De-offshorization law enters into force from 1 January 2015
De-offshorization law enters into force from 1 Ja...
On 24 November 2014 the President of the Russian Federation signed Federal Law No. 376-FZ “On the Introduction of Amendments to Part One and Part Two of the Tax Code of the Russian Federation (Regarding the Taxation of the Profits of Controlled Foreign Companies and the Income of Foreign Organizations)”, better known as the “De-Offshorization” Law ( the “Law”).
The full text of the Law is available by clicking on the link.
In accordance with article 4 of the Law, it will enter into force on 1 January 2015.
Below is an overview of the main provisions of the Law with a focus on the key problem areas that taxpayers should consider when doing business in this new tax framework.
Rules on the Taxation of Controlled Foreign Corporations (“CFC”)
The rules for the taxation of the profits of a CFC include the following key elements:
- Definition of a CFC: a foreign organization (not a tax resident of the Russian Federation) or foreign structure that does not involve the establishment of a formal legal entity (fund, partnership, trust, other form of collective investment vehicle and/or trust management).
- Definition of a Controlling Person:
· Until 1 January 2016, a Russian tax resident (company or individual) that owns directly or indirectly more than 50% of the capital of a CFC;
· After 1 January 2016, a Russian tax resident (company or individual) that owns directly or indirectly more than 25% (or more than 10%, if the equity interests of all persons who are Russian tax residents exceed 50%) of the capital of the CFC.
The equity interest of an individual includes the equity interests of the individual’s spouse and minor children.
Unlike previous versions of the draft Law, “control” over a foreign company (or a structure that does not involve the establishment of a formal legal entity) is a special criterion, whereas the main criterion for recognizing a CFC is the ownership of an equity interest (even if there is no actual control by a controlling person).
- The profits of a legal entity or structure that would otherwise be treated as a CFC are exempt in the following instances:
− The CFC is a non-profit organization that does not distribute profits in accordance with the local legislation under which the organization was founded;
− The CFC is a tax resident of a country which has concluded a double tax treaty (DTT) with Russia and which exchanges tax information , provided (1) the effective tax rate (taking into account withholding tax) is no less than 75% of the weighted average Russian profits tax rate, or (2) the portion of the CFC’s passive income is no more than 20% of all income;
− Other instances: (1) The foreign organization is in an member state of the Eurasian Economic Union; (2) The operators of coastal shelf projects; (3) Participation in PSA projects, and other concession agreements; (4) Banks, insurance companies; (5) Foreign structures that do not involve the establishment of a legal entity (in certain limited cases).
Previous versions of the draft Law had stipulated terms and conditions under which a foreign company should not be recognized as a CFC. The adopted Law follows a different conceptual approach – any foreign organization/structure that meets certain specific conditions (the equity interest of the controlling person, the existence of control) is recognized as a CFC. However, the profits of a CFC are exempted from taxation in a number of cases (Clause 7 of Article 25). At the same time, in order for the CFC to be eligible for exemption from taxation on its profits, the person controlling the CFC is required to submit certain supporting documents.
A number of the aforementioned conditions allowing the exemptions for a CFC’s profits require that a country where the CFC is domiciled exchanges the tax information with Russia (in addition to having concluded a double tax treaty). The list of countries that do not provide for the exchange of tax information will be approved in due course by the Russian Federal Tax Service. At present, the underlying criteria for the compilation of this list are unclear and the date of its publication remains unknown, which could represent significant uncertainty for Russian taxpayers adopting various measures for preparation for new rules.
- Definition of CFC profits: The profit of a CFC is decreased by the amount of dividends (including interim dividends) paid by a CFC from this profit. This income of a CFC is attributed pro-rata to a profits tax base of controlling person. Such CFC profit is recognized for tax purposes on the 31st of December of the year following the year of the tax period on which the end of the financial year falls, i.e. the 12 month period for which financial statements are prepared as per the law of a country where CFC is domiciled (if such law does not require preparation and submission of financial statements, then also on the 31st of December of the year following the year of the tax period on which the end of the financial year falls).
