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The Inward Investment and International Taxation Review

31.01.2014
21 min read
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I INTRODUCTION

In the past 10 years Russia has seen fundamental changes in both its tax system and tax administration. The tax legislation’s unified general provisions are described in Part One of the Tax Code; all of the taxes and tax regimes are described in Part Two. There are 12 taxes and five special tax regimes under the Tax Code. Social security contributions are not formally regarded as tax and, therefore, are regulated by special law. In 2013 there were 25 amendments to the Tax Code.

II COMMON FORMS OF BUSINESS ORGANISATION AND THEIR
TAX TREATMENT

Generally, foreign investors may carry out business in Russia directly through a branch or establish a company in Russia. In the latter scenario the Russian subsidiary may be fully owned by a foreign company. It is also possible to establish a non-commercial organisation to carry out non-commercial activities.
There are some special restrictions that apply in order for foreign investors to be able to participate in certain areas of business or to own certain types of assets. In general, all income from commercial activities is subject to the same taxation regime irrespective of the form of the company.

i Corporate
The general corporate income tax (CIT) rate is 20 per cent. Dividends received by Russian companies are taxed at a rate of 9 per cent, unless a participation exemption applies. Dividends are taxed at the rate of 15 per cent at source by way of withholding.

The dividend withholding tax may be lowered to 10 per cent or 5 per cent under many double taxation treaties (DTTs).

ii Non-corporate
A foreign investor may establish a partnership with a Russian or foreign partner to carry out business activities in Russia. Under Russian law, a partnership does not have legal personality (and hence transparency) for tax purposes. Partnerships, however, are not commonly used as a structure by which to carry on business.

III DIRECT TAXATION OF BUSINESSES

i Tax on profits
Determination of taxable profit
Russian companies are liable to tax on their worldwide profits. Profits are generally defined as income less depreciation and deductible expenses. As a general rule, the accrual method applies.

Deductible expenses
In general, business-related expenses are deductible provided that they are properly documented and economically justified. The deduction of a small number of expenses is limited to certain amounts established in the Tax Code, for example, the deduction of interest, and certain types of advertising expenses and hospitality costs.

The amount of deductible interest for 2011 to 2013 is limited to a 1.8 per cent Central Bank refinancing rate for loans in roubles and a 0.8 per cent refinancing rate for foreign currency loans. The current Central Bank refinancing rate is 8.25 per cent. In addition, interest deductibility may be limited under thin capitalisation provisions.. Another limitation concerns marketing expenses for prizes in advertising campaigns as well as advertising expenses other than outdoor screens, exhibitions, brochures, etc. Such expenses are limited to 1 per cent of turnover. Representative costs are limited to 4 per cent of the amount of wages.

Exempt income
The Tax Code establishes a finite list of income that is exempt from CIT. The most important exemptions include:
a dividends qualifying for participation exemption; and
b assets transferred between a parent and subsidiary, provided that the shareholding is more than 50 per cent and the assets are not alienated to a third person for at least one year.

Exemption (b) is often used in the financing of subsidiaries by their parent companies. At the same time, free transfer of assets from a subsidiary to its parent may be reclassified by the court into distribution of dividends, and the mentioned exemption will be disregarded for the tax purposes.

Depreciation
Depreciable assets are assets with a value above 40,000 roubles. Assets with a lower value are deductible straight away.

Some assets are not depreciable irrespective of value, such as land, securities and works of art. Depreciable assets are divided into 10 depreciable groups, depending on the useful life of an asset. The two major methods are the declining balance and the straightline depreciation methods.

For some types of assets, such as assets leased under a financial lease, depreciation rates may be increased to up to three times the standard rates.

From 10 to 30 per cent of the new assets acquisition costs or of the assets that were reconstructed may be deducted at a time as a ‘depreciation premium’.

Capital and income
Capital gains are included in taxable profits and taxed under general rates. Russian law provides a participation exemption that generally applies to capital gains derived from the sale of shares in joint-stock companies and LLCs that are owned by the company for more than five years, and such shares are not publicly traded.

Losses
Losses can be carried forward for up to 10 years. There are no loss carry-back provisions. According to recent case law, in order to carry forward losses the company must keep accounting documents confirming the amount of the losses during all 10 years.

