The end of 2018 brought a number of highly significant amendments to the Russian Tax Code. Among them are amendments to the beneficial ownership rules dealing with various practice-driven issues, including the application of the so-called look-through approach.
What are the main changes, who will be affected by them and who will benefit? What practical issues are resolved by the new rules and what problems remain? How will the new provisions be applied in practice? These questions are addressed in this article.
The unifying idea behind the amendments is that taxpayers seeking to apply the reduced tax rates under the Russian double tax treaties should apply the look-through approach and name specific qualifying persons as the beneficial owners of income rather than attempting to prove sufficient substance at holding company level. This idea may not always be explicit in the changes themselves, but, in the authors’ view, it still serves as the basis for most, if not all, of them.
Some of the amendments apply retroactively starting January 1, 2018, thus allowing not only future tax risks but also risks relating to 2018 to be managed.
Beneficial ownership status is to be analyzed separately in relation to each dividend payment and/or group of payments under a single contract.
This amendment affects cases where, for instance, the payee is the beneficial owner of some but not all interim dividends, or only of interim and not final dividends, or where a person beneficially owns all Russian-source dividends, but not interest or royalties.
Although the Tax Code never prohibited the splitting of ownership in this way, nor did it prescribe specific rules for such situations, thus making beneficial ownership risks dependent on mere interpretation of existing provisions.
The amendment resolves the problem by letting taxpayers determine the beneficial owners of Russian income based on actual circumstances and without the risk of the incorrect application of law or contradictions between beneficial owner statuses claimed for different types/sets of payments.
In practice, this means that money flows will be more crucial in determining the beneficial owner than, for example, the income recipient’s activities. This also raises the issue whether the rule may make it possible for the immediate recipient to be declared the beneficial owner of some payments while look-through to further ownership levels is applied for other payments.
Another issue is that it is still unclear whether waiving beneficial ownership of dividends under the look-through approach would affect the status/right to apply the cost basis for the purposes of subsequent capital gains taxation.
The lack of a definition for the term “group of payments under single contract” leaves room for uncertainty as does the issue of the frequency with which beneficial ownership confirmations must be provided to the tax agent.
It is now officially possible to “look-through” an income recipient resident in a low-tax country and tax-transparent structures.
Prior law and practice rendered this impossible even if the ultimate beneficial owner was resident in a tax treaty country and was not a transparent entity. This only changed in 2018, when the tax authorities issued guidance to the contrary and the relevant provisions were enacted as a part of the amendments discussed here.
There is no longer a question, therefore, of whether it is appropriate to look-through low-tax and transparent entities to identify actual beneficial owners in treaty-partner countries.
The look-through approach is now available for all types of income and not only for dividends as previously provided. In addition, the approach does not have to be applied pro rata based on ownership shares.
This is a retroactive change. Previously the Tax Code neither allowed nor prohibited the use of the look-through approach in relation to payments other than dividends, which gave rise to much uncertainty. However, it explicitly stated that look-through could only be applied with reference to the ownership share of the indirect shareholder beneficially owning the dividends. This was clearly unfavorable in cases of non-pro rata dividend distributions.
The amended Tax Code allows the look-through approach to be applied in relation to any types of payments while setting an additional requirement for dividends, namely that the recipient must directly/indirectly hold a participating interest in the dividend payer. The pro rata rule is excluded, making it easier to apply the beneficial ownership rules to non-pro rata distributions by following their actual economic fate rather than formal entitlements.
However, it remains unclear whether the change applies to all possible types of income rather than a limited set of passive payments. In particular, this applies to capital gains and the correct determination of the tax base for the beneficial owner of such gains. It is also uncertain whether income conversion scenarios are covered (e.g. Russian royalties subsequently transferred as dividends).
There is still much discussion over the application of the look-through approach to dividends received at any time by a tax transparent entity such as a trust or an investment fund. Although generally allowed, this option is restricted by the ownership requirement discussed above. Since trusts and similar structures do not imply any form of ownership, the requirement is unlikely to be met.
This is reinforced by certain other legal technical ambiguities still present in the Tax Code. Some argue that the transfer pricing provisions for determining the ownership stakes of tax transparent entities may offer a solution. However, this may not be entirely appropriate owing to differences in the underlying concepts.
The Tax Code introduces new rules for so-called circular structures in which the foreign shareholder of a Russian company is itself partly owned by that same Russian company.
The rules imply that as long as certain criteria are met, dividend distributions within such structures should be tax-exempt for the Russian company that becomes the beneficiary of its own dividends. The criteria differ for 2018 and periods starting in 2019, forming a sort of a “transition period” for the new provisions.
Broadly speaking, for 2018 it is important that the investment and holding period requirements are satisfied (which is relatively easier), while from 2019 onward the intervals between and amounts of dividend distributions become relevant.
The new rules are interesting from tax and legal perspectives; but it should be noted that at this point circular structures are not widely popular with purely Russian and international businesses. We believe that these rules should be kept in mind for future group structuring and planning.
Another set of narrow-focused amendments concerns the application of beneficial ownership rules to repurchase, equity loan and other similar agreements. This is a retroactive change.
