On December 30 2011 the Finance Ministry issued Letter 03-08-13/1, setting out the tax authorities' view on the concept of beneficial ownership and the taxation of interest on Eurobonds.

For more than 15 years the authorities have interpreted the term 'beneficial owner' - which appears in many of the double tax treaties signed by Russia - in a strictly legal sense. Thus, an entity has historically been regarded as a beneficial owner if it has obtained the income in question on the basis of a legal relationship (eg, an agreement). Beneficial ownership is a highly significant factor in assessing the application of benefits under double tax treaties, and is invariably taken into consideration in international tax planning for Eurobond schemes and other financial arrangements.

The ministry has reviewed a typical Eurobond listing scheme that uses a special purpose vehicle (SPV). Russian companies have long used SPVs for Eurobond listings to enter the European capital markets. The main aim of using an SPV is to transfer money from shareholders to the Russian company through the SPV and a Russian bank. The SPV lists Eurobonds, receives money from entities around the world and deposits it in a Russian bank, which in turn extends credit to the Russian company. The company then pays the body of the loan and interest to the shareholders through the Russian bank and the SPV.

The Tax Code provides that a Russian legal entity - in this case, the bank - must withhold tax from cross-border payments, including those made to SPVs. However, the double tax treaty with Ireland allows payment to be made abroad without withholding tax if the recipient is the beneficial owner. The ministry has historically viewed such an SPV, which has a legal agreement with a Russian bank, as a beneficial owner. On this basis, it exempted the SPV from taxation in Russia and the Russian bank from its withholding obligations.

The new letter sets out a different position. The ministry states that the SPV cannot be viewed as a beneficial owner, and that all payments must be withheld. Its position is that double tax treaty benefits depend on the residence of the beneficial owner. However, in practice it is difficult (if not impossible) to determine this. Moreover, the term 'beneficial owner' is not clearly established in Russian legislation, making it difficult to determine whether a party is a true beneficial owner - or even how far the search for a beneficial owner should go. The ministry's view puts too great an onus on tax agents, requiring them to unpick corporate structures and human relations to trace the ultimate economic beneficiary of income. However, a tax agent must do so not only to answer the question of benefit, but also for other reasons, such as to determine the rate of tax to be applied.

The letter raised the prospect of high risks for investors and significant losses for leading Russian companies. Following an intense debate between business interests and the authorities, a consensus was reached. The ministry prepared a draft law to amend the code, proposing to exempt Russian tax agents from withholding tax obligations - rather than banks, as in the letter. This has removed a serious tax issue for Russian companies and their investors for the present; however, it has arguably created a latent source of pressure for the future. Having no duty to withhold does not mean that a foreign taxpayer (eg, the SPV) is not required to pay Russian taxes from the interest on Eurobonds if it is not a beneficial owner. Identifying beneficial ownership is set to remain as big an issue for the authorities as for taxpayers.

For further information on this topic please contact Andrey Tereschenko or Ivan Zelenin at Pepeliaev Group by telephone (+7 495 967 0007), fax (+7 495 967 0008) or email ([email protected] or [email protected]).