Development of the Beneficial Ownership Rules Triggers New Tax Risks for Cross-Border Intercompany Payments
At a recent open hearing of the Budget and Taxes Committee of the lower chamber of the Russian Parliament the Minister of Finance confirmed ongoing work on legislative implementation of a beneficial owner requirement. Ahead of this announcement the Russian Ministry of Finance issued a new letter outlining the beneficial ownership concept for withholding tax purposes, discussing common back-to-back arrangements (Letter No. 03-00-RZ/16236, dated 9 April 2014, the “Letter”). This follows Letter No. 03-08-13/1, dated 30 December 2011, which froze the Russian Eurobonds market in the first half of 2012 (please see our Newsletter of March 2012).
Implications for taxpayers and Russian tax agents
The Letter defines the beneficial owner of income for the purposes of applying exemptions or reduced withholding tax rates under tax treaties concluded with Russia as a person having broad economic rights to income received and not being an intermediary such as a conduit company subsequently distributing all or most of the income to parties not having the same tax treaty protection.
The Letter gives examples of common back-to-back dividends, interest and royalties structures with offshore companies. If a foreign entity in a group receives payments from a Russian company and fails to meet this “economic test,” it will be subject to a 20% Russian withholding tax (15% — for dividends). The underpaid tax could be collected from the Russian payer of income (a tax agent) along with a 20% tax penalty for failure to withhold.
What the Letter says
The text of the Letter generally follows the 2010 OECD Commentary with some extentions. But it seems that the recent OECD initiative on a legal rather than economic approach to beneficial ownership and autonomous interpretation is not supported. In contrast, the Letter restates that the term “beneficial owner” is not used in a narrow technical sense, rather it should be understood in its context and in light of the object and purposes of the tax treaty, including avoiding double taxation and the prevention of fiscal evasion and avoidance. It is expressly indicated that an intermediary used as a conduit company cannot be recognized as a beneficial owner if, though the formal owner, it has very narrow powers which render it, in relation to the income concerned, a mere fiduciary or administrator acting on behalf of the interested parties. To date the Russian Tax Code contains no definition of a conduit company, which adds ambiguity to the situation.
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The Letter suggests that to be recognized as the beneficial owner it would be insufficient for a person to only have a legal right to receive income; it should also derive benefits from such income and determine its “economic destiny.” The Letter extends the “economic requirement” by stating that “tax treaty benefits (reduced tax treaty rates or tax exemptions) should not apply to Russian source income, if paid in relation to a transaction or a series of transactions arranged in such a way that a foreign entity claiming reduced tax rates on dividends, interest and royalties directly or indirectly pays all or most of this income (in any form and at any time) to another person.” This economic requirement appears to be quite broad and may even go beyond the current authorized OECD position on the beneficial ownership concept.
The Ministry of Finance outlines the following three examples where the immediate recipient of income — a company in a tax treaty jurisdiction (the “recipient”) — should not be recognized as the beneficial owner and would not be entitled to the respective tax treaty benefits:
– when a recipient has an obligation to transfer all or most of the received dividends directly or via intermediaries to a person that is a tax resident in a jurisdiction that has no tax treaty with Russia (or that is subject to less favorable tax treatment);
– when a recipient transfers all or most of the interest received on a loan initially extended from funds sourced from an offshore company in a back-to-back arrangement to that offshore lender;
– when a recipient transfers all or most of the royalties under a sublicense agreement to the initial licensor (copyright owner) that is a tax resident in a jurisdiction that has no tax treaty with Russia (or that is subject to less favorable tax treatment).
Although the examples used in the Letter seem to suggest a narrow application of the beneficial ownership concept and that the tax treaty benefits should be denied to an intermediary recipient artificially interposed in the structure for treaty shopping purposes, not performing substantial economic activities, and only for income transferred to an offshore company, some more general wording in the Letter creates a risk of the Russian tax authorities challenging tax treaty benefits even in legitimate business structures.
Finally, the Letter expressly indicates that if a Russian payer of income (tax agent) fails to withhold taxes on transferring income to a foreign entity not registered with the Russian tax authorities, the agent may be held liable and may be charged the tax amount and a 20% tax penalty for the failure to withhold and remit taxes due to the Russian budget.
The Letter presumably indicates the direction the Russian Ministry of Finance wants to take in drafting the legislative beneficial owner definition, but it is currently impossible to predict the nature and scope of the final rules to be adopted.
Actions to consider
– Review group structure and identify companies that distribute most of their income to other companies of the group and may fail the “economic test.” Confirm whether such companies may be considered as beneficial owners of Russian source income for tax treaty purposes;
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– Consider collecting additional documents and making changes to the holding, financing and cash-flow structure in a group of companies to support the economic rights of foreign companies to Russian source income;
– Evaluate the possibility of including the appropriate gross-up provisions on payments to be made by Russian companies;
– Consider further restructuring opportunities to mitigate withholding tax risks in Russia.
We will continue to provide you with information on the development of the beneficial ownership concept and various “deoffshorization” initiatives in the Russian tax legislation.
This LEGAL ALERT is issued to inform Baker & McKenzie clients and other interested parties of legal developments that may affect or otherwise be of interest to them. The comments above do not constitute legal or other advice and should not be regarded as a substitute for specific advice in individual cases.