The so-called "deoffshoring" draft law1 (the “Draft Law”) was finally submitted to the Russian Parliament on 22 October 2014 after months of heated discussions between state bodies and the business community.
Implications for taxpayers
The proposed rules dramatically change the tax planning landscape for Russian residents and are aimed at the taxation of undistributed income held offshore and to encourage the return of a part of the capital back to Russia.
The Draft Law introduces a substantial new tax burden on Russian individuals and legal entities that use various international holding, financing, or licensing structures that can be recognized as controlled foreign companies (CFCs). Besides eliminating the Russian tax deferral effect and increasing the tax burden, the new rules would result in significant compliance costs for maintaining foreign structures and increasing their local substance, making notifications and tax filings, calculating and reporting CFC profits, etc.
What the law says
The Draft Law introduces: (1) a controlled foreign companies (CFC) tax regime, (2) Russian tax residency rules for foreign companies based on an effective management and control test, (3) the beneficial ownership concept, and (4) rules on taxation of indirect sale of Russian real property. A summary of key provisions of the Draft Law is given below.
1. Taxation of the Income of Controlled Foreign Companies
Controlled Foreign Companies (CFC)
A CFC is a foreign company (or unincorporated structure) that is controlled by Russian individuals or legal entities or where they own, directly or indirectly (through other Russian or foreign companies), more than 10% of the shares, subject to the exemptions outlined below. Controlled foreign “structures” that are not legal entities, e.g., funds and partnerships, that may engage in business activities on behalf of their partners/beneficiaries are also treated as CFCs. The new rules could also cover certain types of trusts and other popular wealth management tools.
The major exemptions from CFC status include:
- Effective tax rate. Companies established in jurisdictions that have concluded tax treaties with Russia and exchange tax information, whose effective tax rate is 3/4 or higher of the weighted average Russian profits tax rate (composed of 20% standard rate and 9% rate for dividends based on the structure of CFC income);
- Active income companies. Companies established in tax treaty jurisdictions exchanging tax information with no more than 20% of income being passive income. "Passive income" is broadly defined to include dividends, interest, royalties, capital gains, leases, certain services, etc.;
- Licensed banks, insurance companies (but not their subsidiaries), certain other types of companies.
Foreign companies in corporate and private structures may need to be carefully checked to see whether they could rely on any of the exemptions.
CFC Income Attributable to Russian Taxpayers
Russian taxpayers that are controlling persons are required to report a pro rata share of the CFC income in their tax declarations by the end of the year following the year for which the CFC prepared its financial statement (i.e., the first reporting campaign would be for 2016).
CFC income is subject to ordinary tax rates in Russia: 13% for individuals; 20% for legal entities. Consequently, the accumulation of income in offshore companies may become less efficient compared to regular dividend distributions taxed at a lower 9% rate (although there are plans to increase the dividend tax rate up to 13%), which needs to be factored into the analysis of existing structures.
CFC income is determined according to audited financial statements if the CFC is subject to mandatory audit under applicable domestic rules (e.g., for Cypriot companies), otherwise the tax base is determined under the Russian tax rules i.e., Chapter 25 (for typical offshores). CFC income is reduced by the amount of interim and annual dividends distributed by a CFC and related to the period of the financial statement. CFC profit below a minimum threshold (50 million rubles in 2015) is not taxed in Russia.
Tax Incentive for "Bringing" Business to Russia
The Draft Law grants a special tax exemption allowing the liquidation of CFCs free from taxes in Russia. Income received by Russian companies on liquidation of a CFC is tax exempt until January 1, 2017. There are special rules on accounting for assets received on such CFC liquidations. There are no corresponding tax exemptions for Russian individuals.
Notifications on Participation in Foreign Companies (CFCs)
Russian taxpayers are required to file separate notifications with the Russian tax authorities on (1) owning more than 10% of the shares in foreign companies and (2) participation in CFCs:
- Notification on owning shares in foreign companies: must be filed within one month of the acquisition date or by 1 April 2015 for existing shareholdings.