Rates
The general CIT rate is 20 per cent. It may be lowered to 15.5 per cent in certain regions.
Withholding taxes on payments to non-residents are as follows:
a dividends: 15 per cent;
b interest, royalties, rental income, alienation of real estate or shares in real estate reach companies: 20 per cent; and
c in respect of payment to corporate residents, the main withholding tax is a dividend withholding tax at the rate of 9 per cent.

Under the Russian tax treaties, the dividend withholding tax may be reduced by 5 per cent to 10 per cent and other withholding taxes may be reduced to zero.

Administration
The fiscal period for CIT is a calendar year. Interim reporting should be made on a quarterly or monthly basis. Annual tax returns should be submitted by 28 March of the following year.

The Russian tax authorities are generally regarded as strict and conservative intheir interpretation of tax laws, and active in making tax adjustments. In recent years, however, the administration of taxes has significantly improved. Tax reporting is now often done in electronic format.

The major form of tax control for CIT payments is the infield tax audit, which typically takes two months and may cover a three-year period. Tax audits are scheduled by the authorities, depending on the size of the business. Large corporations are checked once a year, medium enterprises every two to three years. The major focus of the tax control during tax audits is the checking of documentation confirming expenses. Typically, intercompany costs, marketing and promotion expenses, and employment bonuses are also usually checked by the authorities. Recently, more attention has started to be paid to cross-border transactions.

The practice of tax rulings is at an early stage of development. At present, it is possible to obtain a formal tax ruling for transfer pricing purposes, which may be done in the form of entering into a transfer pricing agreement with the Federal Tax Service. Such an agreement will not, however, be commonly used in coming years and only large corporations will be able to sign them. It is possible to request clarification from tax authorities on a particular matter, but such a clarification is not binding on the courts or even the tax authorities. If a taxpayer follows such clarifications, the tax office may still charge him or her additional taxes, but any fine and the default interest may not be applied.

Tax disputes are typically resolved in the state courts. It is quite common for Russian taxpayers to apply to the court if they disagree with the tax office’s decisions. It usually takes up to one year to complete a case through all three court levels. Pre-trial negotiations are now mandatory and must be carried out before application to the court.

Tax grouping
At the end of 2011 the new law on consolidated groups of taxpayers, which allows tax consolidation for very large enterprises, was adopted. The major conditions that make tax consolidation possible are as follows:
a the parent company directly or indirectly owns shares of more than 90 per cent of subsidiaries;
b the aggregate taxes paid by the group of companies in the year before registration as a consolidated taxpayer was at least 10 billion roubles;
c the aggregate gross profit of the group of companies in the year before registration  a consolidated taxpayer was at least 100 billion roubles; and
d the aggregate value of assets the group of companies owned in the year before registration as a consolidated taxpayer was at least 300 billion roubles.

Transfer pricing rules
One of the key changes in the Russian tax system that took place in 2011 was the adoption of the Transfer Pricing Law, which resulted in several major and important new provisions.

First, the list of controlled transactions has been amended. The following types of transaction will be controlled:
a transactions between related parties;
b foreign trade transactions with goods traded on international stock exchanges;
and
c transactions where the status of a party to the transaction or the subject of the transaction allows for tax optimisation.

The list of grounds for treating the parties as related has also been considerably extended. The courts will still be able to treat the companies as related based on grounds not envisaged in the Law. At the same time, the threshold participation interest in another company that triggers companies being treated as related has been increased to the amount of a blocking stake (more than 25 per cent). Domestic transactions between related parties will now be controlled if the income from such transactions exceeds 1 billion roubles. During the transition period, domestic transactions will be controlled if proceeds from these transactions exceed 3 billion roubles (in 2012) and 2 billion roubles (in 2013).

The amended law sets out the principles in line with which the controlling authority should use the sources of information required to monitor whether transaction prices are in line with market prices. The amended Law also provides a list of sources of information on transactions.

