Is this the end of Russia as a source of business for international financial centers?
On Nov. 24, 2014, Russian President Vladimir Putin signed Federal Law No. 376-FZ, with the unwieldy title: Concerning the Introduction of Amendments to Parts One and Two of the Tax Code of the Russian Federation (Regarding the Taxation of the Profit of Controlled Foreign Companies and the Income of Foreign Organizations).
This was the culmination of a near two-year campaign by President Putin to “de-offshorize” the Russian economy, an initiative which was first announced in his December 2012 State of the Nation address. It is likely that the new regime will enter into force on Jan. 1, 2015, and will apply to (Controlled Foreign Companies) CFCs’ profits beginning with periods starting in 2015.
Facing a shrinking tax base, and the fact that many major Russian corporations are actually registered offshore in places as diverse as Luxembourg and Cyprus in Europe and the British Virgin Islands in the western Caribbean, President Putin set out in that speech a drive to bring Russian money back home in order to be invested locally and pay taxes. In his 2012 address, he declared that the level of offshore investments and ownership was so high that nine out of ten transactions made by Russian companies were made under foreign, not Russian law.
Having seen very little legislative action to solve the problem after that initial announcement, President Putin returned to the same theme in his December 2013 State of the Nation Address noting that: “I’ll say it directly, the results [of de-offshorization] haven’t been very visible…The income of companies registered in offshore jurisdictions and belonging to Russian owners… should be subject to our tax laws and their taxes should be paid into the Russian budget. We need to think of a system to seize this money.”
At another point during his speech, President Putin stated bluntly: “You’re welcome to use offshores – but the money needs to be [sent] here.” He expressed the view that around US$111 billion of Russian money passed through offshore companies in 2012, equivalent to one-fifth of the nation’s exports. Russia persistently suffers from capital flight with billions leaving the economy annually including US$56.8 billion in 2012.
Within days of President Putin’s speech, several major Russian companies said they would leave their offshore assets and move their business activities back to home soil. Metal producers RusAl and Metalloinvest, telecoms giant MTS, electricity generator RusHydro and vehicle manufacturer Kamaz announced in mid December 2013 that they would either stop using their offshore entities or relocate to Russia altogether.
By way of background, Russian companies traditionally have held money abroad not only to take advantage of lighter tax regimes, but to avoid some of the risks of doing business in Russia, which experts say include an unpredictable business environment, non-independent courts, and weak law enforcement. Firms also were unhappy due to fundamental flaws in the rule of law, widespread corruption in both the state sector and private enterprise and now increasing western sanctions as a result of Russia’s worsening relations with the Ukraine and its annexation of Crimea.
The new CFC rules and their impact on IFCs’ business opportunities
The changes in the law basically create a CFC regime in Russia which did not exist before, but which is common in most other countries such as the United States. IFCs have had to contend with these regimes for years and thus, it is fair to say that this new regime alone should not prevent Russians from using structures domiciled therein.
Under the new law, a Russian resident is to be recognized as a controlling person of a CFC if his participation interest is at least 50 percent during 2015. Starting in 2016, the resident is a controlling person at 10 percent, if his participation interest together with those of other Russian residents constitutes a 50 percent interest in the CFC and 25 percent if it does not.
The new regime provides that certain types of controlled companies are to be exempt from profits tax in Russia. The profits tax or income tax base of controlling persons will not include the profit of active companies (i.e. companies that have more than 80 percent active income). This is somewhat similar to the situation in the U.S. where tax deferral is granted to active income as opposed to passive income.
Also exempted from the new regime are companies registered in a country where the effective tax rate applicable to the CFC is at least 75 percent of the blended tax rate of Russian profits tax and certain types of foreign structures which are not legal entities.
However, the profit will not be tax exempt if the structure has the option of distributing profit under its own private law or foundation documents. Trusts based in IFCs may be useful in this context but specific tax advice should be sought from Russian legal counsel or further information from the Russian Ministry of Finance as to how or if such structures, which are not legal entities, would work under the new regime.
