Although modern day Russia has consistently stayed near the bottom of the “mostly unfree” countries’ list in the Index of Economic Freedom, it has been an attractive destination for foreign investors undeterred by a steep risk curve. At least part of that should be attributed to commendable efforts on the part of the Russian Government, which has brought the Russian tax system’s position in the Doing Business index up from 94th to 64th place over the last year alone. One of the Government’s most important achievements is a significant number of double taxation treaties – presently 81 with nine more in line to become effective.
A substantial amount of capital comes to Russia from offshore jurisdictions, including the likes of the Bahamas and the BVI. Still a much larger proportion arrives from the States that have comprehensive tax agreements with Russia, particularly from the EU, such as Ireland, Luxembourg and the Netherlands. However, for a long time these have been dwarfed by the amount of funds received from Cyprus alone. For over a decade Cyprus has been the major hub that hosted international holding companies for investment into Russia and ultimately the extraction profits from its territory. In the voyage to accession to the EU Cyprus had shed its offshore tax status and introduced a comprehensive tax regime. However, Cyprus’s allure has lain primarily in the tax reliefs available to international holding companies resident in its territory. For many years this dovetailed with a liberal double taxation treaty with Russia and explained Cyprus’s hegemony on the Russian investment plane. However, the author’s experience and official statistics show waning interest in structuring transactions through Cyprus. It is undoubtedly premature to speak of Cyprus leaving the scene completely; however, increasingly sophisticated investors are moving towards establishing their holding companies in other Russian treaty partners.
There two possible reasons for these changes. The first factor that has contributed to the weakening of Cyprus’s influence was the signing of the amending Protocol to the treaty with Russia in 2010. However, this does not match in magnitude the actions of the Cypriot authorities in response to the recent financial crisis – in the eyes of many investors this has been the ultimate breach of trust, which triggered a departure to safer havens.
Before addressing these points in detail, it is useful to summarise Russian tax rules applicable to non-residents. A non-resident company pays 20 percent corporation tax on profits associated with its Russian permanent establishment, whose definition closely follows that adopted in the OECD Model Tax Convention (MTC). Interest and royalties from Russian sources earned by non-residents are taxed at the same rate even without a PE and so are dividends, although at a lower 15 percent rate. Non-residents are also taxed on rental income and gains from disposal of Russia-situs real estate. Additionally, gains from the alienation of Russian companies over 50 percent of whose value is derived from Russian real estate (“property-rich companies”) are taxed at 20 percent.
Russia has a host of anti-avoidance rules, including transfer pricing and a variant of a GAAR; however, these have mostly been used to curb abusive internal transactions and arrangements involving tax havens. Only recently have Russian courts and the tax authorities demonstrated the application of the OECD Commentaries to the Model Tax Convention and started developing a comprehensive beneficial ownership concept.
The post-Soviet Russia–Cyprus tax treaty has been in force since January 1, 2000. It limits Russian dividend withholding tax to 5 percent provided the parent company invested at least EUR100,000 (changed from US dollars on January 1, 2013) in the subsidiary and there is no minimum holding period requirement. As a result, the Treaty has been primarily used to extract dividend income from Russia, which is exempt from tax in Cyprus. The Agreement has also been instrumental in structuring international real estate transactions – in its present form it does not allow Russia to tax capital gains from the alienation of Russian property-rich companies and gains are also exempt from tax in Cyprus. Finally, Cyprus does not impose withholding tax on dividends payable to foreign shareholders.
The Treaty reduces to nil Russian tax on interest and royalties and it has promoted the use of Cypriot financing and licencing group companies to help reduce the taxable profits of Russian enterprises. Foreign interest is liable to 10 percent corporation tax (recently increased to 12.5 per cent); however, in the absence of withholding tax on interest paid to non-resident lenders, back-to-back loans have been used extensively to reduce the tax charge in Cyprus. Thanks to a recently introduced tax relief, only 20 percent of the foreign royalty income is liable to Cyprus tax and this is subject to generous amortization relief. Also, there is no withholding tax on royalties payable abroad provided they relate to intellectual property exploited outside Cyprus.
In addition to the above, unscrupulous taxpayers have relied on the limited anti-avoidance mechanisms envisaged under the Treaty to extract profits from Russia. The Treaty tax reliefs are only available to beneficial owners residing in their relevant Contracting State, which necessitated the creation of a certain level of corporate substance and the leaving of a certain amount of profit margin liable to Cyprus tax. However, Russian lack of experience in effectively dealing with cross-border tax avoidance, the availability of tax rulings issued by the Cypriot tax authorities and the limited scope of the Cypriot anti-avoidance mechanisms have triggered a flight of Russian capital.
