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Factoring As Tax Optimization

The new economic reality of the Russian Federation features the persistent cash gap faced by business owners when suppliers refuse to accept deferred payment terms, buyers are reluctant to pay in advance for delivery, and banks either do not grant working capital loans or increase their interest rates. In such circumstances businesses increasingly turn to alternative financing strategies, including factoring.
In this paper, we consider the implementation of factoring schemes and their target audience.

General Rules for Factoring Operations

Factoring is a financial commission operation whereby the client sells its accounts receivable to the factoring company in exchange for immediate payment of the major portion of the full receivable value along with the remainder of the total outstanding amount less a discount established by the factoring company after the factoring company collects receivables from the account debtor.

Typically, financing is required by companies working with buyers and customers on deferred payment terms. The situation is aggravated if these companies deal with suppliers and contractors on the terms of advanced payment. In this case, in order not to be regarded as non-payers, companies turn to acquisition of financing based on the factoring of accounts receivable of buyers and customers. This financing includes the following steps:
1) The client enters into a deferred payment agreement with the buyer and the customer;
2) The client contracts the factoring company for financing of accounts receivable pursuant to the agreement specified in Item 1;
3) The client submits all the documents confirming accounts receivable to the factoring company;
4) The factoring company remits a major portion (70 to 90%) of the total outstanding amount set forth in the factoring agreement to the client;
5) The factoring company seeks payment of outstanding invoices from the debtor;
6) Once the debtor pays invoices, the factoring company rebates the remaining funds to the client, less a factoring fee.

As a result of these operations, the client will be enabled to:

  • Reduce the risks of cash gaps;
  • Reduce the risks of non-payment to suppliers, contractors, employees, and the budget due to violation of the financial discipline by buyers and customers;
  • Get benefits and discounts from suppliers and contractors owing to the possibility of advanced or timely payment;
  • Attract buyers and customers by providing additional benefits, specifically longer terms of deferred or installment payments compared to those offered by competitors;Reduce the need for loans with high interest rates to replenish borrowed funds;
  • Unlike bank loans, factoring method allows to obtain the greater receivable value (90% of the required amount as opposed to 70% which is normally paid by banks), at lower interest rates (discount fees specified by the factoring company is typically lower than interest rates on bank loans), with neither security nor guarantor requirements.

Accordingly, trading companies use factoring as an efficient tool for management of accounts receivable and adherence to the cash flow budget.

Factoring Involving A Foreign Entity

Factoring scheme can offer more benefits to a company in the event that accounts receivable financing will be performed by a foreign bank (foreign factoring company) since discount fees charged by foreign banks for factoring services are generally lower than those applicable in Russia. However, in addition to paying less money for this financial service, company can gain other benefits, including tax benefits.

Thus, as a general rule, a party (fiscal agent) under the factoring agreement remits or undertakes to remit funds to a second party (client), in exchange for the monetary claims of the client (creditor) related to the delivery of goods, performance of work, or rendering of services to a third party (debtor), and the client transfers or undertakes to transfer this monetary claim1 to the fiscal agent.

A foreign bank will acts as a fiscal agent in the above situation. In accordance with the business practices, a foreign bank will enter into negotiations with the client to discuss potential financing only in the event that this bank has a presence in the jurisdiction wherein the client intends to obtain such financing. The presence can be created either by establishing a new company within this jurisdiction or by setting up an independent branch in this territory.

In this case, the factoring scheme will be as follows:
1) The client, being a resident of the Russian Federation, signs a deferred payment agreement with the buyer or the contractor;
2) The client, being a resident of the Russian Federation, establishes a company or opens an independent branch in a foreign jurisdiction;
3) The client, being a resident of the Russian Federation, or a client’s foreign company /foreign branch, and a foreign bank enter into an agreement for financing of receivables pursuant to the agreement specified in Item 1;
4) A foreign bank advances a portion of the payoff to the client in exchange for the rights associated with accounts receivable;
5) Once the debtor pays the receivables, a foreign bank pays the remaining amount, less the factoring fee.

Accordingly, as a result of the foregoing operations, profit gained under the factoring agreement (payment in exchange for assignment of accounts receivable) is dependent on the form of presence in the foreign jurisdiction maintained by the client, its controlled company or its independent branch. In the event that income tax imposed on operational activities in the specified jurisdiction will be lower than in the Russian Federation, the client will also be able to get income tax savings.

If a factoring transaction is carried out through a controlled foreign company, the indicated foreign company shall:
  • either act as a buyer (a party of the agreement under which receivables are generated) and subsequently sell goods to a Russian company incorporated in the same group; or
  • obtain the rights to collect accounts receivable from a Russian company which is a buyer and a member of the same group.

In the first instance, tax saving will be achieved only if the company accumulates the group’s principal amount of added value (purchases goods from suppliers and sells them at a maximum mark-up to Russian companies that are members of the same group).

