On April 16, 2009, representatives of the Ministries of Finance of the Russian Federation and Cyprus initialed the Protocol to the Double Tax Treaty between Cyprus and Russia dated December 5, 1998 (the Treaty). Initialing a document usually implies completion of negotiations and final coordination of its text before its official signing. It is expected that the Protocol will be ratified by both states in 2009, and pursuant to Article 13 of the Protocol, it will be applicable effective from January 1, 2010. Upon coordination of the Protocol, it was announced that Russia agreed to remove Cyprus from the so called black list of offshore zones issued by the Russian Ministry of Finance. It means that Russian companies may soon be able to apply full tax exemption regarding dividends received as a result of strategic participation in Cyprus subsidiary companies, subject to fulfillment of other conditions established by the Russian legislation.
This overview is intended to outline the key terms of the Protocol, which introduces principal amendments to certain Treaty provisions. We are currently in possession of only the English text of the Protocol, and thus this overview is based on our analysis of the English text of the Protocol.
Limitation on Benefits Granted by the Treaty
One of the Protocol provisions establishes that the Russian tax authorities may deny application of reduced tax rates or tax exemption regarding companies that are Cyprus tax residents, if as a result of consultations between the competent authorities of Russia and Cyprus it is ascertained that the main purpose or one of the main purposes of the setting up or existence of such company was obtaining benefits granted by the Treaty.
This being the case, the Protocol contains no indication as to the requirement of mutual agreement of the tax authorities of the two countries on the issue of non-application of the Treaty to income of particular companies. It may be expected that after holding such consultations, the Russian tax authorities will not consider themselves bound by the opinion of their Cyprus colleagues when adopting a decision on denial of tax benefits provided by the Treaty.
One might also anticipate that in adopting a decision on possible non-application of the Treaty, in each particular case the Russian tax authorities will employ the unjustified tax benefit concept and establish the existence or absence of a business purpose in the use of a Cyprus company.
Importantly, however, the scope of application of this Protocol provision is rather limited: it will only be applicable to companies that are formally registered (incorporated) outside of Cyprus (for instance, in the British Virgin Islands (BVI)), but are deemed Cyprus tax residents by virtue of effecting management and control over their activities on the territory of Cyprus.
Exchange of Information between the Tax Authorities of Russia and Cyprus
The revised article on exchange of information contains substantially new provisions:
- The exchange of information may relate not only to the taxes that are covered by the Treaty, but also to any other taxes (e.g., VAT);
- Banking or any other professional secrecy may not serve as a sufficient ground for refusal to provide information to a competent authority of the other state;
- The fact that the information at issue is not required or valuable for tax collection purposes for the state where it is requested (e.g., due to tax exemption regarding relevant income under the internal legislation), may not serve as the ground for refusal to provide such information.
However, since the procedures for information disclosure to the authorities of other states are strictly regulated in Cyprus, it is unlikely that the Cyprus tax authorities will unconditionally provide all the information (including data on beneficiaries of Cyprus companies) upon any request of Russian colleagues.
As for the Russian side, exchange of tax information was previously effected by the Department of International Cooperation and Information Exchange at the Federal Tax Service of the Russian Federation, but as a result of reorganization of the tax service, it was dissolved. It remains unclear how this function of exchange of tax information with other countries will develop in practice in the absence of a relevant structure in the system of the Russian tax authorities.
Taxation of Income from Sale of Shares in Companies Owning Immovable Property
In accordance with Article 13 of the Treaty that is currently in force, income of Cyprus companies from the sale of shares in Russian companies are not taxable in Russia.
As per the changes introduced by the Protocol, income from the sale of shares may be taxable in Russia if more than 50 percent of the value of such shares is based on the value of immovable property located in Russia.
The new provision will come into effect not simultaneously with the entry of the Protocol into force, but four years later. Thus, this provision will not become applicable before January 1, 2014, provided that the Protocol is ratified in 2009 and enters into force effective from January 1, 2010.
For practical purposes, the new provision will apply in cases where a Russian company that is a tax agent acts as the buyer of shares. Please note that the effective Russian legislation does not provide for a tax payment procedure in the event that a foreign company that does not have a permanent establishment in Russia acts as the buyer.
It is not clear from the text of the Protocol which company is concerned: whether it is a company that directly owns immovable property, or cases of companies holding, directly or indirectly, shares in a company that owns Russian immovable property are also covered by the article. In this connection, it is possible that the Russian tax authorities will seek to apply the new provision in the event of sale of shares in a Cyprus company that owns a Russian entity holding real estate in Russia.
Such interpretation of the Protocol appears reasonable only in cases where a Cyprus company sells shares in another Cyprus entity. If, however, shares of a Cyprus company are sold by a company resident in a third country, for instance, BVI, this Protocol provision should not apply, for BVI is not a contracting party to the Treaty and the Protocol.
