New Definition of the Actual Recipient (“Beneficial Owner”) of Income

 

The 27 May draft includes a separate definition of Actual Recipient (or “Beneficial Owner”; hereafter only the term “Actual Recipient” will be used) in Article 7 of the RF Tax Code.  Article 7 also establishes that the provisions of double tax treaties override the provisions of the RF Tax Code in the case of a conflict. The new CFC provisions (discussed below) which include a new definition of a “controlling person” are to be located in separate articles of the RF Tax Code.  Therefore, the definitions of “Actual Recipient” ” and “controlling person” are entirely separate concepts.

Pursuant to the proposed language for Item 2 of Article 7 of the Tax Code, the Actual Recipient of income is the person who, through direct or indirect ownership in other organizations or through other means, has the right to own, use or dispose of such income. The Actual Recipient also includes a person for whose benefit another person has the right to use and/or dispose of the income.

In determining the Actual Recipient of income, the functions and risks assumed by a person are to be taken into account (as in the 19 May draft).

The 27 May draft also provides scenarios in which the immediate recipient of income should not be recognized as the Actual Recipient of the income. For example, a person should not be recognized as the Actual Recipient of income if the person: has limited authority to dispose of such income; exercises only the functions of an intermediary with respect to such income; does not perform any other functions or assume any risks with respect to such income; and directly or indirectly distributes such income (in full or in part) to another person that would not itself have the right to apply the preferential provisions of a double tax treaty if the income had been distributed directly to such person. 

These provisions of the 27 May draft are also consistent in large part with the MinFin position expressed in Letter No. 03-00-PZ/16236 dated 9 April 2014 (the “MinFin Letter”).

The inclusion of the definition of “Actual Recipient” in the Tax Code will provide a stronger legal basis for the Russian tax authorities to challenge taxpayers’ use of the beneficial tax provisions of double tax treaties in respect of passive income (dividends, interest and royalties).  Such potential challenges will increase the tax risks associated with the use of so-called back-to-back structures in which income is transferred offshore through conduit companies registered in jurisdictions having favorable double tax treaties with Russia.

We recommend undertaking a detailed review of the dividends, interest and royalty payments within a group structure to identify any foreign company that potentially will not be treated as the Actual Recipient of an item of income under the 27 May draft and the MinFin Letter. 

 

New Approach to Trusts under the Proposed CFC Rules

 

Under the 27 May draft, the CFC Rules will also apply to trusts.  Previously, it was not clear whether trust structures would be affected by the new law. 

In addition, Russian tax residents (organizations and individuals) that are the beneficiaries of a trust will be required to file notifications to that effect with the Russian tax authorities.

 

Jurisdictions for Treatment as a CFC

 

In an early draft of the new law, companies registered in jurisdictions contained in a “black” list to be published by MinFin were to be treated as CFCs.  A later draft specifically excluded from CFC status any company registered in a jurisdiction with a relatively unfavorable tax regime included in a “white” list to be published by MinFin. The 27 May draft modifies the “white list” approach as discussed below. 

In the 27 May draft, a CFC does not include a company registered in any of the following countries:

1.     A member country of the Eurasian Economic Union (Belarus and Kazakhstan);

2.     A country (territory) that actually exchanges tax information with the Russian Federation, and where the overall effective tax rate on the income (profits) (ordinary income and dividends) of a given company exceeds 75% of the Russian tax rate of 20% (i.e., where the effective tax rate is higher than 15%). The list of countries which have agreed to exchange tax information and in practice are doing so (a kind of “white list”) must be approved by the RF Federal Tax Service.

Consequently, the RF Ministry of Finance finally rejected the idea of using the predetermined “black lists”/”white lists”.  Often income earned by a foreign holding/financing/trading/IP holding company is taxed at a very low tax rate (or exempt from tax) in a foreign jurisdiction.  The overall effective tax rate of such a company is likely to be 15% or less with the result that such a company could be recognized as a CFC regardless of the jurisdiction of incorporation.

