Russias Tightening Tax Policy on Treaty Benefits

Russia is a very young tax jurisdiction, in which the tax environment and legislation change rapidly. Its courts also develop judicial anti-avoidance doctrines that go beyond the literal interpretation of the statutory tax rules and have a direct impact on the legal and business environment in the country. Most taxpayers have been forced to change their tax behavior.

With the inclusion of participation exemption rules in the Russian Tax Code, the Government’s intention to introduce comprehensive transfer pricing, tax consolidation, and controlled foreign corporation rules, and to amend certain double tax treaties, Russia is going further down the path of tightening state tax policy, removing legislative loopholes and raising the bar for eligibility for domestic and tax treaty benefits.

The recently signed protocol to the popular 1998 Cyprus-Russia double tax treaty has created unexpected turmoil in the business community. Leaving aside insignificant details, the most important change lies in the right of the source jurisdiction to tax capital gains from the sale of shares in companies more than 50% of the assets of which are immovable property. Cyprus-registered developers and portfolio investors selling shares in Russian real estate holding companies or other Russian companies with significant real estate will no longer enjoy treaty protection and may be subject to a 20% Russian withholding tax. This is not a revolutionary change. Similar provisions have existed in tax treaties with other countries for years. Also, for Cyprus and Russia this rule will not become effective before 2014 and the withholding tax could be avoided using other techniques. But clearly Cypriot  structures for investment in Russian real estate should be reconsidered now.

Further amendments are intended to prevent abusive tax structuring through Cyprus. They include new rules on management and consulting permanent establishments, limitations on benefits (not applicable to Cyprus-registered companies at all) and provisions on the exchange of information and assistance in collecting revenue. These provisions pattern the OECD Model Tax Convention and partly follow the recent legislative changes in Cyprus. It is expected that after it ratifies the protocol, Cyprus will be removed from the Russian Finance Ministry’s “blacklist” of countries falling out of the participation exemption for 0% inbound dividend tax rate. The new rules are also expected to accelerate similar tax treaty renegotiations between Russia and several other countries.

Some people have declared that nothing will change in practice if these new provisions appear in other tax treaties. This is only partially true. There have already been attempts to disallow resident status and treaty benefits for some Cypriot companies that were effectively managed from Russia. Whilst these attempts have been rare and not entirely successful this was still a red flag for business.

Now, given the willingness of the government to renegotiate tax treaties and in light of developing case law on anti-avoidance, we need to look at these treaty rules from a different angle. Russia is well behind developed tax jurisdictions in the application of these concepts. And it is only a matter of time before local tax authorities and courts up their level in comprehending and implementing these rules in practice.

In 2006 in Resolution No. 53 the Plenum of the Russian Supreme Arbitration Court introduced the concept of unjustified tax benefits and business purpose into Russian tax laws. This had a tremendous impact on taxpayers and their domestic tax planning. But now everybody has got used to it. It should not come as a surprise if these or similar doctrines are later applied with respect to tax treaties. Of course Russian laws and judicial doctrines cannot override tax treaty provisions. But they could be used as a means for interpreting them (e.g., residence, beneficial ownership, limitation of benefits), in which case the treaty would not be deemed violated or would not even apply.

Clearly, state tax policy will be further tightened, both in a domestic and treaty context. We can expect the introduction of domestic anti-conduit and anti-treaty shopping rules, beneficial ownership criteria and, perhaps, the shift from subjective business purpose test to objective economic substance doctrines in judicial anti-avoidance rules. Apparently, obtaining a high level of confidence that expected tax treaty benefits will truly be realized will become more difficult. The trend is almost certain to continue. Thus, almost any tax structure that previously seemed perfectly justified and risk-free cannot be safely relied on in the long term and may need reconsideration.