Aluminum producer Rusal’s plant in Krasnoyarsk
Interestingly, banks and insurance companies are exempt under the new rules if they operate in a territory that exchanges information with the Russian Federation. Granted the movement towards tax information exchange agreements and automatic exchange of information, IFCs that are parties to any tax information exchange treaties with the Russian Federation should not be negatively affected by these rules.
Issuers of certain types of Eurobonds, if the interest income on such bonds is at least 90 percent of the issuer’s income, are also exempt as well as companies participating in certain foreign industrial projects, primarily oil and gas.
The effective tax rate to be paid by CFCs is to be compared to the blended rate of profits tax applicable in Russia. The threshold for the effective rate is 75 percent of the blended tax rate calculated for two types of income:
- The CFC’s total profit, minus dividends paid and dividends received by the CFC or zero if the result is negative (which is taxed at a rate of 20 percent); and
- Dividends received by the CFC (which are taxed at a rate of 13 percent).
The profits of CFCs registered in jurisdictions that have a tax treaty with Russia are to be calculated based on the company’s financial statements prepared in accordance with the law of the jurisdiction where it is domiciled (provided that the financial statements are subject to a statutory audit). In all other cases, profits are to be calculated in accordance with the Profits Tax Chapter of the Russian Tax Code.
The new law permits a CFC’s losses to be carried forward indefinitely provided that the controlling entity submits a CFC notification for the period in which losses arose. It also allows individuals and legal entities to offset tax paid on a CFC’s profit under the laws of a foreign country and/or Russia thus avoiding double taxation.
These two provisions are especially beneficial to IFCs which are treaty partners of Russia, and will persuade many who are not already to at least consider entering negotiations with Russia so that their entities are not detrimentally affected by the new regime.
First, during a transitional period, nonpayment or incomplete payment of tax due to failure to include CFCs’ profits in the tax base in 2015 to 2017 will not entail criminal liability, provided that the resulting loss to the Russian budget is compensated in full.
The deadline for notifying the tax cauthorities of participation in a foreign company is one month after the grounds for such notification arise.
Second, the deadline for notification of a CFC is the March 20 of the year following the tax period in which a share profit of a CFC is required to be taken into account for a controlling person.
Consequently, the first deadline for notification of a CFC is March 20, 2016. If grounds for notification of participation in foreign companies have arisen before the new changes enter into force, the tax authorities must be notified by April 1, 2015.
Determination of tax residency by place of residence
If any of the following criteria is met, a company’s place of effective management will be considered to be Russia:
- A relative majority of board meetings (more than in any other country) are held in Russia.
- The company’s executive body or bodies regularly conduct company-related activities in Russia (activities are not regarded as regularly conducted in Russia if they are carried on there to a substantially lesser extent than in another country or countries).
- The company’s chief (executive) officers primarily perform their executive management duties in Russia.
- Several exclusions from tax residency are provided, including, amongst others:
- Foreign companies incorporated in the jurisdictions that have tax treaties with Russia under which the companies are treated as tax resident in the jurisdiction of incorporation.
- Foreign companies whose core activity involves participation in production sharing agreements, concession agreements, license agreements or service agreements on a risk basis or other similar agreements with the government of the corresponding state (territory) or with institutions (state authorities, state companies) authorized by that government.
- Foreign companies that are operators of new offshore hydrocarbon deposits (shelf projects) or direct shareholders (participants) in the operators of such deposits.
- Both the exclusions from tax residency and the situations where Russian tax residency is established show that the key here is for mind and management to be outside of Russia whether through the actual Russian citizens being abroad or the majority of board members of the CFC being non-domiciled in Russia.
- In addition, it is clear that they also favor Russian interests by protecting and promoting the oil and gas industry and where the foreign companies have links with their governments.
In an earlier article, ‘Substance over form: How international financial centers can survive in the age of automatic exchange of information and transparency’, I argued that establishing substance in the jurisdiction where the offshore company is domiciled is the only way to take full advantage of the tax benefits of IFCs while being fully compliant with the tax laws of the domicile of the owners of these companies.
This new law only serves to underscore the validity of this argument. It is clear that once the decision-makers are Russians living in Russia, an offshore company will likely fall within the purview of the new law and thus have to comply with its rules on taxation thus reducing the benefits of using it in the first place as a means of legally reducing its tax burden.
