20 March 2018
For many years international tax planning for Russian inbound and outbound investments, and wealth planning for Russian resident individuals, was rather straightforward. That was primarily due to relatively simple domestic tax rules and a degree of inexperience amongst the Russian tax and other interested authorities in relation to international tax concepts and practice.
Traditionally, Russian inbound investments were structured as debt financing from offshore locations through companies registered in treaty countries. Interest payments were subject to deduction for Russian corporate income tax and subject to 0-5% Russian withholding tax (against a 20% domestic withholding tax rate). That also worked quite well in practice, as the tax authorities did not carry out a deep analysis of treaty concepts, but followed a rather formal approach. Although the concept of thin capitalization existed in Russian tax law for a long time, the ambiguity of the provision enabled particular planning to mitigate that risk.
However, during the last few years we have seen the development of significant precedents in relation to a number of issues concerning Russia inbound investments, including thin capitalization rules and the beneficial owner concept as the key test for the application of beneficial tax treaty rates. Although the court practice in relation to both issues was contradictory, more and more decisions went in favour of the tax authorities. As a result, the standard approach to Russia inbound investments became quite risky.
It is important to note that a foreign company could not be treated as Russian tax resident. A foreign company was only taxed in Russia if it had a permanent establishment or received passive income from Russian sources. In practice it was difficult for the tax authorities to apply this concept. This is another reason why numerous offshore companies can be found in any international structure with a Russian element.
Moreover, in practice, many Russia-related structures might not have an appropriate level of substance in their holding, trading, financing or licensing structures in their jurisdictions of incorporation. This means that these companies cannot show that the management, control and day-to-day decisions concerning their business activities are taken in the country where such a company is based.
Wealth planning in its traditional sense was not very popular amongst Russians, probably because most of the concepts and instruments of wealth planning were quite complex and unknown in Russia and because 'traditional' planning based on using off-shore jurisdictions was simple and inexpensive.
Implementation of tax anti-offshore rules
Russia has been considering the introduction of anti-offshore measures for several years. In December 2013 the Russian President in his state-of-the-nation address stressed the need for urgent measures to 'deoffshorise' the economy. Finally, the key anti-offshore tax law (the Federal Law N 376-FZ of 24 November 2014) was adopted and came into force on January, 1 2015. The implementation of a number of this law's measures changed the tax scene dramatically and resulted in most of 'traditional'international structures with Russian elements becoming risky or non-compliant. Importantly, the law does not allow simple solutions which allow clients to avoid disclosure or to escape paying tax under the new rules. Below we provide an overview of the key provisions of the anti-offshore tax rules as at September 2015. However, we expect that particular amendments can be implemented.
Russian tax residency based on the management and control test
The new rules have introduced tests to determine foreign companies as Russian residents for corporate tax purposes based on their effective place of management. A foreign company can be treated as Russian tax resident if one of the following conditions is met:
- The activities of a company's management body are regularly performed in Russia; or
- Key executives predominantly perform management activities within Russia.
There are also additional criteria which should be considered, in case the above conditions are met both in Russia and in any other country.
These rules have had a significant impact on corporate groups with Russian interests and have required reassessment and changes to the existing management structures, as well as future ones. It is important that individuals involved in executive and day-to-day management of foreign companies from Russia ensure that their activities do not raise the risk of exposure to Russian tax for the businesses they are acting for. There are of course questions and areas of regulation that are unclear, and the position will most likely be developed in court proceedings.
Concept of ‘factual right on income'
The tax concept of 'factual right on income' was implemented and should be used in relation to the application of double tax treaties. We would stress that many of the 'common' international tax planning structures based on the application of double tax treaties, including debt financing structures noted above, are now under risk and require restructuring. Close attention should be paid to the functions and risk profile of a foreign person claiming double tax treaty benefits.
Practical difficulties can also arise as, in addition to the obligations of Russian tax agents to obtain a tax residence certificate from a foreign organization, the Russian tax agents now also have the right to request confirmation from foreign organisations as to whether they have a ‘factual right to income'. This requirement can be difficult to comply with in practice and it is uncertain what type of documents would suffice as a confirmation of such a right.
Controlled foreign companies rules (CFC rules)
The main purpose of these rules is to set the framework and instruments for the Russian government to clamp down on tax avoidance by Russian taxpayers using international structures and to tighten control over offshore transactions dealing with Russian assets.
Under these rules, Russian resident individuals will be taxed on the undistributed profits of foreign companies and foreign non-corporate structures if they are classified as controlling persons of these entities. Russian residents will be deemed to be controlling persons of a foreign company if they satisfy the minimum participation share requirements or if they set up foreign structures, such as trusts and foundations.
Russian-resident beneficiaries can also be subject to the new CFC reporting rules if they satisfy certain controlling criteria.
Key risks associated with the CFC law concern Russian tax residents and we expect that strategies implemented to circumvent the residency rules will be closely reviewed in the future and may be challenged. The anti-offshore rules imply increased transparency in relation to the ownership of foreign assets by Russian tax residents. The Russian government has accordingly introduced a voluntary disclosure program which aims to ensure a smoother transition from the existing strategies for structuring business and private affairs to the new tax regime. This program is only open until 31 December 2015.
It is clear that international tax and wealth planning for groups with Russian elements or for Russian individuals have undergone significant changes and will be less flexible going forward. In this new environment, individuals are recommended to seek professional tax and legal advice that considers Russian issues in conjunction with international ones. For both Russian clients and international companies and individuals working with Russia, it is important to understand that tax transparency is becoming a reality in Russia. Therefore, appropriate compliance and professional tax planning becomes more important today as ever before.
Where can we help?
- We can help you to understand the new tax legislation and what it means for you and your clients.
- We can review your corporate structures (holding, financing and trading) and propose changes to the structures to ensure their compliance.
- We can recommend appropriate guidelines for your group of companies so that they are managed and controlled in a tax efficient manner.
- We can review your trust and foundation structures and advise you on what needs to be done to comply with the tax anti-offshore legislation or minimize the exposure.
- If you have an international footprint, we can help you to compare your tax liabilities in various jurisdictions and advise on the best tax position going forward.
This article will be forthcoming in Tax Notes International.