The announcement of the terms of the amending Protocol to the treaty in 2009 dominated Russian headlines for weeks. From the point of view of bona fide international tax planning practice the Protocol brought nothing new; however, many investors started feeling uncomfortable. The provision that drew the most attention was a much expanded exchange of information article based on the wording of the 2010 OECD MTC. As explained by the OECD Commentaries and envisaged by domestic laws, all exchanges of information under the Protocol are subject to strict guidelines and internal checks that eliminate the possibility of “fishing expeditions.” Also, although bank secrecy cannot be used to deny a disclosure, professional legal privilege has remained unchallenged. However, based on the misunderstanding of the true meaning of the new rules and fuelled by the belief in a cosy relationship between the two tax authorities, the amendment caused widespread alarm that details of the beneficial owners of the Cypriot assets would be disclosed to Russian law enforcers upon their first request. The feeling was shared by compliant and non-compliant taxpayers alike. The latter were rightly concerned about being found out; however, both were worried that information about their foreign assets could be used to attack and expropriate their businesses in Russia. Certainly the prosecution of Hermitage Capital Fund and the death of Sergei Magnitsky in a Russian jail did little to alleviate these fears.
Another widely publicised amendment is in line with the new Article 13 of the OECD MTC. It has closed the real estate planning loophole by granting Russia the right to tax disposals of the property-rich companies with Russia-situs real estate. However, unlike the rest of the Protocol, which has been effective since January 1, 2013, this new rule will apply from January 1, 2017.
Although the Protocol was not greeted with enthusiasm and rumours about indiscriminate disclosure of information abounded, particularly in the light of the EUR2.5bn emergency loan from Russia, investors had time to plan their further tax strategy. Also in view of the delayed application of the new capital gains article there was no immediate cause for concern. However, the other shoe dropped at the end of March 2013 when amidst much publicity Cyprus imposed the levy on bank savings as part of the agreed bailout. Many criticise the approach that Cyprus took to meeting its obligations to the eurozone by sequestering foreign assets without warning. The unfortunate outcome of this decision was a mass exodus of international investors to more economically stable climes.
The author believes that Cyprus is still an attractive jurisdiction to host a holding company for investment into Russia. Considering the country’s reliance on foreign capital and the abundance of infrastructure aimed at providing cross-border corporate and financial services, one would hope that no further plagues should be imposed on the assets’ owners. Recent amendments suggest a tightening of the domestic fiscal regime, such as raising the corporation tax rate to 12.5 percent and increasing the ambit of the special defence contribution. This will have only a slight effect on the taxation levied on foreign interest and royalties, particularly in the latter case where the effective rate is still 2.5 percent – unmatched by any other State in the EU. Also nothing has been changed in terms of taxation of foreign passive income and there are no new withholding taxes.
However, there are other planning considerations that have become of the utmost importance. The topic of anti-avoidance has long been and will remain at the top of the agenda of most tax administrations. For instance, the Russian Federal Tax Service has become increasingly sophisticated in denying treaty benefits to persons other than beneficial owners (see the submissions in Eastern Value Partners Limited). Also the Cypriot tax authorities are unlikely to issue tax rulings without the taxpayer demonstrating a necessary level of corporate substance and allocation of a suitable profit margin available for taxation. Finally, treaty benefits will be denied to a corporation failing to satisfy the place of effective management test to demonstrate residence in Cyprus – the Protocol has allowed the tax authorities to determine by mutual agreement the place of effective management of non-individual entities, which limits the scope of residence manipulation.
In expectation of a worst case scenario, it would be wise for a Cyprus holding entity to keep its funds in a bank account outside Cyprus. In the absence of the remittance clauses, populating the treaties concluded by Malta, Singapore and the UK, there should be no problem with accessing treaty benefits provided other conditions are satisfied. Also Cyprus allows for corporate redomiciliation and imposes no exit tax on departing legal entities. One way of achieving this is to assume effective management of the company in a different country – usually a double tax treaty partner – by appointing locally resident directors. Although the company will remain on the Cypriot corporate register it will become resident at its intended destination. Alternatively the company can be struck off the Cypriot corporate register and continued in a country that allows corporate immigration, such as Malta or Luxembourg. The procedure is much akin to liquidation in terms of length and costs and it ensures a complete cessation of ties with Cyprus while maintaining the continuity of the company’s existence.