For tax treaty rates to be applied under such arrangements, the borrower/purchaser must inform the tax agent that it is not the beneficial owner of income associated with the underlying equity and provide the documents specified in the Tax Code. It is also stated that the participation requirement for treaty application is then “deemed to be met.” However, this is not further defined, and it is unclear whether this covers the holding period requirements of tax treaties.
We note that the term “other similar agreements” is likewise not defined, making it uncertain whether the rules apply to mixed contracts or contractually executed collateral arrangements such as a pledge or to contracts concluded under foreign law.
Finally, the beneficial ownership declaration and the look-through approach have now been simplified for a range of qualifying persons.
These include individuals, irrespective of their tax residency, state sovereign funds, companies where more than 25 percent of equity is free-float traded on Russian or Organisation for Economic Co-operation and Development countries’ stock exchanges, and companies where state participation exceeds 50 percent (provided that the state in question is not blacklisted in Russia). This change is retroactive.
The persons referred to above may support their beneficial ownership status by providing only a confirmation letter and evidence of their status as qualifying persons.
On the one hand, this simplified standard of proof largely facilitates the application of the beneficial ownership rules, including the look-through approach, for qualifying persons who in logical and practical terms should not be suspected of treaty abuse or may face difficulties in meeting strict standards even though no abuse was intended.
On the other hand, this simplification was originally planned as a full exemption from the requirement to prove beneficial ownership status, but that is not what is stated in law, thus raising the risk that a qualifying person’s beneficial ownership status would still need to be substantiated (even in the case of an individual).
It is also worth noticing that intermediate income recipients are still not explicitly exempt from substantiating their waiver of status under the look-through approach, which likewise creates certain risks as far as this option is concerned.
Finally, it technically follows from the wording of the Tax Code that only individuals who are Russian tax residents may benefit from the look-through approach and reduced tax rates, whereas in the case of foreign residents this is neither permitted nor prohibited.
Practical Issues and Remaining Problems
In summary, the positive effect of the Tax Code amendments discussed above is quite significant.
Firstly, the new rules “legitimize” the application of the look-through approach not only to dividends but also to interest, royalties and potentially all other types of income.
Second, the amendments eliminate risks associated with looking through residents of low-tax jurisdictions.
Third, the revised Tax Code provisions enable taxpayers to reconsider taking a conservative approach to their beneficial ownership position and to split ownership of particular payments or types of payments.
Fourth, the changes introduce reasonable and simplified beneficial ownership standards for qualifying persons.
Finally, there are new rules for certain complex beneficial ownership cases such as circular ownership structures and repurchase/equity loan agreements.
All these solutions result from addressing key practical issues faced by businesses and substantially reduce the uncertainties and risks previously associated with beneficial ownership rules and loopholes, whereby the outcome depended on the interpretation followed by the tax agent or the tax authorities.
However, certain key issues remain unresolved. For instance, the position of active holding companies with sufficient substance as beneficial owners of Russian-source income is still somewhat vague, especially given the adverse approach to holding companies taken by the fiscal authorities in their latest clarifications.
Interestingly, the Ministry of Finance did in fact propose an amendment to the effect that beneficial ownership status should be analyzed with specific reference to the activities of the income recipient. That provision was not passed, although it could have remedied the inherently adverse position of holding companies found in Russian case law today.
Instead, the Tax Code amendments reflect a quite different stance, whereby the look-through approach and the concept of qualifying persons take priority.
Another point is that the look-through approach and the investment/minimum holding period criteria of double tax treaties are still unsynchronized, and the respective rules may sometimes be incompatible: indirect ownership under the look-through provisions may not constitute qualifying ownership under a tax treaty.
It is also not quite clear how this approach would be applied to joint ventures in which different shareholders may have different beneficial ownership statuses.
Furthermore, the standards of proof for tax agents paying income to independent counterparties and to related persons are not currently differentiated, although gathering information needed to analyze beneficial ownership is much harder in the first case.
Finally, the criteria for analyzing further transfers of income remain unclear from a practical standpoint, for example, the exact amount implied in the phrase “all or almost all income,” the time frame that renders a transfer of money a pass-through payment, etc.
All these issues leave room for further amendments to the Tax Code and clarifications by the Russian tax authorities.
Summary and Planning Points
- The tax authorities are now likely to scrutinize the beneficial ownership status of each dividend payment or group of contractual payments, and taxpayers should take a similar approach;
- It may also be reasonable to alter beneficial ownership strategy towards looking for qualifying persons rather than substance in pure holding companies;
- The absence of a qualifying person in the payment structure should not necessarily have negative implications since a qualifying person is still not a complete and direct alternative to a holding entity with good substance. However, it cannot be ruled out that case law will develop to the contrary, in which case group structures may need to be reconsidered;
- Having a qualifying person within a structure may not be a panacea. There may still be a need for such persons to prove that they dispose of income independently;
- A beneficial ownership waiver may also be challenged by the tax authorities if the waiver could result from look-through approach “shopping” or “abuse”;
- Increased scrutiny and standards of proof for non-pro rata distributions and associated look-through should also be expected.
Finally, it is essential to monitor positive and negative developments in the application of the Tax Code amendments discussed here as well as in the Tax Code provisions themselves and potential future changes in the Russian beneficial ownership rules.
Evgeny Nepomnyashchikh is a Director and Natalia Averina is a Tax Expert at EY Russia.