In December 2013 in the address to the Federal Assembly the president Vladimir Putin stated that Russia needs a system of measures for “deoffshorization” of the Russian economy. “Our entrepreneurs are often criticized for lack of patriotism”, - the president reminded. According to him, some estimates evidence that 9 out of 10 transactions, including transactions with state-owned companies, are not subject to the Russian laws. “We need to ensure transparency of offshore companies, as many countries do”, - Putin said.
He noted that if companies chose other jurisdictions, the deficiencies of our system shall be addressed.
As estimated by the Bank of America Merrill Lynch, Russian budget can get an additional income amounting to 6 billion US dollars only due to taxation of dividends, taken away in offshore zones to avoid taxation. Russian residents own 60 th. of foreign companies, of which 15 th. are registered in Cyprus, 5.5 th. - in the Virgin Islands, 3.5 th. - in the Seychelles.
Inspired by the instructions of the President, the Ministry of Finance developed a bill on controlled foreign companies.
On 18 March 2014 the Ministry of Finance posted on its official website the first version of the bill “On amendments to the first and second parts the Tax Code of the Russian Federation (in terms of taxation of profit of controlled foreign companies and improvement of efficiency of tax administration of foreign organizations)”, which caused active controversy in the business circles. The bill was worked out within eight months repeatedly. Finally, on 25 November 2014 the bill was signed by the President and will become effective on 1 January 2015.
The law on controlled foreign companies (the so-called “CFC law” - a term derived from the abbreviation “Controlled Foreign Company”) is an institution first established in the legal system of the United States of America. The essence of the CFC law consists in the fact that the profit of companies registered in low-tax or tax-exempt jurisdictions and countries controlled by residents applying high rates of profits (income) tax, for tax purposes undertake to report the profit received from controlled companies as their own profit, and pay on it the tax according to the national rates of the actual recipient of profit (income).
Basic Provisions of the Law
The law obliges the Russian companies and individuals to pay the tax (20% or 13% respectively) on retained profit of controlled foreign company.
The law introduces the concept of controlled foreign company and expands the legal interpretation of the term “controlling persons”.
Controlled Foreign Organization
The law provides for two conditions for the recognition of an organization controlled foreign company:
1. The organization is not a tax resident of the Russian Federation;
2. The persons controlling the organization are individuals or legal entities - tax residents of the Russian Federation;
However, the law contains a list of conditions for exemption of profit of controlled foreign companies from taxation, in particular:
1. The organization is a non-profit entity that does not distribute obtained profit (income) among the shareholders (members, founders) or other persons;
2. The organization is established under the legislation of the member-state of the Eurasian Economic Union;
3. The organization is permanently located in the country (territory) included in the list of countries (territories), which provide for the exchange of information for tax purposes with the Russian Federation, and the effective rate of taxation of income (profit) for such foreign organization makes up at least 75% of the weighted average corporate profits tax;
4. The organization is an active company (at most 20% of its income is passive), provided it is located in the countries having an international tax agreement with the Russian Federation;
5. The organization is a foreign entity without legal personality meeting all of the following conditions:
- the incorporator (founder) is not entitled to receive assets of this entity with the property right;
- the rights of the incorporator (founder) can not be transferred to another person except for inheritance or universal succession;
- the incorporator (founder) is not entitled to receive, whether directly or indirectly (receipt by a mutually dependent person of profit (income) of the entity for the benefits of that person) any profit (income) of the entity distributable among all its members (unit holders, principals or others) or beneficiaries;
6. The organization is a bank or an insurance company, the permanent location of which is in the country included in the list of countries (territories) providing for the exchange of information for tax purposes with the Russian Federation;
7. The organization is an issuer of certain types of Eurobonds, if the share of interest income from these bonds makes up at least 90%
8. The organization is involved in foreign oil production projects - the share of income from oil production projects makes up at least 90%;
9. It is operator of offshore projects and their direct shareholders (members).
Controlling Person
Controlling person is:
1. The person whose share of participation in the organization makes up over 25 percent;
2. The person whose share of participation in the organization jointly with his/her spouse and (or) minor children, makes up over 10 percent, if the share of direct and (or) indirect participation of all persons recognized as tax residents of the Russian Federation in this organization jointly with their spouses and (or) minor children makes up over 50 percent.
Note that the share of participation of such person in the organization or other entity is determined by adding the shares of:
- the beneficiary;
- the spouse;
- his/her minor children (including adopted ones);
During the transition period (until 1 January 2016), the percentage of beneficial weight makes up 50% for two criteria mentioned above.
Procedure for Notification about Controlled Companies
Taxpayers are obliged to notify the tax authority about their shares of participation in foreign organizations and foreign entities without legal personality and notify about controlled foreign companies.
The taxpayer must notify the tax authority about:
- its share of participation in foreign organizations, if such share makes up over 10%;
- its share of participation in foreign entities without legal personality, if the taxpayer is incorporator of such entity or a person having actual right to the income (profit) of such entity in case of its distribution;
- controlled foreign companies in respect of which it is a controlling person.
The statements in the form of a notice about share of participation in a foreign organization shall be submitted not later than 1 month from the date of occurrence (change of the share) of participation in such foreign organization. If in the period after notification about participation in a foreign organization the grounds for such notification remain unchanged, no repeat notice shall be provided.
The law lays down the right of the tax authorities in the case where they have reasons to believe that the taxpayer is a controlling person of a foreign organization/entity without legal personality, and provided that such person did not sent to the tax authority a notice of a controlled foreign company, to require the taxpayer to submit within 20 days the necessary explanations or directly the notice.
