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By John Helmer in Moscow

Russian diamond cutters face shutdown of operations or domestic supplies if VAT tax waiver is abolished on January 1.

Alrosa, Russia’s dominant supplier of rough, has sent a notice to domestic diamond cutters, warning that from January 1, it will add 18% value-added tax (VAT) to its rough diamond pricing. The diamond cutters have told Mineweb that, while they understand the move as a cost-cutting expedient for Alrosa, the impact will be ruinous for the low-margin manufacturers. They have asked Alrosa to reconsider, and delay the move for another twelve months, in order to allow time for the government to be persuaded to send a zero-tax amendment to tax legislation for enactment by parliament.

There is suspicion that Alrosa’s move is aimed at reducing the presence in Russia of foreign cutting enterprises, and boosting Alrosa’s cutting plants at their expense. At present, Alrosa reports that its own polished sales amount to about $160 million per annum. This trails well behind sector leader, Smolensk Kristall, which is state owned, and reports sales of $358 million in 2006; and Ruis Diamonds, which is controlled by Lev Leviev, and sells over $220 million in polished. According to one of Moscow’s leading cutters, “I wouldn’t say that Alrosa is making this move intentionally to destroy the remainder of the Russian cutting industry, but this [VAT] decision would be a catastrophe.”

The present Russian tax regulations allow VAT to be recovered from the state treasury that is paid on diamonds which are exported; though the time required for claims processing and reimbursement may be as long as nine months. Alrosa has opted until now to waive the VAT chargeable on its domestic sales, and thus, it has foregone the value it could claim back from the treasury. This is estimated at about 2.4 billion rubles (around $100 million), annually.

In current accounting, this uncollected VAT is treated in Alrosa’s accounts as a cost of sales. An anonymous statement from Alrosa, released to a local wire service, said that the firming of the rouble has been raising Alrosa’s domestic costs against the dollar value fetched by the company’s rough diamond sales.

“In evaluating the impact of this decision on the cutting industry,” Alrosa said, “we have to look at two fundamental factors. Al most all of the diamonds cut in Russia are then exported. It is profitable to cut large diamonds in Russia as demand for them in our country is minimal. So the VAT paid should be reimbursed out of the budget. Secondly, the vast majority of the so-called domestic cutting enterprises are owned by foreigners. Obviously once the decision takes effect the cutting enterprises will need additional working capital, namely for about six to eight months from the payment of VAT to its reimbursement from the budget. Since most cutting enterprises belong to non-residents they all get working capital from foreign banks at 4% – 5%. So, the additional costs resulting from the decision will be about 400 million rubles [$16 million] for all cutting enterprises in Russia.”

Unstated is the relatively higher Russian bank interest charge for such credits to Russian manufacturers, and also for Alrosa, which reports that it currently operates six Yakutia-based and Moscow-based cutting plants. Company reports indicate that in 2006, polished sales amounted to $141.1 million. This was down 1.8% compared to 2005, but up 7.8% compared to the 2004 result. Alrosa’s annual report for 2006 explained the downturn as due to “the lower currency efficiency coefficient” – read falling dollar to rouble – and also due to the dwindling of sales through a joint polishing venture with Lazare Kaplan International, a New York firm. In 2007, Alrosa says it expects to sell $159.7 million in polished.

In a speech at the Antwerrp Diamond conference last month, Alrosa chief executive Sergei Vybornov singled out one of Alrosa’s polishing affiliates, Diamond World, claiming its profitability “amounts to 2.06% of their full cost price. This is less than the interest rate in Russian banks and far below the annual inflation rate. This is typical for Russian diamond processing factories. ” Vybornov went on to call for the elimination of large numbers of cutting and dealing intermediaries. “The diamond’s way from the mine to the jewelry store should be shortened to the maximum extent possible. We believe the ideal structure would be direct sales of rough diamonds to established globally jewelry brands.”

Nikolay Zhuravlev, spokesman for Kristall Smolensk, told Mineweb that “the introduction of VAT would cost us 1-2% from revenues [$7 million]. Of course, we are very negative to such decision, as the cutting business is low margin itself, and any new expenses are a problem. So far as I know, the final decision was not made yet, and several options are still under discussion. We hope that VAT will not be introduced.”

Ararat Evoyan, head of the Russian Diamond Manufacturers Association, told Mineweb his membership is hostile. “This move will bring the cutting business to loss-making. The world cutting industry is low- profit. The main reason is that De Beers and Alrosa and other producers monitor very carefully the price of cut diamonds, and they change the price of rough stones accordingly. All profits go to the rough producers.” He conceded that Alrosa is within its legal right to end its tax waiver, and reintroduce VAT to its supply prices. He was skeptical that the government will agree to amend the current tax law to allow zero-rate VAT for diamond cutters. “The problem with the zero-rate is that it applies only to priority goods and the defense industry.”

Evoyan said that the manufacturers association has proposed a further one-year tax waiver from Alrosa, to allow time to work out a tax code change.

Valeriy Morozov, director of Ruis and spokesman for Leviev’s diamond interests in Moscow, told Mineweb “this is currently a vital question for everybody. Cutters are really hoping that VAT will not be introduced and Alrosa will withdraw its intention. This problem is familiar to everyone – Ministry of Finance, the Diamond Chamber, and others. When Alrosa had higher profits, it could disregard the [domestic VAT] losses, but now, when profit will decline due to various objective and subjective reasons, it can’t.”

Morozov said the practical implication for Russian cutting operations is that, with 18% VAT added to Alrosa’s prices, the domestic cutters will not pay. “There are two outcomes for the cutters who will stop buying stones in Russia: to close their enterprises completely, or to buy Alrosa’s stones in Belgium, Hong Kong and other markets.”

Morozov said that the VAT waiver had originally been introduced a decade ago as a form of super-profits tax for Alrosa. The new VAT move will be a test of Alrosa’s clout with federal financed officials. Either Alrosa is deterred by the federal government from reinstating the charge, Morozov said, or else the federal government will agree to amend the tax legislation, in order to grant zero-rate status to production of rough.

In 2006, Alrosa’s sales to the domestic Russian market rose 3.6% to Rb44 billion ($1.6 billion), comprising just under half of total sales. Export revenues for sales to Western Europe, including the major markets of Antwerp and De Beers, dropped 5% to Rb26.9 billion; while sales to other markets, including Israel, fell more sharply to Rb23.4 billion, a decline of 10.1% compared to 2005.

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