As we promised in the previous issue, we are starting to follow the evolution of an investment project involving enthusiastic investors from Russia, Kazakhstan and Finland. They are ready to build a plant to produce a special nano-bitumen in order to manufacture elastic, ultra-strong asphalt designed to tackle that age-old scourge of this country: its roads. Our company is not over-endowed with assets. It is not affiliated to state corporations or to oligarchs. It wishes to play by the rules and to live inside the law. It has no desire to make use of administrative leverage. The first step is to lay down a corporate structure which both meets the owner's requirements and is suitable in view of the need to obtain bank or investor funding for the project.
When a corporate structure is selected for an investment project being implemented in Russia, several questions must be answered. The first of these is whether a Russian legal entity specifically created for the project will be carrying out operations in Russia, or will a foreign company do so? Here the answer is plain: even though foreign companies are fully able to undertake operations in Russia, we are not aware of a single instance in which a factory that has been built has been directly owned by a foreign company. If a facility is constructed and owned by a foreign company, this will entail various striking, but rather unpleasant, experiences. For this reason, our choice is a limited liability company (LLC).
Who will be the members of the LLC: which persons, which jurisdictions, will own it?
There are a number of options.
А) The foreign investors are members with stakes in line with their shares in the ownership of the project.
In our case, there are Kazakh, Finnish and Russian companies. This means that Russian law will govern the project management issues (members' agreement, distribution of profit and so on). The tax consequences for each member will be governed individually, according to the jurisdiction of the member in question. For a Russian member, it is advantageous to own equity directly. This allows the 0% tax rate to be applied to dividends (if, when the distribution is made the member has held a right of ownership for more than 365 uninterrupted calendar days to a holding of at least 50% in the share capital of the company paying the dividends). Dividends paid to the Kazakh company will be taxed at source in Russia at 10%. Those paid to the Finnish company will be taxed at source at a rate of either 5% or 12%.
B) The member is a foreign legal entity (SPV).
Advantages: Project management issues may be governed by the law of the country in which the SPV has been created. For a long time, one of the advantages was considered to be the possibility of choosing for the SPV the jurisdiction with the most favourable tax conditions. This took into consideration both the taxation of operations in Russia (bearing in mind the double taxation treaties) as well as and taxation in the jurisdiction of the SPV. However, now an earlier assessment needs to be made of whether the SPV may be regarded as the 'beneficial owner' of that income that will be received when income is realised in Russia. If there are doubts, there is a risk that the Russian tax authorities will refuse to apply any treaties with the country of which the SPV is a resident.
How will the project be financed?
The second question that needs to be answered when the corporate structure is selected is how the project is to be financed. There are a number of options.
А) Contributing to the LLC's share capital: in cash or in kind (production equipment and so on).
Advantages: there is no income in the hands of the LLC; if a substantial amount is directly contributed to the share capital, many treaties allow a reduced rate of tax on dividends to be applied (for example, under the treaty with Finland, USD 100,000; under the treaty with Cyprus, EUR 100,000); if an equity holding is sold in future and such sale is subject to tax in Russia, a foreign company will be entitled to reduce its income by the amount of its contribution; if the LLC is liquidated and its property distributed among the members, the value of the property will not - within the limits of the value of the contribution - be taxable in Russia (to the extent that it exceeds such contribution, various options are possible).
Disadvantages: The amount of the net assets and the ratio of these to the share capital needs to be monitored. Accordingly, the greater the share capital, the more net assets there should be. Of course, in Russia many companies carry on for years with negative net assets, but nonetheless for there to be such a risk is hardly a cause for joy.
B) Contributing to the LLC's property (article 27 of Federal Law No. 14-FZ dated 8 February 1998 "On limited liability companies").
Advantages: if the member making the contribution owns more than 50% of the share capital of the recipient, no taxable income arises in the hands of the recipient; no net asset difficulties occur: a contribution to property increases assets, but not liabilities.
Disadvantages: the corporate legislation of various countries does not recognise a comparable institution, which may result in problems facing the member that wishes to make the contribution; the amount of the contribution will not be regarded as an expense of the member that reduces its taxable income, either when it sells its holding or when the LLC is wound up.
C) Loans from members of the group.
Advantages: a flow of cash may be received immediately from the LLC in the form of interest, without any need to wait for profit to be generated and dividends distributed; that cash flow may be managed (the interest rate being adjusted upwards or downwards, the periods changed in which interest is accrued and paid); in many cases, interest paid abroad is not taxed at source (in accordance with the applicable double taxation treaties); and interest for the LLC will be an expense that reduces its taxable income.