In the second instance, tax saving will be achieved if a maximum profit from transfer of receivables will be obtained in the low-tax jurisdiction, i.e. in the event that a foreign company sells accounts receivable to a foreign bank for less than it purchases them from a Russian company.

In either case, execution of business operations will be associated with tax risks since buy/sell and receivable transfer transactions will be subject to price controls as transactions made by companies which are members of the same group.

If a factoring transaction is carried out through an independent branch of a Russian company in the low-tax jurisdiction, it will be more favorable for a tax payer.

In the above situation, a Russian company will purchase goods (work and services) from suppliers through a foreign establishment. Besides, a factoring agreement is entered into by and between a Russian company, on behalf of its foreign branch, and a bank located in this particular jurisdiction for financing of accounts receivable related to sale of goods to the buyer.

Tax saving is therefore achieved if activities of an independent branch operating in the foreign State will result in setting up a permanent establishment in order to enter into force a double taxation avoidance agreement, and taxes will be imposed on income gained by this permanent establishment within the low-tax jurisdiction.

The majority of double taxation avoidance agreements signed in the Russian Federation are executed based on the OECD Model Convention. Formal commentary on the Model Convention has been developed by OECD(1).
In accordance with the Model Convention, a permanent establishment is defined as a fixed place of business. Subject to the provisions of the Commentary, the term “fixed place of business” shall meet the following criteria(2):
  • the existence of “a place of business”, i.e. a facility such as a premise or, in certain instances, machinery and equipment;
  • this place of business must be “fixed”, i.e. must be established at a distinct place with a certain degree of permanence;
  • conducting business through the fixed place of business. This means that persons who, in one way or another, are dependent on the enterprise (personnel) conduct the business in the State in which the fixed place is located.

If all the three conditions are satisfied, it is possible, as a general rule, to make a conclusion that conducting of the business results in setting up a permanent establishment. As indicated in the Commentary, “a place of business” exists if a tax payer has a certain amount of space “with a certain degree of permanence” and “at its disposal”, whether or not it is occupied legally or illegally(3).

Accordingly, the fact that a place of management of the separate foreign branch is located in the foreign State where a bank account is opened, an office is leased, and personnel who are residents of this State are employed full-time, will constitute the main characteristics of the permanent establishment. Thus, income earned through such establishment will be taxed in the foreign State at the national tax rates.

Factoring Through An Independent Branch in Cyprus

The income tax of 10% is imposed in Cyprus, which is the lowest corporate tax rate in the European Union. Cyprus is, therefore, a reasonable choice for implementing the foregoing factoring scheme.

In accordance with the tax agreement between the Russian Federation and Cyprus, the term “permanent establishment” includes a place of management; a branch; an office; a factory; a workshop; or a place of extraction of natural resources(4). Taking account thereof along with the provisions of the Model Convention provided above, financing obtained from a bank’s foreign branch under the factoring agreement can be regarded as transactions leading to creation of a permanent establishment of the Russian company in the foreign State, provided that the following requirements are met:
  • leasing of an office in Cyprus;
  • opening of a bank account in a Cyprian bank;
  • director of a Cyprus office is a permanent resident of Cyprus;
  • hiring of employees to work in a Cyprian office;
  • warehouses and other assets (cars) owned or rented by a particular company for the purpose of deriving revenues have been allocated in Cyprus;

If the above conditions are observed, incomes of a Russian company earned through a foreign branch will be taxed in Cyprus.

If a company being a resident of the Russian Federation earns income which, subject to the provisions of the Treaty, is taxed in Cyprus (as an income obtained through a permanent establishment), the amount of tax due on such income can be deducted from the tax withheld in Russia(5). In this case, this deducted amount must not be in excess of the corresponding income or capital tax imposed in Russia and calculated based on Russian tax legislation and rules. The deduction is performed on condition that a tax payer submits a document confirming payment (withholding) of tax outside the Russian Federation. In case of taxes paid by the organization itself, the document must be certified by the relevant tax authority of the foreign State, whereas taxes withheld by tax agents in compliance with the foreign law or the international treaty require verification of the tax agent.

Therefore, the execution of factoring transactions through an independent branch in Cyprus will allow Russian companies to get tax saving of up to 10% owing to a lower income tax under the factoring agreement: 10% in Cyprus and 20% in the Russian Federation.

Factoring is, consequently, an efficient tool which provides not only management of accounts receivable, but also, in case a foreign company having a presence in the low-tax jurisdiction is involved in the factoring scheme, an opportunity for tax optimization.

(1) - OECD Commentary on the OECD Model Convention with Respect to Taxes on Income and on Capital (September 1992) (hereinafter – Commentary).
(2) - Paragraph 2 of the Commentary on Article 5 of the OECD Model Convention.
(3) - Paragraph 4.1 of the Commentary on Article 5 of the Model Convention.
(4) - Items a-f, Clause 2, Article 5 of the Agreement.
(5) - Clause 1 of Article 23 of the Agreement; Clause 3 of Article 311 of the RF Tax Code.