- Notification on participation in CFCs: due by 20 March of the year following the year for which the CFC's income is included in the tax base of the controlling person (i.e., the first notification will be due by 20 March 2017).
Liability for Non-Compliance
The Draft Law provides an exemption from tax penalties arising in connection with tax underpayments on CFC income for 2015-2017. There is an exemption from criminal liability for 2015-2017 provided all tax amounts (including tax assessed and late payment interest) are paid to the budget.
Starting from the 2018 tax period, Russian controlling persons would be subject to a tax penalty in the amount of 20% of the tax underpayment on CFC income.
Failure to file a notification on owning shares in foreign companies or a notification on participation in CFCs is subject to penalties of 50,000 rubles (approximately USD 1,250) and 100,000 rubles (approximately USD 2,500), respectively, for each company.
2. Russian Tax Residency of Foreign Companies
Foreign companies may be deemed Russian tax residents (subject to taxation in Russia on worldwide income) if any one of the following criteria is met: (1) the majority of board of directors (or similar body) meetings in a calendar year take place in Russia; (2) regular effective management of the day-to-day activities under the competence of the executive bodies is performed in Russia, or (3) the executive bodies take decisions in Russia.
In addition, the following secondary criteria are introduced: (1) accounting and management accounting is performed in Russia, (2) document (records) management is performed in Russia, or (3) operational HR management is performed from Russia.
There is an exemption for companies with commercial activities carried out by local qualified personal and using assets in a state which has a tax treaty with Russia, which is intended to focus the attention of the Russian tax authorities on aggressive use of "paper" offshore companies.
The adoption of these rules may create significant risks for foreign companies that do not have solid local substance e.g., an actual office or functioning decision-making bodies in the state of their registration, and where they are actually managed by beneficiaries from Russia.
3. Beneficial Ownership Concept
The Draft Law introduces the concept of a beneficial owner, which seems to be more onerous than the accepted OECD interpretation. Withholding tax exemptions or reduced tax rates under tax treaties concluded with Russia are only available to beneficial owners of income (exercising functions and risks with respect to such income and determining its "economic destiny") and should not be provided to foreign companies having limited authority to dispose of income and exercising intermediary functions. Russian tax agents are encouraged to obtain beneficial owner status confirmations from recipients. This is likely to result in more uncertainty and tax risks for many cross-border payments. Tax
4. Taxation of Indirect Sale of Russian Real Property
The current version of the Russian Tax Code treats capital gains on the sale of shares in a Russian company by a foreign company without a Russian permanent establishment as being Russian source if more than 50% of the assets of the Russian company are real property located in Russia. The Draft Law extends this rule to include capital gains on the sale of shares in a company (either Russian or foreign) if it has assets directly or indirectly consisting of real property in Russia.
The Draft Law introduces a new requirement for foreign companies (and unincorporated "structures") holding real property in Russia to disclose direct and indirect owners (full ownership chain including individual beneficiaries) along with filing property tax returns.
Actions to consider
The new rules call for immediate attention and actions for most international structures of Russian individuals and companies as the Draft Law is likely to be passed in an expedited process and will apply as of 1 January 2015 leaving little time to prepare.
In preparation for the new rules, the following actions may be suggested:
- review the existing group structure and effective tax rates in relevant jurisdictions to identify all foreign companies/structures that may be caught by the CFC rules;
- analyze potential restructuring opportunities to maintain efficiency under the CFC rules, including reorganization, streamlining of dividends prior to 2015, and eliminating redundant foreign companies. The optimal modifications need to be carefully tailored depending on the existing structures;
- optimize new reporting obligations and consider financing and cash-flow structure to finance additional tax liabilities in Russia (e.g., taxes on CFC profits);
- identify foreign companies that may have insufficient substance and may be recognized as Russian tax residents. Redesign internal management process to avoid Russian tax risks;
- identify the beneficial ownership risks in the existing holding, financing and licensing structures and consider protective measures or restructuring;
- review real property holding structures and consider modifications on exit (sale) strategies in light of the new Russian withholding tax rules.