13% OR 30%: WHICH RATE OF PERSONAL INCOME TAX SHOULD APPLY TO FOREIGN EMPLOYEES?

Amendments to the Russian Tax Code that modified the notion of tax resident for personal income tax purposes came into force on 1 January 2007. The notion is crucial for the establishment of the tax rate (13% or 30%) with respect to the income of foreign employees. To date, the re is no well-established judicial practice on the application of this article. The Russian Ministry of Finance has only recently started to develop its position on this issue and has been very cautious. In practice, this gives rise to numerous questions relating to the essence of such amendments and differences compared to the previous procedure.

For example,

— at what rate should personal income tax be assessed for a foreign employee who leaves Russia in early 2010, if he/ she had the status of tax resident in Russia in 2009?

— at what rate should personal income tax be assessed for a foreign employee (for example, a German citizen) in cases where he/she starts working in Russia in November 2009 and is a non-resident subject to the 30% tax rate?

1. Rate of personal income tax on the 2010 income of a foreign employee who leaves Russia in early 2010, if he/she had the status of tax resident in Russia in 2009.

Pursuant to clause 2, article 207 of the Russian Tax Code, tax residents are individuals that de facto stay in Russia for at least 183 calendar days for 12 consecutive months.

It follows fr om a literal interpretation of the rule of law that 12 consecutive months and, accordingly the aforementioned 183 days, are not pegged to a calendar year and may start in the previous calendar year and finish in the current year.

If at the end of 2009, an employee stayed in Russia for more than 183 calendar days and resigns in early 2010, the n the employee had still been in Russia for more than 183 days for 12 consecutive months on the resignation date and, therefore, remains a resident.

Therefore, the 13% rate would apply to the income of such employee for 2010, with no reassessment of tax obligations at the 30% rate for 2010.

A similar conclusion was drawn by the Thirteenth Arbitra¬tion Court of Appeal in a Resolution dated 28 July 2008 on case No. A56-5933/2008.

The correctness of this interpretation is also substantiated by analysis of the procedure for adopting amendments to legislation concerning determination of a tax resident.

The aforementioned rule of law in article 207 of the Russian Tax Code (clause 2) was introduced by Federal Law No. 137- FZ dated 27 July 2006. Until the n the concept of an individual, who is a tax resident, was contained in article 11 of the Russian Tax Code and was defined as follows: “individuals who are tax residents of the Russian Federation are individuals, who de facto stay in Russia for at least 183 days in a calendar year…”

The Explanatory Note to draft law No. 181057-4 (which abolished the aforementioned clause of article 11 of the Russian Tax Code and introduced clause 2, article 207 of the Russian Tax Code and was adopted in its final version as Federal Law No. 137-FZ dated 27 July 2006) stated that such amendments had been introduced to the Russian Tax Code for the following reason: according to article 11 of the Russian Tax Code, when determining the status of a tax resident “...the periods of the de facto presence of individuals in Russia that precede a specific tax period are not taken into account. The status of a tax resident of the Russian Federation is acquired by an individual with respect to each calendar year. …To guarantee the rights and legitimate interests of individuals, it is proposed that the Code be supplemented by provisions that clarify the notion of tax resident of the Russian Federation with due account of the continuous nature of the actual presence of individuals in Russia for at least 183 calendar days during 12 months, which started in a period that immediately preceded the current tax period and expire in the current tax period”.

This conclusion is also confirmed by the Russian Ministry of Finance, for example, in letters No. 03-04-06- 01/32 and No. 03-04-06-01/331 dated 13 February 2009 and 7 November 2008, respectively.

2 Rate of personal income tax levied on the 2009 income of a foreign employee (for example, a German citizen) who starts working in Russia in November 2009 and is a non-resident at the end of the year

As noted above, pursuant to clause 2, article 207 of the Russian Tax Code, individuals that actually stay in Russia for at least 183 calendar days for twelve consecutive months are deemed to be tax residents of the Russian Federation.

Consequently, if a foreigner is employed in November 2009, he/she will not be a tax resident and may only become a tax resident on the expiry of the specified period.

The Russian Ministry of Finance believes that the 30% rate of tax is only reassessed at the 13% tax rate (refund of excessively personal income tax to the employee) once the employee acquires the status of tax resident and only for the period in which the employee acquired such status. In other words, in the case in question, the reassessments will be performed for 2010, provided that the employee stayed in Russia for at least 183 days fr om November 2009. No reassessment will be carried out for 2009.

These conclusions were formulated by the Russian Ministry of Finance in Letters No. 03-04-06-01/331 and No. 03-04- 05-01/399 dated 7 November 2008 and 24 October 2008, respectively.

Consequently, the least risky option that might be accepted by the tax authorities would involve the withholding of personal income tax from the employee’s salary at the rate of 30% until the expiry of the 183-day period of his/her stay in Russia in 2010 (starting in November 2009, unless the employee stayed in Russia before that date) and a reassessment of the tax at 13% and refund of excessive tax payments for 2010 to the employee. Personal income tax would not be reassessed and refunded for 2009.

However, in our opinion, the company may conduct reassessments and return excessively paid taxes to the employee for both 2010 and 2009 (starting from November).

