How dividend and interest income will be taxed when paid to Cyprus residents
Pepeliaev Group advises that on 31 March 2020 the Russian Ministry of Finance sent Letter No. 03-08-06/25267 to the Cyprus Ministry of Finance through diplomatic channels. The Letter contains a draft of the Protocol to the Double Taxation Treaty that provides for a significant amendment of the taxation procedure with respect to dividend and interest income.
In its letter sent to the Cyprus Ministry of Finance, the Russian Ministry of Finance stated that regardless of international efforts aimed at preventing tax base erosion and profit shifting, multinational corporations continue to use structures and mechanisms leading to the artificial creation of profit centres outside the Russian Federation in jurisdictions where such income is either not subject to tax, or is taxed under a reduced tax rate.
In the opinion of the Russian Ministry of Finance this fact results in bad-faith competition on the part of the international corporations for good-faith Russian taxpayers.
In order to solve this problem the Russian Ministry of Finance has prepared a draft Protocol to the Double Taxation Treaty (the “DTT”) that provides for an increase of the tax rate with respect to dividend and interest income up to 15%, instead of 5% - 10% with respect to dividends and a full exemption with respect to interest income according to the current version of the DTT.
Based on article 1 of the draft Protocol to the DTT that has been proposed for signing, dividends can be taxed in the state in which the company paying the dividends is a tax resident, but if the actual recipient of dividends is a tax resident of the contracting state, then such tax should not exceed 15%.
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In other words, for entrepreneurs this means that the dividends being paid are subject to tax at source in Russia at the rate of 15% pursuant to the DTT. |
According to article 2 of the draft Protocol that has been proposed for signing, interest income can be taxed in the state where it originates. However, if the beneficial owner of such income is a tax resident of the contracting state, the tax should not exceed 15%.
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Therefore, the interest paid to the Cyprus company from sources in Russia will be subject to tax at source at the rate of either 15%, provided that the status of the beneficial ownership of income is confirmed, or under the common rate established under article 284(1) of the Russian Tax Code, if the presence of the beneficial right to income for the purposes of the DTT is not confirmed. As a result, the current full exemption of interest income from taxation at source under the DDT with Cyprus will lose its force if the protocol is signed and ratified. |
It was stated specifically that the Russian Ministry of Finance is waiting for the response to the proposed draft Protocol before 15 June 2020 and if the Cyprus party does not respond, Russia may unilaterally withdraw from the DTT under article 54 of the Vienna Convention on the Law of Treaties 1969 and article 31 of the DTT.
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The Russian Ministry of Finance has promptly started implementing the measures stated by the Russian President in his address to the nation in March 2020. There are all the grounds to suggest that a similar proposal will be forwarded to other states with which Russia has such treaties. |
It is obvious that the Russian Federation, as a sovereign entity of international law does not, in addition to implementing measures of the OECD Multilateral Convention (MLI), refuse to conduct unilateral negotiations with partner states under a DTT.
If the protocol is signed and ratified, for directors, shareholders and controlling persons of the Cyprus companies this will mean the following:
- A tax rate of 15% will be set with respect to dividend income both under the DTT and Russian legislation;
- The current regime of full release from taxation at source of interest income in Russia under the DTT with Cyprus will be cancelled;
- A tax rate of 15% will be set with respect to interest income, provided that the status of a beneficial owner of income is confirmed, while in the other cases the tax rate will be 20% under Russian legislation;
- The Russian tax authorities will be given a carte blanche with regard to refusing the unjustified application of benefits under the DTT with Cyprus, the reclassification of intra-group payments, and the complication of the practice of applying the so-called ‘pass-through approach’ in accordance with articles 7 and 312 of the Tax Code.
What to think about and what to do
Directors, shareholders and controlling persons of companies registered both in Cyprus and other jurisdictions which provide beneficial tax regimes need to perform stress-tests of existing business structures that are used for cross border payments for the purposes of the possible amendment of a business financing model.
Help from your adviser
Pepeliaev Group's team is ready to help in performing stress-tests of business structures and their redomiciliation, as well as in the preparation of tactics and a strategy for protecting current structures when disputes with tax authorities arise.