The International Journal
of Not-for-Profit Law
Volume 8, Issue 4, August 2006
By Vsevolod Ovcharenko1
1. Brief History of the Issue
a. NIS trends since the mid-1990s
In the mid-1990s, many governments in the newly independent states ( NIS) recognized the importance of supporting not-for-profit activities in their countries. There were several reasons: the collapse of a vast Soviet system of welfare and social services; a great demand for social services among the population; the new NGOs’ greater efficiency compared with the old Soviet social institutions; and an opportunity to attract additional resources, primarily from foreign donors, for social services performed by NGOs. There was also the opportunity to use NGOs for misappropriating government funds – with no liability for anyone in the case of their liquidation.
At the beginning, the governments faced some confusion over priorities: to support NGOs or to emphasize high-quality services. The latter would require participation of all competent service providers, not just NGOs, in the competition for government funds. In the absence of an established and well-functioning system of state procurement, in most cases it was decided to use grant mechanisms called zakaz, which can be translated as “order” or “contract.” This Soviet-era term was adopted because the term “grant” was largely associated with foreign assistance to governments and local NGOs.
Unfortunately, the terminology, and in particular the term zakaz, which was never defined clearly in the legislation, resulted in controversial practices and widespread confusion. In some instances, state grants and state procurement both were labeled zakaz.
b. Kazakhstan’s approach – local particularities
In the beginning of the 21st century, the idea of governmental support of social NGOs also became widespread in Kazakhstan. Several NGOs – including the most active, the Confederation of NGOs of Kazakhstan – conducted a long-term campaign advocating a special law on state social contracts (state social zakaz). The idea finally was accepted by the government, and it started the drafting process. The International Center for Not-for-Profit Law (ICNL) provided technical assistance to both the NGOs involved and the governmental drafting group. During the drafting process, participants addressed the problem of determining the mechanism of the social contracts. The following are some of the issues that arose during this process:
i. Constitutional prohibition
Kazakhstan’s Constitution, in Section 5.2, prohibits state financing of public (citizens’) associations. The extent of the constitutional prohibition was unclear in terms both of what qualifies as “state financing” and what qualifies as a “public association.” In the Kazakh Civil Code, “public associations” are listed as one of sixteen legal forms of non-commercial organizations. In common usage, though, the term “public associations” often referred to unregistered groups as well.
So, in the absence of a clear understanding of what the Kazakh Constitution prohibits, participants decided to use a mechanism of state procurement to govern state social contracts.
ii. Local Procurement Law – no room for social services
State procurement is very technical and expensive. The problem was complicated by the fact that the Kazakh Law on State Procurement did not provide an adequate mechanism for procurement of services. The law omitted both qualification requirements for bidders and mechanisms for procuring the services. The Kazakh Procurement Law was based on the UNCITRAL Model Law on State Procurement, but without its Chapter 4, which is devoted to procedures for procurement of services. Officials of the special governmental Agency for State Procurement, which administers the Law on State Procurement, were, and remain, reluctant to develop procedures where the law is silent. Indeed, they have refused to discuss the issue for the last ten years.
iii. “State Grants” in the form of “Procurement Contracts”
The Law on State Social Contracts that finally emerged represented a compromise. NGOs undertook a very active advocacy campaign. Further, the responsible governmental agency, the Ministry of Culture, Information and Public Accord, was reluctant to submit state social contracts to the authority of the Agency for State Procurement. The result is an odd hybrid: state social contracts in Kazakhstan are doled out through a sort of state grant-giving system, yet the agreements between the state and the NGOs take the form of state procurement contracts! Despite the peculiarities of this mechanism, it distributed the equivalent of some $3.5 million during 2005.
c. ICNL’s role in the process
Throughout the process of drafting the law and evaluating it, ICNL provided technical assistance to all interested persons. The deficiencies of the designed mechanism were clearly explained, and it was suggested that this system would not work efficiently and would create broad opportunities for corruption and abuse of governmental funds unless a number of critical amendments were introduced into tax, state budget, and state procurement legislation. Without the critical amendments, the system has indeed proved inefficient.
During the drafting process, some governmental officials tried to use the Law on State Social Contracts to impose additional limitations on NGOs in Kazakhstan. ICNL provided assistance to a group of local NGOs, and, thanks to their active efforts, no such provisions appear in the final text of the Law adopted on April 12, 2005.
