Russian CFCS rules have been updated

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Pepeliaev Group advises that a law has been enacted regulating contentious issues of applying the Russian rules on controlled foreign companies (the "CFC Rules").

On 28 December 2017, the Russian President signed Federal Law No. 436-FZ[1] (the “Law”) to amend the Russian Tax Code. The Law mainly enshrines the approaches of the Russian Ministry of Finance to applying the CFC Rules stated in the Guidelines[2] issued in February 2017.

The Law also specified and supplements the CFC Rules on a number of key issues: the so-called ‘taxless’ liquidation of CFCs[3]; transactions with securities and other assets received during such liquidation; taxation rules for CFCs which are a part of a consolidated group of taxpayers.

The proposal of the Russian President to extend the timeframe for the voluntary taxless liquidation of CFCs was announced at a meeting with business associations after the Law was enacted and has not been added to the text of the Law. For this reason the enactment is expected of a separate law reflecting this proposal.

Please find below the main provisions of the Law.

Tax release of income:

  • For the purposes of profit tax[4] and personal income tax[5], all types of income (not only dividends) received from a CFC by a controlling party as a result of a distribution of profit are no longer booked, if the income in the form of the CFC’s profit was stated by the taxpayer in the tax return filed for the corresponding tax periods and if the conditions established by the Tax Code are complied with.

Комментарий ПГ

The amendment mainly concerns the distribution of the profit of trusts and other similar structures that do not entail a legal entity being formed.

  • The list has been extended of the cases when an individual who has received property (property rights) after a CFC was wound up with no tax exposure may reduce his/her tax base by the value of property determined based on the records of the liquidated CFC (but not above the market value) as of the date when the property (property right) was received. Specifically, this right of a taxpayer occurs:
    • When it receives income that is not a distribution of the profit of an unincorporated foreign entity and if the right to such income was acquired by a taxpayer as a result of his/her contributing to such foreign entity property (property rights) received from the CFC[6];
    • When income was received as a result of the exercise of property rights, regardless of whether this income was received by a taxpayer directly or upon such taxpayer’s instruction was transferred to third parties;

Комментарий ПГ

The Law does not define what the ‘exercise of property rights’ is. Primarily, this may mean raising claims against a debtor and receiving monetary funds or any other property on account of such claim. Proceeding from the uniformity of the legislature’s will, we believe that the same approach should also be applied to the assignment of property rights;

    • when disposing securities acquired by way of a gift (inheritance) from a person which received them from a liquidated CFC.
  • A legal and technical inaccuracy has been eliminated. This was associated with determining the deadline when the liquidation of a foreign entity with no tax exposure should be completed in connection with the restrictions established by the personal law of this organisation or by its participation in court proceedings. The liquidation should be completed within 365 consecutive calendar days from the date when the restrictions ceased to have effect or the court proceedings finished.

Комментарий ПГ

Please note that for rescheduling the liquidation of a CFC for the year 2018 under the above grounds, the decision to liquidate the foreign company still should have been made before 1 January 2017; however we expect that this deadline will be change in future in connection with the Russian President’s position.

  • The profit of a CFC which participates in projects that involve extracting minerals is exempted from taxes if all the following conditions are met:
    • The CFC is a party to a production sharing agreement, concession agreement, licence agreement or any other agreement, or incorporation of a CFC is provided for by these agreements, and such CFC performs activities that involve extracting minerals solely under such agreements.
    • Such agreements are entered into with a state, a government or with institutions authorised by this government, or the activity within the framework these agreements is performed under a licence to use a subsoil plot.
    • The share of income received from being a party to such agreements is at least 90 percent of the total amount of the CFC’s income according to the financial statements or there is no such income at all.
  • A CFC’s profit aimed at the increase of its issued capital will not be booked and nor will profit aimed at forming statutory provisions of the foreign company if such an obligation is provided for by the legislation of a foreign state.
  • The CFC’s profit is outside the scope of audits over transfer pricing activities[7].

Комментарий ПГ

The fact that this provision was introduced does not evidence that there is an opportunity to set discretionary prices in transactions with CFCs, since such transaction can be audited within the framework of an assessment of whether an unjustified tax benefit has been obtained.

Tax residency and permanent establishments of foreign companies

  • The management of assets of a foreign investment fund performed in Russia as well as other activities directly related to the above functions do not on their own lead to the formation in Russia of a permanent establishment of such fund, or of foreign companies (of unincorporated entities) with the direct or indirect involvement of such fund and/or direct or indirect shareholders (members, stockholders, or partners) of such fund (company).
  • Activities performed in Russia through a broker or a commission agent as well as through an investment fund manager do not now lead to a permanent establishment being formed in Russia.
  • The Law has specified the criteria that foreign companies should meet to be classified as Russian tax residents under article 246.2 of the Russian Tax Code as a result of performing any/all of the stated activities.

Комментарий ПГ

In particular, preparing and/or making decisions concerning issues which fall within the authority of the general meeting of shareholders (participants) of a foreign company is not in itself recognised as carrying out the management of a foreign company in Russia. In the same way, preparation for the holding of the meeting of the board of directors, and other collective executive bodies of a foreign company is not in itself recognised as carrying out the management of a foreign company in Russia.

Please note that the amendments came into force from 1 January 2018.

  • When solving the issue of the place of management of a foreign company, a taxpayer must be guided by the Tax Code's provisions as well as by the provisions of internal policies and internal regulations for the purposes of determining the contents of functions for the planning and control of the activity of the foreign company.

