THE INSIDERS: Russia takes on offshorisation

By bne IntelliNews February 21, 2014

Artem Toropov of Goltsblat BLP -

"If you want to go offshore, be my guest, but the money stays here", President Vladimir Putin declared in his state of the nation address in December.

Russia, along with many developed nations, is finally trying to crack down on the scams and schemes that see corporate profits earned on purely domestic business leave the country, barely touching the ground, in what Putin dubbed the "offshorisation of the Russian economy." This year is likely to be a decisive one for the campaign to keep Russian money in Russia.

For much of the last 20 years many Russian businesses have given their postal address as somewhere in an offshore jurisdiction such as the British Virgin Islands (BVI) or Cyprus. Now we are seeing a hard-line fiscal-driven trend to bring the eroded tax base back onto Russian soil. But with new measures being introduced from 2015, what will the de-offshorisation campaign really mean for business?

The hunt for revenues

With the Russian government expecting to run federal budget deficits again for the first time since the 1990s, the state is on the hunt for tax revenues. At the same time, capital flight is bleeding the country of badly needed investment capital and undermining the currency. However, the government doesn't have much room to manoeuvre: the Laffer curve says that at some pointing raising taxes produces less, not more, revenue. It's hardly surprising then that the Russian government is targeting large corporates and high net worth individuals (HNWIs) who hide profits in low-tax jurisdictions.

Protecting recession-stricken tax revenues is of course a global issue and Russia's approach is in line with recent OECD calls for action on tax avoidance. A G20 joint communiqué last year pledged to fight "cross-border tax evasion and avoidance", highlighting that this is an issue on which there is international consensus at the highest level.

However, coordinated global action is hard to both implement and enforce. The situation is particularly difficult in Russia, where the reasons behind the use of offshore structures run much deeper than tax considerations alone. Russian commercial law is still a work in progress and many businesses look to English law in mergers and acquisition deals with all its tools like reps and warranties, which are also common in the offshore havens, such as the BVI, Cyprus, the Netherlands, Luxembourg and Switzerland. Russian companies like these jurisdictions, because if there is a commercial dispute they can expect a fair and impartial resolution.

The government has reluctantly accepted the continued use of English law, non-Russian corporate vehicles and European bank accounts as a normal part of business in Russia. However, the Kremlin intends to aggressively combat tax-driven structures that are specifically designed to simply keep profits out of the hands of the taxman. The new measures are also expected to make capital flight less attractive and more burdensome from a tax viewpoint.

New laws on the books

A key reform to watch is the development of the concept of corporate tax residence in Russian law based on the "place of effective management and control" test. New residence rules will bring onshore any paper companies that - although technically registered abroad with overseas directors - are in fact controlled out of Russia. How this will work in practice remains to be seen, as enforcement will likely be a real challenge. Obtaining conclusive proof to show where a company is controlled from is not going to be easy.

Another important aspect of the reforms is the late arrival of the "controlled foreign companies" (CFC) rules to the Russian tax system. The rules are still being developed, and the Ministry of Finance will decide among "soft" and "hard" variants of such rules with "blacklist" and "whitelist" options.

But whatever choice the ministry makes, it is likely that Russian corporates (including major oil corporations and state-owned companies), as well as individuals, will be required to inform the authorities of all the overseas subsidiaries and holding companies they control. They will be forced to pay Russian tax on undistributed profit from these holdings, even if the profit is accumulated abroad.

No one realistically expects to see Russians rushing to their tax offices to disclose secret overseas holdings, foundations and trusts. However, it is expected that the CFC rules will increase the tax bills of major Russian public corporations that are in no position to conceal overseas structures, as well as increase personal tax and criminal liability risks for Russian HNWIs who use offshore structures.

Finally, we can expect new rules that will force companies to disclose the ultimate beneficiaries of payments made as dividends, interest and royalties to companies in tax treaty jurisdictions. This would make it a lot more difficult for money to be channelled out of Russia through artificial offshore structures.

All these changes are currently being finalised by the finance ministry and could be approved by the parliament in the first half of 2014. But it's not all bad news. Work is already underway on creating tax breaks for dividend income and capital gains from sale of shares by Russian holding companies. These reliefs, coupled with an increased tax burden on non-Russian structures, may give businesses a solid tax-driven incentive to bring corporate structures to Russia.

Will it work?

Protecting the Russian tax base and combating international tax evasion are laudable aims, but will this de-offshorisation drive have a real impact? It seems unlikely that the government's tax take will jump after the new rules go through. It will also take time for the Russian tax authorities to build up an information exchange and improve enforcement before rules on paper can start to work in practice.

International investors are unlikely to be affected by these changes unless they are equally guilty of aggressively structuring overseas vehicles simply to avoid paying taxes in Russia. However, some Western business may become affected if they operate on the ground in Russia through foreign branch structures and have direct contracts with state-owned companies. Such groups may need to undertake expensive restructuring to continue operations using Russian legal entities.

This may, in turn, trigger an assets and employees transfer issue, contractual restructuring, dividend tax, thin capitalisation, transfer pricing, currency control and customs clearance issues. Compliant Western businesses that are affected by this reform should consider the problem in advance and work together to ensure the baby is not thrown out with the bathwater.

Russia still has much work to do in building trust between the government and business community. It needs to give companies a genuine incentive to keep profits and their legal entities onshore or trust the Russian courts. The new anti-avoidance legislation can create instability and dent business confidence. This may lead to a decline in investment and tax revenues, and actually increase capital flight rather than producing a reduction.

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