BRUSSELS  Thu Apr 24, 2014 9:33am EDT

(Reuters) - The European Union may ban transactions with financial institutions in Crimea as part of its response to the annexation of the Ukrainian peninsula by Russia last month, an EU document obtained by Reuters showed.

EU leaders consider the takeover as illegal and have asked the EU executive arm, the European Commission, to propose economic, trade and financial restrictions on Crimea for rapid implementation.

These proposals are separate from an EU discussion on stepped-up sanctions against Russia if Moscow does not help deescalate tensions in eastern Ukraine between pro-Russian separatists and the government in Kiev.

The document spelt out some of the practical difficulties involved in implementing sanctions specifically against Crimea, now that it is de facto a part of Russia.

"Solutions need to be found that at the same time support the territorial integrity of Ukraine, do not recognize the illegal annexation of Crimea, defend European interests in this region and do not penalize the Crimean people," the Commission said in a document prepared for EU governments to consider.

One way to discourage or penalize financial institutions in Crimea that cooperated with the annexation could be to restrict capital movements between the EU and those banks, it said, and bar EU citizens or businesses from carrying out transactions with them.

"The same could hold for prohibiting investments by Crimean investors (companies located or registered in Crimea) into the EU and by EU investors into Crimean entities," it said.

The Commission proposals are still under review and a decision whether to follow them is likely to be taken by EU foreign ministers, whose next meeting is on May 12.

Out of Crimea's 1,000 bank branches, around 60 were owned by EU banks, the Commission said. Italy's Unicredit had 20, Austria's Raiffeisen had 32 and Hungarian OTP had six, the Commission said.

However, Raiffeisen closed its operations in Crimea in early April, it said, and Unicredit wants to transfer its Crimea branches to its Russian subsidiary.

"Russian banks are gradually taking over in Crimea, but the main Russian banks (Sberbank and VTB ) reportedly are reluctant to do so for fear of becoming subject to European or U.S. sanctions," the Commission document said.

NO PREFERENTIAL TRADE TERMS

The Commission noted that by the end of April Ukrainian exporters will be in a position to trade under two preferential arrangements with the EU and enjoy significant tariff reductions.

But the exporters need to have a certificate of origin for their goods and Ukraine will stop issuing such certificates to companies based in Crimea.

However, the Commission document noted that there was practically no way to prevent Crimean products from being exported to the EU via Russia, unless they were clearly of Crimean origin, like wine.

The only way to guarantee an absolute ban on imports from Crimea would be to suspend trade with Russia entirely, the document said - an option which it made clear was not feasible.

"In addition to the political consequences this would have, such a ban would also involve legal risks as it would require justification under World Trade Organisation law. A more practical option would consist in limiting the ban on import only to the products of clear Crimean origin such as wines."

Crimea has taken ownership of Ukraine's state companies on its territory, including the region's Black Sea natural gas fields. Black Sea gas production is currently only one billion cubic meters per year, but Ukraine had hoped it would increase to 3 billion cubic meters in 2015 and it had attracted foreign investors, including majors Exxon Mobil and Royal Dutch Shell.

The paper said Crimea residents would have to apply for visas to the EU through Kiev, because allowing them to apply via an EU consulate in Moscow would amount to indirect recognition of the illegal annexation.

The Commission also proposed that EU countries should not recognize passports issued by Russia to Crimea residents after the annexation.

(Editing by Mark Trevelyan)