Characteristic features of taxation of income from participation in real estate investment trust (REIT) of a non-resident interest holder in the Russian Federation
For a long time, closed real estate investment trusts were powerful legal arrangements for tax planning with the help of which tax payers to execute income tax deferment, or completely avoided paying income tax on compelling legal grounds. Currently, it is a common practice that real estate located in the Russian Federation is transferred to the assets of closed real estate investment trust for discretionary management. Non-resident companies, registered in one of EU countries with which RF has reciprocal contracts on double taxation avoidance, become interest holders. This enables them not to impose taxes onto income from REIT upon sources of payment if the Russian Federation.
Companies registered in Cyprus were the most popular for attracting participants to the paradigm under discussion. This was due to the reciprocal contracts on double taxation avoidance signed by Cyprus with other countries that income gained from REIT considered being another income liable only in Cyprus (Article 22 of the Agreement). And in accordance with national legislation of the Republic of Cyprus, transactions with the shares of investment trusts are beyond income tax imposition.
It was found recently, that such a cloudless picture won’t stay forever. Under the sole discretion of the law-maker sooner or later everything useful shall come to an end. In October 2010, governments of the two countries signed Protocol on modifications’ implementation into Contract on double taxation avoidance signed between Cyprus and the Russian Federation. The Protocol became effective as of April 2nd, 2012 (in accordance with Federal Law №9-FZ dd.28.02.2012) and is to be applied from January 1st, 2013 (with some exceptions). The Protocol introduced a lot of important changes. Legal relations in the sphere of taxation of income received by Cyprus companies from REIT in RF were drastically modified. Namely, according to Article 3 of the Protocol, revenues received through real estate trusts, real estate investment trusts or similar collective investment schemes are now equivalent to the revenues from real estate. This means, that the revenues of interest holder being the resident of Cyprus obtained as progress payments from real estate investment trust share, and also from the share repayment or sale shall be charged on th territory of RF as the revenues from real estate (meaning, at the rate of 20% according to Sub-item 10 Item 1 Article 301 and Sub-item 1 Item 2 Article 284 of the Russian Tax Code). Interpretations of authoritative institutions regarding the issue are already available (letter of the Ministry of Finance of RF № 03-08-05 dd. January 28th, 2011).
In view of the coming changes, RF entrepreneurs face a lot of significant issues regarding the search for the most optimum jurisdiction to register interest holder of RF REIT which can be the answer to Cyprus. In the present article we will try to choose the most appropriate jurisdiction from the point of view of taxation; where it is more appropriate to register a company being the interest holder of a RF REIT.
In the process of analysis and selection carrying out of the most favorable resident country for future interest holder of Russian real estate trust we shall rely upon the following criterion:
- Double taxation avoidance agreement shall be signed between the Russian Federation and this country;
- This double taxation avoidance agreement shall provide for the possibility to treat the income received from real estate investment trusts in RF as other (diverse) income, and lack of necessity for imposing taxes in the country of income payment source (in the Russian Federation);
- In the resident country of income recipient small tax rates per income tax upon shall apply.
In should be noted that in the present article when we are talking about the income derived from REIT we understand income as progress payments under shares received by an interest holder on a regular basis.
First, we would like to carry out comparative analysis of the countries which are very popular currently from the point of view of foreign funds investment. Those countries are Luxemburg, the United Kingdom, the Netherlands, Malta and others. In the present article we will be studying:
Luxemburg:
The Russian Federation also signed Protocol with Grand Duchy of Luxemburg which introduces changes into the already excising Agreement on double taxation avoidance. The changes are similar to those introduced in Cyprus. Currently, the Protocol signed with Luxemburg has not yet come into effect and shall apply starting from January 1st, of the year succeeding the year of its coming into force (Article XII of the Protocol). As it was already pointed out the changes introduced into the Agreement with Luxemburg are similar to those introduced into the Agreement with Cyprus. According to the changes, income from the shares of trusts established first of all to invest into real estate shall be considered the income from real estate. This means, upon entry into force of the Protocol revenues of an interest holder being the resident of the Republic of Luxemburg derived from participation in real estate investment trust in RF shall be charged on the territory of RF as revenues from real estate (i.e.at the rate of 20%).
