On 1 January 2015, Federal Law No. 376-FZ on the taxation of controlled foreign companies and other anti-avoidance measures (the “Law”) became effective
The Law introduces to Russian tax legislation the concepts of controlled foreign companies and of beneficial ownership, as well as tax residency criteria for legal entities and a number of other significant amendments.
The amendments introduced are primarily targeted at limiting the use by Russian taxpayers of low-tax jurisdictions in tax optimisation schemes. At the same time, these amendments are expected to influence the activities of foreign SPVs which are in partnership with Russian residents as well.
Compared with the initial version put forward for public discussion, whose description can be found in our previous Alert, the Law shows that state authorities have taken a huge step towards meeting the interests of the business community. Nevertheless, certain issues still remain.
Below are the main sub-topics that will be covered in this Alert; please click on each sub-topic to be taken to the relevant explanation.
- CFC rules
- Definition of Controlled Foreign Corporation (“CFC”)
- Calculation of CFC profits
- Requirements and penalties
- Transitional period and temporary rules
- Beneficial ownership
- Tax residency criteria
- Taxation of income from the sale of a participation interest in “property-rich companies”
- Provision of gratuitous aid
- Impact on business
In March 2014, the Ministry of Finance put forward for public discussion the first draft version of the Law (the “Bill”). It was both quite strict in its wording and it contained a great number of technical ambiguities and uncertainties which the Russian business community claimed to have removed.
After several months of debates and disputes between the Ministry of Finance on the one side and the Russian business and professional community on the other, a revised Bill was finally submitted to the State Duma in October 2014.
The final version signed by the President represents, to a certain extent, a compromise between the business community and the Russian state authorities.
Definition of Controlled Foreign Corporation (“CFC”)
Compared to previous versions of the Bill, the Law expands the scope of CFC rules to all foreign companies and structures that meet the following participation criterion: any foreign company or unincorporated structure (such as trusts, funds, etc.) which has a 25% participation interest owned by Russian tax residents (although the participation threshold is limited to 10% if other Russian residents also participate in the foreign company (or structure), and the total participation of all these Russian residents exceeds 50%) is recognised as a CFC. The increase of this threshold from the 10% stated in a previous version of the Bill, to the 25% provided in the final version of the Law is one of the most significant amendments made by the lawmakers.
At the same time, the lawmakers have also exempted from taxation in Russia the profit of a CFC if the CFC falls under at least one of the following categories:
- non-commercial organisations;
- residents of the Eurasian Union member states;
- foreign entities or structures which reside in the countries that maintain a Double Tax Treaty (a “DTT”) with Russia (excluding countries that do not guarantee the exchange of tax information), when the entities’ or structures’ profit (both in terms of active and passive income) is taxed in the foreign jurisdiction at an effective rate of more than 75% of the weighted average Russian corporate profits tax rate (calculated based on a formula which considers the different types of income of the foreign entity, and taxes each different type of income in the same manner that it would be taxed in Russia (e.g. taxing dividend income at a rate of 9% and business income at the general rate of 20%));
- foreign entities or structures which reside in the countries that maintain a DTT with Russia (excluding the countries that do not guarantee the exchange of tax information with Russia),when the percentage of their passive income does not exceed 20% of the total income earned;
- structures which meet the following criteria:
- the founder must not be entitled to receive any assets from the structure under the structure’s domestic legislation and incorporation documents;
- after the creation of the structure, the founder is no longer entitled to transfer their rights to another person, save for cases of inheritance or universal succession; and
- the founder is not entitled to directly or indirectly receive any profits distributed between the structure’s members.
In addition to the above, some exemptions also apply to CFCs engaged in specific types of business activities (e.g. banks, insurance companies, etc.).
A simple test, available by clicking here, should assist an interested party in determining whether their controlled companies (including SPVs with Russian partners) fall under the new CFC rules. It is important to note, however, that this test does not cover the exemptions applicable to the companies engaged in the specific types of activities briefly mentioned above.
Calculation of CFC profits
If a CFC is located in a jurisdiction which has a DTT with Russia, its profits are to be calculated on the basis of its accounting statements prepared in accordance with the domestic legislation of the CFC. In all other cases, the profits of the CFC are to be calculated in accordance with Chapter 25 of the Russian Tax Code.
The possibility of calculating the CFC’s profits on the basis of its financial accounting statements prepared in accordance with the CFC’s domestic law is one of the key results of the compromise achieved between the business community and the lawmakers. This new rule allows the CFC to avoid the burdensome procedure of profit recalculation under the rules of Russian tax legislation.