The Law forbids the use of information that constitutes a tax secret, or the use of information, the access to which is limited by law. Information sources must be public. The Law now extends the list of methods for determining, for tax purposes, whether income from controlled transactions is in line with the market level. The methods describing comparable profitability and distribution of profit have been added. A procedure has been introduced under which the taxpayer may draft and submit documents confirming that prices applied in the controlled transaction are in line with the market level. These documents should be submitted at the request of the tax authority no earlier than 1 July of the year following the year when the controlled transaction took place. According to the amended Law, taxpayers will have to report controlled transactions to the tax authority.

The federal tax authority will now perform a tax audit of controlled transactions.The audit will be performed in the office of the controlling authority within six months. The amended Law allows the tax return of the other party to the controlled transaction to be adjusted to mirror the first party’s return. Such adjustment is only possible if the tax authority issues a decision to assess additional taxes to its counterparty, in which case the other party will need to adjust its tax return based on a request from the tax authority, without amending its tax registers or source documents.

Major taxpayers (there is special category of the major taxpayers that are typically very large corporations registered for tax in special tax offices) will be allowed to conclude fixed-term pricing agreements where they will set out the procedure for calculating prices and applying pricing methods. A groundless refusal by the tax authority to conclude such an agreement may be challenged in court.

During 2013, many companies that perform transactions subject to transfer pricing controls are undertaking transfer pricing research and developing their transfer pricing documentation.

ii Other relevant taxes
Other relevant taxes include, in particular, VAT, property tax and social security contributions.

There are no capital duty, net wealth or turnover taxes in Russia. The general VAT rate is 18 per cent. For some goods (mainly foodstuffs), the lower rate of 10 per cent applies.

Property tax is imposed on fixed assets and is paid at a rate of up to 2.2 per cent. This is a regional tax, and hence the rate may be reduced to zero in some regions. Moveable property registered after 1 January 2013 is not subject to property tax. Social security contributions are another tax-like payment to be met by employers and individual entrepreneurs. As of 2011, the general cumulative rate will be 34 per cent of wages.

IV TAX RESIDENCE AND FISCAL DOMICILE

i Corporate residence
At present, Russia uses only the place of incorporation as a test for defining corporate tax residence. Hence, a company incorporated in Russia will always be a Russian tax resident, while a non-Russian company will always be non-resident.

ii Branch or permanent establishment
It is possible to run a business in Russia via opening a branch. In defining when a permanent establishment (PE) exists, Russia generally follows the OECD Model Convention standards.

Under domestic law and tax treaties, a PE is defined as activities of a commercial nature run through a fixed place of business. Auxiliary and preparatory activities do not create the PE in the same way as with an independent agent.
In the allocation of profits, the separate independent entity approach applies.The case law on this matter is not developed, however; therefore the application of the allocation methods may raise issues with the tax authorities.
It must be noted that, as there is no branch profits tax in Russia, after-tax profits derived via a branch may be repatriated without additional taxation.The benefits of carrying on business through a branch are that there is no withholding tax on distributions to headquarters and no thin capitalisation rules apply to financing obtained by the branch.

V TAX INCENTIVES, SPECIAL REGIMES AND RELIEF THAT MAY
ENCOURAGE INWARD INVESTMENT

There are several special economic zones where CIT may be lowered or even exempt (as in Kaliningrad). The Skolkovo innovation special economic zone has obtained an extremely favourable regime, with a 10-year exemption from CIT, VAT and property tax. Some Russian regions also provide special CIT and other incentives for investors who establish new business in the region.

i Holding company regimes
The Russian participation exemption regime is relatively new. It was introduced in 2008 for taxation of dividends. Prior to this, the cascade taxation of dividends was partially prevented through the exemption from withholding tax of redistributed dividends. As of 2008, qualifying inbound dividends may be exempt from tax under the participation exemption regime.

The participation exemption covers qualifying dividends and does not extend to capital gains. To qualify for participation exemption, the holding must meet three tests:
a the minimum ownership duration must be of at least 365 days of continuous ownership as at the day of the adoption of the decision to pay dividends;
b the minimum participation must be of at least 50 per cent of the charter capital of the company paying the dividends, or depositary receipts conferring the right to receive dividends in an amount equal to no less than 50 per cent of the totalamount of dividends payable by the company; and
c dividends must be received from a foreign subsidiary.