In particular, the following relates to planning and control:

  • strategic planning and budgeting;
  • drafting and drawing up consolidated financial and management reports;
  • the analysis of operations;
  • internal audit and internal control;
  • preparing for and arranging the raising of finance;
  • managing investment, financial, production and other risks;
  • adopting (approving) standards, methods and/or policies, which cover foreign companies (a related party of which is a Russian company or an individual recognised as a Russian tax resident) performing similar functions or belonging to separate operational segments or business segments;
  • approving the decisions taken by foreign companies for the purposes of exercising control over the compliance of such decisions with the above standards, methods and/or policies.

Amendments directly relating to the taxation of CFCs’ profit

  • For the purposes of the taxation of foreign companies the term financial assets has been introduced to the Tax Code. This term was borrowed from international financial reporting standards and the provisions of Chapter 20.1 of the Tax Code.

Financial assets mean:

    • monetary funds;
    • securities;
    • derivatives transactions;
    • participation interests in the issued capital of a legal entity;
    • participation interests in an unincorporated foreign entity;
    • a right to claim under an insurance agreement.
  • The profit/loss from the disposal of financial assets is determined as income less expenses. Income is determined in accordance with financial reporting standards. Expenses are determined:
    • either based on the cost of financial assets reflected in the CFC’s books as at the date when such financial assets were booked, if they were booked within the period from the beginning of the year 2015;
    • or according to the CFC’s books as at 1 January 2015, if such financial assets were booked before the year 2015.
  • If the CFC’s books contain no information about the cost of disposed financial assets acquired before the year 2015, then the taxpayer is entitled to determine such cost by correcting the income from their disposal by the amount of its reassessment booked in financial reports of the CFC for the period starting from the year 2015.

Комментарий ПГ

The cost of financial assets is confirmed by the CFC’s books[8], explanations to the financial reports or a calculation based on the correction of income from the sale of financial assets by the amounts of their reassessment.

  • The amendments introduced by the Law also establish that the following is recognised as income from active operations:
    • income from the sale of goods under agreements (contracts) whose terms and conditions provide for the supply of the main asset;
    • income received from hedging operations;
    • income in a case of the sale of the main asset which is a derivative transaction under a sale and purchase agreement if such income is not recognised as income from passive operations.

Комментарий ПГ

The initial version of the draft law provided that when a Russian party buys out financial assets from a CFC without paying taxes it was proposed to be restricted to a maximum threshold of the price - the market price, i.e. to permit a lesser amount to be paid to a CFC, instead of a precise buyout price being paid (which could mean the payment of a significant amount to a CFC and contradicts the goal of returning assets to Russia). But such an amendment was excluded in the second reading of the draft law at the initiative of the Russian Government and was not reflected in the Law.

Amendments to the provisions on carrying forward CFCs’ losses

  • The Law has confirmed the position of the Russian Ministry of Finance that, to carry forward its losses incurred in the three tax periods preceding 2015, a CFC’s financial figures for these three periods must be adjusted. The total amount of losses carried forward may be adjusted by the amount of the revaluation of participatory interests and securities accrued since their purchase and until 2015.
  • If the taxpayer stops being a controlling party of the CFC, it loses its right to carry forward the losses of such CFC to the extent that they were not accounted for previously.
  • The procedure for determining losses (which was established in the version of the Tax Code before the provisions of the Law came into force) can be applied for the purposes of carrying forward the amount of losses received by a CFC for the period from 1 January 2012 to 31 December 2014. In such a case no recalculation of the profit tax base and VAT tax base for the previous tax periods is performed.

Special provisions

  • The amendments have broadened the range of parties which are classified as controlling parties from 1 January 2015 to 1 January 2016. Now the legislature has added to this period a ground for being classified as a controlling party if the party in fact exercised control over a foreign company in his/her own interests or in the interests of his/her spouse and under-age children, and if the participation interest of this party in the company (for individuals together with spouses and under-age children) exceeds 50 percent.
  • Amendments made to the provisions of articles on the exemption of the CFC’s profit from taxes, on the procedure of booking the CFC’s profit for tax purposes, and on special features of the taxation of the CFC’s profit, apply to the CFC’s profit in periods starting from 1 January 2016.
  • The amended provisions on companies recognised as tax residents in the Russian Federation, and provisions on exemptions from taxes, cover legal relationships which arose from 1 January 2016.
  • The amended provisions on a permanent establishment cover legal relationships which arose from 1 January 2017.

What to think about and what to do

We recommend assessing the influence of the amendments on the tax burden of groups with a foreign element that are controlled by Russian parties and to adapt business processes accordingly.

Primarily, the rules for carrying losses forward and the policies regulating transactions with securities might require amendments.

Help from your adviser

Pepeliaev Group’s lawyers have gained unique methodological experience in international taxation matters. They are ready to offer legal support as you adjust to the new rules for the calculation of a controlled foreign company’s income and other provisions of the Law.

[1] Federal Law No. 435-FZ “On amending parts one and two of the Russian Tax Code and certain items of Russian legislation” dated 28 December 2017.

[2] Letter No. 03-12-11/2/7395 of the Russian Ministry of Finance dated 10 December 2017.

[3] Article 217(60) and article 277(2.2-2.3) of the Russian Tax Code (the “Tax Code”).

[4] Article 251(1)(53) of the Tax Code.

[5] Article 217(66) of the Tax Code.

[6] Article 217(67) of the Tax Code.

[7] Article 105.3(4)(1) of the Tax Code.

[8] Article 309.1(10) of the Tax Code.

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