A third alternative combines both methods and can be used in a situation where the asset – a loan or an intellectual property right – should cease all ties with Cyprus and there is insufficient time to go through the corporate emigration process. Broadly, it involves creating a holding company in the destination jurisdiction, which becomes the shareholder of the Cypriot company holding the relevant asset through a share-for-share exchange executed by the original shareholders. Subject to satisfaction of company law and accounting requirements, the Cypriot company then distributes the asset to the holding company as a dividend in specie or as liquidation proceeds on its dissolution. Alternatively, provided there are rules allowing for group relief, the Cypriot company should become resident in its parent’s country by changing the place of its effective management and transfer the asset to the latter, following which it can be liquidated at leisure. In all cases one should establish an advance relationship with the legal advisors and directors resident in the potential country of immigration.
Presently Cyprus is very active in attempting to reinstate the confidence of those who lost money as a result of the banking crisis, and at the moment one cannot tell the long-term effectiveness of the steps that it is taking. In the meantime other players with comparable treaties are attempting to fill the vacuum created by Cyprus’s mishaps. There are plenty of States that have comprehensive holding company regimes and for the purposes of this article a succinct overview will suffice.
Singapore has recently experienced a surge in popularity amongst Russian investors. The applicable treaty limits Russian dividend withholding tax to 5 percent subject to the parent holding directly at least 15 percent of the Russian subsidiary’s capital and has invested in it at least USD100,000. Russian dividends are exempt from tax in Singapore and so are capital gains from share disposals without any conditions. This is coupled with the absence of a dividend withholding tax. However, the treaty allows for a 7.5 percent Russian tax on interest and royalties, which are further taxed at the prevailing corporate income tax rate in Singapore. The country’s tax regime is notable for its territorial basis of taxation, whereby income not received in Singapore’s territory is not liable to tax. Unfortunately, Article 22 of the treaty with Russia limits planning opportunities by imposing the remittance clause and denying treaty benefits to income not received in Singapore. Another difficulty stems from the distance between the two countries, which makes it physically difficult to attend board meetings in Singapore and fulfil the effective management condition.
The Netherlands–Russia treaty also limits the dividend withholding tax to 5 percent subject to the satisfaction of the 25 percent participation and EUR75,000 investment condition. There is no withholding tax on interest and royalties, which together with the availability of tax rulings has made Dutch companies popular financing and licencing entities. Although the 25 percent corporation tax rate is relatively high, there is a full participation exemption in respect of Russian dividends and capital gains complemented by the 5 percent Innovation Box in respect of royalty income. Unlike many other treaties, the agreement with the Netherlands exempts from Russian tax capital gains on disposals of property-rich companies, which for the moment makes it ideal to structure real estate transactions. Although the Netherlands does not tax outgoing interest and royalties, dividends payable abroad are taxed at 15 percent, which can only be reduced by another tax treaty or the Parent–Subsidiary Directive. As a result, it is common to structure ownership of Dutch companies through Maltese, Cypriot or UK entities, which are not taxed on distributions to non-treaty States.
Austria’s tax benefits as a holding jurisdiction are also underestimated. The treaty with Russia limits dividend withholding tax to 5 percent subject to the satisfaction of the 10 percent participation and USD100,000 investment conditions and there is no withholding tax on interest and royalties. Austria fully exempts Russian dividends and capital gains from tax provided the holding company has held 10 percent of the subsidiary for at least one year. This together with the limitation of the Russia’s right to tax capital gains on disposal of property-rich companies makes it a suitable jurisdiction to host a real estate group holding company. In 2011 the Russian Ministry of Finance announced that it was in the process of negotiating an amending protocol to the Austria–Russia treaty. It remains to be seen what amendments to the tax agreement the protocol will introduce.
The scope of the article only permits to touch on the planning opportunities granted by Russia’s double tax treaty network. It is still exceptionally tax-effective to structure cross-border investments through Cyprus. However, there are a growing number of investors willing to sacrifice lower treaty tax rates and endure higher operational costs in exchange for stability associated with holding the assets through Ireland, Luxembourg, Switzerland and the UK. Others are prepared to test the water and establish presence in the newer entrants to the planning market, such as Hungary and the Baltic states. Also the recently signed treaty with Malta is bound to expand the choice of holding jurisdictions once it becomes effective. Although the possibilities are limitless, one should never lose sight of anti-avoidance considerations, recently highlighted in the OECD’s BEPS report and the European Commission’s Action plan. Also Russia has been quickly catching up by developing domestic anti-avoidance rules and signing amending protocols to its tax treaties bringing them in line with the OECD’s trends. Therefore, “place of effective management”, “beneficial ownership” and “exchange of information” are the key terms to consider.
This article written by Dmitry Zapol of IFS is reprinted with the publisher’s permission from Global Tax Weekly—A Closer Look, an on-line journal published by CCH INCORPORATED, a Wolters Kluwer business. Copying or distribution without the publisher’s permission is prohibited.