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CFC Russia IFA December 2014

  1. 1. 24© 17th December 2014 SPECIAL REPORT TAXATION By Roustam Vakhitov Attention should first be drawn to several important matters: 1. Controlled foreign companies. 2. Beneficial ownership. 3. Tax residence determination by the company’s management place. 4. Taxation of real estate transactions. 5. Criminal liability for the use of offshore companies. It should be also noted that these amendments should be considered within the context of the international developments. 1. Controlled foreign companies Trusts and funds: General provisions of the Tax Code have been amended to define the concept of an international structure without legal personality. It is a structure which can carry out activities aimed at deriving income for the benefit of shareholders (members, trustees or other persons), or other beneficiaries. The mentioned activities should not necessarily be of business or commercial nature, therefore trusts and similar structures receiving dividends and other income which can be used for the benefit or in the interest of “trustees or other persons” are clearly covered by the definition of the structure subject to CFC legislation. Consequently, as we have expected, multilevel, discretionary trusts and other sophisticated structures cannot be an effective way of mitigating the impact of CFC legislation. At the same time such structures unnecessarily complicate the control over property and increase the risks of losing thereof. Moreover, the threshold for Russian beneficiary to disclosure participation in the case of a foreign legal entity if 10% if Russian residents control 50% of such foreign company and 25% in other cases. It is worth noting that there is no threshold in respect of the unincorporated structures (trusts). Although the law contains a number of provisions which appear to allow an effective use of such structures in certain cases, in general, trusts and similar structures should not be considered as a strategically successful solution. Companies: Public companies which were to be excluded from the scope of CFC regulations during discussions on earlier stage of drafting the law are not given any exemptions in the final text of the law. The following companies shall not be regarded as CFCs: • Banks and insurance companies operating in countries which conduct effective information exchange with Russian Federation; • Structures of eurobonds and similar SPVs; • Companies participating in the Production Sharing Agreements; • Companies registered in the countries of the Eurasian Economic Union (Russia, Kazakhstan, Belarus, Armenia; possibility of joining by Kyrgyzstan and Tajikistan). • Qualifying companies with at least 80% of ‘active’ income. It should be noted that many types of income, e.g. leasing, management, consulting fees etc., are defined as ‘passive’ for this purpose. Among all the countries listed above, only Kazakhstan provides with tested and efficient system of participation exemption for inbound and outbound dividends (under certain conditions), and possibly the country’s companies can be used for intermediate placement of dividends, sourced from covered by Russian CFC taxation companies. However, Kazakhstan has its own CFC legislation; therefore using Kazakhstan will not solve the issue of tax deferral regarding funds, sourced from offshore countries. Information disclosure In case of direct or indirect control of the trust or fund, and 10% (25%) in respect of a foreign company, the entity must submit a notification to the tax authorities by the 1st April 2015 in respect of control existing as of the 1st January 2015. If the control occurs after this date, the notification shall be submitted within a month after such control arisen. On taxation of controlled foreign companies and other anti-offshore measures in Russia The amendments to the tax code on controlled foreign companies (CFC) and other anti-offshore measures are one of the most fundamental game-changers over the few decades in respect of taxation of the international structures and the fight against tax evasion in Russia. ROUSTAM VAKHITOV provides an analysis of the new legislation. continued...
  2. 2. 25© 17th December 2014 SPECIAL REPORT It should be noted, that most likely this information will be compared with the data on control for the purpose of transfer pricing, therefore reports on transfer pricing and CFC must be in line with each other. Tax payments Under certain conditions, the main of which are: 1) The amount of profit of CFC is RUB50 million (US$872,609) in 2015, RUB30 million (US$523,566) in 2016 and RUB10 million (US$174,522) as of 2017. 2) Any degree of control over the trust/ fund; participation in a foreign company more than 25% or 10%, if Russian residents control not less than 50% in total. 3) The taxation of foreign profits of CFC not more than 75% of comparable Russian tax (effectively 15% in general and 9.75% for dividends). The profit of a foreign company shall be subject to taxation as a Russian company at the rate of 20% or individual tax at the rate of 13%. Obviously, the threshold for CFC taxation is much higher, than the threshold for disclosure of participation, therefore quite often reported entities will not be subject to effective taxation. Upon receipt of dividends from the Russian company with tax paid in Russia at a minimum rate of 5% (the lowest rate of tax on dividends at source under the Russian tax treaties), the effective amount of the surcharge to be paid, which qualifies the foreign company into the category of exempt from CFC taxation, will constitute 4.75% for the dividends. This amount of tax in many cases can be easily reached through the provision of any type of services or generating other income by a foreign entity. Therefore, the adverse effects on the level of European holdings with Russian subsidiaries are not likely to arise. However, the problems will occur in the structures, in which the classic offshore territories operate as profit centers. 2. Bene icial ownership The law defines the concept of beneficial owner of income. Russian beneficial owner test shall be applied only in cases when such test is established by the relevant international double tax treaty. The key test evaluates the effective right to use and (or) dispose the income. The functions and risks incurred by beneficial owner are also taken into account. If a person exercises limited powers and performs just an intermediary function without incurring other risks and functions, he/she will not be regarded as a beneficial owner. Therefore such a person will have no right to use the benefits of international tax treaties. A person is also not considered as a beneficial owner, if he/she transmits the full amount of income or its part to third parties. In the context of international double tax treaty application the withholding agent “has a right” to request a confirmation of the status of a beneficial owner. This, in practice, is likely to result in the duty of such withholding agent to collect proof on status of income’s recipient as a beneficial owner thereof. On the one hand, the test of beneficial owner is present in almost all Russian tax treaties in respect of dividends, and often in the case of interest and royalties. At the same time, the introduction of definition of this term in national legislation, as in case of Ukraine as of 2011, has resulted a sharp increase in litigation on this issue. It would be reasonable to expect similar scenario to develop in Russia. 3. Tax residence determination by the company’s place of management The introduction of this measure has been discussed for a long time. Its implementation will also be an effective way of recognizing the offshore and other non-residential companies as Russian taxpayers in case if actual management of such companies shall be made from Russia. In particular, similar provision is implemented in Belarusian practice by conducting interrogation of employees, including top managers, within the tax and administrative investigations. If it becomes clear that the actual management over the offshore company is undertaken by Belarusian individuals/ beneficiaries, the appropriate additional charge shall be made. Accordingly, transfer of powers for independent decision-making to the foreign company and refusal from direct management instructions by the Russian resident company/individual shall be a solution to the above-mentioned issue. 4. Taxation of real estate transactions The changes of Article 309 of the Tax Code of Russia concern the companies whose income from share/equity sales shall be taxable. In particular, the above- mentioned will apply not only to the Russian companies the assets of which for more than 50% consist of Russian real estate, but to any companies the assets of which directly or indirectly for more than 50 % consist of Russian real estate. This shall prevent the possibility of the Russian real estate to be effectively sold via sale of foreign companies. It should be noted that the appropriate changes were made to the Russian double tax treaties with Cyprus, Luxembourg and Switzerland. Accordingly, the Russian rules’ changes will not breach any of the most actively applied double tax treaties, except for the double tax treaty with the Netherlands prohibiting such continued... Continued The Russian rules’ changes will not breach any of the most actively applied double tax treaties, except for the double tax treaty with the Netherlands prohibiting such taxation
  3. 3. 26© 17th December 2014 SPECIAL REPORT taxation. This treaty will be most likely renegotiated anyway. Although an effective mechanism for application of the new rules is not established, in similar cases (taxation of subsoil users) in Kazakhstan an effective liability for the tax payment is borne by the buyer, while the property being sold also serves as a security. It is possible that the Russian legislator will adapt a similar approach. 5. Criminal liability for the use of offshore companies The draft law 599584-6, adopted by the Russian Parliament in the first reading on the 21st November 2014, provides for an introduction of special criminal liability for tax and customs duties evasion by the company through the “concealment or distortion of information” on controlled foreign companies and transfer pricing. The proposed changes stipulate a fine ranging from RUB200-500 thousand (US$3,490-8,726), a fine in the amount of income received by the convicted person for a period up to three years, as well as imprisonment of up to six years with deprivation of the right to occupy certain positions or to engage in certain activities for a term up to three years. In other words, if the tax avoidance involves the CFC and information is not fully disclosed, the penalties for tax evasion in particularly large amounts will be applied to situations of tax evasion in cases of underpayment of 10% of taxes and duties or RUB6 million (US$104,713). RUB6 million is currently around EUR84,000. This is the amount of unpaid tax in the distribution of, for example, dividends in the amount of EUR1 million (US$1.24 million) through a transit Cyprus-controlled company to an offshore. The tax rate on dividends in this case shall 5% instead of 15%, which should be used if a Cyprus company is not the beneficial owner of the dividends. This means that the threshold for criminal liability is actually quite low. At the same time, the sanctions are not applicable if the information on CFC and transfer pricing is fully disclosed. The purpose of the changes proposed is, obviously, to encourage the disclosure of information on CFC. However, it is unclear what the concept of “concealment or distortion” covers. 6. The changes within the context of the provisions of foreign legislation European legislation, including the legislation of Cyprus, envisages severe liability for money-laundering operations, which cover both the criminally related transactions and the funds received as a result of such transactions. The amount of unpaid taxes in Russia might be considered as such ‘bad’ funds. As a result of application of CFC provisions the amount of funds subject to taxation in Russia will significantly increase. Potentially, the failure to pay taxes on the CFC funds may lead to the liability of foreign companies’ directors according to the local anti-money laundering legislation. Special attention must be paid to these aspects of the Russian tax and criminal law application. The expected joining of Russia to the G20 initiative on automatic exchange of information with more than 50 members of the Multilateral Convention of OECD and the Council of Europe Convention on mutual assistance in administrative matters will give the Russian tax authorities access to information, including a large number of the offshore jurisdictions, as well as will give an opportunity to verify the correctness of the information provided in respect of CFC reporting. Concluding our analysis, we should note that only the most important of the introduced changes were highlighted. Recent jurisprudence also delivers number of adverse decisions in tax cases against such companies as Mail.Ru, Oriflame and Freshfields Bruckhaus Deringer. These developments will affect a large number of Russian and non- Russian companies. Roustam Vakhitov is a partner at International Tax Associates. He can be contacted at Continued As a result of application of CFC provisions the amount of funds subject to taxation in Russia will signi icantly increase