- Calculation of CFC profits: The profits of a CFC domiciled in a country which has a double tax treaty with the Russian Federation should be calculated on the basis of financial statements subject to a statutory audit in accordance with the domestic law applicable to the CFC, taking into account certain special adjustments and special procedures for carrying forward losses. In all other cases, the calculation should be performed in accordance with Chapter 25 of the RF Tax Code.
One of the criteria for the calculation of the profits of the CFC on the basis of its financial statements is the statutory audit of such financial statements in accordance with the domestic law under which the CFC was formed. In a number of foreign countries, a statutory audit is only required for public companies or companies with a certain level of revenues, assets or personnel. Thus, in respect of foreign companies (recognized as CFCs) that are not subject to an audit requirement, there is a risk that it will be necessary to recalculate profits in accordance with Chapter 25 of the RF Tax Code, which would increase materially the administrative burden on taxpayers. Therefore, as Cypriot companies are subject to a statutory audit in accordance with Cypriot legislation, such companies might be in a more favorable position compared to other foreign companies registered, for example, in the Netherlands or Austria, since a recalculation of profits according to Chapter 25 will not be required for a Cypriot company.
- De minimis Criteria: the profits of the CFC are not chargeable to tax if the profits for the tax period do not exceed RUB 10 million (phased introduction: for 2015 – do not exceed RUB 50 million, for 2016 – do not exceed RUB 30 million).
- Notification as to Shareholdings in CFCs and other foreign organizations: Russian tax residents are required to provide notification as to shareholdings in CFCs, and also on their participation in foreign organizations/structures (in the case of such organizations – if they hold an equity interest of more than 10%).
The process for preparing and filing notifications was set out in more detail in KPMG’s publication dated 6 November 2014.
- Penalties for Violation of the CFC rules: (1) Non-payment of Russian tax as a result of the non-inclusion of CFC profits in the tax base – 20% fine of the amount of the unpaid tax, but no less than RUB 100,000 (starting from 2018), exemption until 2018 from criminal liability for the non-payment of CFC profits tax if the losses are repaid to the Russian budget; (2) failure to submit a notification as to shareholdings in CFCs (inter alia, the submission of incorrect data) – fine of RUB 100,000 for each CFC; (3) failure to submit a notification as to participation in a foreign organization (inter alia, submission of incorrect data) – fine of RUB 50,000 for each foreign organization.
The introduction of the CFC rules in Russian tax legislation increases the administrative and tax burden on Russian taxpayers. The following measures are recommended as possible options to reduce the adverse impact of the CFC rules:
− Performing a detailed review of the financial statements and assets/liabilities of potential CFC for the purpose of identifying circumstances, which could result in “paper” profits of the CFC (for example, interest on intra-group loans, in particular in a situation where the corresponding interest expense does not reduce the tax base in Russia);
− Restructuring of foreign sub-groups of Russian groups for the purpose of eliminating “redundant” CFCs, i.e., the simplification and consolidation of companies.
Tax residency of organizations
The law establishes rules for recognizing the tax residency of a foreign organization in Russia in instances where the place of effective management is Russia (Article 2462 of the RF Tax Code).
Russia will be recognized as the place of effective management if at least one of the following terms and conditions (main criteria) is met:
1. Most of the meetings of the board of directors (or another analogous body of the organization, other than the executive body) are convened in Russia (more meetings are convened in Russia than in another country).
2. The executive (strategic/operating management) function is performed on a regular basis from Russia (the performance of activities in Russia in a scope that is significantly less than in any other country is not recognized as the regular performance of such activities).
Consequently, the Law allows for certain activities of the executive function (strategic/operating management) of the foreign company to be performed in Russia (periodically, irregularly), but at the same time does not establish clear criteria to be used to compare the scope and volume of such activities with those performed in another jurisdiction. Consequently, the tax authorities will interpret how to apply these criteria, which creates a risk for taxpayers.