As of 2011, a participation exemption is also applicable to the capital gain derived from the sale of shares in joint-stock companies or in LLCs. The capital gain is exempt if:
a shares have belonged to the seller for more than five years; and
b shares are not publicly traded; publicly traded shares are eligible for the participation exemption only if the issuer is a high-tech or R&D company.A participation exemption on capital gains is applicable with respect to shares acquired after 1 January 2011.

ii IP regimes
There is no IP box regime in Russia. Under VAT regulations, royalties may be exempt from taxation.

VI WITHHOLDING AND TAXATION OF NON-LOCAL SOURCE
INCOME STREAMS

i Withholding outward-bound payments (domestic law)
Under domestic law, outbound dividends paid to companies are subject to tax at the rate of 15 per cent.

Interest, royalties, lease payments, sale of immoveable property in Russia and shares in Russian property-reach companies, and other similar income, are taxable in Russia at the rate of 20 per cent. Under recent amendments to the Tax Code, in certain cases if the beneficial owner of shares is not disclosed, dividends are subject to an increased tax rate of 30 per cent.

ii Domestic law exclusions or exemptions from withholding on outward-bound
payments
There are no major domestic withholding tax exemptions on outbound payments.

iii Double taxation treaties
At present Russia has more than 80 effective tax treaties, based on the OECD Model Convention. Under the treaties, normally the 15 per cent domestic withholding tax on dividends would be reduced to 5 to 10 per cent, and withholding tax on interest and royalties would often be reduced to zero.

Recently, Russia has begun renegotiation of these treaties. Currently, the protocols to the treaties with Cyprus, Switzerland and Luxembourg have been signed. The most important amendments to the treaties provided by the protocols are:
a exchanging information on tax issues between the competent authorities of Russia and Luxembourg;
b limiting the application of benefits stipulated by the agreement;
c prevailing of national thin capitalisation rules over DTT provisions; and
d taxing specific types of income, including income from shares as well as units in unit investment trusts.

Following item (a), new text in Article 26 of this agreement will provide that such an exchange of information is possible in relation to any taxes; in addition, it specifically states that it will not be possible to refuse to provide this information ‘solely on the grounds that the information is at the disposal only of a bank or other financial institution, nominee holder, agent or trustee or that such information reveals the owners of a particular entity’.

Various provisions of the Swiss protocol are also aimed at increasing the effectiveness of information exchange between the tax authorities of Russia and Switzerland. In particular, it is specifically stated that:
[…] in order to obtain information that has been requested, the ‘tax authorities of the Contracting State which has received the request, may, to perform the obligations established by this clause, apply compulsory measures to ensure the disclosure of information […] regardless of […] any provisions of the legislation of such Contracting State.

In the agreement with Luxembourg, Article 29 will be amended, as well as being renamed ‘Limitation of benefits’. The new text will stipulate that taxpayers may not apply exemptions to any tax benefits if it is established that one of the principal reasons for the creation or existence of a taxpayer was to obtain benefits under this agreement. At the same time, a specific article is proposed for inclusion in the text of the agreement with Switzerland aimed at ‘combating conduit companies’. The effect of this new provision will be to make it impossible to claim benefits under the agreement with Switzerland if, for example, a Russian resident that is receiving income from sources in Switzerland pays that income to a third party that could not have claimed such tax benefit had it received the income itself directly.

The protocols with Cyprus and Switzerland were ratified in 2012. Meanwhile,some Russian tax officials have already announced plans for the future renegotiation of the DTTs with some other states.

iv Taxation on receipt
As a general rule, Russia applies a tax credit system. Foreign dividends are taxed at the rate of 9 per cent and interest at the rate of 20 per cent. As a double taxation relief, Russia applies a credit method both domestically and under tax treaties. No credit is given for underlying taxes.