The Law states that the CFC must split its income into “passive” and “active” income. Passive income covers dividends, interests, royalties, income from the sale of shares, and income from the provision of consulting, legal, accounting, auditing, engineering, advertising, marketing and other services. All other income is “active” by default.
However, the distinction between active and passive income is performed solely in order to define whether the exemption for companies generating more than 80% of active income (please refer to the section Definition of CFC above) applies. Both active and passive income are then ultimately included in the taxable base of the CFC without any distinction.
Should the profits of a CFC be lower than or equal to RUB 10,000,000, they will be disregarded and will not be included in the taxable base of a controlling person.
The Law also provides for the offset of:
- tax computed in respect of the CFC’s profits in accordance with the legislation of the foreign country and/or Russian legislation, and the tax on profits owed in relation to the Russian permanent establishment of this CFC against
- the amount of tax due on the profits of the CFC in Russia based on the new rules of CFC profit calculation.
Requirements and penalties
The Law provides for two key types of requirements that must be satisfied by Russian taxpayers who participate in CFCs and/or foreign companies: notification requirements and the obligation to pay taxes from the undistributed profits of the CFC.
Russian taxpayers must submit two types of notifications to the tax authorities:
- one which sets out the details of the CFCs controlled by the taxpayer, and which must be submitted on a yearly basis; as well as
- one which sets out the taxpayer’s participation interest in any foreign companies or structures other than CFCs, but only if such an interest exceeds 10%.
The form of the notifications in question has not yet been defined; however, looking at the list of information required under the Law, it is likely that the preparation of the above notifications will constitute a significant administrative burden for the taxpayers involved.
Under the Law, Russian tax residents are also required to include in their taxable income the undistributed profit of their CFCs, unless these CFCs fall within the exempt categories described in the section Definition of CFC above.
If these requirements (the obligation to file the notifications and to pay tax from the CFC’s undistributed profit) are not met, the following fines may be imposed:
Failure to pay (in full or in part) the tax due on the CFC’s profits
20% of the amount of unpaid tax
Failure to submit or improper submission of documentation (such as financial statements and audit reports), or submission of documents containing deliberately false information
Failure to notify of details of the CFC (or submitting a notification
with false information on such details)
Failure to notify of participation in a foreign company (or submitting
a notification with false information on such participation)
Transitional period and temporary rules
The Law sets out a number of temporary rules.
Until 1 January 2016, “control” will be deemed to exist only when the participation interest exceeds 50% of the foreign company’s charter capital (instead of 25%).
Moreover, even if under the above criterion a company or structure is deemed to be a CFC, it will not have to pay Russian profits tax as long as its profits do not exceed:
- RUB 50,000,000 for 2015; and
- RUB 30,000,000 for 2016.
Criminal liability for non-payment of tax will not apply during the period of 2015-2017, but only if the taxpayer compensates any losses borne by the Russian treasury in full.
Finally, the Law also provides several temporary provisions that allow Russian taxpayers to liquidate or reorganise their controlled structures without incurring any adverse tax consequences in Russia.
The Law has codified the concept of beneficial ownership, as previously elaborated by the Ministry of Finance in its official letters (Letter No. 03-08-05 of 15 October 2007 and Letter No. 03-00-Р3/16236 of 9 April 2014).
Accordingly, a person who has full ownership of an income due to their direct or indirect participation in organisations or due to other means is now deemed to be a beneficial owner. The term also covers a person for whose interest another person has the right to use and dispose of the income.
However, there are still no clear criteria to date which define the beneficial owner of an income and, in practice, the beneficial owner should be defined on the basis of a functions and risks analysis.
If, based on this analysis, one can conclude that the beneficial owner of a particular income is a person other than the one actually receiving the income (“a nominal recipient”), the effect would be that any benefits granted under a relevant DTT signed with the nominal recipient’s state of residency would be denied.
The Law states that Russian companies who transfer their income to foreign companies (and who would therefore qualify as tax agents) can now request from their foreign counterparts a document supporting the fact that the foreign company is recognised as the actual recipient of the transferred income (the supporting document would be requested together with the tax residency certificate). It should be noted however, that according to the Law, it is a right, rather than an obligation, of the Russian taxpayer to request the supporting document. Nevertheless, it is assumed that, in practice, Russian tax authorities will be likely to request the relevant supporting document on a regular basis and the absence of such a supporting document will raise some concerns.
It is also important to note that even if the nominal recipient of the income is not recognised as an actual recipient, the actual recipient will not be deprived from the benefits of the applicable DTT as long as they are able to show a relevant tax residency certificate to the Russian tax agent.
Tax residency criteria
Foreign companies may be deemed Russian tax residents under the Law if certain criteria are met.
The Law sets forth detailed criteria for determining tax residency. These can be divided into “key” and “auxiliary” criteria.
