As part of the Russian government’s “deoffshorisation” drive, which is aimed at increasing tax collection through combating the unjustified use of offshore jurisdictions to structure investments and hold Russian assets, the Russian Parliament has passed a law1 which introduces “controlled foreign corporation” (or CFC) rules into Russian tax law for the first time.
In broad terms, the CFC rules would apply in relation to non-Russian tax resident corporations (and other entities) controlled by one or more Russian tax residents. The rules would:
- deny double tax treaty benefits to CFCs;
- instead treat the income of the CFC as taxable in the hands of the Russian controlling party when received by the CFC, regardless of whether an actual distribution to any Russian controlling party took place; and
- require Russian tax residents to report their interests in foreign companies to the Russian tax authorities.
The law also introduces a new “place of effective management” test for determining whether a foreign company is tax resident in Russia. This test will apply in addition to the existing tests for establishing tax residency under the double tax treaty provisions.
The proposed changes will have potentially far-reaching consequences for Russian business owners who hold their business interests through offshore holding structures. This briefing explains the key features of the draft law and suggests what actions clients should take to assess the impact of the proposed tax law changes and how best to respond to them.
The law takes effect from 1 January 2015.
Proposed new CFC rules
What is a CFC under the draft law?
A controlled foreign corporation (or CFC) is a non-Russian entity which:
- is not tax resident in Russia; and
- is controlled by legal entities and/or individuals that are treated as Russian tax residents.
The definition of a CFC covers pass-through entities (such as funds, trusts, partnerships and collective investment vehicles) which generate income for the benefit of their participants / settlors or beneficiaries, as well as corporate entities. There are however exemptions in relation to:
- foreign non-commercial companies which do not distribute income to their participants / shareholders;
- foreign companies where their place of registration is in one of the member-countries of the Eurasian Economic Union;
- companies with their place of registration in a country which has a double tax treaty with Russia and a tax information exchange agreement with Russia and which has an effective annual income tax rate of not less than 75% from the weighted average corporate profits tax rate in Russia;
- companies where their place of registration is in a country which has a double tax treaty and a tax information exchange agreement with Russia and not more than 20% of the company’s income consists of passive types of income (dividends, royalties, interest, etc.);
- pass-through entities:
- the participants / settlors of which are not entitled to receive assets of the entity;
- the rights of participants / settlors cannot be assigned to third parties;
- the participants / settlors are not entitled to any income from the entity;
- the entity has no right to distribute profits to its participants / settlors (or their related parties);
- banks or insurance companies resident in a jurisdiction which has a tax information exchange agreement with Russia;
- Eurobond issuers (or SPVs involved in Eurobond structures), if the interest receivables from its parent comprise at least 90% of its annual income);
- companies participating in production sharing agreements, concession agreements or other agreements of a similar nature with foreign governments; and
- companies/operators of new offshore deposits of hydrocarbons (special newly introduced regime for the exploitation of offshore licence areas) in Russia (or a shareholder of such operator).
The draft law defines “control” over a corporate entity as exercising influence (or having the ability to exercise influence) over the distribution of profits of that entity through:
- direct or indirect participation in the capital of that entity (e.g. as a shareholder); and
- having rights under a shareholders’ agreement regulating the management of that entity, or
- other criteria,
there is a similar definition in relation to pass-through structures.
Establishing whether “control” (as defined above) exists will require proof of factual circumstances which demonstrate influence over decision making in relation to distributions of income in an entity, which is likely to be difficult in practice for the Russian tax authorities. However, the CFC rules in the draft law also contain objective “control” tests.
A Russian taxpayer will be deemed to “control” a corporate entity if that person, together with his/her/its affiliates (including certain family members), is beneficially entitled to:
- from 1 January 2015 until 31 December 2016 - more than 50% of the interest in that entity; or
- from 1 January 2017 onwards - either:
- more than 25% of the interest in that entity, or
- more than 10 % of the interest in that entity and Russian tax residents (together with their respective affiliates including certain family members) are in aggregate beneficially entitled to more than 50% of the interest in that entity.
A “beneficial ownership of income” test may apply to foreign company (including a CFC) to determine whether the company serves merely as a conduit function.
A person will be treated as “beneficially entitled” to the income from the entity if he/she/it has the right to use or dispose of that income through, among other things:
- direct or indirect participation in the capital of the income distributing entity (e.g. as a shareholder); or
- being able to decide whether to consume or direct the transfer of such income to any third person.
Where a person (e.g. an offshore holding company) has a right to use or dispose of income which it receives, the functions performed and risks assumed by that person will be taken into account in order to determine whether that person is “beneficially entitled” to that income. The person will not be treated as beneficially entitled to that income if it:
- has limited rights to dispose of that income;
- performs purely intermediary functions in respect of that income and does not enter into any commercial activities nor does it perform any other functions; and
- transfers that income, all or part, to another person who (or which), if they had received that income directly from the original source of such income, would not have been able to claim double tax treaty benefits.
What reporting obligations will apply?
