Controlled foreign companies legislation
Legislation on controlled foreign companies (so-called “CFC-legislation” – a term derived from an abbreviation of “Controlled Foreign Company”) – Institute, first implemented in the legal system of the United States. The idea of CFC legislation is that the profits of companies registered in low-tax or tax-free jurisdictions and controlled by residents of states applying high rates of income tax (income) agree for tax purposes to declare income received from controlled entities as their own, and to pay tax in respect of it subject to national rates of actual recipient of profit (income).
On March 18, 2014 Ministry of Finance of Russia posted on its official website the draft law “On Amendments to Parts One and Two of the Tax Code of the Russian Federation (tax profits of controlled foreign companies and increase of efficiency of tax administration of foreign companies), if it is enacted, it will change completely the approach to the taxation of foreign companies in Russia.
Basic regulations of the draft law
The draft law introduces the concept of controlled foreign companies and expands legal definition of the term “controlling person”.
The Ministry of Finance proposes to treat as controlled foreign company foreign companies, which during any period within the calendar year satisfy the following conditions:
- Company is not a tax resident of the Russian Federation1.
- Company is a tax resident of the country (territory) included into approved by the Ministry of Finance of Russia list of states and territories providing beneficial tax regime with regard to taxation of profits (income)2. This list includes the following jurisdictions:
- The Principality of Andorra;
- Antigua Barbuda;
- The commonwealth of the Bahamas;
- The Kingdom of Bahrain;
- State of Brunei Darussalam;
- The Republic of Vanuatu;
- British Virgin Islands;
- The Commonwealth of Dominica;
- Special administrative region Hong Kong (The People’s Republic of China);
- Special administrative region Macau (The People’s Republic of China);
- Anjouan Island (The Union of Comoros)
- The Republic of Liberia;
- The Principality of Liechtenstein;
- The Republic of Mauritius;
- Labuan Island (Malaysia);
- The Republic of Maldives;
- The Republic of Malta;
- The Republic of the Marshall Islands;
- The Principality of Monaco;
- The Republic of Nauru;
- The Netherlands Antilles;
- The Republic of Niue;
- The United Arab Emirates;
- Cayman Islands;
- Cook Islands;
- Turks and Caicos Islands;
- The Republic of Palau;
- The Republic of Panama;
- The Republic of Samoa;
- The Republic of San Marino;
- Saint Vincent and the Grenadines;
- Saint Kitts and Nevis;
- Saint Lucia;
- The Isle of Man (the United Kingdom of Great Britain and Northern Ireland;
- The Channel Islands(Guernsey, Jersey, Sark, Alderney Islands);
- The Republic of Seychelles.
- Company is controlled by individual or legal person – tax residents of the Russian Federation.
- Interests of the company are not listed or traded on the stock exchanges approved by the Central Bank of the Russian Federation.
In addition, controlled companies, according to draft law shall be deemed any legal entity (“structures” as law drafters call them), including funds, partnerships, associations, and so on, which are not legal entities, but have the right to engage in entrepreneurial activities in the interests of its members, beneficiaries, shareholders or third parties in respect of which the following requirements shall be complied with:
- Specified structure is a tax resident of the country (territory) included into the list of countries and territories providing beneficial tax regime with regard to taxation of profits (income) stated above.
- Controlled persons of structure include individuals or legal persons – tax residents of the Russian Federation.
Thus, the initiator of the draft law have actually covered by definition of controlled foreign company all legal persons, operating in offshore jurisdictions (within the meaning of the Resolution of the Ministry of Finance of Russia as of 13.11.2007 № 108), irrespective of whether they carry out their activities with or without formation of legal entity.
In addition, the draft law broadly interprets the concept of controlling person. Controlling persons are expected to include not only registered shareholders, members, and (or) property owners, but also those who make profit (income) via such companies or other entities in the absence of formally proven connection between them. In particular, the latter includes beneficiaries under trust agreements or other agreements. In addition, in order to treat a person as controlling person, according to the draft law, it would be enough to prove that actual interest of the beneficiary and its affiliates in the company constitutes 10%.
The draft law determines in very extraordinary way the principle of establishing affiliated entities for determining participatory interest. Participatory interest of a person in the company or other entity is determined by adding participatory interests:
- of beneficiary;
- of his/her spouse;
- of his minor children;
- of other persons (taking into account the relationship with the person or persons).
The last point should be elaborated. A literal interpretation of the text of the draft law allows to refer to “other persons” any person as there are no criteria that would determine whether there is “particular relationship” sufficient to include their interests in general “beneficial pool”. In other words, relationship with neighbors, friends or relatives (godfather, brother-in-law) are very likely to be treated as sufficient, and the interest of neighbors, friends, or cousins-in-law shall be aggregated for determining controlling persons.
Notification of controlled entities
Authors of the draft law impose on taxpayers, the interest of which in foreign companies, complying with features described above, as well as in companies, tax residency of which can not be determined, constitutes not less than 1%, the obligation of notifying tax authority regarding the fact of their participation in such companies. Taxpayers will have to report about their participation in other legal entities, irrespective of interest.
The reports are expected to be submitted annually, i.e. notification shall be sent every year, even if alterations of terms of participation in controlled foreign companies over the past year did not occur.
In addition, if final beneficiary controls the activities of foreign companies indirectly, that is through a third party which is not controlled by foreign company, beneficiary and third party shall independently determine which of them will provide information regarding profit of the controlled person.
