her, even through personal connections and trust, it is often not possible to bring investors to the country.
Additional incentives can be put in place to encourage remuneration through stock options. The Baltic countries have a successful track record in this regard, which led them to become recognized as “start-up friendly” countries.
The lack of specialists is a serious problem, and it is necessary to close that gap, at least temporarily, with the help of foreign specialists, while simultaneously improving the education system so that newly-graduated specialists from universities are competitive in the market. Once established in their field, the best specialists can often make significantly more if they emigrate to another country.
Nobody says no to a tax rebate, but the Government must understand that there are more pressing issues holding us back.