April 21, 2023

Tax Implications of Inbound Investments into Russia

Boris Bruk,

Of Counsel,

Salans Moscow

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Key questions

Form of presence: branch vs. subsidiary

How to finance your activities in Russia

Repatriation of profits

Divestment (exit from the project)

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Branch vs. Subsidiary

Benefits:

No thin capitalization rules apply No taxation on profits distributable to

the head office Usually served by specially designated

“advanced” tax inspectors Sale of foreign companies having real

estate in Russia not subject to capital gains tax

Benefits:

Limited exposure of foreign investor to Russian commercial and legal risks (although limited liability may sometimes be removed)

Capital contribution of technological equipment free of customs duties available (however, no disposal of equipment allowed)

BRANCH SUBSIDIARY:

Drawbacks:

Accreditation procedure more expensive

No limited liability available Limited rights to clear the imported

goods at customs Additional currency control formalities

for the Russian customers dealing with branches

Drawbacks:

Dividend distributions subject to withholding tax (minimum treaty withholding tax – 5%)

Additional currency control formalities in dealing with foreign suppliers or customers

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How to finance your activities

Capital contribution (including share premium)

Contribution to assets

Debt financing

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Capital contribution

Tax free (special exemptions for imported technological equipment for VAT and customs duties); VAT exemption limited to the equipment listed by the Government

Share premium absorbs losses and provides additional cushion against negative net assets position

BUT the subsidiary may not be able to distribute charter capital and share premium at will

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Contribution to assets Does not trigger increase of charter capital or share premium (treated as

profits for accounting purposes)

Tax free (provided the contributor has a more than 50% participation in the receiving Russian entity or the receiving Russian entity owns more than 50% in the capital of the contributor)

NB! Under latest legislative amendments additional exemption applies to transfer of assets and proprietory rights by shareholders to subsidiaries starting from January 1, 2007 aimed at increase of the net assets of the subsidiary (50% participation is no longer required)

BUT applies to Russian limited liability companies only

BUT input VAT recovery and deductibility risks (now remote)

BUT may be prohibited or may trigger negative tax implications in the country of the contributor (i.e. Cyprus?)

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Debt financing Could be rather flexible as profit repatriation tool (where properly

structured)

BUT general limitations on interest deductibility (apply on loans from both Russian and foreign lenders)

- statutory safe harbor (also default interest rates): 1.8 * CBR refinancing rate (current CBR rate is 7.75%) for ruble denominated loans; 0.8 *

CBR refinancing rate - foreign currency denominated loans; OR

- average interest rate on similar loans (same currency, similar principal amount, similar terms of repayment, similar types of security etc.) received by the Russian borrower from Russian lenders in the same quarter +/- 20%

BUT thin capitalization rules apply to loans from related parties (will discuss in detail in a minute)

BUT general deductibility requirements: economic justifiability (connection with income generating activities; if the borrower has enough equity cash – unjustified tax benefit) and proper documentation

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Thin capitalization rules Apply where

I. (A) debt financing is provided by a foreign legal entity which directly or indirectly owns more than 20% of the Russian entity financed;

OR

(B) debt financing is provided by a Russian affiliate of such foreign entity;

OR

(C) debt financing is provided by another person but repayment of the loan is guaranteed or secured in any other way by such foreign entity or its Russian affiliate (the "controlled debt“)

AND

II. The controlled debt/equity (equity = net assets + accrued tax liabilities) ratio of the borrower exceeds 3:1 (12.5:1 – for banks and lease companies) as of the last date of each reporting (tax) period

“Excessive” interest generally treated as dividend: non deductible, dividend withholding tax applies

RF Ministry of Finance: treaty dividend rate applies to “excessive” interest

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Thin capitalization – inefficient structure

Russian borrower

Russia

Shareholder(Cyprus)

Loan Cyprus

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Thin capitalization – inefficient structure

Russian borrower

Russia

Bank (Cyprus)

Shareholder(Cyprus)

Loan

Guarantee

Cyprus

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Thin capitalization – inefficient structure

