We have repeatedly highlighted in our journal “Analytics” the issues related to the signing of Protocol to the Agreement for the Avoidance of Double Taxation with Respect to Taxes on Income and Capital between Government of the Russian Federation and Government of the Republic of Cyprus. Upon ratification of the protocol one of the most favorable and the oldest tax regimes in Russia will cease to exist. However, the signing of the protocol is the first step taken by Russia toward unification of tax agreements, restriction of tax exemptions and bringing the agreements into conformity with the model OECD convention. After Cyprus the protocol amending the tax agreement with Luxembourg was signed in 2011.
The instruction issued to the Government of the Russian Federation regarding signing of the Protocol and the approval of the text was provided in August, the Protocol itself was signed in November, and it has not been ratified yet. In essence, the alterations are similar to the alterations contained in the Cyprus protocol. In this article we are going to consider the most important of them.
Tax agreement with Luxembourg, in its current edition, without reference to the Protocol, provides the following terms and conditions for taxpayers:
1) income from real property is taxed in the country where such property is located
2) real property shall have a meaning which is defined by national legislation of the country in which the property is located
3) dividends are taxed in jurisdiction from which the dividends originate, and in the jurisdiction in which the dividends are distributed. In the "paying" jurisdiction dividends are taxed (tax deducted from source of payment) at the following rates:
- 10%, provided that the shareholder owns at least 30% of the share capital and the share in the share capital exceeds 75 000 ECU
- 15% in other cases
4) dividends mean an income from shares or other rights which do not constitute a debt
5) interest shall be taxed only in the jurisdiction of the lender (recipient of interest)
6) percent means an income from debt claims of every kind, irrespective of any mortgage and any right of interest in the debtor's profits;
7) royalty is taxed only in the jurisdiction of the holder (recipient of royalty)
8) income from sale of shares are taxed in the jurisdiction of the seller of shares, regardless of the structure of the assets of the company which shares are being sold
At the same time tax agreement with Luxembourg, as well as with Cyprus, being one of the oldest agreements concluded by the Russian Federation, does not contain:
1) conditions for admission of interest on controlled debt as dividends
2) restrictions related to structure of property when levying taxes on income from the sale of shares
3) provisions concerning taxation of equity in the funds created to real estate investment purposes
4) information exchange provisions
5) unfair provisions
that is, does not contain all the restrictions which are included into agreements with other traditional holdings jurisdictions, and due to absence of which the taxpayers in many instances chose Luxembourg. The changes contained in the Protocol have influenced all these provisions.
Tax agreement with Luxembourg and agreement with Cyprus are one of the first agreements concluded by the Russian Federation.
Dividends
On the one hand, the Protocol has had positive changes. First, the reduction of tax rates.The following rates will apply to dividend withholding tax:
- 5% provided that the shareholder owns at least 10% of the share capital and shareholder invested in the company an amount exceeding 80 000 ECU
- 15% in other cases
Secondly, the list of cases when allowing the application of a reduced rate of 5% has been broadened, because the phrase "share in the share capital" contained in the Convention was substituted by "investment into share holding".The latter pursuant to clarifications of tax authorities and commentaries to the OECD Model Convention allows those shareholders who actually contributed capital in the prescribed limit, and those shareholders who purchased shares at the appropriate price to enjoy tax exemptions.
However, pursuant to a new version, the dividend shall constitute an income from shares or other rights, which are not debt claims, authorizing to share profits, as well as income (even paid in the form of interest), subject to the same taxation as income from shares in accordance with national laws of the jurisdiction in which the company paying the dividends is registered. Thus, after Protocol enters into force, the interest transferredfrom Russia to Luxembourg with regard to controlled indebtedness should be taxed in the manner prescribed for dividends.
Equity in real estate funds
According to the amendments made to the Protocol, the procedures of taxation of income from real property, also apply to the taxation of income from the equity of unit investment funds formed primarily to carry out real estate invest activity. Therefore such income will be taxed in the jurisdiction where the fund paying the income is formed. Income from equity of units investment funds formed primarily to carry out real estate invest activity will be taxed in the jurisdiction where the fund paying the income is formed.
