Russia is proposing to tighten up rules on controlled foreign companies - a thorny issue at the best of times but even more so as the country remains at odds with the West over Ukraine. Withers, the law firm, examines the fine print.

In the sometimes tortured language of the financial industry, this publication can pass on another tongue-twister: “Deoffshorisation” – relating to how the offshore world is changing. At present, a significant threat to global financial flows comes from the sanctions against Russia over that country’s annexation of part of Ukraine (Crimea) and ongoing events in eastern Ukraine. The Russian government is proposing to tighten rules on foreign control/ownership of companies. In this briefing note, lawyers from Withers, Olga Boltenko and Ayshat Gaydarova explore the finer details. The views expressed are not necessarily those of this publication but the editors are very pleased to share these insights and invite readers to respond.

The Russian Ministry of Finance has published an updated version of the draft controlled foreign company rules (hereinafter – "CFC") on the 2 September (hereinafter – ‘the new Draft’). The new Draft follows active lobbying and discussions of the rules over the summer. Not surprisingly, the updated rules do not substantially favour businesses, however some of the critical proposals, including a penalty-free transitional implementation period (although only in part), have been accepted.

The new Draft has not yet been submitted to the Russian State Duma for consideration and most likely will undergo further changes in the next few months. We comment here only on key provisions proposed in the new Draft and will update you on further changes in due course.

Highlights

The new Draft introduces the definition of a foreign non-corporate structure to the list of Russian taxpayers, regardless of the residency status of the structure’s controlling persons. A foreign non-corporate structure will be subject to CFC rules if it is controlled by Russian resident persons. Although the definition has not changed substantially from the previous drafts, when coupled with other new provisions on reporting obligations for “founders” of structure and for structures holding Russian real estate, the new rules clearly attempt to establish tools to capture information on beneficial owners and to tax offshore transactions in the long run.

The Draft extends the CFC exemptions list for foreign organisations. It also raises the minimum participation threshold for reporting on participation in foreign companies from 1 per cent to 10 per cent (a 25 per cent transitional threshold is set until 1 January 2017), as well as increasing the default control threshold from 10 per cent to 25 per cent for companies to be considered CFCs (a 50 per cent transitional threshold is set until 1 January 2017).

No changes have been introduced to the earlier CFC exemption proposed for foreign companies registered in a “white list” of jurisdictions (largely the countries which exchange information with Russia for tax purposes, though the list has not yet been published). These companies will still need to meet the effective tax rate test to qualify and this significantly limits the list of CFC neutral jurisdictions.

Also, in the context of the CFC rules, a new exemption is proposed for foreign non-corporate structures which meet a specific set of conditions. These include, inter alia, cases where the founder is unable to acquire ownership rights to the assets of the structure once it has been established, cannot directly or indirectly receive profits (income) of the structure, and cannot transfer personal rights exercised in connection with his status in the structure (such as rights to dispose of property, determine beneficiaries, and others) to other persons.

Interestingly, or rather confusingly, the exemption applies to the structures only until such a structure has no possibility to distribute profits (income) among the participants or beneficiaries. Although there are strictly conditional structures which may qualify for the exemption in the proposed form, this provision seems to be somewhat contradictory to the conditions set for the exemption to apply, and clearly needs further clarification by the legislator.

Profits

The new Draft still provides that the CFC rules should apply to the profits of CFC’s determined for tax periods starting on 1 January 2015. The exempt amount of CFC profits is set at 10 million RUB, and transitional provisions increase this exemption to 50 million RUB ($1.3 million) in 2015 and to 30 million RUB in 2016. Failure to comply with the tax rules will not trigger penalties for the tax years 2015 – 2017. Please note, however, that the penalty-free transitional period is not provided for failure to report on participation in foreign companies or CFCs. Failure to report will trigger an annual penalty of up to 100,000 RUB.

There is also no penalty-free transitional period provided for reporting on participation in foreign non-corporate structures. Moreover, new reporting obligations are proposed for the founders of such structures, along with those already proposed for the persons who have the right to receive profits (income) from the structure when they are distributed. In the absence of definitions or clarifications on who should qualify as “founders”, “beneficiaries”, “person who has the right to income” the proposed rules can be read in a wider conservative context as covering the majority of the existing wealth planning structures to date. The proposed set of rules creates an asymmetrically heavier burden and more uncertain position for foreign structures in comparison with foreign companies.

The rules relating to the definition of Russian tax residence for foreign organisations have also been revised and specified. The proposed criteria are still subject to interpretation.

An interesting new change is also proposed to the definition of “interrelated parties” to determine affiliation of parties for tax purposes. This definition will now consider the participation of a person in a foreign non-corporate structure (having interest in the capital of foreign companies) in order to determine this person’s share of participation interest in an organisation. If implemented in this proposed wide context, tax authorities will have a strong tool to challenge complex international wealth planning structures.

There are also important changes (briefly mentioned above) concerning the taxation rules of Russian real estate held by foreign organisations and structures. The rules require foreign organisations and foreign non-corporate structures holding Russian real estate to notify the Russian tax authorities on participants of the organisations and on founders/beneficiaries and fiduciary managers of the structures. Failure to notify will trigger a penalty equal to 100 per cent of the applicable property tax amount. Also, indirect disposal of the Russian real estate will be taxable in Russia (subject to new exemptions, including a five year ownership period of shares in the company holding property).