In 2022, the procedure for economic and tax cooperation between Russia and many Western countries underwent significant changes. At the official level initiatives are being taken to terminate agreements on the avoidance of double taxation with “unfriendly” countries (the “Agreements“). In particular, the Ministry of Finance and the Russian Foreign Ministry made a proposal to this effect in mid-March 2023.
Since the termination of the Agreements and a refusal to engage in tax cooperation will entail significant changes in the taxation of international structures and of persons with personal, family or property ties with unfriendly countries, we will consider the most significant consequences of the breakdown of tax relations:
- Taxation of dividends. Preferential withholding tax rates will be terminated, with payments to residents of “unfriendly” countries being subject to the standard rate of 15% established by the Tax Code of the Russian Federation.
The Agreement between Russia and Cyprus, as well as those with Malta and Luxembourg, were previously amended, which increased the basic tax rate at source to the specified level. Despite this fact, dividends paid from Russia, for example, to the USA or Great Britain in particular are subject to reduced rates of 5% or 10%, depending on whether certain conditions are met. For dividends paid to Switzerland and Germany, the applicable rates are 5% and 15%.
- Taxation of interest and royalties. Payments of interest and royalties to “unfriendly” countries will be taxed at the rate of 20% at source in the Russian Federation. Currently, interest and royalties paid to the countries in question are generally not subject to withholding tax.
- Dual residency. The criteria based on which a person’s tax residence is determined in controversial cases will cease to apply. There will be a risk that a person can be recognized as a tax resident of two countries at the same time based on domestic legislation and, as a result, will be subject to double taxation
The Mutual Agreement Procedure between the authorized bodies of the Russian Federation and a specific “unfriendly” country, used to eliminate disputes about tax residency and double taxation in relation to a particular person, will also become inaccessible.
- Elimination of double taxation. Individuals will be completely deprived of the opportunity to set-off in Russia any taxes paid in other countries. Russian members (shareholders) will lose the opportunity to set-off tax paid at source in the countries referred to when distributing dividends in their favor.
- Permanent establishment. In the absence of an Agreement, the extended grace period (usually 12 months) during which the activities of a company from an “unfriendly” country on a construction site does not lead to the formation of a permanent establishment will cease to exist. In certain Agreements, such grace period may even be 18 months.
- Taxation of controlled foreign companies (CFCs). Russian residents will lose the opportunity to exempt the profits of CFCs established in “unfriendly” countries from taxation in Russia based on the effective tax rate (at least 75% of the Russian rate)[1].A CFC’s[2] financial statements will only need to be prepared in accordance with Russian accounting standards.
- Exchange of tax information. Despite the fact that, in 2022, some countries unilaterally stopped the exchange of tax information with Russia, the termination of the Agreements could completely stop the exchange of such data between countries. At the same time, the obligation to exchange tax information is also enshrined in the Convention on Mutual Administrative Assistance in Tax Matters[3]. Its provisions are general in nature, so “unfriendly” countries will have more opportunities not to comply with requests from Russian tax authorities
- Currency regulation. Termination of the Agreements will also have a negative effect on currency regulation, since, starting from January 1, 2020, Russian residents have the opportunity to transfer funds from non-residents directly to foreign banks located in foreign countries that automatically exchange financial information with Russia[4]. In relation to other countries, a strict regime for the use of foreign accounts has been established.
Particular attention should be paid to the position of Switzerland, which in the autumn of 2022 announced the suspension of the exchange of financial information with Russia. As a result of such statement, Switzerland was not included in the updated list of countries that exchange tax information with Russia. Since it is quite common for Russian individuals and legal entities to have accounts in Swiss banks, such residents have already faced the problem of using Swiss accounts and complying with Russian currency legislation and, in particular, submitting notifications about the movement of funds in foreign accounts.
Thus, it is worth considering that the termination of the Agreements will have significant negative consequences for businesses still structured using “unfriendly” countries, and for persons with personal, family or property ties to both jurisdictions.
We recommend that you first analyze the effect that termination of Agreements may have and then develop an action plan to minimize the negative consequences should the expected consequences actually occur.
[1] Nevertheless, Russian residents will retain the opportunity to exempt a CFC’s profits from taxation on other grounds provided for by Russian law. An example is if the CFC is an active foreign company, i.e., active income accounts for at least 80% of all the CFC’s revenues.
[2] Excluding the special fixed profit tax regime for CFCs.
[3] The Convention on Mutual Administrative Assistance in Tax Matters (concluded in Strasbourg on January 25, 1988).
[4] The Federal Tax Service’s Order No. ED-7-17/986@ dated October 28, 2022 “On approving the List of states (territories) with which the automatic exchange of financial information is carried out” (registered with the Russian Ministry of Justice on December 5, 2022 under No. 71361)