In addition, a CFC does not include any of the following entities:

• A foreign company whose shares are listed on a stock exchange included in a list to approved by the RF Central Bank and also a foreign company owned directly or indirectly through such a listed company;
• A foreign non-profit or other organization that does not distribute profits (income) to shareholders (participants, founders) under applicable law. However, unlike the 19 May draft, under the 27 May draft a CFC can include a subsidiary of a non-profit organization.

 

New Rules as to When to Include CFC Income

 

Under the 19 May draft, the profits of a CFC should be included in the Russian corporate profits tax base in the taxable period (year) in which the income is earned by the CFC. The 27 May draft changes that rule to include the CFC profits on 31 December of the calendar year following the tax period (i.e. calendar year) in which falls the end of the period for which financial statements are prepared in accordance with the law of the jurisdiction in which such CFC was formed.  

Consequently, the current version of the draft law accounts for differences in the tax (reporting) periods of foreign and Russian companies. This also potentially gives the Russian taxpayer time to distribute a dividend after the end of the financial year in which the CFC income was earned.  

 

New Tax Residency Rules for Foreign Companies

 

Under the 19 May draft, a foreign company was treated as a Russian tax resident if at least one of the criteria listed in the draft was met, while the 27 May draft does not specify how many criteria must  be met before a foreign company is treated as a Russian tax resident.  This change suggests that all of the criteria should be considered rather than there being a technical “one bad fact and the taxpayer loses” approach. Under the 27 May draft, the place of effective management of a foreign company is treated as in Russia if the following criteria (again, all considered together) are met:

• the meetings of the board of directors (or other management body of the organization) are held in Russia;
• the steering management of the company is usually conducted from Russia;
• the top management of the company carry out their duties in respect of the company in Russia.  

The 27 May draft contains an updated list of additional criteria to take into account in determining whether a company should be treated as a Russian tax resident if the above criteria are fulfilled with respect to more than one country (i.e., the following are additional tie-breaking rules):

• the company's statutory or management accounting is performed in Russia;
• the company’s documents are generated and processed in Russia;
• formal legal decisions (orders) and other internal regulations in respect of the company’s activities are issued in Russia;
• the recruitment of employees and HR management is performed in Russia.

 

Expansion of the “Thin Capitalization Rules” to “Sister” Finance Companies

 

Currently, the provisions of Item 2 of Article 269 of the RF Tax Code limiting the deductibility of interest for corporate tax purposes (the so-called “thin capitalization rules”) only apply to cases where a loan is received by a Russian company from a foreign company that owns directly or indirectly more than 20% of its charter capital (the rules also apply to a loan from a Russian company that is an affiliate of this foreign company or where a loan is guaranteed by such a foreign or Russian entity). 

As a result, based on a literal reading of this provision, the “thin capitalization rules” do not apply to the case where a loan is provided by a foreign company that is an affiliate, but not a direct or indirect owner, of the Russian borrower, such as a “sister” company.

The omission of such a “sister” company from application of the “thin capitalization rules” has until recently been exploited by taxpayers to avoid application of the rules by using a “sister” company to issue debt to a Russian related company. However, some recent court decisions, including decisions of the RF Supreme Arbitration Court, have already extended the application of the “thin capitalization rules” to certain “sister” company loans.

The 27 May draft introduces amendments to Item 2, Article 269 of the RF Tax Code under which a loan is also treated as a controlled debt if the loan is provided by a foreign lender that is a related party of the Russian borrower.  A related party includes interalia: a company that owns directly or indirectly more than 25% of the capital of another company; and a company that owns directly or indirectly more than 25% of the capital of two companies (in which case all three of the companies are considered to be related). 

As a result, under the 27 May draft, the “thin capitalization rules” would also apply to a loan from a foreign “sister” company.

We will continue to keep you informed as to the status of the 27 May draft and any other legislative developments with respect to deoffshorisation.

If you have any questions, please do not hesitate to contact us.

Best regards,

 

International Tax Group

Tax and Legal Department

KPMG in Russia and the CIS