Disadvantages: the "thin capitalisation" rules are applied (articles 269(2) to 269(4) of the Russian Tax Code). In view of this, the risk may currently be regarded as arising in all situations when more than 20% of the capital of a foreign company borrower belongs to a foreign company either directly or indirectly and the amount of the debt may exceed the threshold figures established by article 269(2) of the Tax Code (three times or more greater than the amount of its own capital, i.e. of its net assets increased by its tax debt). According to the case law that has evolved, not a single double taxation treaty unambiguously allows the application of the thin capitalisation rules to be excluded. Nor can the application of the "thin capitalisation" rules be fully excluded for example, when loans are received from foreign companies that are a party of the same group but do not themselves either directly or indirectly own equity interests in the LLC (so-called "sister" companies).
C) Obtaining credit (loans) on the open market from persons outside the group.
We draw the reader's attention to the fact that if, under such credit (loan), a foreign member or its affiliates are guarantors, sureties or otherwise secure the performance of obligations, the risk also occurs that the "thin capitalisation" rules will be applied.
Repatriating the profit received
The next issue that needs to be resolved is how it is proposed to repatriate the profit generated from the implementation of the project. It is understood that even if events develop as auspiciously as possible, profitability will be far from immediate; nonetheless, this needs to be considered beforehand. One of three options will have to be selected.
A) The LLC distributing profit.
Advantages: the most "transparent" option. When all is said and done, commercial companies are created precisely so that profit will be generated and distributed among the company's members.
Disadvantages: for profit to be distributed, it first has to be earned (before payback of the project, dividends cannot be paid); only post-tax profit may be distributed; in addition, if dividends are paid in favour of any foreign members, tax must be withheld at source in Russia (the rates will depend on which double taxation treaty is applicable).
B) Obtaining income in the form of interest on loan financing.
The advantages and disadvantages are described above.
C) Obtaining income in the form of a fee for services (notably, consulting services) supplied.
Advantages: there is a stable flow of cash; the income will not be taxable at source in Russia; the LLC will reduce its taxable profit by the amount it pays; and VAT withheld when payment is made may be treated as deductible.
Disadvantages: there is a risk of the tax authority attempting to challenge the expenses. Naturally, we are looking only at options that involve services actually being supplied. But even if the services are actually supplied, the tax authority will need to be convinced of the fact. This requires a considerable volume of documents to be executed. To exaggerate, from the standpoint of the Russian tax authorities the ideal would be to have a transcript of all the phone calls, minutes of all meetings and printouts of all email correspondence, as well as documents for all business trips of consultants with notarially certified explanations from the LLC's employees, in which they confirm that the relevant advice was indeed obtained. Of course, this 'ideal' is unattainable in practice, and attempts to get close to it can paralyse the LLC's operations. However, the further we stray from the "ideal", the greater the risk becomes.
Г) Obtaining income in the form of a fee for intellectual property granted (patents, know-how, and trademarks).
Advantages: a stable flow of cash, which may depend on the outcome of operations; the ability to vary the amounts of payments; in a number of cases, royalty payments will not be taxable at source in Russia.
The table sets out a comparison of certain double taxation treaties (with Kazakhstan and Finland as our investors' countries of residence, and Cyprus and the Netherlands as potential jurisdictions for an SPV) in relation to the main issues likely to matter in our case. We have examined our case, in which the equity interests are distributed equally among the members (33.33% each) and the amounts of their investments are significantly greater than EUR 100,000 for each of the investors.
Table 1 Comparing double taxation treaties:
Click here to view table.
A shareholders' agreement: under Russian law or English law?
Now we will turn back to the issue of the relationship between the partners in the project. Conflicts may occur if everything is not agreed at the outset, when the business is launching its assault, or, on the other hand, if profitability is off the scale, and there are problems with the distribution of profits. Therefore our investors have begun by entering into a shareholders' agreement, in order to identify beforehand ways to resolve most contentious issues.
When foreign investors appeared in Russia, the institution of shareholders' agreements became fairly widespread among the shareholders of large and medium-sized companies. The institution was enacted in legislation in 2009. From 1 September 2014, a company must be notified of the fact that a shareholders' agreement has been entered into. If it is established that the shareholders of private companies have rights that are not equal in scope, then information must be entered in Russia's companies register to the effect that such an agreement exists, along with the scope of the rights in provides for. The content of shareholders' agreements is confidential, except in cases stipulated by the law. This factor creates certain difficulties in challenging transactions that a shareholder has entered into in violation of a shareholders' agreement. This is because, for such a transaction to be held invalid, there is a mandatory condition that the counterparty of the shareholder know or should have known of the restrictions set by the shareholders' agreement. With the content of a shareholders' agreement being confidential, it is difficult to prove this fact.