In the above letters, the Russian Ministry of Finance does not cite the provisions of the Russian Tax Code that expressly stipulate the impossibility of reassessing taxes for the tax period that preceded the one when the individual acquired the status of tax resident. On the contrary, as stated above, both the current and preceding tax periods should be taken into account when determining this status.

The Russian Tax Code does not regulate the procedure for the reassessment of personal income tax, nor does it restrict such right to the period preceding the one when the individual acquired the status of tax resident, provided that it is within the period of 12 consecutive months.

In this case, a reassessment for the current period that does not take into account the previous period would attest to a lack of consistency in the application of this rule of law by the Russian Ministry of Finance. Such an approach of the competent authority would also violate the principle of taxation equality (clause 1, article 3 of the Russian Tax Code) in a situation wh ere, for example, one foreigner comes to work to Russia in December, while the other comes in August. In both scenarios, the se individuals would not be tax residents of the Russian Federation at the end of the year and would only become tax residents once the y have been resident in Russia for 183 days. However, proceeding from the position adopted by the Russian Ministry of Finance, the first foreigner would be entitled (on the expiry of 183 days in the next tax period) to a reassessment and refund of personal income tax for all the months (from January to May), other than December of the previous year, wh ereas the second foreigner would “lose” five months (from August to December) and would only be entitled to a reassessment of personal income tax for January of the following year (on the expiry of 183 days).

Moreover, article 207 of the Russian Tax Code does not link the status of resident to the individual’s citizenship.

At the same time, however, the fact that an individual does not have Russian citizenship serves as grounds for applying the presumption that this individual does not have the status of tax resident in Russia, until it has been confirmed by supporting documentation that he/she actually stayed in Russia for at least 183 days.

Neither article of the Russian Tax Code contains legal grounds for the application of the aforementioned presumption. Otherwise, personal income tax should have been assessed at the 30% rate from the salary received by Russian citizens, until the latter proved that the y actually stayed in Russia for at least 183 days. As we know, however, this does not happen.

In our opinion, such a difference in the taxation of Russian citizens and foreigners, which is not explicitly implied by the Russian Tax Code, violates the principles of universality and equality of taxation (clause 1, article 3 of the Russian Tax Code) and the principle of non-discrimination (clause 2, article 3 of the Russian Tax Code).

Furthermore, application of the last principle mentioned above is even more important given that the foreigners in case in question are citizens of Germany with which Russia concluded on 29 May 1996 a Convention for the Avoidance of Double Taxation with Respect to Taxes on Income and on Capital.

Pursuant to clause 1, article 24 of this Convention, the citizens of one Contracting State may not be subject to taxation or assume a relevant obligation in the other Contracting State that would be different or more onerous than the taxation or relevant obligations that are or may be imposed on the citizens of such a state in the same circumstances.

The Convention takes precedence over Russian tax legislation (article 7 of the Russian Tax Code).
At the same time, however, the incomes of Russian citizens that work in Russia are subject to 13% tax from the first day of the tax period.

Accordingly, the German citizens appear to be in a worse position than Russian citizens, which results in more onerous taxation of the former (with due account of the above explanations of the Russian Ministry of Finance).

We would like to note here that this conclusion is substantiated by the fact that, according to a similar provision in the Double Tax Treaty with Belarus (when article 11 of the Russian Tax Code was effective until the entry into force of the Protocol to the Treaty as at 31 May 2007 that regulated this procedure), the Russian Ministry of Finance in Letter No. 03-05-01-03/82 dated 15 August 2005 and the Russian Federal Tax Service in Letter No. VE-6-26/786@ dated 21 September 2005 indicated to discrimination in this case and the need to apply the non-discrimination article of the international treaty.

This conclusion is also confirmed by previous judicial practice, which upheld the above position of the Russian Ministry of Finance, for example, Resolution of the Federal Arbitration Court for the Moscow Circuit dated 2 September 2008 on case No. A40-53140/07-4-317.

In its Letter No. 03-05-01-03/82 dated 15 August 2005 the Russian Ministry of Finance pointed out that the 13% tax should accrue on employment income generated by nationals of the republic of Belarus who are potential tax residents of the Russian Federation (with due account of duration of their employment agreements) starting from the first day of their presence in Russia. Moscow Department of the RF Federal Tax Service provided similar clarifications in its Letter No. 18-11/3/104917 dated 30 November 2006.

Therefore, the company is entitled to withhold the tax at the rate of 13% from the beginning, if the employment agreement was signed for an indefinite term or a term exceeding 183 days. If the employee terminates the employment before the expiry of 183 days, then a re-calculation should be performed and the employee should be charged additional tax based on the 30% rate. If it is impossible to withhold the tax, the company should notify the tax authority to this effect within one month (clause 5, article 226 of the Russian Tax Code).

Clause 2, article 207 of the Russian Tax Code is comparatively new (effective since 1 January 2007), which is why there is no relevant court practice yet. However, in light of aforementioned clarifications of the Russian Ministry of Finance, if the individual income tax for 2009 (from November 2009) is re-calculated and returned to the employee, the company is highly likely to face claims of the tax authorities. In this case the dispute will have to be settled in court.