We frequently observe that globalization activities, which reached a rapid speed after the dissolution of the Union of Soviet Socialist Republics and its eastern bloc, have been reversed for various reasons. When it comes to taxes, countries have begun to voice their rights louder regarding taxation, although they continue to keep their borders open to foreign investment.
With the opening up of the Russian Federation (Russia) to the world, there is no doubt that Russia has attracted investments at a considerable rate in the last 30 years, and a vast majority of these investments are made by using Dutch holding companies, as is the case all over the world.
According to press reports, dividend and interest payments made by companies resident in Russia to its shareholders resident in the Netherlands were realized as $6.2 billion in 2017, $5.6 billion in 2018 and $4.6 billion in 2019. When a country that has such a huge market and a country that can attract such a huge investment power come face to face, things may not always be calm.
What is Happening between the Netherlands and Russia?
It is necessary to look at 2015 in order to get to the root of the subject. In accordance with the concept of beneficial ownership, which was added to Russian tax legislation in 2015, foreign companies that have had subsidiaries in Russia since 2017 had to document and prove that they are the beneficial owners of this income in order to benefit from the advantageous tax rates included in the tax treaties with respect to the income they have obtained from their subsidiaries.
This situation was in line with the basic logic of the Organization for Economic Co-operation and Development BEPS (Base Erosion and Profit Shifting) initiative, which has been the hottest topic in the last decade in terms of international taxation; and, of course, companies resident in the Netherlands were also affected by such developments. With this process, Dutch resident companies started to strive to fulfill the expectations of the Russian tax legislation from beneficial owners.
By 2020, possibly due to the global epidemic conditions, Russia had begun to take stricter and more protective measures relating to taxation. Russia, which has very close economic relations with Luxembourg, Malta, Cyprus and the Netherlands, made an explicit request for the revision of the tax treaties to increase the right of Russia to collect taxes, especially on interest and dividends, and declared that they would withdraw from the tax treaty unilaterally if the requests were not realized. This showdown was immediately responded to by Luxembourg and Malta, and the process of revising tax treaties began.
Cyprus, on the other hand, did not want to accept Russia’s request, but had to accept it with the announcement that Russia had started the unilateral withdrawal process from the tax treaty. The current situation between the Netherlands and Russia is that the Netherlands did not accept Russia’s request, and Russia announced that it had started the unilateral withdrawal process from the tax treaty. It is very clear that the Netherlands is not like Cyprus, however, Russia is not an insignificant market so we will be closely following how this showdown evolves.
What are Russia’s Requests?
Russia would like to increase the rates included in tax treaties in a way that is in line with the local legislation. The changes on the agenda at the end of the similar process in the Cyprus tax treaty will probably be the same for the Netherlands. Accordingly, Russia, as the source country, wants to increase its right to levy tax over the dividends from 5%, as it is in the tax treaty, to 15% in parallel with the rate in the local legislation. Likewise, Russia, as the source country, also wants to increase its right to levy tax over interest payments, for which all taxation rights are given to the Netherlands in the current tax treaty, to 15%.
If these offers are accepted, the tax burden on the interest and dividend income to be obtained indirectly from the Netherlands by companies investing through Dutch holding companies in Russia will increase significantly, and the investment will become considerably more expensive.
Unilateral Withdrawal Process from the Tax Treaty
If Russia decides to unilaterally withdraw from the tax treaty, Russia must notify the Netherlands six months before the end of any fiscal year, at the latest, and the tax treaty will be terminated from the following year. It is too late for 2020, but if the notification regarding the process is made by the end of June 2021, it means that there will be no tax treaty as of January 1, 2022. In other words, the tax treaty will remain in effect until at least January 1, 2022.
In the event that the tax treaty is no longer in force, dividend payments to be made by Russian resident companies to their shareholders resident in the Netherlands will be subject to withholding tax over dividend and interest payments at a rate of 15% and 20%, respectively. There is not much difference for Russia between withdrawal from the tax treaty and its revision. Russia is playing this game with a showdown, exactly the way it was played with Cyprus, but we do not know how the Netherlands will play this game. We will wait and see.
Impact on Turkish Investors
We know that a significant majority of investments from Turkey are made through the Netherlands, and we also know that the vast majority of such investments which are made through the Netherlands go to Russia. Therefore, the developments in the tax treaty between the Netherlands and Russia will seriously affect Turkish investors, and if Russia does not accept the Netherlands’ counter-proposals regarding the conservation of the tax treaty provisions, the tax burden on dividends and interest income will increase remarkably.
We certainly must interpret this development together with the development of the entry into force of the Multilateral Convention (MLI) which has been on the agenda in Turkey. While, for the last six months, Turkish investors have already focused on whether the exemption clause of the Dutch tax treaty will be disabled, and, consequently, whether the tax burden on dividends will increase by 20%, news coming from a completely different front will further increase their apprehension. While the current tax burden on investments made by Turkish companies in Russia through the Netherlands is 24%, consisting entirely of taxes paid in Russia, (20% corporate tax in Russia + 5% dividend withholding tax over after-tax profit in Russia), this rate will increase to 45.6% (20% corporate tax in Russia plus 5% dividend withholding tax over after-tax profit in Russia plus 20% corporate tax in Turkey over the dividends received by Turkey) in case of the dissolution of the exemption clause in the tax treaty between Turkey and the Netherlands together with unilateral withdrawal of Russia from the double tax treaty with the Netherlands.
It is clear that the outcome is intolerable, and Turkish companies investing in Russia through the Netherlands have to closely follow the developments not only in Turkey, but also between the Netherlands and Russia. However, while fulfilling the duties assigned by the BEPS initiative, it is highly likely for the Dutch holding companies, whose position against the venture capital funds abroad has been weakened, and which have to maintain a stricter stance with the CFC (Controlled Foreign Companies) regulations, to face new threats directly (as in the case of Russia) or indirectly (as in the case of Turkey) in this general international tax agenda. Accordingly, it seems that the business of Turkish investors will get harder day by day.
Considering the alternatives to the Netherlands as a holding location, we will come across provisions regarding the main purpose test of the MLI. With increasing protectionism and cross-border cooperation of tax administrations when it comes to tax collection, the world will gradually become a smaller place.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Eray Büyüksekban is a Partner, Head of Global Tax Advisory Services, KPMG Turkey.
He can be contacted at firstname.lastname@example.org