Parliament adopts a draft law on controlled foreign companies

Russian residents make active use of foreign (incl. offshore) "layer-type" companies which hold Russian and foreign assets beneficially owned by Russian residents.

Today, foreign companies' return on business assets is not subject to taxation in Russia until it is distributed, e.g. as dividends, for the benefit of Russian owners, in which case such distribution may be delayed or not happen at all. Therefore, the Russian budget may have a substantial shortfall of income tax revenues from Russian natural bodies and legal entities – beneficiaries.

A law was adopted on the 25th of November, introducing rules effective January 1, 2015 for profit tax of controlled foreign companies (CFCs), rules for identifying companies' tax residence, the concept of person beneficially entitled to income, as well as a provision specifying that the allowances provided by Russia's international tax treaties only may be applied to such beneficial recipients of income (limitation of benefits).

For the purposes of the Tax Code of Russia and international treaties, the person beneficially entitled to income shall be recognized as a person who by virtue of (direct and/or indirect) participation in organizations or controlling the same or by force of other circumstances is entitled to individually use and/or dispose of such income, or a person for the benefit of which other person is entitled to dispose of the income. At the same time, this person's functions and risks are considered.

Under the draft law, CFC means a foreign company or foreign unincorporated organization (FUO) which is not Russian tax resident but controlled by Russian tax residents.

The controlling person of a CFC may be a natural person or legal entity holding directly or indirectly an equity interest of more 25% in the CFC or more than 10% if all Russian residents' total equity interest in the CFC is more than 50%. At the same time, natural bodies' equity interest is determined with due consideration of the interest held by spouses and minor children.

The controlling person may be recognized as such without meeting the equity interest criteria, if such person controls the CFC, i.e. has or may have a decisive sway in the decision making process concerning CFC's after- tax profit (income) distribution for his/her own benefit or for the benefit of his/her spouse and minor children.

Finally, a Russian tax resident may individually recognize itself as the controlling person of CFC, of which the former must inform Russian tax authorities.

CFC's profit is not taxable in Russia in case of:

• a non-profit organization not involved in profit distribution;
• an organization established under the legislation of Eurasian Economic Community;
• a FUO in which the founder isn't entitled to the assets transferred by the same to the FUO, may not convey its rights to other person (except by way of inheritance or by universal succession of title), as well as generates (together with founder's related parties) no income (profit) from the FUO;
• a bank or insurance company holding a respective license and domiciling in a "good" state;
• a SPV established for the purpose of issuing Eurobonds; in this case, bond yield must account for at least 90% of such SPV's income;
• an organization participating in concession projects, product sharing agreement, etc., except that projects' revenues must account for at least 90% of the organization's total income;
• an operator of new offshore hydrocarbons deposit or immediate shareholder (participant) in the operator;
• an organization domiciling in a "good" state, provided that such organization has 20% or less of passive income share during a respective period;
• an organization domiciling in a "good" state, provided that such organization has an effective income tax rate of more than 75% of Russia's average weighted profit tax rate as of the end of a respective period.

Listed below are some of the definitions used in this list.

A "good" state means a state having an international taxation treaty in force with Russia, except those states which provide no exchange of information for tax proposes. The Federal Tax Service of Russia will publish a list of the states which don't exchange tax information.

Passive income is the income specified in subparagraph 1-12, paragraph 4, article 309.1 of the Tax Code of the Russian Federation. The law in question also introduced this article ("Specifics of CFC's profit tax") into the Tax Code of Russia. The article contains a list of CFC's income, including the passive income consisting of dividends, interest, royalty, income from sales of shares (interest), from sales and lease of property, from the provision of consultancy, legal and other services, and some other income.

Effective rate means the ratio of company's income tax (including the tax charged by the company with its standalone subdivisions, and tax deducted at source) to its profit (income) as defined under article 309.1 of the Tax Code. However, if the profit (income) is negative or zero during the period, the entity shall be automatically recognized as CFC.

To calculate the average weighted rate, CFC's profit should be broken down into dividend income (D) and other income (P – D), and respective Russian profit tax rates should be applied to these income groups:

Ст.ср. = ((P – D)*20% + D*9%) / P;

while, if P – D <0, then P – D =0 is excepted.

Once a foreign company (FUO) has been recognized as CFC, its retained profit as dividends for the period, if more than Rb 10m, is to be included into the tax base of the controlling person pro rata to its interest in the CFC. The amount of tax on the CFC's profit is to be reduced by the amount of tax assessed on this profit in a foreign state.

CFC's tax loss may be carried forward indefinitely (losses incurred by the CFC prior to 2015 only may be carried forward in an amount equal or less than the amount of loss incurred during the three fiscal years preceding the date of 01.01.2015).

Taxpayers are obliged to inform tax authorities of holding an interest in Russian and foreign organizations and FUOs, as well as of CFCs in which such taxpayers are controlling persons. Non-reporting or misreporting about holding an interest in foreign organizations, as well as failure to submit CFC's profit tax returns is subject to substantial penalties: Rb 50,000 for notification of holding an interest in foreign organizations, and Rb 100,000 for notification of CFC, for each organization /CFC.

Failure to provide tax authorities with financial statements and auditor's report (if it is compulsory for a CFC under its governing law) attached to CFC's tax return or provision of these documents with false representations is subject to a penalty of Rb 100,000.

Non-payment or underpayment of CFC's profit tax will be subject to a penalty on the controlling person, 20% of the underpaid amount, but not less than Rb 100,000.

The law establishes a transition period for new provisions:

• in 2015, the interest holding threshold will be increased to 50% to recognize control over CFC;
• threshold amount of CFC's profit considered by a Russian resident will be increased to Rb 50m in 2015 and Rb 30m in 2016;
• in 2015–2017, nonpayment of CFC's profit tax will be subject to no penalties;
• in the same period, nonpayment of CFC's profit tax will be subject to no criminal liability if the damage to the budget has been reimbursed in full.
The same law establishes new rules for identifying organizations' tax residence. While tax residence is currently identified at the place of incorporation, in 2015 it will also be identified at the place of actual corporate governance of the organization. This will allow companies registered in other jurisdictions but managed from Russia to be recognized as Russian tax residents.
Russia will be recognized as the place of effective management of a foreign organization if one of the following conditions is met:
• most of the meetings of the board of directors (any other management board) are held on the territory of the Russian Federation;
• the executive body of an organization conducts its activities from Russia on a regular basis;
• senior (managers) officials of an organization (persons authorized and in charge of planning, management and supervision over the organization) conduct their activity with regard to this foreign organization mostly in Russia.
Should just one or none of the foregoing conditions be met, Russia may be recognized as the place of effective management if at least one of the following conditions is met:
• bookkeeping or management accounting in the organization (except consolidated financial statements);
• paperwork management;
• day-to-day staff management.

In certain circumstances, a foreign organization may individually recognize itself as resident of the Russian Federation, in which case it may not be recognized as CFC.

Svetlana Shatalova, senior researcher, the Center for Macroeconomics and Finance