For many foreign companies, the localization of production could be the key to establishing a foothold in a volatile, yet high potential Russian market.

Recently, a major German firm, DMK Deutsches Milchkontor, received permission to buy a number of cheese production facilities in Russia. Photo: TASS

Low oil prices, lack of structural economic reforms and sanctions imposed on Russia with regard to its role in the Ukraine crisis have affected the Russian economy in many ways and created a new economic reality which has both positive and negative effects. That new reality has forced the Russian authorities to undertake serious measures to adjust to it, including the nation’s controversial import substitution policy.

The significant devaluation of the Russian ruble against the U.S. dollar and euro made the Russian market quite attractive for investors as it has become a lot cheaper to invest. Yet, even with the devaluation, the market is still too risky for many investors.

Thus, the question arises: Could the localization of production be the key to reducing this risk and helping companies establish a foothold in a volatile, yet high potential Russian market?

This is the question many foreign companies of several key industries have been asking themselves recently due to certain policy changes that make localization an attractive and even necessary strategy.

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Key areas for localization

In the wake of the recent crisis, there are various measures being taken by the Russian government to move the economy away from overdependence on imports and towards competitive, high tech and innovative industry with high rates of local production. The Ministry of Industry has even set the goal of localizing the production of 800 key products in 18 key industries.

These measures consist of various financial and tax incentives provided to companies operating in strategic industries on the Russian market, and preferable conditions for local companies and “goods of local origin” participating in state tenders. They are largely either introduced or reinforced by Federal Law No. 488-FZ "On Industrial Policy" of December 2014, which came into force on June 30, 2015.  

This law foresees various incentives for foreign and local companies operating in the government’s key industries, which include the mechanical engineering, electronics, automobile, pharmaceutical and medical, oil and gas (equipment), shipbuilding, aviation, agricultural, energy, and construction industries. It also outlined main incentives, which in some cases include penalties for foreign companies without local production.

New incentives for moving production to Russia

The companies investing locally in these key industries can count on financial support in the form of subsidies and grants awarded on the basis of tenders, loans with preferable conditions, contributions towards companies’ charter capital, and financial leasing.

Moreover, preferential treatment will be provided to local companies and locally produced goods in state procurement and tenders of state owned enterprises, and in some cases, bans on foreign companies participating in state tenders and goods of foreign origin being considered in state procurement (primarily relevant to the automotive, heavy equipment, light industry and pharmaceutical sectors).

Certain research and development (R&D) activity is exempt from value added tax (VAT) and service-related expenses defined as R&D are deductible using a preferential coefficient. Moreover, there are reduced social contribution rates for companies’ employees within the IT sphere.

There are additional measures for stimulating local production. Special investment contracts (or so-called “SPICs”) are entered into by the investor and the Russian federal government (or regional government) for a period of up to 10 years, and provide investors with a stable and preferential tax burden in exchange for adherence to certain conditions. They are most prominent in the machinery, metallurgy, light industry, chemicals, pharmaceuticals, health care and electronics industries.

The program is run and facilitated by the Industry Development Fund of the Ministry of Industry. The fund’s job is to assist investors negotiating the SPICs and ensure that the expert council approves the contract.

This fund handles all industry support programs financed by the Ministry of Industry, including project finance, preferential interest rates on loans to replenish working capital, state guarantees for investment projects, amongst others.

The requirements to qualify for and maintain the benefits of these special investment contracts vary from industry to industry, contract to contract as well as the regional authorities granting the contract, however, they focus around the idea of stimulating the production of “locally made goods” using “locally sourced products,” often obliging investors to either create new or upgrade existing production facilities. There are also different criteria for what constitutes a “locally made product,” which vary by industry.

Finally, the benefits from these special investment contracts can be combined with the other available benefits, such as those mentioned above or the preferable environments offered by Special Economic Zones (SEZs).

Special Economic Zones and industrial parks

The development of Special Economic Zones and industrial parks are also referenced in Federal Law No. 488-FZ as a means of achieving its goals. SEZs, launched 10 years ago, are dedicated areas within Russia that provide residents with a series of benefits and are established under a program overseen by the Russian Ministry for Economic Development.

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SEZ residents may take advantage of different combinations of preferential conditions, such as tax benefits (reduced profits tax, exemption from property tax and land tax, and, in some cases, exemption from customs duty and VAT), cheaper land (up to 3-4 percent of cadastral value), close proximity to economic clusters, support of local authorities in receiving essential permits (e.g. construction permits), and generally reduced bureaucracy for the starting phases.

The law covers 34 sites across Russia, all of which are at different stages of maturity. SEZs are exclusively federal, and the Russian government undertook to maintain the “rules of the game” until 2054, i.e. guaranteeing residents long-term, stable benefits.

The benefits depend on the type of economic zone, which at present can be split into the following categories:

- Technical research and implementation zones for scientific projects;

- Industrial production zones to develop industrial products;

- Tourism and recreation zones for the development and effective use of Russian tourist resources;

- Port zones.

They often also offer extensive on site infrastructure such as on site gas supply, water treatment facilities, gas transferring stations, customs posts, electricity generators and direct links to major railways and roads.

Industrial parks are very similar to SEZs, however they can be either run by the regional authorities or privately run (often with state funding), and the legislative environment varies from park to park (whereas the legal environments in SEZs are unified). They offer similar benefits and on-site infrastructure to the SEZs, and some also focus on providing extensive warehousing and along with the necessary infrastructure for launching production.

There are other such similar concepts, such as Fast-Track Development Zones in the Far East (offering tax holidays and simplified rules for hiring foreign employees), innovative regional clusters, technoparks and business incubators which all either facilitate business setup or improve the business environments for residents, and often benefit from state funding. Although the above concepts are most prominent in the Central Federal, Northwest and Volga Districts, they are scattered across the whole country.

Economic uncertainty and the planning decision

The question of whether or not now is the right time to fully commit to the Russian market depends largely on the industry in which a company is operating.

On the one hand, although the opportunities on offer may not be so prevalent as in the past, they certainly still exist and there will certainly be many success stories from the companies who are currently taking counter-cyclical decisions. The ruble devaluation makes investing cheaper in many different areas than before, and there are major upcoming projects such as the FIFA World Cup 2018 offering vast opportunities.

On the other hand, good investment projects are now harder to find, and the economic uncertainty will certainly act as a deterrent to many potential investors.  

This being said, the incentives available to foreign companies setting up production in Russia are vast. What remains to be seen, however, is whether companies will decide to implement localization projects at a time when the geopolitical environment surrounding Russia is uncertain at best.