The ‘de-offshorisation’ of the Russian economy
As early as 2005, Russian President Vladimir Putin voiced his concerns in Parliament over the extensive use of offshore structures by Russian companies and individuals. However, it was not until December 2013 that the President requested the government take measures to ensure that:
- undistributed profits of offshore companies controlled by Russian entities and individuals be taxed in Russia (the controlled foreign company (‘CFC’) rules);
- no government support be available to offshore companies;
- no contracts to satisfy state and municipal needs be concluded with offshore companies.
This article is based on the second draft of the CFC regulations but, at the time of going to press, a third draft was released. Readers should refer to this latest draft for the most up-to-date provisions
The Russian Ministry of Finance (MinFin) and several governmental groups are working on various measures to increase tax revenue. There are currently around 30 anti-offshore initiatives, including several draft laws that seek to restrict all foreign companies from participating in state and municipal tenders. If one of these drafts is signed into law, foreign companies would have to register Russian entities to be able to formally comply with the relevant requirement.
CFC rules: the main tool of ‘de-offshorisation’
Following the President’s request to the government, on 27 May 2014 the MinFin published a draft law proposing amendments to the Russian Tax Code, and introducing: the CFC rules, a definition of ‘beneficial owner’, tax residency rules for companies, and other new regulations that will have a significant impact on cross-border structuring.
The draft law defines a CFC as a foreign company that:
- is a non-Russian tax resident; and
- has controlling persons that are Russian tax residents (companies or individuals); and
- is not listed on any stock exchange included on the list of stock exchanges issued by the Russian Central Bank and the MinFin.
The definition of a CFC also covers structures (including, but not limited to, trusts, partnerships, associations and other forms of collective investments) that:
- are established under the laws of a foreign country;
- carry out profit-making activities for the benefit of their participants (beneficiaries, stockholders, principals and other persons); and
- are controlled by Russian tax residents (companies and individuals).
The controlling person of a company or structure is a person who individually or jointly with other persons exercises control over the company or structure. Inter alia, the controlling person is a person who has a direct or indirect participation interest (individually or jointly with their spouse and/or infant children and other persons by virtue of their specific relations) exceeding 10 per cent.
The draft law establishes significant penalties for violation of the new rules. For non-notification, the fine is RUB100,000, and, for non-payment or underpayment of tax on CFC profit, the fine is 20 per cent of the non-paid tax
The taxpayer has two basic obligations with regards to a CFC: to notify the relevant tax authorities of the CFC; and to pay tax on the CFC’s profit at the base rates (13 per cent for individuals; 20 per cent for companies) if the profit exceeds RUB3 million (approximately EUR62,000).
It is worth noting that the taxpayer must also notify the Russian tax authorities of any foreign company in which the taxpayer has an interest exceeding 1 per cent, or any foreign structure where the taxpayer has an actual right to income in the case of its distribution.
Taxable profit will be defined in accordance with the provisions of the Russian Tax Code and reduced by dividends paid therefrom. The calculated tax is further reduced by taxes paid in the foreign jurisdiction on the profit. The amount of profit will be confirmed by the foreign company’s financial statements, auditors’ statement and other documents.
A foreign company is not regarded as a CFC if it is:
- a non-commercial organisation or any other organisation that does not distribute its profit among its shareholders or other persons under the laws of its jurisdiction;
- resident in Belarus or Kazakhstan;
- resident in a country on the ‘white list’ of jurisdictions exchanging tax information approved by the Federal Taxation Service, and its income/profit is subject to taxation at an effective rate exceeding 15 per cent.
An effective tax rate will be calculated as the ratio of taxes payable in any foreign jurisdiction and the amount of taxable profit/income. It is not clear if the amount of taxable profit/income should be calculated based on the Russian Tax Code or (more beneficial for the taxpayer) based on the laws of its jurisdiction.
Application of the effective tax rate approach gives more clarity as to which jurisdictions will not give protection against the CFC rules even though they are on the white list. Hence, taxpayers may already review the existing structures, calculate the effective tax rates, identify possible exposure to tax residency and thin capitalisation risks, and adjust their structures to the new requirements.
