Tax Implications of Inbound Investments into Russia

1
Tax Implications of Inbound Investments into
Russia

• Boris Bruk,
• Of Counsel,
• Salans Moscow

2
Key questions

• Form of presence branch vs. subsidiary
• How to finance your activities in Russia
• Repatriation of profits
• Divestment (exit from the project)

3
Branch vs. Subsidiary
SUBSIDIARY
BRANCH

• Benefits
• No thin capitalization rules apply
• No taxation on profits distributable 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

• Benefits
• Limited exposure of foreign investor to 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 expensive
• No limited liability available
• Limited rights to clear the imported goods at
  customs
• Additional currency control formalities for the
  Russian customers dealing with branches

• Drawbacks
• Dividend distributions subject to withholding tax
  (minimum treaty withholding tax 5)
• Additional currency control formalities in
  dealing with foreign suppliers or customers

4
How to finance your activities

• Capital contribution (including share premium)
• Contribution to assets
• Debt financing

5
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

6
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?)

7
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 (connection with income generating
  activities if the borrower has enough equity
  cash unjustified tax benefit) and proper
  documentation

8
Thin capitalization rules

• Apply where
• (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
• The controlled debt/equity (equity net assets
  accrued tax liabilities) ratio of the borrower
  exceeds 31 (12.51 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

9
Thin capitalization inefficient structure
Shareholder (Cyprus)
Loan
Cyprus
Russia
Russian borrower
10
Thin capitalization inefficient structure
Shareholder (Cyprus)
Guarantee
Bank (Cyprus)
Loan
Cyprus
Russia
Russian borrower
11
Thin capitalization inefficient structure
Shareholder (Cyprus)
Guarantee
Cyprus
Bank (Russia)
Russia
Loan
Russian borrower
12
Thin capitalization current circumvention
structure
Shareholder
Loan
Financial Company
Foreign country
Russia
Loan
100
Operating company
13
Thin capitalization advanced circumvention
structure
Shareholder
Financial company
holding
loans
Sub-holding
Operating company
holding
Foreign countries
Russia
Operating company
Operating company
Operating company
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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

15
Thin capitalization non-discrimination in action
Shareholder (Cyprus)
Guarantee
Loan
Bank (Cyprus)
Unsecured loan
Cyprus
Russia
Loan
Russian borrower
16
Thin capitalization non-discrimination in action
Bank (Cyprus)
Guarantee
Cyprus
Loan
Shareholder (Russia)
Loan
Unsecured loan
Russia
Russian borrower
17
Thin capitalization non-discrimination trap
Shareholder (outside Russia)
Bank (Cyprus)
Shareholder (Cyprus)
Guarantee
Loan
Foreign countries
Russia
Unsecured loan
Russian borrower
18
Thin capitalization non-discrimination trap in
action
Shareholder (outside Russia)
Bank (Cyprus)
Guarantee
Foreign countries
Loan
Shareholder (Russia)
Russia
Unsecured loan
Russian borrower
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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

RusHoldCo
IsrHold Co

• 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?

CypCo
100 EUR 107 000
5 WHT
RusCo
15/ 10 WHT
9 WHT
22

• Beneficial Ownership Impact of Treaty
  Application

• What factors may indicate person is not
  beneficial owner of income?
• - 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)

23

• Beneficial Owner Impact of Treaty Application

• How could we mitigate the risks? Case by case
  approach
• General recommendations
• - 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
• - arms 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)

24

• 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
• - 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)
• 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
  

CypCo 1
RusCo1
SPA
RusCo
25

• 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)
• Currently the Cyprus Russia DTT protects sale
  of shares/ interest in qualifying real estate
  companies
• The Protocol to the treaty allows taxation of
  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

CypCo 1
CypCo
SPA
RusCo
26

• Advanced Exit Structure

• Russian domestic tax law currently does not
  target sale of shares/ interest in foreign
  companies
• 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
• Still may become an issue if purchaser is a
  Russian company or a foreign company with Russian
  PE

CypCo
CypCo1
SPA
Cyp HoldCo
RusCo
27

• Alternative Exit Structure EU Cross Border Merger

EU Co

• CypCo owns Russian real estate company
• The Protocol to the Cyprus Russia DTT
  exemption of capital gains from sale of
  qualifying real estate companies is no longer
  available
• Purchaser is hesitant to acquire shares of CypCo
  
• 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)

CypCo
sale
RusCo
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Contact
Boris Bruk, Of Counsel
Tax Practice, Salans Moscow bbruk_at_salans.com Sala
ns Balchug Plaza, Ul. Balchug, 7 115035 Moscow,
Russia Tel. [phone] (ext.4534) Fax
7 [phone]