New Approach to the Determination of Tax Residency of Legal Entities: Now We’ll Begin to Live Like in Europe
At present, almost all countries over the world are involved in globalization. The gradual international division of labor and its deepening, opening of borders of different countries for sales and capital turnovers, emergence of new communication and transport means – all of these became reasons for the emergence of the phenomenon of globalization. There are a number of factors proving that companies indeed have many benefits from a single global strategy. However, the development of such a strategy is a very difficult and lengthy process during which many factors shall be taken into account, such as legislation of countries in which business is done.
Taking into account the current economic situation it is difficult to overestimate the importance of such institution as tax residency, which is the cornerstone of corporate taxation. At the same time, the risks of claims of tax authorities on this matter shall be noted.
So far, in the Russian law tax residency of a legal entity was determined either by the place of its state registration (incorporation), or by availability of permanent establishment of the entity. This is also true for foreign companies recognized tax residents of the Russian Federation only if they operate through a permanent establishment.
However, the above approach to the determination of tax residency undergone a significant change due to the new law on controlled foreign companies adopted at the end of 2014 and effective from 1 January 2015.
The authors of this law offer a new approach, which exists in a number of European countries, where the place of the effective management of the organization also affects its tax residency.
We can not say that the determination of residency subject to the place of effective management is something new. There are many countries over the world, where this criterion is already used, primarily these are common law countries, in which, in fact, it appeared in the late XIX century, as well as the countries where similar criteria are used (for example, in Germany or Belgium this criteria is the location of the head office). By the end of XX century the place of the effective management became a so common residency indicator that it was included in the OECD Model Convention and in many double taxation agreements (including those signed by the Russian Federation) as a decisive criterion in the cases where each of the contracting countries consider a legal entity its resident.
Hypothetically, the emerging problem of dual residency must be solved with the appropriate international tax agreement. But agreements usually do not describe in too many details how the place of effective management shall be determined. Different countries have different approaches to this issue, and the mutually agreed procedure, which is provided for these cases by agreements, is used by competent authorities (and not in Russia only) rather in exceptional cases.
Meanwhile, the indicators of the place of effective management listed in the law on controlled foreign companies are known to the world practice as well; moreover, they almost literally reproduce the concept of resident under the Tax Agreement between the Russian Federation and Armenia1.
Following the international experience, we can assume that the main criterion for Russia could be either the place where strategic decisions important and necessary for the company as a whole are made (this function is usually performed by the board of directors or an equivalent body), or rather the place where the current (operational) management of the company is carried out (i.e. the place where usually the chief officials are located and work, or where the head office is located). However, although the idea embodied in the law on controlled foreign organizations is very close to this concept, things are not so simple and obvious as we would like them to be.
In accordance with the law on controlled foreign companies the place of effective management of foreign organization is recognized the Russian Federation provided that at least one of the following conditions applicable to foreign organization and its activity is met:
- The majority of the board meetings (or meetings of other similar body of the organization, except for the executive body) are held in the Russian Federation. The majority of meetings is recognized the relative majority of meetings, that is the situation where the number of meetings held in the Russian Federation is larger than in other states;
- The executive body (executive bodies) of the organization regularly carries out its activity in relation to that organization from the Russian Federation. In this case, regular activity is not recognized the activity carried out in the Russian Federation if its amount is significantly less here than in other country (countries);
- The main (senior) officials of the organization (persons authorized and responsible for planning, management and control over the activity of the enterprise) work mainly in the form of a governing management of such foreign organization in the Russian Federation. The governing management of the organization is recognized decision making and other actions related to the issues of the current activity of the organization falling within the competence of executive governing bodies.
However, despite the above-described closed list of conditions, a foreign company will be recognized a tax resident of the Russian Federation provided it meets at least one of them, as stated in the law, while in another point of the same article the legislator stated that if a foreign organization fails to meet any condition provided for by point 1 and 2 from the list of conditions listed above, or it meets only one of them, the Russian Federation is recognized place of effective management of such foreign organization subject to meeting at least one of the following conditions:
- Bookkeeping or managerial accounting of the organization in the Russian Federation;
- Record keeping of the organization in the Russian Federation;
- Operational management of personnel in the Russian Federation.
Exceptions to the above rule for determination of the country of tax residency will be foreign organizations if their business is carried out using their own qualified personnel and assets in the country (the territory) of their permanent location, which has an international tax agreement with the Russian Federation. In this case, a foreign organization shall confirm the above facts by providing documentary evidence of fulfilment of these conditions.
However, it is not clear whether the foreign organization will be recognized resident of the Russian Federation only due to holding the majority of board meetings in the Russian Federation or additional indicators are needed.
The law also attracts attention to the point that particularly specifies that conduct of the following activity of the foreign organization in the Russian Federation itself can not be regarded as effective management of the foreign organization in the Russian Federation:
- Preparation and (or) making decisions on matters falling within the competence of the general meeting of shareholders (members) of the foreign organization;
- Preparation for the meeting of the board of directors of the foreign organization;
- Implementation in the Russian Federation of particular functions as part of planning and control of activity of the foreign organization. Such functions, in particular, include strategic planning, budgeting, preparation and drafting of the consolidated financial statements, internal audit and internal control, as well as adoption (approval) of standards, methods and (or) policies, which apply to all or a substantial part of subsidiaries of such organization.
