As outlined in the Presidential Address to the Federal Assembly last December, the Ministry of Finance has prepared a bill to combat the use of tax optimisation schemes whereby chains of companies are created in various jurisdictions and used in order to reduce the tax burden to the maximum possible extent when allocating the profits to the ultimate beneficiary (the “Bill”).
The Bill was published on 18 March 2014, as the first of a package of anticipated anti-offshore bills. The Bill introduces the concept of a controlled foreign company (“CFC”) to the Tax Code and imposes new requirements on taxpayers. It is expected to become effective on 1 January 2015.
Key features of the Bill
The Bill provides for the following changes that will have a significant effect on existing tax planning schemes when the Bill becomes effective:
- the introduction of the CFC concept, whereby Russian tax residents (whether individuals or companies) holding more than 10% in a CFC are obliged to declare and pay taxes on the CFC’s direct undistributed income;
- an obligation for Russian individuals and companies to notify Russian tax authorities of all participations exceeding 1% in any CFC;
- the recognition of a foreign company as Russian tax resident when the place of management of such company is in Russia;
- the taxation in Russia of income from the sale of shares in an entity where the assets of such entity consist of indirectly owned immovable property located in Russia.
What is a CFC?
CFCs are incorporated foreign entities and other unincorporated structures (such as funds and partnerships) registered in countries included by the Ministry of Finance on a black list of countries and territories recognised as tax havens, save for companies being Russian residents and entities listed or which can be traded on a stock exchange. The Bill does not give an exhaustive list of these organisations and is silent on how the so-called “structure” concept should be interpreted in this context.
It is in particular unclear from the wording of the Bill whether this black list will be identical to or will differ from the Ministry of Finance’s existing black list (as per Order No. 108n of the Ministry of Finance dated 13 November 2007). The Bill does not contain any well-defined criteria for the Ministry of Finance to apply when creating the list of territories which are deemed to have a preferential tax treatment status. This gives rise to certain concerns because the existing list includes countries and territories that have not signed double-tax treaties with Russia but the new criteria may also include the minimum effective tax rate and the level of information disclosure of a country or territory. If these criteria are used, the Ministry’s list may well include new jurisdictions frequently chosen to set up foreign holding companies for preferential tax treatment and tax planning purposes (such as for instance Cyprus and Luxemburg).
A controlling person means a Russian resident (whether an individual or a legal entity) that controls the above companies or structures. As control criteria, the Bill specifies the ability to determine decisions on the distribution of a CFC’s profits and, in particular, holding an ownership interest of more than 10%.
The 10% threshold appears to be quite harsh and not in the spirit of the general CFC concept insofar as it is often impossible for such minority shareholders to influence the CFC’s management decisions notably on distribution of profits.
The Bill requires a Russian resident’s tax base to include its share in the CFC’s profits which corresponds to its ownership interest. The CFC’s profits have to be calculated in accordance with Chapter 25 of the Russian Tax Code, which, among other things, means the application of the Russian tax base calculation rules.
To this end, the taxpayer can reduce their taxable base by the amount of the distributed dividends. However, the Bill establishes neither a foreign tax credit nor an active income exemption, which may lead to multiple taxations and thus dramatically decreases the efficiency of the foreign investment structures traditionally used.
In practice, if profits are calculated under the rules of Chapter 25 of the Tax Code, it will be a fairly burdensome, time-consuming and costly exercise since Russian tax base formation rules often differ from those in foreign jurisdictions and this will double the work of collecting and formalising accounting documents as well as calculating relevant tax liabilities under the Russian tax rules.
In addition, a taxpayer has to submit to its competent local tax authority a notice of any direct or indirect interests over 1% held in any CFC.
If these requirements are not met, taxpayers risk having to pay significant fines, namely the Bill provides for:
Click here to view table.
By envisaging such fines, the Ministry of Finance clearly aims to encourage CFCs to repatriate their profits and pay taxes in Russia.
Indeed, based on the current provisions of the Bill, it will be economically advantageous for Russian tax residents to repatriate profits from a CFC in the form of dividends taxed at the rate of 9% in Russia, rather than accumulate undistributed profits abroad that may be taxed at 20% (plus penalties).
Recognition of foreign companies as Russian tax residents based on the place of management being in Russia
The Bill provides for certain innovations in determining the tax residence of legal entities. In particular, foreign companies will be recognised as tax residents of Russia if at least one of the following criteria is met:
- meetings of the Board of Directors are held in Russia;
- top management is usually carried out from Russia;
- chief (senior) officers of the entity pursue their activities in Russia;
- accounting records are maintained in Russia; or
- the company’s archives are kept in Russia.
But, here again, one of the weaknesses of the Bill lies in the fact that it does not specify detailed conditions or guidance to apply (for instance, it is unclear whether holding a single meeting of the Board of Directors in Russia would suffice to deem a company to be a Russian tax resident).
In any event, based on the Bill’s current wording, there is strong risk that foreign companies with little (or no) substance in their country of incorporation and partially or entirely managed from Russia will be recognised as Russian tax residents, and will therefore be required to comply with Russian tax laws.
Taxation of income from the sale of participations in companies whose assets mainly consist of real property (“property-rich companies”)
According to current tax legislation, income from the sale of a participation in a Russian property-rich company by a foreign company without a permanent establishment in Russia is a Russian-sourced income.
The current version of the Bill extends this rule to the sale of shares in companies whose assets consist not only directly, but also indirectly, of real property.
Interestingly, the Bill defines neither the indirect real-property ownership concept, nor mechanics for the payment of taxes upon the disposal of shares between two foreign entities with no permanent establishment in Russia.
Impact on business and next steps
Despite the fact that the Ministry of Finance built on foreign legislations and practices to prepare the Bill, in its current state, the Bill contains numerous ambiguities and uncertainties. These will be a source of conflicts in its interpretation and practical implementation, which may significantly affect cross-border structures commonly used for investments in Russia and indirectly deteriorate the investment climate.
As the list of territories which are to be regarded as providing preferential tax treatment under the Bill has not yet been prepared, it is difficult to assess how the Bill will impact existing tax optimisation structures. However, one can anticipate that many existing foreign holding companies will need to be reorganised.
Practically, it makes sense to start analysing existing holding structures to see if they may fall under CFC rules and consider where relevant possible changes of jurisdiction in the ownership chain may need to be made, as well as reviewing corporate governance and management rules to strengthen foreign management control and, more generally, the substance of the foreign element in the holding structures.
The Bill has been put up for public discussions and, therefore, it may be subject to further amendments when it emerges from parliamentary process. We will keep you informed in due course regarding any further developments on this matter.