Dentons’ Russia Tax practice would like to remind that, starting from 1 January 2017, the procedure for confirming entitlement to tax benefits under relevant double tax treaties when paying income to foreign companies from the Russian Federation has changed.
In particular, in order to apply tax exemption and reduced tax rates under double tax treaties (conventions, agreements) to which the Russian Federation is a party, before paying such income foreign companies must provide Russian companies (tax agents) with confirmation that such foreign companies are the beneficial owners of the income.
Prior to 2017 the RF Tax Code empowered Russian tax agents to request, in addition to a certificate of tax residency, the relevant information from foreign companies receiving income from the Russian Federation.
Who is affected?
The new requirements primarily affect tax agents paying dividends, interest and royalties to foreign companies and applying exemptions, reduced tax rates under double tax treaties.
The RF Tax Code does not explicitly provide for a list and form of documents confirming that a foreign company is the person beneficially entitled to income, which the Russian Finance Ministry has noted more than once.
In practice, foreign companies draft letters (signed by their director) which list circumstances evidencing that the foreign company is the person beneficially entitled to the income. Where possible, copies of contracts with third parties and financial analytics of the foreign recipient of the income showing that the funds are accumulated and reinvested at the level of the recipient of the income are also attached to such letters.
What difficulties might arise?
As you probably know, since 1 January 2015, the concept of the person beneficially entitled to income (“beneficial owner”) has become an inseparable and full-fledged part of Russian tax law.
The new rules clearly suit the tastes of the tax authorities, who view these provisions as an effective mechanism for challenging the right of foreign companies (and, as a consequence of this, the right of Russian entities paying income to those foreign companies and performing the obligations of tax agents) to apply benefits (exemption from Russian tax on the income of foreign entities or reduction of the rates of that tax) set by treaties (conventions, agreements) on the avoidance of double taxation with respect to so-called passive income (dividends, interest, royalties). This is evidenced by the clearly exponential growth in the number of disputes related to application of the beneficial owner concept that have gone to court. And those disputes often have to do with periods before the beneficial owner provisions were incorporated into the RF Tax Code.
The cases of Votek Mobile, Bank Inteza, Credit Europe Bank, MDM Bank, Krasnobrodsky Yuzhny, Severstal and Vladimir Energy Retail Company make up a far from complete list of the court cases in which the subject (or one of the subjects) was whether a foreign company recipient of income from sources in the Russian Federation met the beneficial owner criteria. At the same time, one cannot leave unmentioned the Russian tax authorities’ ever growing mastery of collecting information about foreign holdings and operating structures, in building their case in a dispute with taxpayers, and in manipulating the facts characterizing how foreign entities that are recipients of income from Russia conduct their business.
On the contrary, it is becoming more difficult for tax agents (generally Russian entities) to defend the status of beneficial owner with respect to foreign companies that are the formal recipients of income, which cannot but negatively impact the outcome of litigation involving them. The result is the recovery of tax amounts not withheld, a fine and late payment interest from Russian company tax agents.
Practice shows that the closest attention needs to be paid to protecting the right to apply benefits established by international tax treaties, correctly structuring the activity of foreign companies receiving income from sources in Russia, and properly documenting the facts of that activity. Essentially this means creating in advance a file that would contain documentation that foreign company recipients of Russian income meet the beneficial owner criteria.
This will help to strengthen the position of the tax agent paying the income to the foreign recipient and assuming the risks related to not withholding tax on income of foreign entities or withholding that tax at reduced rates provided for by international tax treaties, in a potential dispute with the tax authority, at the same time avoiding a rush to gather the appropriate evidence when the information is requested by the tax authority or, what is even worse, when the tax authority has drawn up a report of improper non-withholding or incomplete withholding of tax by the tax agent.
It also needs to be borne in mind that the new legislation provides previously absent opportunities to reduce risks associated with applying the beneficial owner concept by identifying the actual recipient of Russian income and voluntarily declaring that person as the person beneficially entitled to one or another type of income. This option may not be best for all situations; however, it is worth considering in any event. Furthermore, using it requires the taking of an informed decision, which again anticipates the need for careful and comprehensive examination of the facts of the activity of companies/beneficiaries of the group even before Russian income starts to be paid to foreign entities.
Dentons is prepared to offer its assistance in resolving problems related to application of the beneficial owner concept. In particular, our lawyers can assist in:
- Advising clients on various aspects of applying the beneficial owner rules;
- Analyzing the client's corporate structure and the structure of the client’s cross-border transactions for the presence of risks related to the beneficial owner rules, assessing the degree and magnitude of risks identified;
- Developing a “Defense File” to identify the circumstances and facts of activity of the client's corporate structure that occurred in past periods, and subsequently identifying strengths and weaknesses in the event of a possible tax dispute, and determining a strategy for gathering evidence if there is a risk of a tax dispute;
- Developing a system of steps and recommendations to eliminate or to minimize identified risks of future periods, including changing the corporate structure and redistributing functions within the group of companies, changing the structure and/or substance of cross-border transactions, changing the content of documentation of such transactions;
- Supporting the client’s tax audits and tax disputes related to the application of the beneficial owner rules, compiling a tax file, developing a legal position and gathering evidences;
- Drafting confirmation letters listing the circumstances of foreign companies’ activity evidencing beneficial entitlement to income or indicating the person possessing such a right;
- Assisting in drafting the relevant confirmation letters for a chain of companies that are not the beneficial owners of dividends while applying the “look-through” approach.
- Drafting amendments to license agreements used by clients, loan agreements and shareholder agreements, in particular, by including provisions in them requiring foreign companies to provide not only a tax residency certificate, but also confirmation of actual entitlement to income;
- Legal assistance in structuring a foreign company’s economic substance.
In recent years, Dentons’ Tax practice team has gained considerable experience in applying the beneficial owner concept and reducing risks related to its application. Below are a few examples of the projects in which we have provided legal assistance to the clients.
- American group of companies: analyzing the structure of dividend and interest payments to foreign companies as to whether the formal recipients of the income met the beneficial owner test; providing recommendations on improving the handling of contractual arrangements with those companies in order to strengthen the position of the tax agent (a Russian entity paying income to foreign recipients);
- Swedish group of companies: assessing the risk of the beneficial owner concept being applied to the existing Russian asset holding structure, developing scenarios for applying the Russian asset holding structure in order to reduce that risk;
- Russian individual: preparing a tax file to confirm observance of the conditions for applying reduced tax rates on income of foreign entities (including beneficial owner conditions) for a Cyprus company owned by that individual;
- Foreign bank: participating in drafting a form confirming beneficial owner of income status;
- International group of companies: assessing the steps taken by the client in several jurisdictions from the perspective of the risk of beneficial owner rules being applied to the payment of dividends and royalties, developing ways of minimizing the risk factors we identified and enhancing the economic substance in each of those jurisdictions;
- Foreign group of companies with manufacturing subsidiaries in several jurisdictions: supporting a tax audit of matters of applying beneficial owner rules;
- Russian subsidiary of a global holding: assessing the risk of beneficial owner rules being applied to dividends payable to a subholding, assessing the possibility of applying the “look-through” approach;
- Russian group of companies: advising on the possibility of deeming a foreign licensor the beneficial owner of royalties payable by the Russian licensee to a Cyprus company and then transferable by the Cyprus company to the foreign licensor.