Tax Implications of Inbound
Investments into Russia
Boris Bruk,
Of Counsel,
Salans Moscow
24 February 2011
Key questions
 Form of presence: branch vs. subsidiary
 How to finance your activities in Russia
 Repatriation of profits
 Divestment (exit from the project)
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Branch vs. Subsidiary
BRANCH
Benefits:
SUBSIDIARY:
 No thin capitalization rules apply
 No taxation on profits distributable to
 Limited exposure of foreign investor to


the head office
Usually served by specially designated
“advanced” tax inspectors
Sale of foreign companies having real
estate in Russia not subject to capital
gains tax
Drawbacks:
Benefits:

Russian commercial and legal risks
(although limited liability may sometimes
be removed)
Capital contribution of technological
equipment free of customs duties available
(however, no disposal of equipment
allowed)
Drawbacks:
 Accreditation procedure more
 Dividend distributions subject to
expensive
withholding tax (minimum treaty
 No limited liability available
withholding tax – 5%)
 Limited rights to clear the imported
 Additional currency control formalities in
goods at customs
dealing with foreign suppliers or customers
 Additional currency control formalities
for the Russian customers dealing with
branches
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How to finance your activities
 Capital contribution (including share premium)
 Contribution to assets
 Debt financing
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Capital contribution
 Tax free (special exemptions for imported
technological equipment for VAT and customs duties);
VAT exemption limited to the equipment listed by the
Government
 Share premium absorbs losses and provides
additional cushion against negative net assets
position
 BUT the subsidiary may not be able to distribute
charter capital and share premium at will
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Contribution to assets
 Does not trigger increase of charter capital or share premium (treated as
profits for accounting purposes)
 Tax free (provided the contributor has a more than 50% participation in
the receiving Russian entity or the receiving Russian entity owns more
than 50% in the capital of the contributor)
NB! Under latest legislative amendments additional exemption applies
to transfer of assets and proprietory rights by shareholders to
subsidiaries starting from January 1, 2007 aimed at increase of the net
assets of the subsidiary (50% participation is no longer required)
 BUT applies to Russian limited liability companies only
 BUT input VAT recovery and deductibility risks (now remote)
 BUT may be prohibited or may trigger negative tax implications in the
country of the contributor (i.e. Cyprus?)
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Debt financing
 Could be rather flexible as profit repatriation tool (where properly
structured)
 BUT general limitations on interest deductibility (apply on loans from
both Russian and foreign lenders)
-
statutory safe harbor (also default interest rates): 1.8 * CBR refinancing
rate (current CBR rate is 7.75%) for ruble denominated loans; 0.8 * CBR
refinancing rate - foreign currency denominated loans; OR
-
average interest rate on similar loans (same currency, similar
principal amount, similar terms of repayment, similar types of security
etc.) received by the Russian borrower from Russian lenders in the same
quarter +/- 20%
 BUT thin capitalization rules apply to loans from related parties (will
discuss in detail in a minute)
 BUT general deductibility requirements: economic justifiability
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(connection with income generating activities; if the borrower has
enough equity cash – unjustified tax benefit) and proper
documentation
Thin capitalization rules
 Apply where
I.
(A)
debt financing is provided by a foreign legal entity which directly or indirectly owns more than
20% of the Russian entity financed;
OR
(B)
debt financing is provided by a Russian affiliate of such foreign entity;
OR
(C)
debt financing is provided by another person but repayment of the loan is guaranteed or
secured in any other way by such foreign entity or its Russian affiliate (the
"controlled debt“)
AND
II. The controlled debt/equity (equity = net assets + accrued tax liabilities) ratio of the borrower
exceeds 3:1 (12.5:1 – for banks and lease companies) as of the last date of each reporting (tax)
period
 “Excessive” interest generally treated as dividend: non deductible, dividend withholding
tax applies
 RF Ministry of Finance: treaty dividend rate applies to “excessive” interest
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Thin capitalization – inefficient structure
Shareholder
(Cyprus)
Loan
Cyprus
Russia
Russian borrower
9
Thin capitalization – inefficient structure
Shareholder
(Cyprus)
Guarantee
Bank (Cyprus)
Loan
Cyprus
Russia