The purpose of this point remains a mystery, because the legislator particularly stressed that meeting the conditions specified above by itself can not be regarded implementation of effective management of the foreign organization in the Russian Federation, fact which suggests that these indicators may be considered jointly with other conditions, but we find no further confirmation of its assumption.
In such situation, we can only make assumptions as to the logic of the legislator and seek clarifications of the tax authorities.
Thus, going back to the comparative analysis of the national approach to the determination of residency and foreign countries, we can note the following. The approaches used in other countries and those proposed in the law have an important difference: in determining the place of effective management, the legislation of other countries usually relies on one determining indicator, which, as a rule, is the place of making key decisions important for the whole company (the place of meetings of the board of directors or other main governing body), or the place of the current (operational) management of the company. It means that it is not assumed that residency will be determined at the discretion of the tax authorities and according to any indicator that they will consider crucial in that situation.
This position is laid down in the tax agreements entered into with Russia as well, many of which determine the place of residency according to the location of the effective governing body (for example, the agreements with the Netherlands, Switzerland, Germany). Some of them contain additional indicators, such as place of taxation of income of shareholders of the company (Convention with France).
This applies to other criteria to an even greater extent: bookkeeping, storage of archive and print documents of the company, citizenship, place of residence of members of the board of directors, location of the main business operations – all these circumstances, of course, are important, but they are never determinative. Anyway, the decision on the residency is made following the evaluation of all facts, rather than of a single criterion, the more such a secondary one like storage of archive or bookkeeping. Even if the above-mentioned Agreement with Armenia lists the same indicators of residency, it nevertheless states that they “will be taken into account among others.”
According to the comments to p. 3 art. 4 of the Model Convention (which Russian law enforcers increasingly refer to), it is expected that for the residency to be determined the competent authorities will consider the most various indicators. In this case, “the countries that believe that the competent authorities should not be given a free hand… can complete the provision with a reference to the factors they consider relevant.” As we can see, the position of the OECD is that residency shall be determined on the basis of the analysis of various circumstances and, if necessary, the circumstances, which particularly should be taken into account, can be pointed out.
The law provides a voluntary procedure for the recognition of the country of tax residency the Russian Federation for the following foreign organizations:
- The foreign organization has a permanent location in the country, with which the Russian Federation has a current international tax agreement, and is recognized tax resident of that foreign country in accordance with the provisions established by the specified international agreement;
- The main activity of the foreign organization is involvement in projects under production sharing agreements, concession agreements, license agreements or service agreements (contracts) on the conditions of risk or under other similar agreements with the government of the relevant country (territory) or with institutions (public authorities, state-owned companies) authorized by such government;
- The foreign organization, the direct (indirect) shareholder (member) of which is a Russian controlling person, the share of direct (indirect) participation of which in the authorized (joint) capital (fund) of such foreign organization makes up at least 50% for at least 365 calendar days, while meeting all of the following conditions:
- According to the financial statements over 50% of the assets of such foreign organization consist of investments in foreign subsidiaries, which are not tax residents of the Russian Federation, and the country or the territory of permanent location of which is not included in the list of countries and territories, approved by the Ministry of Finance of the Russian Federation.
- The share of participation of such foreign organization in the authorized (joint) capital (fund) of such subsidiaries makes up at least 50%.
- The income (profit) of such foreign organization lacks or over 95% thereof is income referred to in sub-point 1 of point 4 of article 3091 of this Code and is directly or indirectly derived from such subsidiaries.
- The foreign organization is the operator of the new offshore raw hydrocarbon deposit or direct shareholder (member) of the operator of the new offshore raw hydrocarbon deposit.
It should be also noted that if the foreign organization independently recognized itself tax resident of the Russian Federation, the said foreign organization is not recognized controlled foreign company.
At the same time, the organization, which previously voluntarily recognized itself tax resident of the Russian Federation, may refuse the status of tax resident of the Russian Federation.
This foreign organization shall notify the tax authority at the place of tax registration of the separate division about its recognition as a tax resident of the Russian Federation, as well as about the rejection of the status of tax resident of the Russian Federation as determined by the Ministry of Finance of the Russian Federation, in the form approved by the federal executive body authorized to perform control and supervision of taxes and fees.
It wouldn’t go amiss to draw attention to the fact that the recognition of the organization (individual), which is the managing company (managing partner or other entity managing the fund resources) of an investment fund (mutual fund or other form of implementation of collective investments) – a foreign organization (foreign entity without legal personality), tax resident of the Russian Federation is not itself grounds for recognition of this investment fund (mutual fund or other form of implementation of collective investments) a tax resident of the Russian Federation.
The legislator also stated separately that a foreign organization issuing marketable bonds, an organization authorized to receive interest income payable on outstanding bonds, or an organization, to which rights and obligations on bonds issued by other foreign organizations were ceded, can not be tax residents of the Russian Federation. However the share of this income for the period, for which, financial statements for the fiscal year are prepared in accordance with the personal law of the foreign organization, makes up at least 90% of all income of such organization for the specified period.
As can be seen from the analysis of changes of the procedure for determination of tax residency of foreign companies, although the aim of the legislator was obviously bringing the domestic tax legislation close to international standards, there are still many unsolved issues that, we hope, will be solved in the near future.
- Point 3 of article 4 of the Agreement between the Government of the RF and the Government of the Republic of Armenia from 28.12.1996 “On avoidance of double taxation of income and property”.
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