VII TAXATION OF FUNDING STRUCTURES

In general, funding is a mixture of equity and debt.
i Thin capitalisation
Interest paid by a resident company to a non-resident company that directly or indirectly holds more than 20 per cent of the resident company is subject to thin capitalisation limitations. Under Russian thin capitalisation rules, interest is only partially deductible if the debt-to-equity ratio exceeds 3:1 (12.5:1 for companies engaged exclusively in banking or leasing activities); the remainder is reclassified as dividends and taxed accordingly. Thin capitalisation rules extend to cases of financing through a resident company affiliated with a non-resident lender, and also apply when a non-resident lender or affiliated resident company entity provides a guarantee or security for a loan. Interest exceeding this ratio is regarded as dividend and is taxed accordingly. A number of tax treaties, in particular those with Germany, France, the Netherlands, the UK, and the US, have protocols effectively restricting the application of Russian thin capitalisation rules under the rule about unlimited deduction of costs by Russian subsidiaries of a parent company from some of the mentioned countries, or under nondiscrimination provisions.

Such approach was also supported by previous court practice, which clearly stated with respect to the non-discrimination rules that they protect Russian companies with foreign shareholders from the application of the national thin capitalisation rule, since this rule leaves these companies in a worse tax position than Russian companies without foreign investment. This court practice has developed over recent years and has become one of the features of the available tax-structuring opportunities in Russia. After the North Kuzbass case, heard by the Russian Supreme Arbitration Court in November 2011, however, such practice has changed. During 2013 several cases were heard at the level of the Supreme Court of Arbitration, and the court stated that DTTs’ and protocol provisions on the unlimited deductibility of interest do not prevail over national thin capitalisation rules.

ii Return of capital
Capital can be repaid free of tax in the case of liquidation, provided it does not exceed the initial contribution. In a case of reduction of the charter capital, the distributed amounts are generally qualified under domestic rules as other income rather than dividends.

VIII ACQUISITION STRUCTURES, RESTRUCTURING AND EXIT
CHARGES

i Acquisition
In Russian commercial practice, share deals are the commonly used instruments for the acquisition of businesses.

Share deal: major tax consequences
Sales of shares are not subject to Russian VAT. In some cases, the tax authorities try to requalify share deals into the sales of assets, and charge VAT on such sale; the courts support them, however, only when there is the clear evidence that the real intention of the parties was to sell the assets. Capital gains on share deals are subject to Russian CIT at the rate of 20 per cent for both types of seller (i.e., the Russian company of the foreign company PE, unless a participation exemption is applicable). The participation exemption will become effectively applicable only to sales that take place from 2016. If a foreign company sells the shares of the Russian subsidiary, capital gains on such sale are taxable in Russia if the purchaser is located in Russia and the Russian company’s assets consist of more than 50 per cent of the Russian real estate. Most of the DTTs, however, exempt capital gain from the sale of real estate companies from taxation in Russia. Sale of Russian real estate company shares that tok place between two foreign companies are tax-exempt.

Asset deal: major tax consequences
Capital gains on the sale of assets are taxable at the general CIT rate of 20 per cent. The gain is generally calculated as the amount of the sale price above the book value of the asset. An asset deal is generally subject to Russian VAT at the rate of 18 per cent. Sale of land plots are exempt from VAT.

ii Reorganisation
Reorganisations are tax-neutral in Russia. The tax rights and liabilities of reorganised entities are not affected by the reorganisation. The tax authorities may not charge penalties to the surviving company that were not presented to the company that ceased to exist.

iii Exit
It is quite common for a non-resident investor to sell Russian assets on a non-resident basis in order to obtain a tax-free exit. Under local legislation, the sale of shares between two foreign companies is tax-exempt in Russia.

IX YEAR IN REVIEW

The major occurrences of 2013 were further application of the new transfer pricing legislation, and the development of case law with respect to cross-border taxation, such as intercompany services, and application of the thin capitalisation rules. The Russian fiscal authorities are continuing their collaboration with the authorities of foreign states to improve the exchange of information and renegotiate DTTs.

X OUTLOOK AND CONCLUSIONS

We expect that the quality of Russia’s tax administration will continue to improve, including the current institutions, alongside the development of new processes for matters including tax ruling and consolidation. In addition, the tax system will continue to focus, inter alia, on the development of international communication in the area of DTTs and combating tax evasion.

Please click here to view the  full version of the fourth edition of The Inward Investment and International Taxation Review.

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