A Russian tax resident must file a report with his/her/its local tax inspectorate to notify the Russian tax authorities of:
- any CFC which the taxpayer together with its affiliates controls, by not later than 20 March in the year following the tax year in which his/her control of the CFC began;
- any direct or indirect shareholding or other relevant interest of more than: (i) 25% (until 31 December 2016); or (ii) 10% (from 1 January 2017 onwards) in any foreign company within 1 month after that interest is obtained (for interest held before 1 January 2015 the reporting deadline is 1 April 2015); and
- any direct or indirect foreign pass-through structures (e.g. funds, partnerships, trusts and other forms of collective investments) due to participation in which the Russian tax resident would have the right to the income.
Reports must also be filed by the taxpayer upon the cessation of holding any of the abovementioned interests.
How will the taxable income of a Russian controlling party be calculated?
The income of a CFC:
- will be treated as the income of the relevant Russian controlling party (whether corporate or individual) of the CFC in proportion to the interest of that controlling party in the capital of the CFC;
- will be deemed to be received by the relevant Russian controlling party when it is distributed by the CFC or, if there is no such distribution in the relevant tax year, on 31 December in that tax year (with proportionate reductions made where the relevant controlling party held its interest for less than the full tax year); and
- will be calculated based on the financial reporting period of the CFC under the laws applicable to the CFC.
The income of a CFC will not need to be accounted for by a Russian controlling party if the income of the CFC does not exceed:
- 50 million Rubles in the year ending 31 December 2015;
- 30 million Rubles in the year ending 31 December 2016; or
- 10 million Rubles thereafter.
Otherwise taxable income will be calculated by applying the rules of general application in the Russian Tax Code. Accordingly, for example:
- the applicable tax rates will be 20% for corporate and 13% for individual controlling parties;
- the taxable income of the CFC will be reduced by the amount of any dividends distributed by it;
- the income of the CFC will need to be supported by appropriate financial reporting documentation for the relevant tax period(s) of the CFC;
- the income of the CFC which is denominated in foreign currency will need to be converted into Russian Rubles at the average exchange rate of the Central Bank of Russia for the relevant tax period(s) of the CFC; and
- tax credits will be available to a Russian controlling party - Russian tax payable on the income of the CFC will be reduced by: (i) any tax paid by the CFC (or withheld on behalf of the CFC) on that income in the country of its incorporation or in Russia; and (ii) any tax paid by a Russian branch of the CFC.
- If the CFC is indirectly controlled through other entities which also qualify as “controlling” with respect to the CFC, the income of the “top” controlling entity is reduced by income reported by the other controlling entities through which the indirect control is exercised; and
- the losses of the CFC are indefinitely carried forward.
What penalties will apply for non-compliance?
The draft law contains the following main penalties for non-compliance:
- failure to report and pay tax on a CFC’s income - 20% of the underpaid tax (does not apply until 1 January 2017);
- failure to report participation in a CFC and a foreign company on time – 100,000 Rubles; and
- failure to report participation in a foreign company on time - 50 000 Rubles.
Proposed changes to rules for determining tax residency
The “place of effective management” test establishes the basis for determining whether a foreign company is tax resident in Russia, except where double tax treaty provisions treat the company as being tax resident outside Russia.
A foreign company will be deemed to have its place of effective management in Russia if:
- more than one half of the meetings of the board of directors or other governing body of that company during the relevant year take place in Russia;
- the management of the Company is performed primarily from Russia (this will not be the case if the company can demonstrate that it has qualified management personnel engaged in decision making and systems in a jurisdiction with which Russia has a double tax treaty); and
- the main executive personnel of that company conduct their functions primarily in Russia.
If the above three criteria are not met, then several additional criteria will apply to determine whether a foreign company will be treated as having its place of effective management in Russia, including the locations at which:
- the company’s accounting functions are conducted;
- the company’s administration functions are conducted and related records are kept,
- the company issues orders or other documents of a similar nature with respect to its activities (excluding internal standards, methodologies and policies); and
- the company exercises operating control over its personnel.
A foreign company will not be treated as a Russian tax resident (unless it elects to be so treated) if it:
- is treated under the provisions of a double tax treaty to which Russia is a party as being tax resident in another state;
- is engaged in activities under production sharing agreements, concession agreements, licensing or service agreements or certain other prescribed agreements with a foreign government; or
- has a separate branch in Russia.
What actions should clients take
It is clear that many holding companies for businesses with Russian shareholders (including offshore joint venture vehicles) that are located in jurisdictions which:
- have zero tax or effective corporate tax rates of less than 75% of the weighted average Russian corporate profits tax rate (including Cyprus, the British Virgin Islands and the Cayman Islands); and
- do not have tax information exchange agreements with Russia,
will be treated as CFCs under the proposed new rules.
Moreover, changes to the tax residency rules will mean that many foreign holding companies which have not to date been treated as tax resident in Russia are increasingly at risk of being taxed on their dividend income in Russia.
Russian clients with significant shareholdings through offshore holding structures should:
- analyze their expected additional tax expenses after the introduction of the CFC rules;
- consider potential ways to reorganise their holding structures so as to mitigate or exclude CFC risks, and weigh the expense of transitioning to a new holding structure (including ongoing administration costs) against the expected tax benefits; and
- consider whether the manner and location of decision making by offshore holding companies needs to be altered to address increased Russian tax residency risks.
Potential CFC risk mitigation strategies could include the following:
- the use of holding companies or other vehicles in a jurisdiction with effective corporate tax rates of 75% or more of the Russian average weighted corporate profits tax rate and with which Russia has a tax information exchange agreement in force.