The United Kingdom:
Great Britain is rather popular from the point of view of taxation. Mostly it is due to the fact that double taxation avoidance agreements are signed with more than 100 countries. Companies registered in the UK are often used as an effective remedy for tax avoidance.
Compared to other jurisdictions (Cyprus, Luxemburg), and according to the provisions of Convention on double taxation avoidance as of 15.02.1994 signed between two companies, income received from holding a share in real estate investment trust in the UK are not directly classified as the income from real estate.
Article 21 “Other income” of the Convention in force contains an exception stating that payments from trust funds or from the heritage received because of the death cannot be classified as other income. In view of the exception, at first sight it seems to be impossible to classify progress payments under investment trusts shares as other income. But actually it is not quite so. The term “trust fund” is the definition of English law. RF legislation does not contain such definition. According to English law, trust fund is the obligation of an agent to administrate the property transferred under his control in favor of third parties (fund beneficiaries) among those both an agent himself and a person who entrusts him to do so. According to RF legislation, share investment trust is an isolated property complex consisting of the property transferred to discretionary management by a trustor under the condition of unification of the property with the property of other trustors, and from the property received in cause of such discretionary management the ownership share to which is certified by a security issued by managing company (Article 10 of Federal law as of 29.11.01 № 156-FZ “On the investment funds”. As one can see, the terms “trust fund” and “share investment trust” are not identical as for their legal nature. In case a term is used not provisioned in RF Convention it accepts the meaning which is assigned by RF legislation (Item 2 Article 3 of the Convention).
In view of the above, we suppose that progress payments under the shares of real estate investment trusts registered in RF in favor of interest holder being the resident of the UK, shall be classified as other income in interest holder residence country (the UK). The rate of income tax in the UK is low compared to income tax rate in RF and amounts from 21% to 28% (the rate varies depending on the amount of net profit for year of a company).
It should be noted that currently a lot of specialists claim that there is a possibility to optimize the scheme “REIT in RF – interest holder in the UK” by means of using such legal person as Limited Liability Partnership (LLP) as an interest holder. Offshore residents are the participants of such LLP. According to the specialists, it will enable to considerably optimize taxation of interest holders’ income (Scheme 1).
The characteristic feature of such legal person is that the income of LLP is not subject to taxation under the UK legislation in case its participants are not residents of the UK, they do not conduct business activity in the UK and do not have payment sources. In this case, LLP participants shall pay taxes in residence country. Taking into the account that on the territory of British Virgin Islands there is no corporate tax and individual income tax, it appears to be tax-free arrangement of income receipt from RF REIT.
We believe such arrangement cannot be implemented in practice due to the following reasons. Under the considering circumstances, LPP will not be admitted as the UK resident and the provisions of the Convention on double taxation avoidance shall not apply. The income of an interest holder of RF REIT will be charged as per payment source in RF (Item 6 Article 309 of the Russian Tax Code). The use of such legal person as LLP is not suitable for financial activity with those countries where withholding tax exists (RF included) .
The Netherlands:
Double taxation avoidance agreement is also signed between RF and the Netherlands on December 16th, 1996. The Protocol was signed simultaneously. Judging from the provisions of the Agreement, income received by Dutch interest holders from RF REITs can be classified as other income subject to taxation only on the territory of Kingdom of the Netherlands. In this case payment source in RF is not subject for taxation. Income tax rate in the Netherlands is graduated and depends on Net Profit for Year of a company and amounts up to 20% (in case Net Profit for Year of a company is less than 200 000 Euro) or 25% (in case Net Profit for Year of a company is more than 200 000 Euro).
According to the provisions of double taxation avoidance agreement it is impossible to classify such income as dividends as it is provisioned by the Protocol that the term “dividends” includes income transferred from RF and received by the Netherlands resident from the participation in joint venture having Russian and foreign investments, which for the taxation purposes is treated as corporate entities or legal person (to which according to RF legislation REIT does not belong).
Malta:
The Convention on double taxation avoidance and prevention of fiscal evasion regarding income tax was signed by the governments of RF and Malta in Moscow on December 15th, 2000. But until now the Convention was not yet validated by RF and did not become valid (it becomes valid within 30 days from the date of the last notification about the fulfillments of the Parties of all domestic procedures).