Russian borrower

RussiaBank (Russia)

Shareholder(Cyprus)

Loan

Guarantee

Cyprus

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Thin capitalization – current circumvention structure

Shareholder

100%

FinancialCompany

Operating company

Loan

Loan

Russia

Foreign country

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Thin capitalization – advanced circumvention structure

ShareholderFinancial company

Operating company

holding

loans

Russia

Foreign countries

Sub-holding

Operatingcompany

Operating company

Operating company

holding

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Thin capitalization – fresh view Positive court practice developed:

- interest paid to a German resident lender (Federal Moscow District Arbitration Court, 2005)- interest paid to a Dutch resident lender (Federal North Western District Arbitration Court, 2007)- interest paid to a Finnish resident lender (Federal North Western District Arbitration Court, 2009)- interest paid to a Cyprus resident lender (Federal Moscow District Arbitration Court, 2009 and 2010) - interest paid to a Cyprus and a Hundarian resident lender (Federal Moscow District Arbitration Court, 2010)

Courts denied application of thin capitalization rules:

- reclassification of interest as dividend income for treaty purposes impossible as the treaties contain autonomous definitions of “dividends” and “interest”;

- reclassification of interest as dividend income and denial of deductibility of “excessive interest” does not comply with the treaty non-discrimination rules (should be deductible as if paid to or guaranteed by a Russian parent or an affiliate of a Russian parent)

Special circumstances: both Russia – Germany tax treaty and Russia – Netherlands tax treaty contain special “unlimited deductibility” clause

The tax authorities still try to argue with the above position of the courts

No “unlimited deductibility" clauses in Russia – Cyprus double tax treaty

Protocol to the Russia – Cyprus double tax treaty: interest reclassified into dividend income to be treated as dividend income for treaty purposes; non-discrimination rules will not change

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Thin capitalization – non-discrimination in action

Russian borrower

Russia

Bank (Cyprus)

Shareholder(Cyprus)

Loan

Cyprus

Unsecured loan

Guarantee

Loan

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Thin capitalization – non-discrimination in action

Russian borrower

Russia

Bank (Cyprus)

Shareholder(Russia)

Loan

Guarantee Cyprus

Unsecured loan

Loan

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Thin capitalization – non-discrimination trap

Russian borrower

Russia

Bank (Cyprus)Shareholder(Cyprus)

Loan

Guarantee

Foreign countries

Unsecured loan

Shareholder (outside Russia)

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Thin capitalization – non-discrimination trap in action

Russian borrower

Russia

Bank (Cyprus)

Shareholder(Russia)

Loan

Guarantee

Foreign countries

Unsecured loan

Shareholder (outside Russia)

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Repatriation of profits

No withholding tax on repatriation of profits from the branch

Dividend distributions from Russian subsidiary generally subject to 15% domestic withholding tax

Domestic withholding tax may be reduced to 5% under the Russia – Cyprus treaty, if:

- beneficial owner of dividends is a tax resident in Cyprus;

- cumulative direct investment of at least USD 100 000 (EUR 100 000 under the Protocol)

Non-qualifying participations may still reduce withholding tax to 10%

Direct participations:

- contributions to the charter capital of Russian subsidiary in exchange for shares/ interest;

- Sale and purchase of shares/ interest in the Russian subsidiary from a third party

NB! Receiving stake in a Russian company as capital contribution will not qualify as direct investment

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Beneficial ownership Cyprus – Russia DTT: dividend income, may also apply to interest and royalties

in the future

RF President and RF Ministry of Finance seek to use this concept to combat treaty shopping

This concept targets multilayer structures

How does it work? No treaty benefits (0% or reduced withholding tax rates) apply to income received by person not qualifying as beneficial owner

Who is beneficial owner of income (Russian approach)?

- person having formal title on income AND- person detemining «economic destiny of income»

Beneficial ownership concept does not apply to repatriation of profits from branches/ rep. offices

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Beneficial Ownership: Impact on Treaty Application

If CypCo not considered beneficial owner of dividend income, benefits under Cyprus – Russia DTT will be denied;

If treaty benefits denied then

Russian domestic tax rules should apply;

May Israel – Russia DTT apply?