According to the Law, the key criteria are as follows:
- the majority of meetings of the board of directors are held in Russia;
- the activities of the executive body are regularly exercised in Russia, and more so than in any other country; and
- the key corporate officials (i.e. the persons in charge of strategic planning, of management and of control of the foreign company) perform their actual daily management activities in Russia.
If one or more of the key criteria (depending on the specifics of each particular case) apply to the company, it will be recognised as a Russian tax resident.
Auxiliary criteria apply by default when it is impossible to recognise a foreign company as a tax resident by using the key criteria above.
The list of auxiliary criteria notably includes the preparation of accounting and financial statements in Russia, as well as operational personnel management in Russia and record-keeping in Russia.
That being said, the Law also lists certain activities which will not be considered sufficient to result in a Russian tax residency status, even if they are carried out in Russia. These include budgeting, preparation of consolidated statements, and adoption of group standards and policies.
The Law also states that, in a number of cases, a Russian tax residency status cannot be forcibly placed on the company. For example, this provision applies to companies that (i) have a permanent place of business in another country that has signed a DTT with Russia and (ii) are deemed under the DTT provisions to be tax resident in this other country.
Taxation of income from the sale of a participation interest in “property-rich companies”
Until the Law became effective on 1 January 2015, it was possible under Russian law to withhold tax at source in Russia on the income derived by a foreign company (with no Russian permanent establishment) from the sale of a direct participation interest in a Russian property-rich company.
The Law has now extended this provision to cover the indirect sale of a participation interest in Russian property-rich companies as well.
This means that, in practice, the sale of a participation interest in a foreign company that in turn participates in a Russian property-rich company should, from now on, give rise to a withholding tax payment at its source in Russia.
Provision of gratuitous aid
The Law specifies a new requirement under which gratuitous aid will not be recognised as taxable income in Russia. The foreign subsidiary providing gratuitous aid must be based in a state other than a low-tax jurisdiction that is on the Russian Ministry of Finance’s black list under Article 284 of the Russian Tax Code. When this requirement is not met, gratuitous aid will be taxed in Russia even if the parent company satisfies the criterion of owning 50% of the participation interest in the subsidiary.
Impact on business
One of the key goals of the Law is to repatriate funds back to Russia. This is to be achieved through the passing of rules that will render the use of aggressive tax optimisation schemes, which channel profits to low-tax jurisdictions, highly unbeneficial tax-wise.
The impact of the new Russian CFC tax regime varies significantly depending on whether the CFCs reside in states which maintain a DTT with Russia or not:
- If the relevant CFC resides in a state which maintains a DTT with Russia, it will benefit from a number of exemptions and incentives and, in particular, it will have the possibility of exempting its income from taxation in Russia.
- If the CFC is incorporated in a low-tax jurisdiction and meets the participation criteria, then it will be taxable by default in Russia, regardless of the type of activity performed.
Based on the above, one can anticipate that the maintenance of business activities in low-tax jurisdictions may eventually become less tax efficient. It is highly likely that this will lead a number of CFC owners to consider reorganising the corporate structure of their businesses. ]
Although the Law will have a primary influence on businesses in low-tax jurisdictions, a number of changes in the activities of SPVs incorporated in European jurisdictions can also be expected.
In particular, Russian partners of foreign SPVs will likely seek a regular distribution of dividends, and they may even try to renegotiate with their foreign partners the possibility of transferring the SPVs to Russia in order to avoid the application of the newly-introduced adverse CFC tax rules.
In addition to the above, Russian taxpayers who hold participation interests in CFCs will also face significant new administrative burdens. Firstly, they are now obliged to notify the tax authorities of their participations in CFCs on a yearly basis, and secondly, they have to furnish proper documentation in support of the correctness of the profits calculations for the CFC.
Finally, while a significant number of the technical ambiguities and uncertainties that were present in previous versions of the Bill have been amended, the wording used in certain parts of the final version of the Law still remains unclear and contradictory.
In particular, the way the Law coincides with the existing legal framework gives rise to a number of questions. For example, where a company which has been incorporated in a foreign jurisdiction is recognised as a Russian tax resident under the new rules, it could create some uncertainties on the application of Russian VAT territoriality rules (e.g. it may create a conflict between the company’s tax residency criterion and its place of incorporation criterion).
In any event, we strongly recommend that parties who hold a relevant participation interest in foreign companies review their existing tax structures in order to determine whether their participation interests may ultimately be caught by the new rules. If this is found to be the case, the parties should undertake appropriate risk-mitigation measures, such as a corporate reorganisation, as soon as possible.
It should also be noted that, based on the information available in Russian business circles, the Law might be subject to further amendments over the course of this year.