The Convention on double taxation avoidance and prevention of fiscal evasion signed by RF and Malta does not provision for the detailed taxation procedure of income received from REITs in RF. This means, such income shall be treated as “other income” and, according to the provisions of the Convention, the taxes will be imposed only in the country the resident of which received the income (i.e.in Malta). In Malta income tax rate is one of the highest in Europe and amounts up to 35%.
Imputation tax system is used in Malta. The system provides for the tax refund in the amount from 2/3 to 6/7 off the tax paid.
For example, the income received from the investments is distributed by Malta companies as the dividends. The tax paid by Malta company is subject for the refund in case these dividends are distributed from the revenues rating to the rest of the state account to which the tax is imposed. Income rated to the rest of the state account is the income received outside Malta, such as dividends, income from investments, etc.
The income from participation in REIT is not explicitly named. We believe, they can also be entered to the rest of the state account of a Malta company.
Taxes refund is calculated on the basis of the tax paid above required according to bilateral agreements on double taxation exemption, one-side tax deductions and agreements on income tax decrease within the Commonwealth. This means that taxes paid abroad can be considered at tax refund calculation provided the total refund does not exceed total tax amount paid in Malta. In case the calculation is done basis flat rate FRFTC the refund shall be calculated upon taxes paid in Malta.
In case Malta company requests flat rate FRFTC which is one of the four forms of double taxation exemption procedure under Malta legislation. Any refund will be limited by 2/3 off Malta taxes which as a result gives the ultimate efficient tax rate of 6.25%.
Switzerland:
In the currently existing revision of the Agreement signed with Switzerland there is some uncertainty with regards to classification of the payments under the shares of REITs as taxable or non-taxable income; and uncertainty with regards to tax rate applicable to the source. Such uncertainty was in a way eliminated by Protocol to the Agreement signed on September 24th, 2011. But until now the Protocol did not become effective as it comes into force upon the date of the last notification on domestic procedures fulfillment that are required for the validation of the Protocol. The Protocol was approved and introduced for ratification to State Duma of RF by RF Government Decree as of April 23rd, 2012 №354.
As compared to the Protocols to the Agreements on double taxation avoidance signed by Russia with Luxemburg and Cyprus, and following the negotiations between Russia and Switzerland it was agreed not to change the term “property income” with regards to the taxation of REITs’ income established mainly to invest into the real estate. It is a good news for tax payers as such type of income as income from REIT will no longer be liable to unlimited tax in the country of such income origin. To the contrary, upon validation of the Protocol, such income will be treated as dividends liable to taxation with income payment source at the corresponding rates of 5% of total dividends amount (in case dividends’ acquiring company owns at least 20% of REIT assets and foreign funds invested into trust exceeds 200 000 CHF) or 15% of the total amount of dividends (in all other cases). It should be noted that any other payments under REIT shares exceeding 50% of the income received for the account of shares shall also be considered dividends. Payments under REIT shares income of which is composed of less than 50% of the income received for the account of shares shall be considered interests exempt from taxation with income payment source in the country of origin of such income.
The article on methods of elimination of double taxation (Article 23 of the Agreement) provides for method of exclusion of double taxation with regards to Switzerland residents for all types of revenues liable for taxation in RF. In case a Switzerland company receives income which according to the provisions of the Agreement is liable for taxation in RF the income tax amount to be paid in RF can be deducted from the tax imposed in Switzerland.
According to Switzerland federal legislation, dividends received by a Switzerland company are included into taxation base (effective tax rate is 7,83%).
Therewith, upon dividends payment by a Switzerland company to a nonresident shareholder, the tax shall also be paid. In this case the provisions of the Agreements shall apply. If Russian resident individual is a shareholder of a Switzerland company, the source tax imposed in Switzerland will amount up to 15% (instead of the usual one in the amount of 35%). At first the tax is paid by a company in full and then the repayment is done upon the confirmation of the right for reduced tax rate.
