On 18 March 2014, the Russian Ministry of Finance (Minfin) published a draft law which will introduce controlled foreign companies (CFC) rules in Russia for the first time. This is the most significant reform of the Russian tax legislation during recent years. If these rules are adopted, individuals who mainly reside in Russia as well as Russian companies and foreign companies controlled from within Russia, will be taxed on the undistributed profit of their offshore assets.
Although the proposal as currently drafted will almost inevitably be amended, there is little doubt that the draft law will be ultimately adopted in one form or another. CFC rules are one of the key elements of the de-offshorization plan which the President of the Russian Federation announced in December 2013 in his message to the Parliament. It is expected that the Russian State Duma (the lower house of the Russian Parliament) will consider the CFC draft law in its spring session.
As Russian legislation has never provided any rules similar to the CFC rules before, it is important to assess the potential consequences for beneficiaries of offshore companies.
The provisions in the draft law cover three separate areas:
- the rules on the taxation of profit of Russian residents which they have not actually yet received but which have been received by their controlled foreign companies;
- the requirements on Russian residents holding shares in foreign companies or controlling such companies to notify the Russian tax authorities of such shareholding; and
- the rules for establishing a legal entity’s residence which provide that a foreign company may be recognised as a Russian tax resident if its place of effective management is Russia.
To assess whether there is a relevant foreign company for the purposes of the first two areas, the “black list” of jurisdictions to be issued by Minfin will need to be referred to. This list is expected to include not only traditional offshore jurisdictions but also Cyprus, Luxemburg or even the Netherlands. With regard to the third area the jurisdiction in which a company is incorporated will make no difference. The key factor will be whether the place of management of the company in question is located in Russia.
The new rules set out the procedure for paying taxes on CFC’s profit, allow the Russian tax authorities to get information on the shareholdings of Russian residents in such companies and seek to bring within the Russian authorities’ jurisdiction the companies which are actually controlled from Russia but which are incorporated overseas and therefore not subject to Russian taxes.
All three areas of the draft law are aimed at levying from the Russian taxpayers – both individuals and legal entities – tax on profit not distributed by their CFCs at the rate of 13% and 20% respectively. Given that the rates of the profits tax on dividends are lower than the rates which would be otherwise payable under the CFC rules for non-repatriated profit, the CFC rules should incentivise the transfer of offshore profit back to Russia.
Although Russian CFC rules are generally in line with international practices, there are several distinctive features.
First, in the Russian CFC rules the situation in which a person will “control” a company include if he is a shareholder who hold more than 10% of the company’s shares and therefore may not actually have real control over the company.
Second, the Russian CFC rules do not allow any credit for taxes paid by the CFC in the country of its residency.
Third, the draft law does not make any distinction between active and passive income of the CFC.
Finally while the draft law establishes the residency rules for corporations, it is not intended to amend the current rules of residence of individuals, which remain formal.
In addition the proposed CFC rules apply also to collective investments structures which are not legal entities. Currently it is not clear whether all types of trusts and funds will be included in this category.
The current draft law introduces strict liability for the failure to comply with its requirements. A failure to notify the tax authorities of participation in foreign companies will lead to a RUB 100,000 fine. Failure to pay tax on CFC’s profit will lead to a fine equal to 20% of CFC’s profit (and not of the unpaid tax). The adequacy of this fine raises doubts taking into account legal positions of the Constitutional Court of the Russian Federation.
Based on the draft law, it is possible to analyse what structures would not fall under CFC rules. The chart below illustrates different ways of holding the same asset: (i) a direct holding which falls under CFC rules, with the distribution of dividends to the Russian resident; (ii) holding through a Russian company which is eligible for participation exemption and distribution in favour of such company; (iii) holding through a company incorporated in high-tax jurisdiction which caters for participation exemption:
Click here to view image.
Generally, one is left with two impressions of the draft law. On the one hand, it has been prepared with regard to international practices in relation to the taxation of CFCs; but on the other hand, it is disproportionally severe and lacks economic balance. Moreover, the draft law remains inconsistent and incomplete. Therefore, we suggest monitoring the draft law and any proposed amendments to it carefully whilst it is discussed and considered in the Parliament. Currently, the draft law is open to public comments until 26 May 2012 via the following link: http://regulation.gov.ru/project/13067.html
The new law is expected to come into force on 1 January, 2015. Notwithstanding this we recommend that interested parties analyse their existing corporate structures in the light of the draft law and, if necessary, implement a restructuring.
SCHEDULE: CFC RULES IN FACTS AND FIGURES
Key information on Minfin’s draft law is set out below.
Who are taxpayers? Russian resident individuals and legal entities controlling foreign companies.
Which companies are recognised as Russian residents? Legal entities with their place of effective management in Russia.
What is CFC? A foreign company (i) which is not a Russian tax resident, but which is the resident in a jurisdiction on the «black list» approved by Minfin, (ii) whose shares are not listed on a stock exchange and (iii) which is controlled by Russian residents. CFCs also include structures, which meet all of the following criteria: (i) they do not have status of legal entities; (ii) they are established in accordance with the laws of a «black list» jurisdiction; (iii) they are entitled to perform entrepreneurial activity; and (iv) they are controlled by the Russian residents.
What is control? Influencing or an ability to have a decisive influence over a CFC in relation to profit distribution due to direct or indirect participation, contractual arrangement or some other grounds. In case of a structure, “control” means influencing or the ability to have a decisive influence over a person who manages the assets of the structure.
What are control thresholds? 10% for a person jointly with spouse, infants and other persons. However, the control is possible with a share of less than 10%.
What CFC’s profit is subject to taxation? The CFC’s profit not distributed in the form of dividends, calculated under principles of Chapter 25 of the Russian Tax Code, by reference to the controlling person’s shareholding and the period of control, without foreign taxes deduction.
What is the tax rate for paying tax on CFC’ profit? 20% for legal entities and 13% for individuals.
Is it possible to obtain credit for Russian tax previously paid on CFC’s profit? Yes, a shareholder may deduct from the amount of tax it is to due to pay any tax paid by an intermediary Russian corporate shareholder.
What is the liability for a failure to pay tax on the CFC’s profit? A fine equal to 20% of CFC’s profit (and not of the unpaid tax).
What are the obligations with respect to notifying tax authorities of holdings in foreign companies? If the taxpayer directly or indirectly owns a shareholding of at least 1 % in any company incorporated in any of the “black list” jurisdictions, it is required to notify its holding.
What is liability for a failure to make the notification? A RUB 100,000 fine
What other significant amendments does the draft law propose? Article 309 of the Russian Tax code is fundamentally amended with respect to withholding tax on the sale of shares of the companies with assets consisting mainly of immovable property located in Russia. The draft law specifies that the sale of shares of any (currently – only Russian) company is subject to Russian withholding tax if the assets of this company directly or indirectly (currently – directly) consist by more than 50% of immovable property located in Russia
When the draft law will come into force? The anticipated entry into force date is 1 January 2015.