Russian tax residents had to report for the first time on controlled foreign companies (“CFCs”) by 20 March 2017, as we reported in a previous Alert, and declare the profits of CFCs by 2 May 2017. In light of inquiries by taxpayers on their participation in CFCs, the taxation of profits and income of controlling persons, the Ministry of Finance of the Russian Federation issued Letters* No. 03-12-11/2/7395 of 10 February 2017 and No. 03-12-11/2/9197 of 17 February 2017.
These letters deal with a wide range of issues that are often encountered by controlling persons in the context of the application of the CFC rules. The most significant explanations of the Ministry of Finance are considered below.
General issues concerning controlled structures that are not separate legal entities and participation in the CFC
Recognition of a foreign person as a foreign organisation or structure that is not a separate legal entity
When determining the status of a foreign person, a taxpayer is entitled to be guided by the available information about the legal basis of the foreign person’s activity in the legislation of the foreign state where such a person was formed. At the same time, the Ministry of Finance recommends that if a foreign person is not an individual and it is impossible to determine whether or not it is a foreign organisation or structure that is not a separate legal entity, for the purposes of taxation, such a person should be considered as a foreign organisation.
Recognition of a foreign person as a legal entity for which no participation in capital is provided
Whether or not the person in question is a legal entity for which no participation in capital is provided will be determined on the basis of all the characteristics of the powers of a participant (contributor) it receives in each specific case, taking into account the applicable provisions of legislation, statutory and/or other legal documents.
Participation in a CFC through a partnership
A partnership is not recognised as a CFC’s controlling person. The members of the partnership will be controlling persons of the CFC if the relationship between the partnership and the foreign organisation (foreign structure that is not a separate legal entity) meets the criteria for recognising a person as a controlling person. The members of the partnership are responsible for implementing the CFC rules, while the share of participation in the CFC is determined proportionally to the share of the taxpayer in the profits of the partnership in accordance with the partnership agreement.
Participation in a foreign organisation through a Russian public company and a CFC
A company participating directly or indirectly in a foreign organisation through one or several public companies that are resident in the Russian Federation is not recognised as a controlling person.
At the same time, it should be noted that the participation of the latter in a CFC can also be structured through a chain of organisations that are not public companies.
In this case, the share of the taxpayer for the purposes of recognising it as a controlling person is determined by the total amount of the participatory interests through which the public company’s participation in the foreign organisation is structured.
Similarly, if a controlling person that is resident in the Russian Federation participates indirectly (through another controlling foreign legal entity) in the CFC, information about such a company should be reflected when the resident of the Russian Federation declares its profits. In its turn, the profit of this CFC is not reflected in the tax return of the foreign controlling entity.
The application of the CFC rules to foreign structures that are not separate legal entities
Exemption from taxation for a CFC, in the cases established by Art. 25.13-1 of the Russian Tax Code* (the “Tax Code”), extends to foreign structures that are not separate legal entities.
The Ministry of Finance recommends that taxpayers take into account that control over the relevant structure can be achieved not only directly but also through another structure that is not a separate legal entity, over whose distribution of profit the taxpayer exerts a determining influence.
Exempting the CFC’s profit from taxation
Exempting the CFC’s profit by the effective tax rate criterion
When calculating the effective tax rate of the CFC, taxes and direct taxes (including those withheld at the source) are taken into account, whereas indirect taxes are not taken into account. The amount of tax payable is confirmed by a tax return certified by the tax authority of the relevant foreign state or by notification of the amount of the calculated tax.
Particulars of recognising income from current activities in order to confirm the status of foreign persons as active foreign companies
Clarifications on this issue relate to income in the form of differences in exchange rates, income from brokerage, depository commissions, income from receivables and various other types of income.
Despite the fact that various ways of presenting information about exchange rate differences may be used in financial statements, the amounts of exchange rate difference arising from the sale and purchase of currency recognised in the CFC’s profit and loss account for the purpose of revaluing its assets and liabilities in accordance with the standards the foreign organisation uses for its financial reporting should not be included when calculating the income.
According to the Ministry of Finance, the income in the form of brokerage and depository commissions can be classified as active, unless in essence they are similar to passive income.
Income from the assignment of receivables can be recognised as active if the proceeds of the contract under which the receivables were assigned qualify as income from active operations.
Other questions on calculating the profit of the CFC
The use of certain terminology for the purposes of taxation by the CFC
In the context of the CFC rules, the terms used have the meaning provided for by the relevant financial reporting standards. If such terms are not defined by the financial reporting standards used by the CFC, they have the meaning established by the Tax Code.
