In the past, foreign investment in Russia has been characterized by the use of offshore structures. Typically, foreign investment would be via a joint venture arrangement, whereby the parties establish an offshore holding company and regulate cooperation through a JVA. However, recent developments in Russia may impact the use of offshore structures going forward and force a reevaluation of existing structures.
The Russian Government has identified “deoffshorization” as a key objective to combat the increasingly offshore nature of the Russian economy and limit capital outflow. On March 18, 2014 the Ministry of Finance published a bill on proposed deoffshorization measures (“Bill”). Following a period of public consultation, on May, 27 2014 the Ministry of Finance published a revised Bill, which was then submitted for consideration to the State Duma.
Broadly, the Bill introduces three key measures.
First, controlled foreign companies (“CFC”) rules, whereby Russian tax residents are required to pay Russian corporate tax (20%) or personal income tax (13%) on attributed, undistributed CFC profits in excess of RUB 3 million, in respect of CFCs they “control” (i.e. exert or may exert a determining influence over decisions concerning CFC profit distribution), or CFCs in which their interest exceeds 10%. “CFC” is broadly defined. It can be a “foreign entity” that is not Russian tax resident and whose securities are not listed on a Russian Central Bank-approved stock exchange. It can also be a “foreign structure” (e.g. a fund, trust or other form of collective investment). However, a foreign entity will be exempt in certain circumstances; in particular, where its permanent residence is in a jurisdiction included in the list of states that exchange tax information with Russia (the “white list”), provided it also meets an effective tax rate test (15%). So far, there has been no indication of the jurisdictions to be included on the “white list”. However, as the effective tax rate test applies to gross income, the effective tax rate will most likely be lower than 15% for foreign entities receiving primarily tax exempt passive income. Consequently, a significant number of existing offshore structures may be caught by the CFC rules.
Second, reporting obligations for Russian tax residents in respect of their participation in all foreign entities in which their participation is 1% or more or where they are a controlling person. There are also similar reporting obligations proposed in respect of foreign structures.
Third, a “management and control” test for assessing the Russian tax residence of foreign entities, whereby a foreign entity whose effective management and control is found to take place in Russia will be subject to Russian taxation, regardless of its jurisdiction of incorporation.
Significant fines are proposed for non-compliance.
Implemented in its current form, the Bill will substantially alter the tax landscape for Russian tax residents that use offshore structures. The CFC rules could potentially apply to a large number of offshore structures. If not careful, offshore structures may also be deemed Russian tax resident by virtue of the “management and control test” and subject to Russian taxation. Proposed reporting obligations cover almost every participation of Russian tax residents in foreign entities and structures.
In addition to increased tax exposure, the Bill may result in extensive compliance related costs and increased complexity and costs in maintaining existing offshore structures.
Consequently, Russian business is currently lobbying the Russian Government to revise certain aspects of the Bill (e.g. reduce tax rates applicable to CFCs; increase default “control” threshold from 10% to 50% (plus one vote); increase reporting threshold from 1% to 25%; removal of “management and control test”; phased introduction of deoffshorization measures; moratorium on enforcement of penalties until 2017). Although the Russian Government has been receptive to some changes, discussions are still ongoing and it remains to be seen what form any concessions ultimately take.
Nevertheless, participants should review existing structures and consider potential restructuring opportunities, to mitigate the effect of the contemplated measures.
If passed, the Bill may render offshore structures less attractive to Russian counterparties, making it difficult for foreign investors to insist on their future use. Tax considerations aside, foreign investor preference for offshore structures has predominantly been driven by the greater legal certainty, flexibility and protection such structures afford. However, recent amendments to the Civil Code, in force from September 2014, encourage the use of onshore structures by addressing perceived shortcomings under Russian law. In particular, the amendments clarify rules governing Russian-law governed JVAs and introduce additional flexibility with regard to the classification of Russian legal entities and corporate governance.
In conjunction with proposed deoffshorization measures, the Civil Code amendments may result in a greater insistence on the use of onshore structures by Russian counterparties. However, until foreign investors can be confident that they are able to implement all their desired commercial arrangements comprehensibly and reliably under Russian law and enforce their rights thereunder, resistance to the use of onshore structures will remain; notwithstanding the form that any deoffshorization measures take.
By Sebastian Lawson, Partner, and Sean Huber, Senior Associate, Freshfields
This Article was originally published in Issue 4 of the CEE Legal Matters Magazine. If you would like to receive a hard copy of the magazine, you can subscribe here.