In case the article on methods of elimination of double taxation is applied upon paying taxes in RF, the resident of Russia receives the deduction in the amount of the source tax paid in Switzerland but not more than the total amount of Russian tax. In RF personal income tax rate amounts up to 9%, so actually the tax is not paid in RF.
Denmark:
The Convention on double taxation avoidance signed between RF and Denmark as of 08.02.1996 enables to treat revenues of a Danish company received from progress payments under the shares of REITs in RF as other income liable for taxation only in Denmark (Article 21 of the Convention). But Denmark is not famous for low income tax rate, currently income tax rate in Denmark amounts up to 32%. At the same time, Danish legislation provides for the possibility to register and use a company with zero tax rates in one’s activity. We are talking about such companies as K/S which year by year become more and more popular with the businessmen. It is the partnership having at least two settlors one being General Partner, and the others being Limited Partners.
Danish companies such as K/S having foreign settlors and conducting no commercial activity on the territory of Denmark are not tax residents of Denmark. According to Danish tax legislation, the company K/S is not treated as particular taxation subject (hence, a tax payer number is not assigned to the company K/S in Denmark), and income taxes are payable by the settlors of the company K/S (by General Partner and Limited Partners) at their residence place proportional to the shares within the partnership.
One thing is also very important here: as the companies such as K/S are not Danish taxpayers, they do not fall within the scope of interstate agreements on double taxation avoidance signed by Denmark. This means, income of Danish company such as K/S from participation in RF REIT will be liable to taxation at payment source in RF.
At the same time, Danish legislation provides for the possibility for Danish Holding Companies to transfer dividends received abroad further to parent company from those countries with which Denmark has signed taxation agreements without any taxes imposing. Considering the fact that dividends can be transferred from Denmark to many other companies under preferred conditions of the agreements on double taxation avoidance, a Danish company is an advantageous tool to be used as the settlor of residence companies in other countries (RF is also included). As it was already mentioned, the procedure is the most attractive for the distribution of dividends received abroad. According to RF legislation, progress payments under shares of REIT cannot be treated as dividends.
And now let us consider some European countries and bordering with RF countries having relatively low income tax rates, such countries as Latvia, Lithuania, Ireland, Bulgaria, Romania and others.
Latvia:
The Agreement on double taxation avoidance and prevention of fiscal evasion with regards to income and capital taxes was signed by the Governments of RF and Latvia in Moscow on December 20th, 2010. The Agreement was approved and introduced for ratification by RF Government Decree №465 as of May 05, 2012. But until now it was not ratified and did not become effective. The Agreement comes into force upon the date of the last notification on all necessary procedures fulfillment. The Agreement does not provide for the procedure of taxation of income received from REIT, and the income shall be classified as other income tax exempted in the payment source country. Income of Latvian REIT interest holder shall be taxed at the income tax rate of 15% currently in force in Latvia.
Lithuania:
RF also has effective Agreement on double taxation avoidance and prevention of fiscal evasion with regards to income and capital taxes with Lithuania signed in Moscow on June 29th, 2005, 40-FZ. The Agreement came into force on April 29th, 2005 and has application to taxes as of January 01st, 2006. The provisions of the Agreement are similar to those considered above. Income tax rate in Lithuania also corresponds to that in Latvia and amounts up to 15%.
RF also has agreements on double taxation avoidance signed with some other countries which are in force currently and have application to fiscal legal relations between the parties. Wordings of the Agreements with such companies as Ireland (Agreement as of April 29th, 1994), Bulgaria (Agreement as of June 08th, 1993), Romania (Agreement as of September 27th, 1993), Moldova (Agreement as of April 12th, 1996) contain similar provisions according to which interest holder income from REIT shall be classified as other income and are liable to taxation in the state of residence of an interest holder (income recipient). Income tax rates applied in the above-mentioned countries only differ. In Ireland income tax rate is 12,5%, in Bulgaria – 10%, in Rumania – 16%, in Moldova – 12% correspondently.
In order to systemize the above-mentioned information, characteristic features of resident companies' income from RF REIT taxation, the following table can be used:
Judging from the analysis of bilateral agreements on double taxation avoidance signed by RF with other countries and also from the table below the following countries are the most advantageous jurisdictions for income from REIT optimization: