By Olga Boltenko, Evgenia Martin, and Ayshat Gaydarova
On the 18th of March the Russian Ministry of Finance published a draft law on anti-offshore measures. Following wide public discussion, a revised draft was published on the 27th of May. The Draft introduces four key concepts:
• Controlled foreign companies (CFC) rules;
• Russian tax residence for foreign companies, based on tests of management and control;
• Concepts of ‘factual right to income’ and ‘beneficial owner’ in the context of applying international tax treaties; and
• New rules on taxation of the indirect disposal of Russian real estate.
Implementation of the CFC rules will provide the Russian tax authorities with legal mechanisms for taxing international corporate and private structures controlled by Russian individuals and corporate tax residents (irrespective their nationality). Implementation of other concepts will have an impact on any structure with any degree of Russian involvement, irrespective of the tax residency of its beneficiaries.
It is strongly recommended that all Russian tax residents, and anyone with a business connection with Russia, should review and revise their corporate and private international arrangements as a matter of urgency.
Below we examine the key provisions of the Draft, which it is expected will be implemented in 2014 and start applying in 2015.
1. CFC rules
The approach to the definition of a CFC is rather strict in comparison with existing international practice and includes foreign organizations and structures.
A ‘foreign organization’ will be considered as a CFC if it meets all three of the following conditions:
• It is not a Russian tax resident; and
• It is controlled by Russian resident legal entities or individuals; and
• Shares of the legal entity are not listed on a stock exchange approved by the Russian Central Bank.
However, a foreign legal entity is exempted from the CFC rules if it is:
• Listed on a stock exchange approved by the Russian Central Bank;
• A non-commercial organization or an organization which does not distribute profits to participants in accordance with its governing law;
• An organization with permanent residence in the Eurasian Economic Union, (currently Russia, Belorussia and Kazakhstan);
• An organization with permanent residence in a state which exchanges tax information with Russia AND its effective tax rate exceeds 15%.
The proposed approach to calculating the effective tax rate of a foreign organization applies to its gross income (profits); therefore for foreign companies receiving primarily tax exempt passive income, the effective tax rate would most likely be lower than 15%. As a result, a significant section of current international structures using holding companies which are registered in non-blacklisted jurisdictions will become CFCs.
A ‘foreign structure’ will become a CFC if:
• It is not a legal entity and is set up in accordance with the law of a foreign state; and
• Its activity is aimed at profit generation for the benefit of its participants or beneficiaries; and
• It is controlled by Russian tax residents.
The definition of ‘structures’ falling into the CFC scope includes any structures meeting CFC conditions, irrespective of their governing laws.
The definition of a ‘controlling person’ includes Russian tax resident organizations or individuals controlling a foreign organization/structure, either individually or jointly. ‘Control’ over a foreign organization is in principal defined as exerting determining influence or the ability to exert determining influence on the decisions of such an entity related to the distribution of its profits after tax. However, the Draft also provides a default control definition where Russian residents own over 10% (directly or indirectly), together with spouses and minor children (and other persons).
Control over a foreign structure is in principal defined as exerting determining influence or the ability to exert determining influence on the decisions of a person managing the assets of this structure in relation to the distribution of the profits to beneficiaries.
Effectively, controlling persons, both corporate entities and private individuals, will be taxed in Russia on undistributed income of controlled companies and structures.
Importantly, Russian tax resident individuals and companies have reporting obligations which are much wider than CFCs. They must report their participation in CFCs and participation in foreign organizations. The latter covers:
• Foreign organizations which are tax residents in foreign jurisdictions or where the tax residency is unknown – if the direct or indirect participation of a Russian tax resident is 1% and above;
• Where Russian tax residents have the factual right to receive income (profits) from a foreign structure.
In effect, the reporting obligations cover almost every involvement of Russian tax residents in foreign companies and structures.
2. Management and control test
Foreign legal entities which are managed in Russia can be considered liable for corporate income tax based on ‘key’ or ‘additional criteria’.
The key criteria are:
• Board of directors or other management meetings are usually held in Russia;
• Principal management is usually undertaken from Russia;
• Key officers perform their activities from Russia.
If the key criteria are met in several jurisdictions, additional criteria can determine tax residence:
• Statutory and management accounting is performed in Russia;
• Documentation management is performed in Russia;
• Orders or other administrative documents are issued in Russia; or
• Recruitment and personnel management is performed in Russia.
As a result, foreign companies can be treated as Russian tax residents for corporate income tax, with corresponding obligations of registration, tax reporting and payment.
The management and control of international groups will become the determining factor in identifying their Russian tax liability. This risk covers any structure with a Russian element, irrespective of the tax residence of its beneficiaries.
3. Implementation of ‘factual right on income’ and ‘beneficial owner’ concepts
The new Draft provides new tax concepts to be used in relation to the application of double tax treaties.
‘Factual recipient of income’ (‘beneficial owner’) is defined as a person who directly, or through direct or indirect participation in other organizations, or in any other way, simultaneously has rights of ownership, use or disposal of income; or a person acting on behalf of another person who has the right to use or dispose of the income. Further, it is stated that for purposes of determining a beneficial owner, the functions and risk profile of a foreign person claiming double tax treaty benefits should also be considered.
At the same time, the new Draft law provides that a foreign organisation has a ‘factual right to income’ if it is an actual beneficiary of the income, i.e. receives actual benefits from distributed income and has a right to dispose of this income.
The proposed wording is subject to interpretation and increases the practical risk of the Russian tax authorities rejecting the application of double tax treaties to existing and new arrangements. This is an important change which could impact all international tax structures in the future.
4. Indirect disposal of Russian real estate
The Russian Government intends to stop the current use of tax efficient offshore sale and purchase transactions for Russian real estate owned via foreign holding structures.
The current law provides that the income of foreign legal entities is subject to Russian tax at source if they sell shares in Russian companies with assets comprised of more than 50% Russian real estate. Therefore, disposal of shares in a non-Russian company holding Russian real estate will not trigger Russian tax.
The Draft proposes to treat the disposal of such shares (either in a foreign or in a Russian company) as Russian income. A number of Russian double tax treaties allow for this to be taxed in Russia. However, the actual mechanism for the implementation of the new rules has not yet been proposed.
Olga Boltenko, partner, firstname.lastname@example.org, +41 44 488 8809
Olga’s practice focuses on Russian, UK and international tax matters for wealthy entrepreneurs from Russia/CIS, with an emphasis on tax efficient cross-border financing structures, advising companies and their shareholders on the tax efficient structuring of their international operations.
Evgenia Martin, senior Russian tax specialist, email@example.com, +41 44 488 8806
Evgenia deals primarily with international and Russian corporate tax issues, focusing on international tax structuring for Russian and CIS clients, including development and implementation of corporate structures, trading, financing and IP operations.
Ayshat Gaydarova, associate, firstname.lastname@example.org, +41 44 488 8808
Ayshat is a Russian qualified tax lawyer and a UK qualified tax technician focusing on international cross border complex tax and succession issues. She has particular expertise in UK pre-immigration tax planning, structuring inbound UK real estate investments and international family wealth and governance planning.