From 1 September 2014, only all or some of the company's shareholders may be parties to such an agreement. A company itself may not be a party to a shareholders' agreement. Shareholders' agreements are not in essence a constituent document and may not establish corporate rights. In this, they differ from shareholders' agreements under English law. Another way in which Russian shareholders' agreements differ from their English equivalents lies in the fact that English shareholders' agreements may make provision not only for voting options to be agreed with other shareholders and for votes to be cast in a particular way. They may also stipulate a procedure for forming a company's management bodies, the number of candidates each shareholder may put forward for the company's management bodies, and the number of shareholders' representatives on the company's management bodies. Further, they may include what are known as deadlock provisions, which aim to surmount deadlock situations that will lead to a corporate conflict. Under Russian legislation, it is the law and a company's charter that govern the procedures for shareholder voting, for companies' management bodies to be formed and for equity holdings and shares to be disposed of. A shareholders' agreement may not stipulate such provisions if they are at odds with those set out by law or the charter.
Shareholders' agreements under English law also differ from those under Russian law in that the former may lay down mechanisms for implementing tag along rights and/or drag along rights, which aim to safeguard the interests of minority and majority shareholders when equity holdings and shares are sold. Also possible under English law are a put option and/or call option, which are targeted at the acquisition or sale of shares (equity holdings) should specified circumstances occur.
Given that Russian legislation has not been perfected, the provisions of shareholders' agreements may be held to be invalid if they: oblige shareholders to vote in a specified manner; set restrictions on the disposal of shares with a view to protecting the interests of both minority and majority shareholders; and regulate ways to overcome conflict situations. The following may also to be invalid because they contravene the company's charter and the law: the provisions of a shareholders' agreement that contradict the company's charter; and the provisions of an agreement that provide for additional rights and/or impose additional obligations on the company's members without the company's charter containing the same provisions. This is the direction in which the case law is moving.
If a shareholder's agreement is breached, then as long as the provisions of the law and the company's charter have been observed, such breach may not be a ground for decisions of a company's management bodies, or for transactions companies have entered it no based on those decisions, to be held invalid. However, the breach can be a ground for the shareholder that is at fault to pay a penalty provided by the agreement and/or to reimburse losses incurred by other shareholders as a result of the agreement being breached and pay compensation (a set amount of money or an amount to be determined according to a procedure stated in the shareholders' agreement). If it goes to court to make the relevant claim, a shareholder whose rights have been infringed will have to prove and substantiate the amount of the losses inflicted on it. It will also have to prove a causal link between the amount of the losses it has incurred and the breach of the shareholders' agreement.
From 1 September 2014, amendments come into force which establish that decisions of a company's management body may be challenged if: those decisions were taken as a result of the agreement being breached, as long as the agreement was entered into by all shareholders. The amendments also establish prohibitions on: shareholders relying on an agreement being invalid if it contradicts the company's charter; and shareholders establishing by a shareholders' agreement the structure and competencies of a company's management body. These amendments are positive in nature. However, they do not eliminate all or even most of the gaps and issues in the regulation of shareholders' agreements. Over the five years during which the institution of shareholders' agreements has been regulated by statute, the case law has not developed significantly to plug the gaps and to smooth out the inconsistencies in the legislation.
Overall in Russia, the institution of shareholders' agreements has become widespread. However, Russian legislation does not allow the interests of minority and majority shareholders to be protected, nor corporate conflicts to be averted, to the extent that the rules of certain foreign jurisdictions allow. In view of this, the approach to structuring business using those foreign jurisdictions is retained. This means that our investors face a dilemma. Do they create an SPV in Cyprus and enter into a shareholders' agreement under English law that will give them a rich choice of legal tools to cover all eventualities of corporate life? Or do they enter into an agreement on Russian law in the hope that their project partners will show decency and loyalty?
After discussing the matter over at length, the investors placed more weight on the tax aspects, which presented more danger in the context of the forthcoming 'deoffshorisation' of the economy. They chose Russian law for the agreement. This makes the ownership structure more transparent and will be an advantage when it comes to loan financing. Without such financing, no serious project can be implemented.
Credit institutions willingly become involved in providing credit to manufacturing start-up projects as long as they understand the group of investors and the business model that is being implemented. The Finnish partners, as the most experienced in the financial sector, immediately determined that prospective lenders should be brought in to discuss the structure when the project is in its infancy. The lenders' requirements can then be taken into account. We note in particular that a business plan that sets out a procedure and timeframe for the project to deliver returns is underpinned by the results of negotiations aimed at concluding long-term contracts with buyers of the future business's products. Such arrangements would guarantee stable and predictable cashflow, confirming that the business will be profitable. If funding is to be obtained for the project, it is necessary to ensure that products are sold. Our project faces no troubles on this score.
One of the important requirements of banks for the security (guarantees, pledges and so on) to be provided in relation to the financing of a project is that there must be clean title to the assets the investors use to secure loans. This must include those to be acquired by the new business, so that these may subsequently also be used for the purpose of giving security for loans (thus reducing the cost of the financing). One such asset will be the future factory, or more accurately, the land plot, building and structures, together with the equipment. In the next issue, we will tell you how such a high-quality asset may be selected and acquired.