The exclusions also stress the benefits of a treaty with Russia to IFCs and how transparency is key if centres like Anguilla are to continue being used by Russian clients.
Minor provisions of the CFC rules
The new law contains a few provisions that are worthy of note from the perspective of an IFC service provider and it is to these that we turn our attention. The law includes a provision that would exempt income in the form of property transferred to a Russian company without consideration by a shareholder (participant) individual or legal entity that has an equity interest exceeding 50 percent.
Property received from a foreign company must pass an additional test to qualify for exemption under the law: i.e., the foreign company must not be permanently resident in a jurisdiction blacklisted by the Ministry of Finance.
Further, income from sales of shares in companies more than 50 percent of whose assets consist, directly or indirectly, of immovable property in Russia (subject to certain exceptions) is to be taxable for Russian nonresidents and for residents. It should be noted that the mechanism for tax payment is not established in the new law and remains unclear.
Also worth noting is the fact that for the purposes of calculating an entity’s interest in a CFC in order to establish whether it is a controlling person, any interests held via foreign structures that are not legal entities are to be taken into account.
The risk that a CFC’s profits will be subject to double taxation cannot be ruled out if dividends are paid out of retained earnings of prior years. This is because a CFC’s retained earnings are included in the tax base of the Russian controlling person and subject to profits tax or personal income tax in Russia. If dividends are subsequently paid out of this profit, such dividend income will be taxable as well.
What does this mean in practice?
For the Russian clients, the new rules will require them to carefully analyze their current situation and make the necessary adjustments to become compliant. Some critics of President Putin have argued that his “de-offshorization” initiative will be used selectively to punish opponents.
Be that as it may, all persons holding non-Russian companies will need to ensure that they have a strategy in place to ensure that they are compliant. For IFC service providers, the new rules may cause a reduction in the services that they can offer clients. Alternatively, the more thoughtful providers can provide solutions including full company administration so that mind and management is based in the IFC jurisdiction as opposed to within Russia.
There will also be a need for them to perhaps persuade their jurisdictions, if they are not already, to become treaty partners with Russia to take advantage of the exemptions which are clearly set out in the new rules. While at face value the rules may be perceived as being negative, opportunities do exist for both the IFCs and their service providers.
The most basic one is the chance to offer more substance within the geographical confines of the IFC and center administration and control in the IFC itself as opposed to using gimmicks like a trust or the risible general power of attorney with a nominee director.
Encouraging Russians to follow their company and reside in the IFC is the ultimate way of ensuring that the clients are outside of the net of the new CFC rules and jurisdictions like Anguilla are actively seeking to attract clients to come “offshore” and operate their businesses on island.
De-offshorization is the latest attempt by a leading country, Russia in this case, to acquire more revenue by clamping down on aspects of capital flight and tax evasion/avoidance, as it perceives these threats to be. IFCs should not adopt a sky-is-falling approach or imagine that Russians will no longer make use of their structures. It is my view that the new legal framework will serve to spur creative and sound solutions for clients resident in Russia.
The exemptions within the rules provide a clear pathway for IFCs. Yes, the new regime itself will cause some dislocation, but it will lead to more efficient, transparent and compliant tax planning and structuring and thus not have the major detrimental effect on IFCs as some had feared when President Putin launched his initiative back in December 2012.
Several IFCs including Anguilla are signatories to the OECD Multilateral Convention on Mutual Administrative Assistance in Tax Matters and so is Russia, thus these new rules may, subject to what I shall say below, serve to spur business opportunities in these jurisdictions and away from others which are not effective parties to said Convention.
It is worth noting, however, that at the time of writing this article, despite having signed the Convention in 2011, it is still not in force in the Russian Federation. This may mean that the exemption benefits which seem to be mainly afforded to treaty partners may not be realized and readers of this article may wish to investigate this further once the new rules come into effect in 2015 with the Russian Ministry of Finance.
Irrespective, President Putin’s push for de-offshorization is not the end of the world and IFCs need to continue to be nimble and adapt to an increasingly shifting landscape as always.