The draft law establishes fairly significant penalties for violation of the new rules. For example, for non-notification, the fine is RUB100,000 (approximately EUR2,000), and, for non-payment or underpayment of tax on CFC profit, the fine is 20 per cent of the non-paid tax, but not less than RUB100,000.
The draft law is supplemented with transitional provisions under which the tax on the CFC’s profit will be calculated in respect of the profit gained starting from 2015 – i.e. such tax will be paid in 2016.
Other key changes
Although most double-tax treaties signed by Russia state that a favourable tax rate or exemption is available to the beneficial owner of the income, there is no definition of ‘beneficial owner’ in Russian tax law.
However, on 9 April 2014, the MinFin issued a letter clarifying how to approach the issue of beneficial ownership of income for tax purposes. On the whole, the letter reiterates the MinFin’s previously outlined approach that ‘a beneficial owner is the individual/entity who determines the further economic destiny of income received’. The MinFin has also provided a more detailed explanation, pointing to concrete scenarios where beneficial ownership terms are not met, thus precluding the application of double-tax treaty benefits.
According to the draft law, the beneficial owner is a person that is directly or indirectly entitled to possess, use and dispose of any income gained, or a person for whose benefit another person can use and/or dispose of such income. Functions performed and risks assumed by the taxpayer are analysed to determine if the taxpayer is the beneficial owner of the income.
Thin capitalisation rules
The draft law also seeks to broaden the scope of the Russian thin capitalisation rules. Currently, the rules apply to loans issued by foreign direct or indirect shareholders and their Russian affiliates. The new version of the rules proposes that limitations additionally apply to loans issued by all interdependent foreign companies, and not only by shareholders.
Indirect sale of Russian real estate
The draft law covers indirect sales of shares in Russian property-rich companies. Thus, income from the sale of shares and interests in foreign holding companies, over 50 per cent of whose assets are real estate located in Russia, will be taxable in Russia.
Concept of tax residence for companies
The draft law proposes that foreign companies be recognised as Russian tax residents and taxed in Russia in respect of their worldwide income if they are managed from Russia. A foreign company is deemed to be managed from Russia if one of the below conditions is met:
- meetings of the board of directors (or another governing body of the company) are held on Russian territory;
- management of the company is usually performed in Russia;
- chief officers of the company carry out their activities with regard to the company in Russia.
If the above conditions are fulfilled in several countries, additional criteria are applied:
- accounting of the company is conducted in Russia;
- record-keeping is performed in Russia;
- internal documents governing the company’s activities are prepared in Russia;
- recruitment and HR management is carried out in Russia.
The devil is not so black
The draft law will be reviewed by the government and then passed to Parliament, where it is likely to undergo further changes.
The Russian business community is actively involved in the legislative process and has proposed the following changes to the CFC rules of the draft law:
- increase the threshold for recognition of a person as ‘controlling’ from 10 per cent to 50 per cent;
- withdraw the taxpayer’s obligation to notify the Russian tax authorities of any foreign company in which the taxpayer has an interest exceeding only 1 per cent.
It is likely that the government will take these proposals into account.
Russia is not trying to reinvent the wheel. The proposed measures have been successfully implemented by other jurisdictions, and Russian government experts looked to these jurisdictions’ experiences when drafting the new law. It is likely that foreign investors will be familiar with rules in the draft law from their experience with EU member states and the US.
The proposed changes to Russian tax law will inevitably affect artificial structures in which ‘postbox’ companies located in jurisdictions with favourable tax regimes are used without a sound business purpose, but purely to obtain tax benefits. Conversely, robust structures are unlikely to be affected if the foreign companies involved have proper substance, their introduction into a structure has a business purpose and they are managed from the jurisdiction of their residence.
In light of the possible changes, new structures should be developed carefully and existing structures should be reviewed to determine whether reorganisation of the structure is necessary.
The content displayed here is subject to our disclaimer. Read more