2. Current Status of the Issue
Now that more than a year has passed since the law was adopted, we can begin to assess the law and its consequences. It should be noted that pilot state social contract tenders were started two years before the law’s adoption, so we have three years in which the government has financed some Kazakhstan NGOs.
a. Money allocated by the Government
The program began with the equivalent of $400,000 in 2003 and finished 2005 with $3.5 million. The President, speaking at the Second Civic Forum in September 2005, said that by 2010, this figure should reach $8 million.
b. Government’s vision of the process
The government’s main incentive for increasing its funding is to “outbid” local NGOs and end their reliance on foreign funding. Kazakh officials believe that donors determine the policy of organizations they finance. The government thus wants to supplant foreign donors and set the policy of local NGOs.
c. Legislative “coincidences”
This widespread view of financing as a rivalry between foreign donors and the state can be illustrated by a “coincidence.” One week after the Law on State Social Contracts was signed by the President and came into force, a group of patriotic deputies initiated two extremely repressive laws in draft form – (1) on activity of foreign and international NGOs in Kazakhstan, and (2) on amendments of some other laws designed to limit NGOs’ foreign financing. Fortunately, the draft laws were of such poor quality that some of their provisions were declared unconstitutional by the Constitutional Council, and the laws were not put into effect. Restrictions on foreign donors, such as those in the two draft laws, became possible only after the law legalizing government financing of NGOs came into effect. One might conclude, as a result, that the main reason for the Law on State Social Contract was political: to keep local NGOs from fighting the repressive provisions on foreign financing by promising them state financing instead.
3. Problems Revealed Before and During the Process
Three years after the practical launch of State Social Contracts (SSCs), most of ICNL’s predictions have come true.
a. Legislative inconsistencies
First of all, even government officials involved in the SSC process now agree that proper administration of funds is impossible without changing other laws.
i. Constitution
As noted above, the Constitution prohibits state financing of public associations but does not define the boundaries of “state financing.” The situation has been complicated by the recently adopted Budget Code, which indicates that state contracts for services constitute “state financing.” Interpreted literally, this means that public associations, which constitute at least 40% of all NGO in Kazakhstan, are ineligible for SSCs. Modifying the Budget Code could resolve this problem, but the government has not moved to do so.
ii. Budget Regulations
Funds allocated for SSCs do not have one unified respective budget code. Only local divisions of the Ministry of Culture and Information are bound by the Ministry’s rules. Local governments and other ministries make their own decisions about how to allocate funds, and face serious technical problems in doing so.
iii. Procurement Regulations
Procurement methods (open one-round tenders) and qualification requirements (minimum price principle) applied to SSCs are not consistent with the nature of social service procurement. The problem is unlikely to be resolved, because the responsible Agency for State Procurement refuses even to discuss it. An open tender is the most expensive method of procurement, and the least effective one for procuring social services. As a result, local administrators often have only one entity in their region that is qualified to deliver a particular social service – or none at all. Also, administering the procurement often costs as much as the contract granted. As result, officials have favored larger and larger lots for SSC tenders. Starting from $5,000 to $15,000 in 2003, some in 2005 reached $150,000.
iv. Tax Regulations
The most serious and distressing problems for NGOs are associated with the taxation of SSCs. According to tax laws, an SSC is for-fee income and not subject to any exemptions. Most local NGOs have no experience in for-fee activities and the accounting and tax management/planning that they entail. Further, the tax rules require calculating corporate income tax at the beginning of the year, in advance, and paying it in four installments during the year. The penalty for failing to declare or underestimating the coming year’s income tax due is 70% of the omitted amount.
No NGO engaged in an SSC declared its income, because they had never done so before. The result was not as drastic as it could have been. Penalties were often waived (a lot of government-operated NGOs (GONGOs) faced this problem, along with conventional NGOs). Even if applied, the penalties were generally small.
The government has recognized this problem and made a practical effort to resolve it now. ICNL’s view is that if procurement is simply state grants given through an SSC mechanism, the tax regime should treat them as it treats ordinary grants for SSC funds – with full exemption from corporate income tax and VAT. The Government agreed with this approach. The respective amendments were introduced to the Parliament in May 2006, adopted in June, and signed into law by the President on July 7. They will take effect on January 1, 2007.
b. Government officials’ violations
In addition to obvious legislative inconsistencies, many reports indicate that administrators have violated the SSC tender rules.
i. Corruption complaints
Several applicants reported that officials requested kickbacks, ranging from 10% to 30% of the contracted amount.
ii. No competition
The tenders are often an empty exercise, because some regions have no alternative vendors of social services. Because the rules require more than one bidder in order to conduct an open tender, a friendly NGO may agree to be listed as an alternative bidder at the request of a state funds administrator, even though the NGO has not in fact bid on the project.
iii. No consultations on topics of bids
The biggest criticism surrounds the topics of the bids, the content of the lots: what particular social services a state funds administrator will seek. No criteria or mechanisms prescribe how the administrator should decide what shall be procured. In practice, administrators often define the services to be procured with a particular NGO or (more often) GONGO in mind.
iv. Rapid creation of GONGOs in the absence of NGOs
Sometimes no NGOs in the region offer the services to be sought. In several such instances, we understand that local authorities responsible for procurement have quickly established and registered NGOs, consisting of their relatives or friends, solely for SSC purposes.