3. The steering management of a foreign company is performed primarily in Russia by the senior management of the company.
While not specifically defined, the term steering management is understood to mean the adoption of decisions or other actions in respect of issues pertaining to the day-to-day operations of the organization, which fall within the competence of the executive management function.
If the main criteria 1 and 2 are not met, or only one of them is met, the tax residency of the foreign company may be determined on the basis of additional criteria: (1) whether the company’s financial accounting or management accounting is performed in Russia; (2) whether the company’s documents are generated and processed in Russia; (3) whether the HR function at an operational level is performed in Russia.
In this respect the Law contains a number of ambiguities. For example, it is unclear whether the additional criteria should be applied if one of the two main criteria is met, which in itself is a basis for shifting of tax residency to the Russian Federation. It is also unclear why the third main criterion is not mentioned in this clause of the Law. It is quite possible that the Law will be revised in this section in future.
Exemption for strategic management performed by the shareholder
The Law also establishes a list of activities, the performance of which should not per se lead to treatment of a foreign company as tax resident in Russia:
− The preparation and/or adoption of decisions on issues within the competence of the general meeting of shareholders (participants) of the foreign company;
− Preparations for holding the board of directors’ meetings of the foreign company;
− The exercise in the Russian Federation of individual functions within the framework of the planning and control of the activities of the foreign company, in particular, strategic planning, budgeting, the preparation and compilation of the consolidated financial statements, internal audit and internal control, the adoption (approval) of standards, methodologies and/or policies that apply to the entire group.
This provision makes it possible to retain the centralization of strategic management (the functions of the controlling shareholder) over foreign subsidiaries in the Russian Federation without the risk of shifting the tax residency of these companies to Russia.
Exemption for active companies
The Law establishes that effective management of a foreign company is deemed to be performed outside Russia if its commercial activities are conducted using its own qualified staff and assets in a country with which Russia has concluded a double tax treaty.
In order to be eligible for this exemption, supporting documentation confirming compliance with the aforementioned terms and conditions is required. However, there are no clarifications as to the specific personnel that should be considered qualified for the purpose of performing such commercial activities, and also regarding the composition of the assets of the foreign company. The list of the required supporting documentation is also not determined. It is highly likely that this issue will be resolved on a case-by-case basis, which leaves the risk of disputes with the tax authorities.
Other special exemptions
The following foreign companies may only be recognized as Russian tax residents on a voluntary basis (if there is a double tax treaty with the country where they are domiciled and such companies have separate divisions in the Russian Federation):
− The foreign company is recognized as a tax resident in the jurisdiction where it is domiciled pursuant to the double tax treaty;
− The main business of the company is participation in PSAs, concession agreements and other agreements with the government of the corresponding jurisdiction;
− They are operators of new offshore fields or direct shareholders therein;
− They are holding companies if the Russian controlling person owns (directly or indirectly) at least 50% of the charter capital for no less than 365 calendar days, and also provided that the following terms and conditions are met:
1. The company’s assets consist of more than 50% of investments in foreign subsidiaries, which in turn:
· Engage primarily in active businesses (passive income accounts for no more than 20% of total income);
· Are recognized as tax residents in a country with which Russia has concluded a double tax treaty and there is an exchange of tax information with Russia.
2. The holding company has equity interests of at least 50% in the charter capital of these subsidiaries.
3. The holding company has no operating income (profits) or the income (profits) consist of more than 95% income in the form of dividends.
The current wording for the holding company exemption, in particular, the lack of a direct reference to the possibility of indirect participation in subsidiaries, and also the income criterion (95% - dividends) could significantly restrict the range of companies that could apply for this exemption. In addition, in order to be eligible for this exemption, it is necessary to constantly monitor the compliance of the holding company with the aforementioned criteria (in particular, the tests as to the “active nature” of the activities of the subsidiaries and the composition of income of the holding company). However, this exemption could be applied potentially to the foreign sub-holding companies of Russian groups used to own foreign operating companies.
