Government’s draft law to materially amend the Russian Tax Code: taxation of cross-border transactions

Pepeliaev Group advises that the Russian Government has prepared a draft law to amend the Russian Tax Code in order to implement certain areas of the tax policy.

Please find below our description of the possible changes in the international taxation which we believe to be the most important[1].

The application of the “pass-through approach” for Russian beneficiaries

At present, when dividends are paid to a foreign entity, such entity may recognise a Russian entity to be the beneficial owner of the income and a zero tax rate may be applied to the dividends if the Russian entity is qualified for it. The proposed amendments would cancel such possibility. Therefore, the Russian shareholders who have indirect membership of Russian companies through foreign companies may be entitled only to a 13% profit tax rate.

The transitional provisions specify that the right to apply the zero rate remains in force until 31 December 2023 provided that specific conditions are met which include the requirement that the Russian entity should actually receive funds within a certain period and restrictions for offshore jurisdictions.

The reasons for the “pass-through approach” to be renounced are not quite clear, since such approach is in line with the requirement for prioritising the economic substance of a transaction over its legal form when the beneficial owner of income is disclosed and the funds are repatriated. If a beneficial owner of the dividends could have applied the zero rate in the event it receives the dividends directly, the rate should not be increased only owing to the transit of payments. Even if the reduction in the rate of the tax on dividends is treated as a benefit, the legislature may not establish different tax burden for the entities in similar economic conditions, i.e. if such entities receive dividends directly or through foreign entities that are not beneficial owners. Probably, such proposal is grounded in seeking to simplify the administration of the withholding tax. However, convenience of administration may not in itself determine the tax consequences. It is unclear whether the “pass-through approach” will remain in force for foreign entities willing to obtain benefits set out in international double taxation treaties. We believe that as the draft law will be refined, the conditions for the “pass-through approach” may be toughened for the foreign beneficial owners of income as well. For instance, this may be done by establishing a uniform requirement for a transit entity to actually transfer the funds to the beneficial owner of income.

The foreign companies that have recognised themselves as Russian tax residents are deprived of the benefit

The zero rate is cancelled for the tax on dividends received by a foreign entity that has independently recognised itself as a Russian tax resident.

However, as in the case of Russian beneficiaries, the draft law permits the benefit to be retained until 31 December 2023 provided that the above specific conditions are met.

This measure triggers the same questions as in the case of the “ordinary” Russian companies. At first the legislature encouraged the foreign companies that have recognised themselves as Russian residents for being transparent. Now it is unclear for foreign companies what for should they recognise themselves as Russian residents. Moreover, the list of offshore jurisdictions is established at the level of a subordinate regulation. Therefore, it is possible that the benefit for Maltese, Cypriot and Luxembourg companies that previously recognised themselves as Russian residents will not be preserved in the transitional period either if the international treaties with such jurisdictions are terminated and the relevant countries are entered into the list of offshore jurisdictions

Eliminating double taxation of dividends obtained by individuals

There is a provision whereby the dividends generated from a Russian company of which an individual has indirect membership through foreign companies may be recognised in a personal income tax return, provided that the following conditions are met:

• the individual must have sequential membership solely of foreign companies;
• the foreign entity to which the Russian entity pays the dividends must be a resident of the OECD member state, except for the countries that do not ensure exchange of tax information with Russia;
• a certain sequence of payments in the ownership chain must be complied with in terms of the deadlines and amounts.

Such procedure is aimed at eliminating double taxation, i.e. deducting the Russian tax at source that was withheld when the dividends were being paid to the foreign entity. Nevertheless, the condition whereby the number of countries of incorporation of foreign entities is fairly limited is likely to deprive the procedure of its practical significance.

The taxable passive income of the foreign members of mutual investment funds has been extended

A foreign company’s income from the trust management of a mutual investment fund’s (MIF’s) property is classified as dividends.

The range of mutual investment funds has been extended that generate income from the sale of their units which is recognised as passive income from a Russian source. Among other things, the treatment of income from the sale of units in closed-type MIFs classified as annuity funds or real estate funds is also extended to include units of closed-type MIFs classified as combined, as well as of other funds in which 50% of the assets consist, directly or indirectly, of the real estate located in the Russian Federation.

What to think about and what to do

As the draft law passes all the stages to become a law, the final version of the amendments may change and we recommend keeping track of how the draft law develops. However, with respect to the cross-border transactions it is already obvious that a thorough analysis (a stress test) of the structures should be carried out in connection with the proposed amendments. The cancellation of some grounds for tax benefits to be applied to dividends raises an issue of the country of incorporation being changed for foreign entities and such foreign entities being placed in Russian special administrative districts (redomiciliation), including taking into account the planned amendments that extend such opportunities for entities in offshore jurisdictions.

Help from your adviser

The Pepeliaev Group team provides a wide range of services in the area of taxation, including in cross-border transactions. With regard to the international taxation our specialists have extensive experience in conducting stress tests of structures, including for the beneficial ownership of income, and represent clients in cross-border taxation disputes at all stages.