Legal consequences of availability of controlled foreign companies in Group structure
The main purpose of the draft law – creation of legal basis for including profits of controlled foreign companies of offshore jurisdictions into tax base of the Russian companies with regard to income tax (or into tax base of individuals with regard to individual income tax).
The draft law in current version assumes that the amount for which the tax base of controlling entity will increase – resident of the Russian Federation – shall be interpreted as profit subject to financial statements of foreign company, reduced by the amount of paid dividends.
The said amount is divided between controlling parties in proportion to their participation in the company. If such interest can not be determined, then taxpayer’s income will include profit of foreign company in full.
Failure to provide notification, as well as misstatement with regard to income of controlled foreign companies shall incur substantial liability. The draft law stipulates the following tax liability:
- A penalty in the amount of 100,000 rubles for failing to provide information about companies , which are controlled by taxpayer through third party (it should be noted that although the draft law provides that subject to the agreement between taxpayer and third party the obligation to provide information may be imposed on any of such persons, liability for violation of proposed legislation will be incurred by the beneficiary). Similar penalty is set forth for provision of false documents and information by taxpayer.
- A penalty in the amount of 100,000 rubles for each controlled foreign companies, details of which have not been submitted by the taxpayer to tax authority.
- A penalty in the amount of 20% of misstated profit, but not less than 100 000 rubles for nonpayment or underpayment of corporate tax or individual income tax in respect of profits of controlled foreign company.
New approach for determining tax residence of legal person
Until recently in the Russian law tax residency of legal person was determined by place of its official registration, or by availability of permanent representative office of the company. This is also true for foreign companies, which are deemed tax residents of the Russian Federation only if they operate through permanent representative offices.
The authors of the draft law suggest a new approach, which exists in some European countries, where the place of actual management of the company also affects its tax residency. This means that if:
- meetings of the governing bodies of the company are held in Russia;
- management of the company is carried out in Russia;
- directors of the company operate in Russia;
- accounting is maintained in Russia;
- documents of the company are kept in Russia;
- such companies will be recognized as tax residents of the Russian Federation.
Adoption of such approach by the legislator will entail significant difficulties not only for actual but also for registered and acting on their own behalf shareholders, members and directors of foreign companies permanently residing or located in Russia. It seems that in case of adoption of the draft law with such condition, retaining Russian nationals among shareholders and directors of foreign companies will entail significant risks.
Application of the draft law
If we assume that the draft law is passed, it will generate several questions, the main of which – what are instruments that could encourage taxpayers to comply with such obligations stated therein.
Questions regarding application of Western experience of control of foreign companies in Russia shall be addressed. Real opportunity of Russian tax authorities to obtain information about beneficiaries and shareholders of foreign companies entails application of international agreements with regard to exchange of information. However, there are no such agreements between the Russian Federation and territories, included into “black list” by the Ministry of Finance of Russia.
Thus, the following compulsory action of the Ministry of Finance of Russia should be development of strategy to obtain information about generation of income by Russian individuals and legal entities from entities registered in offshore zones, such as, for example, information about bank account transactions of Russian nationals outside Russian Federation. It seems that the only effective method to obtain such information is introduction of control tool of bank account transaction of Russian nationals and legal persons, including outside Russian Federation. Similar method is used by public authorities of U.S. when implementing FATCA, obliging all banks in which the accounts of American residents are opened, to disclose relevant information to U.S. tax department. However:
- objectively FATCA legislation is imposed on international community by establishing prohibitive tax rates for banks refusing to provide such information;
- sanctions mentioned above may only apply to transactions conducted by relevant banks on the territory of the country which enforced such measures. Thus, the banks that have not joined FATCA, are subject to 30% tax on transactions conducted via accounts opened in the United States;
- such legislation implies significant violations by national banks of bank secrecy laws in most countries where banking operations are conducted.
Consequently, for introduction of similar tool in Russia foreign banks should be interested in conducting operations on the territory of Russia to such extant, that they would be ready to transfer relevant information to Russian tax authorities. As for Russian banks, their fate is clear: in case of adoption of the law in Russia on the basis of aforesaid draft law, as well as introduction of a tool similar to FATCA, Russian banks will have to disclose such information.
In addition, if in Russia a system of control of foreign companies will be established by beneficiaries which are Russian persons (regardless of whether it is made on the basis of consideration of the draft law or any other document), the beneficiaries will be obliged to notify the controlling authorities regarding available controlled foreign companies. And in this case, the only truly effective instrument of enforcement will be penalties imposed on violators. Proposed by the authors of the new draft law penalties in the amount of 100,000 rubles can not become a truly effective tool, and will be considered by taxpayers only as additional fee (not too substantial) relating to conduct of their business activities.
Effectiveness of high penalties for breach of legislation can be seen in currency regulation. Enforcement of penalties of up to 100% of an illegal currency transactions made subjects of control comply with requirements of currency legislation, such as, for example, notification of accounts opened outside the territory of the Russian Federation, even though proving the offence is a great challenge.
Legal status of the draft law
It should be noted that at present the considered draft law has been removed from the Russian Ministry of Finance website. Reference thereto is contained in other sources. The draft law has not been submitted to State Duma of the Russian Federation.
The text of the draft law, as it can be seen when reading it, has not been finalized: there are inconsistencies in terminology, vaguely described procedures and conditions for submitting reports, the grounds for holding persons liable for violating the law have not been properly determined, the tools that would allow tax authorities apply its provisions effectively have not been identified.
- Residency is determined in accordance with the Tax Code of the Russian Federation or an international treaty (agreement) in the field of taxation.
- Specified list is approved by Resolution of the Ministry of Finance of Russia as of 13.11.2007 № 108.
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