Companies in the process of liquidation (if the liquidation procedure is completed before 1 January 2017) and also the issuers of specific types of bonds (subject to compliance with the required terms and conditions) are not recognized as Russian tax residents.
Person having the actual right to income (beneficial owner of the income)
The Law introduces the concept of a person having the actual right to income (in international practice – “beneficial owner”), for the purposes of applying a double tax treaty.
A person having the actual right to income is the person that:
– By virtue of participation (direct and/or indirect) in the company, or
– Control over the company, or
– By virtue of other circumstances,
has the right to independently use and/or dispose of this income, or the person in whose interests another person has the power to dispose of such income.
When determining the status of a company as a beneficial owner, the functions and risks of the company should be considered.
Previously, the RF Ministry of Finance formulated similar criteria for recognizing a company as the beneficial owner (Letter No. 03-00-RZ/16236 dated 9 April 2014) and also a list of documents required to determine the beneficial owner of dividends (Letter No. 03-08-05/36499 dated 24 July 2014).
From a literal interpretation of the proposed provisions it is unclear whether a national definition of beneficial owner should apply if the double tax treaty does not separately require a taxpayer to be the “beneficial owner” to obtain the benefits of a given article of a double tax treaty (for example, in respect of interest pursuant to the double tax treaty between the Russian Federation and Luxembourg or between the Russian Federation and Cyprus).
The Law also confirms the application of the DTT of the jurisdiction in which the beneficial owner of income is resident if such person is not the direct recipient of the income (e.g., dividends, interest, royalties) (the so-called “look through approach”). At the same time, in respect of dividends the Law stipulates that Russian profits tax rates may be applied (0%, 13%, if the beneficial owner is a Russian tax resident (legal entity or individual) (subject to compliance with specific terms and conditions).
In order to mitigate possible risks that the application of a DTT could be challenged, it is recommended that taxpayers:
- Perform a critical analysis of existing foreign holding, finance and licensing structures for the purpose of identifying companies – which are recipients of passive Russian source income, and in respect of which there is a risk that they might not be recognized as the beneficial owners of such income.
- Develop alternative structures that ensure the required level of tax efficiency.
- Prepare a detailed plan for the transition to the target structures and ensure their timely implementation.
Taxation of the sale of shares (equity interests) of a foreign organization more than 50% of the assets of which consist directly or indirectly of immovable property in Russia
Pursuant to the Law, foreign companies earning income from the sale of the shares (equity interests) of Russian or foreign organizations, more than 50% of whose assets consist directly or indirectly of immovable property in Russia, with the exception of securities trading on an organized securities market in accordance with clause 9 of article 280 of the RF Tax Code, will be taxed at the 20% rate in the Russian Federation.
The Law introduces an obligation of foreign companies (and structures that do not involve the establishment of a legal entity) owning real estate to submit information to the Russian tax authorities on their participants (in the case of structures that do not involve the establishment of a legal entity – on their founders, beneficiaries and managers). The failure to submit (late submission of) such information will result in a fine in the amount of 100% of the total property tax due on such real estate.
At present the mechanism for enforcing such new rules remains unclear. For example, in order to apply the norms on the taxation of income from the sale of the shares of a company, more than 50% of whose assets consist of immovable property in Russia, within the framework of a transaction between two foreign organizations not registered in the Russian Federation, there needs to be an obligation for the foreign company-seller or buyer, accordingly, to pay or to withhold the taxes.
In order to mitigate the possible tax consequences in Russia as a result of this provision, the ownership of immovable property in Russia should be restructured so as to rely on favorable double tax treaties, which exempt income from taxation in Russia.
If you have any questions, please do not hesitate to contact us.
Should you have any questions, please do not hesitate to contact us.
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