v. Violation of payment terms by administrators
Many reports indicate that state administrators are violating payment terms, most commonly by refusing to pay the final installment – often 70% of the cost of the contract – to a conventional NGO (there are no such complaints involving GONGOs). NGOs are afraid to sue the government for violating the contract, and in any event the contract terms often give the administrators discretion to refuse to pay the final installment.
vi. Broad use of NGOs to channel the money
According to some reports, the government has used an SSC to support a governmentally controlled company, such as a TV channel, by requiring the NGO to use that company as a vendor.
vii. Legalized support of GONGOs and quasi-NGOs
In 2004 and 2005, the majority of SSC tenders went to GONGOs – meaning that the government is using state money to finance not-for-profit organizations established or controlled by the government.
c. Omissions and shortcomings from NGOs
For the sake of a comprehensive account, we must note that conventional NGOs themselves bear a measure of the blame for their problems here.
i. Poor legal knowledge
A significant factor is the low level of legal knowledge, especially on tax matters, among NGO leaders and managers. Most of them make decisions with possible financial implications without consulting anyone on the attendant legal issues.
ii. Ignorance of tax regulations and respective implications
Likewise, most NGOs engaged in SSCs believe that they applying for state grants; the tax implications come as a surprise. We see that once they learn about their tax liability, often the hard way, they are reluctant to engage into the SSC process again.
d. Potential implications for NGOs
There are several current and potential implications for NGOs involved in the SSC process. Unfortunately, many of them are negative.
i. Current implications:
Current implications proceed from the fact that an SSC is deemed an entrepreneurial activity for tax purposes. Implications include the following:
(1) NGOs must declare their business income and pay corporate income tax in advance. If they fail to do it properly, they are subject to strict penalties.
(2) To avoid penalties, NGOs must improve their financial management and accounting. In the long run, this improvement can increase an NGO’s capacity as well as its proficiency – a long-term positive result that comes at a cost.
(3) With both taxes and professional accounting eating into the budget, the cost of social services is increasing for NGOs. As a result, they become less competitive with governmental institutions providing comparable services. NGOs may function as “gap fillers,” with their services merely supplementing those provided by the government. It is difficult to tell whether this is a positive or negative outcome, but it is the reality.
ii. Potential implications:
(1) The first problem proceeds from the constitutional prohibition against state financing of public associations, and the Budget Code’s broad definition of “state financing.” As a result, every public association engaged in an SSC must recognize the state procurement contract could be declared illegal, and the government could demand the return of its funds.
(2) The second problem grows out of the fact that many NGOs engaged in SSCs did not declare their corporate income tax yet were not punished. The tax authorities have discretion on whether to impose penalties. Avoiding a penalty may sound like a positive outcome, but the tax authorities could impose it sometime in the future. With this threat of punishment, thus, the government, through its tax authorities, can influence and even control NGOs that received SSC funds.
e. Implications for foreign funding
The government’s original hope – that SSCs would lure NGOs away from foreign financing – did not come true, and will not, for a good reason: the creation of GONGOs. With most SSC funds going to government-organized or -controlled entities, authentically independent NGOs still depend on foreign financing. The SSC program will have scarcely any impact here, because NGOs know they are doomed to lose SSC tenders to GONGOs, which have better relations with the government officials overseeing the process.
So, contrary to the government’s hopes, the SSC program has not significantly reduced the foreign funding of NGOs in Kazakhstan. But that does not mean that the government is going to give up. It may pursue other means of creating unfavorable conditions for foreign funding of NGOs in Kazakhstan.
4. Future Plans and Expectations
a. Constant increase of government funds allocated for SSC
The government is going to double the amount of funds allocated to SSC, from $4 million planned in 2006 to $8 million by 2010.
b. Tax authorities to make SSCs more attractive for NGOs in 2006
As noted above, tax authorities have recognized the problem with corporate income taxation of SSC funding and the financial hardships associated with properly declaring and paying this tax in advance. Discussions with the Tax Committee and the Ministry of Budget Planning (responsible for tax reform plans) started in January 2006, producing three amendments that were adopted in July and will come into force on January 1, 2007. The amendments will finally place SSC funds within the same tax regime as ordinary grants. It will eliminate the most complicated and technical problem that NGOs confront with regard to SSCs.
c. External and internal political environment
The contours of the SSC system have been influenced by events both in neighboring countries and inside Kazakhstan.
i. “Colored revolutions”
It is no secret that the changes of governments in Georgia, Ukraine, and Kyrgyzstan came about with the active participation of some local and foreign NGOs. This fact has caused the governments of neighboring countries, including Kazakhstan, to see NGOs as a potential threat to the stability of their regimes.