Russian borrower
10
Thin capitalization – inefficient structure
Shareholder
(Cyprus)
Guarantee
Cyprus
Loan
Russia
Bank (Russia)
Russian borrower
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Thin capitalization – current circumvention
structure
Loan
Shareholder
Financial
Company
Foreign country
Russia
Loan
100%
Operating company
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Thin capitalization – advanced
circumvention structure
Shareholder
Financial
company
holding
loans
Sub-holding
Operating
company
holding
Foreign countries
Russia
Operating
company
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Operating
company
Operating
company
Thin capitalization – fresh view
 Positive court practice developed:
-
interest paid to a German resident lender (Federal Moscow District Arbitration Court, 2005)
interest paid to a Dutch resident lender (Federal North Western District Arbitration Court, 2007)
interest paid to a Finnish resident lender (Federal North Western District Arbitration Court, 2009)
interest paid to a Cyprus resident lender (Federal Moscow District Arbitration Court, 2009 and 2010)
interest paid to a Cyprus and a Hundarian resident lender (Federal Moscow District Arbitration Court, 2010)
Courts denied application of thin capitalization rules:
-
reclassification of interest as dividend income for treaty purposes impossible as the treaties contain autonomous
definitions of “dividends” and “interest”;
reclassification of interest as dividend income and denial of deductibility of “excessive interest” does not comply with
the treaty non-discrimination rules (should be deductible as if paid to or guaranteed by a Russian parent or an affiliate
of a Russian parent)
 Special circumstances: both Russia – Germany tax treaty and Russia – Netherlands tax treaty
contain special “unlimited deductibility” clause
 The tax authorities still try to argue with the above position of the courts
 No “unlimited deductibility" clauses in Russia – Cyprus double tax treaty
 Protocol to the Russia – Cyprus double tax treaty: interest reclassified into dividend income to be
treated as dividend income for treaty purposes; non-discrimination rules will not change
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Thin capitalization – non-discrimination in
action
Shareholder
(Cyprus)
Guarantee
Loan
Bank (Cyprus)
Unsecured loan
Cyprus
Russia
Loan
Russian borrower
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Thin capitalization – non-discrimination in
action
Bank (Cyprus)
Guarantee
Cyprus
Loan
Shareholder
(Russia)
Loan
Unsecured loan
Russia
Russian borrower
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Thin capitalization – non-discrimination trap
Shareholder
(outside Russia)
Guarantee
Shareholder
(Cyprus)
Bank (Cyprus)
Loan
Foreign countries
Russia
Unsecured loan
Russian borrower
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Thin capitalization – non-discrimination trap in
action
Shareholder
(outside Russia)
Bank (Cyprus)
Guarantee
Loan
Shareholder
(Russia)
Russia
Unsecured loan
Russian borrower
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Foreign countries
Repatriation of profits
 No withholding tax on repatriation of profits from the branch
 Dividend distributions from Russian subsidiary generally subject to 15% domestic
withholding tax
 Domestic withholding tax may be reduced to 5% under the Russia – Cyprus
treaty, if:
-
beneficial owner of dividends is a tax resident in Cyprus;
-
cumulative direct investment of at least USD 100 000 (EUR 100 000 under the Protocol)
 Non-qualifying participations may still reduce withholding tax to 10%
 Direct participations:
-
contributions to the charter capital of Russian subsidiary in exchange for shares/ interest;
-
Sale and purchase of shares/ interest in the Russian subsidiary from a third party
NB! Receiving stake in a Russian company as capital contribution will not qualify as
direct investment
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Beneficial ownership
 Cyprus – Russia DTT: dividend income, may also apply to interest and royalties
in the future
 RF President and RF Ministry of Finance seek to use this concept to combat
treaty shopping
 This concept targets multilayer structures
 How does it work? No treaty benefits (0% or reduced withholding tax rates) apply
to income received by person not qualifying as beneficial owner
 Who is beneficial owner of income (Russian approach)?
-
person having formal title on income AND
person detemining «economic destiny of income»
 Beneficial ownership concept does not apply to repatriation of profits from
branches/ rep. offices
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Beneficial Ownership: Impact on Treaty Application
IsrHold
Co
RusHol
dCo
CypCo
5% WHT
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If CypCo not considered beneficial
owner of dividend income, benefits
under Cyprus – Russia DTT will be
denied;

