Russia has entered 2021 with several major changes in its tax laws that deserve special attention. Specifically, Russia introduced a beneficial tax regime for local software development companies, but has canceled the value-added tax (VAT) exemption for software use licenses for the vast majority of nonresident vendors.
Russia’s unique VAT regime on electronically supplied services (ESS) in business-to-business (B2B) transactions may be relaxed, with a possible introduction of an additional digital services tax (DST). The place of supply rules for VAT purposes for cross-border services may be also revisited within a few years, requiring alignment in the Eurasian Economic Union (EAEU) space.
This article briefly elaborates on these changes and related developments affecting software and e-commerce industries.
Preferential Tax Regime for Domestic Software Companies
For eligible Russian IT companies and electronic hardware developers, the new rules will reduce corporate profits tax from 20% to 3%, and social security contributions from 14% to 7.6%.
This preferential regime is subject to compliance with a number of conditions that many market players may be unable to fulfill. To apply the reduced profits tax and social security contributions rates, Russian companies must fulfill the following conditions simultaneously:
- Accreditation as an IT organization: the current accreditation rules are straightforward and impose no restrictions on foreign ownership in a Russian company applying for accreditation. Thus, Russian subsidiaries of foreign companies could enjoy the beneficial tax regime. Similar requirements apply to developers of electronic hardware. They must be included in a special register maintained by the Russian Ministry of Industry and Trade. Same as in the case of IT companies, there are no restrictions on foreign participation in Russian companies applying for the accreditation.
- Headcount: there must be a staff of at least seven employees.
- Revenue structure: at least 90% of the company’s revenues must be derived from sales of software developed by this company, provision of related services or design and development of electronic hardware.
Revenues from the provision of access to advertising and online marketplace software do not qualify as income from eligible IT activities. Thus, the preferential tax regime is not available to online aggregators, search engine operators, social networks, streaming services or many software distributors.
It is critically important to carefully analyze the target business model, structure of revenues and intended service/product lines in order to fit into the qualified services basket and assess potential weak spots.
Following these legislative changes, there has been a drastic increase in the number of applications for IT organization accreditation. In this context, any restructuring, for example, a factual spin-off of in-house IT function into a separate legal entity that would enjoy the beneficial tax regime, should be tested under the statutory general anti-avoidance rules and relevant court-made doctrines (e.g., doctrines of business purpose and unjustified tax benefits).
Cancellation of the VAT Exemption on Software Licenses
The 2008 VAT exemption for software and database licenses will be substantially restricted. The exemption will only apply to software and databases included in Russia’s National Software Register, and will not be available to foreign software vendors. Also, the exemption does not extend to the provision of access to advertising and online marketplace software.
This significant change may adversely affect the profitability of foreign IT companies in the Russian market. Depending on the circumstances, current prices and existing contracts for the supply of software and related services may need to be revisited.
The abolished exemption may have the greatest impact on sales of foreign software to customers that may not recover “input” VAT: individuals and companies with VAT-exempt revenues—for example, businesses in the financial sector, small and medium-sized enterprises (SMEs) applying special tax regimes.
The healthcare sector has been also affected. Many foreign vendors licensing software (and its updates) installed on medical equipment imported into Russia VAT-free now have to charge 20% VAT on their license fees. It is, however, possible to register medical software as a medical device that may potentially enjoy a VAT-exempt status. At the same time, it remains to be seen how the regulator and the Russian courts address the conflict between the prior statutory VAT exemption on medical devices and the 2021 rule canceling the VAT exemption on software use licenses.
The existing VAT exemption for patent and know-how licenses remains unchanged and is still available to both Russian and foreign companies.
Unique VAT Regime on B2B ESS and Expected Changes
Starting from 2019 (the VAT regime for B2C ESS came into force in 2017) foreign suppliers of e-services to Russian companies and individual entrepreneurs must register for Russian tax purposes, collect, report and remit VAT in Russian rubles to the Russian budget themselves. There are no thresholds for this mandatory tax registration. Technically, if a foreign vendor has even one minor transaction with an ESS component with just one Russian customer (including the vendor’s Russian affiliate), it must tax register in Russia.
Compliance with the Russian ESS regime is burdensome and implies investing in significant adaptation of enterprise resource planning systems and necessary advice on legal, tax and accounting matters, which overall does not contribute to greater efficiency in groups’ business processes.
Unlike many European jurisdictions, Russia does not have a separate VAT-taxpayer registration. Foreign entities that register in Russia to comply with the VAT regime on ESS are also deemed registered for other tax purposes. For many foreign vendors such registration and compliance is a substantial extra cost and exposure. Many market players decided not to “sell” into Russia for the same reason.