Income from sale of shares
Income from sale of shares, after the ratification of the Protocol, will be taxed in the same order as as currently set forth in the Tax Code of the Russian Federation, i.e. the source of payment will be required to withhold the tax when paying the income from the sale of shares, if the assets of the company selling the shares consist in more than 50% of real estate.
Other withholding taxes
Another important innovation introduced by the Protocol is extension of the list of income/ When such income us paid the source of payment is obliged to withhold and pay tax into the budget. The Convention as amended identifies specific instances when these taxes are withheld, and does not contain extended interpretation. The Protocol contains a new article pursuant to which the income of person being a resident of a particular country, generated in other country and not expressly provided in the tax agreement, may be taxed in that other country if it constitutes an object of taxation under national laws. Taking into account that the Tax Code of the Russian Federation contains an extensive list of income subject to withholding tax, such provision in the agreement will result in increase of tax burden with regard to transactions related to payment of Income from the Russian Federation to Luxembourg.
Information Exchange
The Protocol (as well as the schedule - the Additional Protocol) expands the section of the Convention regarding information exchange, providing that the party,which received an inquiry, is obliged to gather information about a taxpayer, including the information which the party that received the inquiry does not need for its own tax purposes. For more information about the potential disclosure as part of official information exchange please refer to our previous edition of the journal "Analytics". Despite the fact that the article is based on an analysis of documents regulating the relations regarding the disclosure of information between Russia and Cyprus, the basic principles discussed herein can be applied to relations with Luxembourg.
Restriction of tax exemptions
Protocol to the Convention entered as a reservation of bad faith, according to which the taxpayer will not be eligible for benefits under the agreement, if the main purpose or one of the main goals of such a company was to receive benefits in accordance with this agreement. In practice, this will be associated with the occurrence of the same risks that we have already examined by analyzing the Protocol to the Agreement with Cyprus, that is, of risks arising from the payment from Russia to Luxembourg income from dividends, interest and royalty.
The place of residence and permanent representative office
Other alterations are worth mentioning as well. First, it is determination of the location of the governing body, which is necessary for determining the permanent residence of the person intending to dispose tax exemptions provided by the convention. If such place can not be determined, the tax authorities by mutual agreement, will be entitled to determine this location, having considered all the factors which according to the tax authorities will be involved in determining the location. In this case, among other factors, the tax authorities will have to take into account such criteria as:
- place where meeting of the Board of Directors or similar body are held
- place where day-to-day management of the affairs of the person is carried out
- place where senior management carries out its ordinary activity
An alteration has been made into procedure for determining the fact whether the activity of a person resident of one country to the formation of a permanent representative office in another country. As in the case of Cyprus Protocol, the Protocol concluded with Luxembourg introduces the concept which is close to the concept of "dependent agent" used in the draft version of OECD convention. Thus, the activity of a person - resident of one country will lead to the formation of a permanent representative office in another county,
1) if the person renders services
- by virtue of an individual which is deemed to be a resident of that other country on the basis of the duration of his residence in Luxembourg (within the term which constitutes or exceeds in aggregate 183 days of any twelve months period)
- and the main source of income of the company - Russian resident is located in Luxembourg (more than 50% of total income related to active business activities of the company generated from services rendered in Luxembourg via aforesaid individual)
2) if a person renders services on the territory of another country within the term which constitutes or exceeds in aggregate 183 days of any twelve months period and such services are provided via individuals who sell and provide such services for a company in Luxembourg:
- within the same project
- within several related projects
We have to admit that the Protocol brings the tax agreement with Luxembourg closer to the draft version of OECD Convention and tax agreements with several other European jurisdictions, restricting the number of benefits that taxpayers can use now. But in the case of Luxembourg, as well as in the case of Cyprus, there are still a lot of procedural aspects by virtue of which certain provisions (for the exchange of information and restriction of tax exemptions) can not be implemented. Therefore, taxpayers engaged in the structuring of holding via Luxembourg, should not categorically refuse to use this jurisdiction, and alter the structure of the group, but it is worth thinking about changing intra-group business relations and choosing high-quality providers, and should it be considered possible, think of using other jurisdictions.