Legal Consequences of Presence of Controlled Foreign Companies in the Group Structure
As for the procedure for calculation of the profit of the controlled foreign company, the law provides for the following:
- The profit of a controlled foreign company registered in a jurisdiction which has an international tax agreement with the Russian Federation, is subject to calculation on the basis of the financial statements of such company prepared in accordance with its own legislation (provided that the financial statements are subject to mandatory audit);
- In all other cases, the mechanism for the calculation of profit “in accordance with chapter 25 of the TC RF” applies.
If according to the financial statements of the controlled foreign company prepared in accordance with its legislation for the fiscal year, a loss incurred, such loss can be carried forward to future periods without restrictions and can be taken into account in determining the tax base of such company.
The specified amount of profit of the controlled foreign company shall be divided between the controlling persons in proportion to their shares of participation in the organization. If such share can not be determined, the profit of such foreign company is taken into account in proportion to the number of members.
However, it should be noted that the profit of the controlled foreign company shall be taken into account in determining the tax base, if its value make up over 10,000,000 rubles.
It is expected to establish significant penalties for violation of the obligations of notification and for failure to disclose data on profit of controlled foreign companies. The law provides for the following tax-related penalties:
1. A fine of 100,000 rubles for failure to provide information about the companies, the activity of which is controlled by the taxpayer through a third party. A similar penalty is provided for provision by the taxpayer of false documents and information.
2. A fine of 100,000 rubles for each controlled foreign company, the data about which were not submitted by the taxpayer to the tax authority.
3. A fine of 20% of the hidden profit, but not less than 100,000 rubles for failure to pay or partial payment of corporate profits tax or personal income tax in respect of the profit of controlled foreign company (no fine is charged in the transition period 2015-2017).
Tax Aspects of Liquidation of a Foreign Company
In accordance with the law if the organization under liquidation is a foreign organization, the income in the form of the cost of obtained property (property rights) of the taxpayer-shareholder (member, unit holder) recognized as a controlling person of such foreign organization is not included in the tax base. This provision is temporary and applies only till 1 January 2017. This rule is transitory and is introduced in order to encourage restructuring of Russian groups to comply with the new rules of controlled foreign companies.
Issues on Application of the Law
The issue on the applicability of the Western experience of control of foreign companies in Russia remains unsolved. The real possibility of the Russian tax authorities to obtain information on the beneficiaries and shareholders of foreign companies consists in the application of international agreements on the exchange of information. However, there are no such agreements signed between the Russian Federation and the territories blacklisted by the Russian Finance Ministry.
Thus, the following mandatory action of the Russian Finance Ministry shall be development of the strategy allowing obtaining information about availability at the Russian individuals and legal entities of income from organizations registered in offshore zones, such as, for example, information about the flow of the accounts of Russian entities in banks outside the Russian Federation. It seems that the only effective method allowing receiving such information is the introduction of tools of control over the transactions made through the accounts of the Russian citizens and legal entities opened with banks, including outside the Russian Federation. A similar method is used by the US public authorities in the implementation of the FATCA, obliging all banks with which accounts of American residents are opened to disclose relevant information to the US tax department. However:
- objectively FATCA is imposed to the international community by establishing prohibitive tax rates for banks that refuse to provide such information;
- the prohibitive measures described above can apply only to transactions carried out by the relevant banks in the country that established them. Thus, the banks that did not adhere to FATCA shall pay a 30% tax on transactions on accounts opened in the USA;
- similar legislation implies a significant violation of the banks of the national legislation on bank secrecy in most countries where banking transactions are carried out.
Consequently, for a similar tool to be implemented in Russia, foreign banks shall be so interested in carrying out transactions in Russia as to be ready to provide the relevant information to the Russian tax authorities.
In addition, if a system of control of foreign companies, the beneficiaries of which Russian persons/entities are, is established in Russia (irrespective of whether it is established on the basis of the considered law or on any other document), the beneficiaries will be obliged to a certain extent to notify the supervisory authorities whether they have or not controlled foreign companies. And in this case, the only truly effective tool of coercion will be sanctions imposed on offenders. The fines proposed by the authors of the new law amounting to 100,000 rubles will not be able to become a truly effective tool, and will be considered by taxpayers just an additional (not too significant) fee charged from their business.
Problems and Solutions
The CIC law lays down two obligations:
- to provide information on holding shares of participation in foreign companies
- to pay tax on undistributed profit of CIC to the Russian budget
Thus, when deciding on restructuring their business taxpayers shall answer for themselves the following questions: is critical for the beneficiary the disclosure of information on share of participation in foreign companies? If the answer is positive, almost the only way out for taxpayers is to cease to be tax residents of Russia. In this case, it will be necessary to choose the appropriate country to move taking into account the local legislation on the similar issue.
If the answer is negative, the simplest and the most obvious solution would be: simple distribution of dividends; nevertheless dividends will still be subject to taxation. It should be noted that from the next year the personal income tax rate on dividends increases to 13%.
However, the law provides for the possibility for CICs to voluntarily recognize themselves residents of the Russian Federation, and thus to be able to enjoy the benefits provided for by the tax legislation of the Russian Federation.
A foreign company may be also transferred into a jurisdiction with a higher effective tax rate, thus exempting from taxation the CIC profit.
If it becomes obvious that doing business through foreign organization is not feasible, a possible solution to be considered may be liquidation of the foreign company before 1 January 2017, taking into account the benefits applicable in the transition period.
Of course, this list of possible solutions is far from being exhaustive, and it is clear that, over time, increasingly sophisticated methods of tax optimization more or less aggressive appear, but still we have to remember that tax authorities will also improve their methods and possibly some solutions will be only temporary in their nature.