ii. New enemies – exporters of democracy
Many NGOs whose activities relate to citizens’ political rights have been declared “exporters of democracy” and public enemies in Kazakhstan. In some NIS countries, witch-hunting has started against the leaders of such NGOs.
iii. Audits by government agencies
Kazakhstan has also reacted by undertaking unprecedented audits of foreign NGOs and those local NGOs receiving foreign financing. In January and February 2005, foreign NGOs were subjected to in-depth tax audits. Then in March and April, they were audited further by the prosecutors and the Financial Police. In April and May, a lot of foreign NGOs in Kazakhstan were harassed by Immigration Police. So far as one can tell, none of these organizations cut back on its anti-governmental activities as a result. Nevertheless, both the government and the majority of the Parliament members still favor limiting the activities of foreign NGOs and their donors as much as possible. New initiatives are likely, and soon.
iv. Government Legislative Initiatives
In January 2006, the government started drafting the Law on Charitable Activities, using a similar Russian law as the model. Such a law would overturn the existing system of basic tax preferences for NGOs (all gratuitous donations to NGOs are exempt from corporate income tax and VAT), which is functioning very well.
d. NGOs face a challenging time
The Kazakh government’s attitude toward NGOs and their activities is quite common now in the NIS and other parts of the world. To some extent it is a predictable consequence of NGOs’ more prominent role, which many governments have proved unready to confront in a friendly, constructive fashion.
As for NGOs in Kazakhstan, it is time for them to choose their future: continue their operations using government funds and facing increased government control; or avoid governmental financing and depend instead on foreign donors (though they are gradually leaving Kazakhstan); or engage in for-fee activities to fund their operations. Each NGO will have to make its own decision. One thing is clear: the government’s attitude toward NGOs is no longer favorable but suspicious. NGO leaders must adjust to this new reality.
5. Conclusions – Positives and Negatives
a. Positive points and areas of potential improvement
The general process of governmental financing has had several positive aspects.
(1) The government has recognized the private sector for social services and decided to support such services. This marks a first step toward establishing a competitive environment for social services, which in theory will improve the quality of the services without increasing the price.
(2) The government is going to continue this practice of funding until at least 2010, according to the President.
(3) The government has recognized the problems associated with taxing SSCs and made energetic steps to remedy this problem.
(4) Social sphere NGOs have an alternative source of financial support, which gives them a better chance to survive and preserve their professional capacity during the current freeze in relations between the state and civil society.
b. Negative points and obstacles to their amelioration
The status quo also features many negative points, most of them addressed above. Here is a summary of the shortcomings of the SSC process that need to be addressed.
(1) The constitutional prohibition against state financing of public associations prevents the development of a straightforward, effective grant mechanism. With the government’s current distrust of NGOs, the situation is unlikely to change soon.
(2) The system of distributing state funds to NGOs through the procurement mechanism has proved inefficient and controversial. To summarize the problems, inconsistencies, gaps, and omissions in laws and regulations prevent the system from effective operation. Reforms, based on international best practices, would ameliorate or eliminate most of the technical problems.
(3) Limiting potential vendors to NGOs, though reasonable in a grant-giving mechanism, is inconsistent with a procurement mechanism, given the fair-competition foundation of state procurement as well as WTO standards (which allow preferences for state procurement only in the form of quotas for local suppliers). Kazakhstan’s desire to enter the WTO may force a reconsideration of the current practice.
c. Summary of what should be done to improve SSC process
There are several obvious steps to improve the SSC process:
(1) Incorporate the proper criteria into the state procurement law, so that service procurement can be assessed based on effective price rather than, as now, minimum price;
(2) Add specific procedures for service procurement to the state procurement law;
(3) Resolve the budget codification problem to clarify and unify treatment of SSC funds by state funds administrators;
(4) Change the Budget Code’s definition of “state financing” to exclude all state procurement contracts, including SSCs; and
(5) Establish advisory councils to help to decide which social services the state administrators ought to procure, in order to use tax funds more efficiently in the SSC process.
d. Overall assessment of the future
Though it is difficult to predict anything in this part of the world, several possibilities could easily develop in the next two years:
(1) The government will continue to finance social NGO activities, and the amount of the funds allocated will gradually increase.
(2) The funds will continue to be used inefficiently, due to the many problems in the process. Efficiency in fact is likely to decrease, given that the stakeholders responsible for the process are not inclined to change anything. The corporate income tax exemption would help NGOs but not affect the SSC process itself.
(3) The government will continue its attempt to limit and harass NGOs that receive foreign financing, as well as try to prevent foreign and international NGOs from effectively operating in the country.
As for ICNL, it will continue to provide technical, legal assistance to all interested stakeholders working to improve the legal environment for governmental financing of NGO activities in Kazakhstan.
Notes
1 Vsevolod Ovcharenko is Regional Legal Consultant for Central Asia, International Center for Not-for-Profit Law.