RusHoldCo

CypCo

RusCo

IsrHoldCo

100%; EUR 107 0005% WHT

9% WHT 15%/ 10% WHT

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What factors may indicate person is not beneficial owner of income?

- person has no presence in the residence state (no office, no personnel, no bank accounts, no financial reporting obligations etc);

- person has no activities other than those which treaty benefits are claimed for;

- person does not bear normal commercial risks (subsidies from parent company; no adequate margin);

- person assumes legal obligations to distribute income it receives;

- the terms of back - to - back operations are same or similar (e.g. for debt financing: principal amount, currency, interest rate, payment terms etc)

Beneficial Ownership: Impact of Treaty Application

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How could we mitigate the risks? Case by case approach

General recommendations:

- simplify structures: do not use multilevel structures until necessary;

- substance and presence in residence state: office space, personnel, bank accounts, board and shareholders meetings, bookkeeping and

accounting,general overhead expenses etc;

- consolidation of business functions (group financing company; group IP holding company);

- multiple project vehicles;

- arm’s length remuneration (margin);

- sound economic reasons behind use of offshore companies (foreign markets, foreign investors and flexibility of foreign law, statutory requirements under

foreign law when making outbound investments)

Beneficial Owner: Impact of Treaty Application

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Basic Exit Structure: Onshore Sale

No VAT on share deals;

Capital gains generally subject to 20% Profit tax

0% Profit tax introduced on capital gains from alienation of stakes in the capital of Russian companies, provided:

- applies to both corporate and individual shareholders

- uninterrupted more than 5 year holding period by the date of alienation of stake in the capital

- if shares of joint stock companies (additionally): should be non-tradeable securities within the term of holding; or

if tradeable – should qualify as the high tech shares within the term of holdig; or

should be non-tradeable securities when acquired and tradeable high tech shares when disposed of

RusCo1

RusCo

CypCo 1 SPA

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Basic Exit Structure: Offshore Sale

No Russian wihtholding tax on capital gains unless RusCo is a qualifying real estate company (more than 50% of assets – immovable property in Russia);

Currently the Cyprus – Russia DTT protects sale of shares/ interest in qualifying real estate companies;

The Protocol to the treaty allows taxation of capital gains prom alienation of qualifying real estate companies;

No withholding mechanism when seller and purchaser – foreign companies, but could become an issue if purchaser is a Russian company or a foreign company with Russian PE

CypCo

RusCo

CypCo 1 SPA

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Advanced Exit Structure

Russian domestic tax law currently does not target sale of shares/ interest in foreign companies;

Although the Protocol to the Cyprus – Russia DTT does not limit the scope of taxation to Russian real estate companies only, it is believed that Russia may not expand its taxing jurisdiction unless domestic law is changed

No withholding mechanism if sale preformed between two foreign companies

Still may become an issue if purchaser is a Russian company or a foreign company with Russian PE

CypCo

Cyp HoldCo

RusCo

CypCo1

SPA

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Alternative Exit Structure: EU Cross Border Merger

CypCo owns Russian real estate company The Protocol to the Cyprus – Russia DTT: exemption of capital gains from sale of qualifying real estate companies is no longer available

Purchaser is hesitant to acquire shares of CypCo

Alternative solution: upstream merger of CypCo into LuxCo and sale of shares in Russian real estate company (still exempt from Russian withholding tax under many DTTs of Russia with EU states)

Transfer of shares by CypCo to LuxCo as part of merger should not be subject to tax in Russia (Art.251-3 of the RF Tax Code + no tax agent)

CypCo

RusCo

EU Co

sale

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Contact

Tax Practice, Salans Moscow bbruk@salans.com

Salans

Balchug Plaza,

Ul. Balchug, 7

115035 Moscow, Russia

Tel.: + 7 (495) 644 0500 (ext.4534)

Fax: + 7 (495) 644 0599

Boris Bruk, Of Counsel