On April 24, 2019, the Russian Federal Tax Service issued a legally non-binding guidance letter that has essentially “allowed” parallel use of the “old” rules on ESS in B2B transactions starting from January 1, 2019. Formally, relying on either the new regime or the approach expressed in the letter carries incremental risks for the business, including the 10% turnover fine for lack of required registration. Some Russian customers even refuse to acquire ESS from non-registered ESS vendors.
Overall, the new regime has brought greater disruption to business and is unlikely to have contributed to a better investment climate in Russia.
Many foreign business associations are now actively discussing the boundaries of the target regulation for B2B ESS with the Federal Tax Service. The regulator has tentatively agreed to carve out inter-company transactions from the regime. The key open issue on the agenda is whether the regulator will also agree to introduce a tax registration threshold based on a meaningful minimum number of Russian “business” customers of a particular vendor.
It remains to be seen how far the Russian government would be prepared to go in order to soften the unpopular ESS regime and at the same time ensure maximum VAT collection results for the budget (mainly with respect to transactions with Russian SMEs that might never be audited by the Russian tax authorities).
Nonresident IT/Software Companies May be Required to Open Representative Offices in Russia
In early February 2020, the Russian mass media was filled with news on the initiative by the lower chamber of the Russian parliament to develop measures aimed at “procurement of compliance of foreign IT companies with Russian legislation and their presence in Russia.” The draft law is expected to be published soon. It is as yet unclear which companies will be affected and whether a “virtual representative office” would suffice for the intended compliance (e.g., for receipt of official communications from the Russian regulatory authorities).
The implications of such initiative could be too far-reaching and may adversely affect nonresident IT companies doing business in Russia. The interplay with the Russian VAT regime on ESS is yet to be determined.
It is also possible that, from a Russian tax law perspective, existence of a local representative office could potentially facilitate collection of turnover fines for failure to tax register under the VAT regime on ESS.
In the long run, such registration could also contribute to a greater nexus of nonresident enterprises with the Russian taxing jurisdiction, whether for the purposes of recognition of a digital permanent establishment or allocation of greater audit and taxing rights to Russia based on rules to be developed.
The impact of such initiative has to be carefully assessed among other factors for structuring purposes in Russia.
Place of Supply Rules for Cross-Border Service Transactions
Currently, the Russian place of supply rules for VAT purposes are not harmonized with those in the EU. Except for certain limited categories of services (including ESS, software development, IT consulting), the default place of supply of cross-border services is considered the jurisdiction of supplier’s residence.
This discrepancy produces multiple disputes between contracting parties on the Russian VAT treatment of cross-border services with an ESS element. The latter might not be separately priced, and it is often difficult to determine whether they should be considered auxiliary to other services and follow their place of supply. There is no clear threshold in the statutory rules or regulatory guidance. Case law is also limited on these matters, which creates a considerable level of uncertainty for businesses.
Harmonizing the place of supply rules with the EU VAT Directive could arguably resolve the issue of different treatment of ESS and non-ESS in mixed service contracts with Russian customers.
Recently, the Ministry of Finance of Russia announced that in its published tax policy for 2021–2023 it may revisit its place of supply rules based on the principle of the country of customer residence. Russia is an import-oriented jurisdiction, including with respect to services. Thus, overall, it will likely receive greater VAT revenues into its federal budget as a result of the potential changes.
However, the implications of such radical changes require careful assessment based on results of macroeconomic analysis and input from various government bodies and businesses. Special rules may need to be developed for some sectors of the economy, for example, financial, banking, SMEs, education and healthcare. Most market players in these segments are not considered VAT taxpayers: any extra non-recoverable VAT may lead to adverse consequences for such businesses.
Also, the target regulation needs to be harmonized with the supranational place of supply rules in the EAEU, which includes Russia, Kazakhstan, Kyrgyzstan, Armenia and Belarus. Recently, these rules have been adjusted to comply with the Russian VAT regime on B2B ESS.
Overall, any changes to the contractual model and pricing of cross-border services with Russian customers should be also double checked from the EAEU perspective.
Related Legislative Initiatives
Pending global consensus on OECD Pillar I, Russia is considering introducing a DST on top of the VAT on ESS; such a proposal has already been announced by the Finance Ministry in 2019. The likely parameters of the potential DST have not been disclosed, and so far, the Russian DST remains only a potential future development.
Russia is also paying close attention to the new EU rules on VAT taxation of offshore retailers and marketplaces with respect to cross-border online sales of tangible goods. While no relevant draft VAT legislation exists in Russia as yet, the Russian customs authorities are now testing an experimental regime allowing major foreign marketplaces to charge Russian customs duties on top of retail prices of goods. If the results of the experiment prove to be successful, this could expedite the adoption of EU-like VAT requirements to foreign retailers and marketplaces.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Arseny Seidov is a tax partner with Baker McKenzie in Moscow. He also leads the working group on taxation of e-commerce at the Association of European Businesses and a working group on taxation of the digital economy at the American Chamber of Commerce in Russia, where he is also a member of the board of directors.
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