For example, when calculating the profit of the CFC, the tax base is reduced by dividends paid by it, which may be recognised as distribution of profit by the CFC after tax or any similar indicator in accordance with International Financial Reporting Standards (“IFRS”).
The term “profit before tax” is the amount of the corresponding indicator in the unconsolidated profit and loss account prepared in accordance with IFRS and defined as the difference between total income and expenses of a foreign organisation for a fiscal year, not including other indicators or elements of other aggregate income.
From the periods relating to 2015, the profit of the CFC is taken into account in the taxable base of the controlling person. If the fiscal year of the CFC does not coincide with the calendar year and the corresponding reporting is provided, for example, for the period from 1 October to 30 September of each year, the profit of the fiscal year from 1 October 2014 to 30 September 2015 is not taken into account when determining the profit of the controlling person. In its turn, the profit of the fiscal year from 1 October 2015 to 30 September 2016 is taken into account in the tax period beginning on 1 January 2017.
The profit of the CFC is taken into account in the tax base of the controlling person proportionately to the share of its participation.
If the controlling entity has lost its status because of the sale or liquidation of the CFC before the date on which its share in such a foreign organisation (profit distribution) is determined, the profit of the CFC is not included in the taxable base of the taxpayer.
The amount of tax paid by the CFC in the country of residence is to be deducted from taxes due by the controlling person in proportion to the share of its participation. Satisfaction of a tax obligation in a foreign country can be confirmed by submitting to the tax body (i) a declaration certified by the competent authority of a foreign state; (ii) notifications from the tax authority about the amount of the calculated tax; or (iii) payment documents or written confirmation from the tax agent that the tax has been paid or similar information.
If the controlling person ceases to participate in the CFC because it is restructured (in the form of an acquisition), this alone is not a basis for excluding the profits of the restructured company when determining profit from the successor CFC.
Accounting for losses of the CFC
Accounting for losses for the periods preceding 1 January 2015
The tax base of a CFC may be reduced by the amount of the loss reflected in its financial statements as of the first day of the fiscal year in 2015. It should be borne in mind that such a loss is included in the taxable base of the controlling person, provided that this period was reflected in the notice of participation in the foreign organisation that it submitted.
The legislation does not contain specific provisions for the particulars of calculating the profits (losses) of the CFC for the fiscal years preceding 1 January 2015.
The Ministry of Finance points out that the taxpayer is entitled to reduce the CFC’s tax base by the amount of losses suffered by this company, but these losses do not reduce the profit of the CFC when applying the threshold value established by Sub-art. 7 of Art. 25.15 of the Tax Code* necessary for determining the tax base for the corresponding tax.
In addition, the established threshold value is applied without taking into account any decrease by the amount of dividends paid by the CFC.
Documentary evidence of the right to apply exemptions and the amount of profit or loss of the CFC
Due to the fact that the legislation does not provide for an exhaustive list of documents that can confirm compliance with the conditions for exemption from taxation for the CFC, the Ministry of Finance indicates that each set of documents confirming compliance with such conditions will be determined individually. In general, the set may include:
(i) data from the CFC’s accounting and analytical records; (ii) information from tax and financial statements;
(iii) certificates of incorporation and residency; (iv) extracts from the CFC’s charter; (v) various certificates; and
(vi) other documents usually used in accordance with the business practices of the state where the CFC is located.
In the opinion of the Ministry of Finance, when a taxpayer declares exemption from profit taxation in connection with a CFC, it is not necessary to present documents confirming the profit of the CFC together with the income tax return, as the profit of such companies is not included as part of the tax base of the controlling person.
The profit of the CFC must be confirmed by financial statements and an audit report that meets the requirements of the Tax Code. If, in accordance with the internal rules of the CFC, its financial statements are not subject to financial audit, the definition of the profit and loss of such a controlled company is based on financial statements that are audited in accordance with international auditing standards.
Despite the fact that these letters bring some certainty with respect to controversial issues arising when applying the CFC rules, uncertainties remain in certain respects:
- The procedure for classifying certain types of income as active or passive remains unclear.
- The procedure for determining the result of transactions with securities and other financial instruments included in the profit of the controlling person remains ambiguous.
- It is not clear whether the CFC rules apply to consolidated groups of taxpayers.
Taxpayers in Russia who are controlling persons and do not wish to be faced with the difficulties arising from the new rules can, as part of the tax amnesty and until 31 December 2017 inclusive, opt for the voluntary liquidation of their CFCs, to avoid being held liable for failure to pay taxes and fees.
* In Russian