If treaty benefits denied then
Russian domestic tax rules should
apply;

May Israel – Russia DTT apply?
100%; EUR 107 000
RusCo
9% WHT

15%/ 10% WHT
Beneficial Ownership: Impact of Treaty Application
 What factors may indicate person is not beneficial owner of income?
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-
person has no presence in the residence state (no office, no personnel, no bank
accounts, no financial reporting obligations etc);
-
person has no activities other than those which treaty benefits are claimed for;
-
person does not bear normal commercial risks (subsidies from parent
company; no adequate margin);
-
person assumes legal obligations to distribute income it receives;
-
the terms of back - to - back operations are same or similar (e.g. for debt
financing: principal amount, currency, interest rate, payment terms etc)
Beneficial Owner: Impact of Treaty Application
 How could we mitigate the risks? Case by case approach
 General recommendations:
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-
simplify structures: do not use multilevel structures until necessary;
-
substance and presence in residence state: office space, personnel, bank
accounts, board and shareholders meetings, bookkeeping and
accounting,general overhead expenses etc;
-
consolidation of business functions (group financing company; group IP holding
company);
-
multiple project vehicles;
-
arm’s length remuneration (margin);
-
sound economic reasons behind use of offshore companies (foreign markets,
foreign investors and flexibility of foreign law, statutory requirements under
foreign law when making outbound investments)
Basic Exit Structure: Onshore Sale
 No VAT on share deals;
 Capital gains generally subject to 20% Profit tax
 0% Profit tax introduced on capital gains from
alienation of stakes in the capital of Russian companies,
provided:
CypCo 1
RusCo1
SPA
- applies to both corporate and individual shareholders
- uninterrupted more than 5 year holding period by the
date of alienation of stake in the capital
- if shares of joint stock companies (additionally):
RusCo
should be non-tradeable securities within the term of holding; or
if tradeable – should qualify as the high tech shares within the term of holdig; or
should be non-tradeable securities when acquired and tradeable high tech
shares when disposed of
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Basic Exit Structure: Offshore Sale
 No Russian wihtholding tax on capital gains
unless RusCo is a qualifying real estate company
(more than 50% of assets – immovable property
in Russia);
CypCo 1
CypCo
SPA
 Currently the Cyprus – Russia DTT protects
sale of shares/ interest in qualifying real estate
companies;
 The Protocol to the treaty allows taxation of
RusCo
capital gains prom alienation of qualifying real
estate companies;
 No withholding mechanism when seller and
purchaser – foreign companies, but could
become an issue if purchaser is a Russian
company or a foreign company with Russian PE
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Advanced Exit Structure
 Russian domestic tax law currently does not target
sale of shares/ interest in foreign companies;
CypCo1
CypCo
SPA
Cyp HoldCo
 Although the Protocol to the Cyprus – Russia DTT
does not limit the scope of taxation to Russian real
estate companies only, it is believed that Russia may
not expand its taxing jurisdiction unless domestic law
is changed
 No withholding mechanism if sale preformed
between two foreign companies
RusCo
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Still may become an issue if purchaser is a Russian
company or a foreign company with Russian PE
Alternative Exit Structure: EU Cross Border Merger
 CypCo owns Russian real estate company
EU Co
 The Protocol to the Cyprus – Russia DTT:
exemption of capital gains from sale of qualifying real
estate companies is no longer available
CypCo
 Purchaser is hesitant to acquire shares of CypCo
sale
RusCo
 Alternative solution: upstream merger of CypCo
into LuxCo and sale of shares in Russian real estate
company (still exempt from Russian withholding tax
under many DTTs of Russia with EU states)
 Transfer of shares by CypCo to LuxCo as part of
merger should not be subject to tax in Russia
(Art.251-3 of the RF Tax Code + no tax agent)
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Contact
Boris Bruk, Of Counsel
Tax Practice, Salans Moscow
bbruk@salans.com
Salans
Balchug Plaza,
Ul. Balchug, 7
115035 Moscow, Russia
Tel.: + 7 (495) 644 0500 (ext.4534)
Fax: + 7 (495) 644 0599
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