Theoretically, in the latter case, the Russian tax authorities may invoke the unjustified tax benefit concept to substantiate tax claims with regard to the income of such company resident in the BVI derived as a result of an indirect sale of real property in Russia.
As a final remark in this section, a number of exceptions from the new rule are contemplated. In particular, it does not apply to income from the sale of shares:
- in the course of company reorganizations;
- if such shares are listed on a recognized stock exchange;
- if the shares are obtained by a pension fund, a provident fund or the government of Russia or Cyprus.
Dividends and Interest
The Protocol expands the definition of the terms “dividend” and “interest” as contained in the Treaty. According to the amendments introduced by the Protocol, income from mutual investment funds or similar collective investment vehicles, as well as income from depositary receipts for shares (save for income obtained from real estate investment funds) shall be recognized as dividend.
It remains unclear whether in such cases, the reduced withholding tax rate of 5 percent applies. Formally, an investment fund does not have any capital and thus, the Treaty provision on the minimally required “direct investment in the capital” may not be fulfilled.
The Protocol also provides that income in the form of interest taxable as dividends under the internal legislation of Russia or Cyprus is treated as dividend. This implies, in particular, that depending on the amount of investment into the capital of a Cyprus company (for details, see below), the withholding tax rate of 5 percent or 10 percent provided by the Treaty will be applicable to interest paid in favor of Cyprus companies that is deemed dividend by virtue of the thin capitalization rules established by Article 269(2) of the Russian Tax Code.
The Protocol amends the term “interest” to include interest on loans involving participation in debtor’s profits. In contrast, penalty charges for late payment will not be deemed interest under the Treaty.
Applicability of the 5 percent Withholding Tax Rate to Dividends
The Protocol also amends the conditions for applicability of the 5 percent withholding tax rate to dividends. The minimum required investment (the so called direct investment) into the capital of a company distributing dividends must amount to €100,000, as opposed to the effective $100,000. This amendment is obviously due to the entry of Cyprus into the Euro area last year. Based on the present currency rates, it implies an increase of the minimum investment by nearly 30 percent.
Thus, companies that currently do not comply with the new criterion, will have to increase their authorized capital to the required amount of €100,000 to be able to apply the reduced tax rate to dividends distributed to Cyprus.
However, theoretically such capital increase might be treated by the Russian tax authorities as aimed exclusively at taking advantage of the tax benefit, resulting in a refusal of application of the reduced withholding tax rate.
Taxation of Real Estate Investment Funds
Currently, in application of the Treaty provisions, the tax treatment of income derived by a Cyprus company from a Russian closed real estate investment fund (REIF) remains unclear. Possible interpretations include income from immovable property (Article 6 of the Treaty), dividends (Article 10 of the Treaty) and other income (Article 22 of the Treaty).
The Protocol establishes that income from investment funds that invest exclusively into real estate will be treated as income from immovable property and be subject to withholding tax at the location of such property. Regarding real estate in Russia, the withholding tax rate is 20 percent.
It is quite possible that the Russian tax authorities will apply this provision to incomes of Russian REIF’s. At the same time, the extent to which a REIF may be treated as a fund investing exclusively in real estate objects remains to be clarified, since assets of a REIF may include assets that do not constitute immovable property.
In addition to the above novelties, the Protocol also introduces amendments to the following provisions of the Treaty:
- In accordance with the current edition of the Treaty, a legal entity is considered to be a resident of the state where the place of its effective management is located. In accordance with the new paragraph introduced by the Protocol, where the place of effective management of a legal entity cannot be determined, the Russian and Cypriot tax authorities shall endeavor to determine by mutual agreement the place of effective management in each individual case.
- The Protocol amends the list of cases, in which a permanent establishment may originate, with the situation when an enterprise of one State renders services through an individual present in the other State for 183 or more days during any 12 month period.
- According to the new edition of Article 8 “Income from International Traffic”, income from such operations shall be taxable only in the State in which the place of effective management of the person deriving such income is situated, and not in the State in which such person is a resident.
We recommend that you discuss with your tax consultant possible effects of the provisions of the Protocol on your tax liabilities and your business in general if, in particular:
- You hold, through a Cypriot company, shares in a Russian company with the acquisition cost of less than €100,000;
- You hold, through a Cypriot company, participation interest in a Russian REIF or shares in a company, which major assets consist of real estate located in the territory of the Russian Federation;
- Your company has obligations to Cypriot companies under loan or credit agreements;
- Your company is a tax resident of Cyprus, yet is established and registered outside Cyprus;
- You are interested in acquisition of participation interest in investment funds and intend to take advantage of the reduced withholding tax rates with regard to payments made by such funds;
- You render services through individuals who are present for a long time in Russia or Cyprus;
- You enjoy privileges established by the current edition of Article 8 of the Treaty “Income from International Traffic”, but the state of incorporation and the place of effective management of your company are not the same;
- You are interested in receiving detailed information about the powers and duties of the Russian and Cypriot tax authorities with regard to information exchange and assistance in tax collection, and about the respective legal procedures.