Russia: the first hardline draft law on CFC rules & corporate tax residency is out

28.04.2014

The Legal500

By Artem Toropov, senior associate in international tax, Goltsblat BLP
On March 18, following the Russian President's address on "de-offshorisation" of the Russian economy and only a few months of drafting, the Russian Finance Ministry published the first draft law on anti-avoidance rules that has already sent ripples through the Russian business community.

While the draft law may be amended following discussions with corporates and readings in the Duma, the law, along with other laws on "de-offshorisation", is expected to be passed before 15 June 2014 and come into effect on 1 January 2015. Now is the time for Russian corporates and Russian HNWIs to urgently assess the risk of their existing international structures - both corporate and private - and identify the best strategies going forward.

CFC rules to fight cash accumulation offshore

From 1 January 2015, any individual or company that is a Russian tax resident will be required to notify the Russian tax authorities about their controlled foreign companies (CFCs) and pay Russian tax on undistributed profits of such CFCs unless such profits are upstreamed in the form of dividends to Russian controlling persons and their Russian bank accounts.

The rules create a fiscal incentive to bring cash back onshore to Russian banks and benefit from the lower dividend tax rates or domestic participation exemption. This, however, may in practice be accompanied with stricter exchange controls for those taxpayers who want to play "ping-pong" and repatriate profits back to non-Russian bank accounts, which may prove to be a not so easy task in the future.

The rules will apply to all Russian-controlled vehicles registered in countries on the Finance Ministry's ‘blacklist'.

  • If there is "control" in relation to the vehicle, or at least 1%direct or indirect equity participation, a notification has to be submitted together with financial statements of a CFC and auditor's report, if necessary under local law. The rules can also be interpreted such that notification should be filed in relation to any, even non-blacklisted entity, in relation to which a Russian resident individual or company exercises "control" (i.e., ability to exercise decisive influence over profit distribution) or in which it has more than 10% direct or indirect equity participation.
  • If there is "control" or over 10% direct or indirect equity participation, Russian tax (20% corporate profit tax for companies or 13% personal income tax for individuals) has to be annually paid on the full amount of undistributed profits in proportion to the participation share in a CFC. In other words, tax will now have to be paid even if this profit is not distributed directly to the Russian taxpayer and is not paid into a Russian bank account. In case of non-compliance, punitive measures apply (tax effectively doubles for corporates and more than doubles for individuals, and there can be grounds for criminal liability).

Yet the biggest unknown at the moment is how far the blacklist will extend for CFC purposes. According to the public statements made by the Finance Ministry, the blacklist for CFC purposes may be extended to cover not only the most popular offshore destinations but also tax treaty countries including Cyprus and some of other popular European jurisdictions. Of course, many of such jurisdictions are now actively working in order not to fall under the new Russian CFC rules and not to lose Russian businesses that have set up structures in such jurisdictions.

The CFC rules are drafted in a "catch-all" style to apply not only to personal and corporate holding companies, but also other "structures" - in particular, foundations, partnerships, companies and other forms of collective investment -that operate in the interests of their stakeholders or beneficiaries, thus cutting out the easiest ways to avoid CFC rules by using various creative vehicles from blacklisted jurisdictions.

Corporate tax residency rules to combat "letterbox" companies

An important pillar of the new anti-avoidance rules that should combat non-Russian structures with no substance is the corporate tax residency concept based on the "place of effective management & control" test. Currently, Russian tax authorities can go after non-Russian companies only based on the poorly-enforced permanent establishment concept. Under the new rules, non-Russian companies, including the ones not from currently non-blacklisted jurisdictions (e.g., Cyprus, the Netherlands, Luxembourg, Switzerland, etc.) can be deemed as Russian tax residents if they are effectively managed and controlled from Russia.

The draft law provides for a number of broad self-sufficient tests for deeming a non-Russian company a Russian tax resident, including storage of archives of a non-Russian company in Russia. Should such fact be discovered, including in the course of domestic investigation, payment of the CFC tax by a controlling person does not legally exempt the company itself from the Russian corporate tax obligation - double taxation is possible in such case until overpaid CFC tax is refunded, this being effectively a penalty for using structures with no substance. It cannot be excluded that offshore companies that are voluntarily disclosed under the CFC rules would be first in line for attack under the "management & control" test.

The law, on the other hand, provides an "easy" way out for taxpayers who wish to comply - non-Russian companies will be able to deem themselves as Russian tax residents and, as such, will not fall under the CFC rules.

What will taxpayers do?

There will no doubt be many taxpayers who would still play it the old way and simply rely on non-disclosure while carelessly waiting for the taxman to knock on the doorstep. It is fair to assume that some taxpayers, particularly large corporates and UHNWIs will transfer their structures to "white" jurisdictions and create proper substance there. Some others will keep the existing structures and reluctantly declare these as Russian tax residents (thus keeping the right to use English law and flexibility of non-Russian corporate law mechanisms), while others will be forced to restructure in favour of a set of Russian "full onshore" corporate vehicles, which may require a lengthy transition process and lots of work. But there will also be many compliant HNIWIs and UHNWIs who may opt to change their tax residency in order not to fall under the new restrictions - a possibility that not all large corporates have at hand.

The Russian government needs to be careful not to throw the baby out with the bathwater. Both domestic and international businesses need a genuine incentive and some form of a "carrot", not only a fiscal "stick", to keep profits in Russian banks and their legal entities onshore with attractive domestic corporate law regume or trust the Russian courts for dispute resolution and asset protection purposes. If not handled correctly, the new anti-avoidance legislation may create instability and dent business confidence and result in a decline in investment and tax revenues, and actually an increase in capital flight rather than a reduction.

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