Russia's tax reform improve the investment climate
The Russian Federation is the world's largest country in terms of territory and has a population of 143.5 million.
By YOUR TAXES WITH LEON HARRIS, EKATERINA DOKHLOVA
The Russian Federation is the world's largest country in terms of territory and has a population of 143.5 million. With vast natural resources and a highly educated work force, Russia is considered to have tremendous growth potential. After the collapse of the Soviet Union in 1991, Russia launched reforms aimed at transforming its centrally planned economy into a free-market system. The Russian tax system has also undergone significant changes aiming at improving the investment climate and stimulating business development.
The Russian tax system: Russian taxes are governed by the Russian Tax Code and include federal, regional and local taxes. Two of the major taxes are corporate profits tax and VAT.
Taxpayers for corporate profits tax purposes are Russian legal entities and foreign legal entities that have a "permanent establishment" in Russia or receive income from Russian sources. The concept of a "permanent establishment" is not well developed in Russia. The result is often uncertainty and ambiguous interpretation by the tax authorities and the courts.
Corporate profits tax rate is imposed at a flat rate of 24% on Russian entities and permanent establishments of foreign entities. Some types of income sourced in Russia received by foreign companies that do not have a permanent establishment in Russia are subject to withholding tax at a rate of 20%. Russia also levies withholding taxes on dividends paid to a foreign resident at a rate of 15% and on interest and royalties paid to a foreign resident at a rate of 20%. However, Israeli resident recipients are eligible for a reduced rate of 10% on all such payments, pursuant to the Israel-Russia tax treaty. Russia has an extensive network of double tax treaties with countries in the Eastern and Western hemispheres.
Corporate profits tax is imposed on profit earned, which means gross income received minus tax-deductible expenses incurred. The Tax Code contains a list of tax-deductible expenses but deductibility is subject to a business purpose criterion. In principle, expenses that are considered "economically justified" and supported by documentation (drawn up in accordance with the Russian laws) are deductible, unless specifically disallowed by the Tax Code.
Losses incurred by a taxpayer can be carried forward up to 10 years.
Interest paid by a Russian company is deductible provided its rate does not exceed limits stated by the law. There are also "thin capitalization" rules that limit the deductibility of interest paid on "controlled" debt that have been tightened up recently - but certain loopholes remain.
Russia has transfer pricing rules for transactions between related parties. Until now they could be easily avoided, but proposed new rules are under consideration by the Russian Government and Parliament. It is expected that transfer pricing rules will be significantly changed and documentation requirements will be introduced shortly. If you have business interests in Russia you are advised to monitor these developments.
Capital gains realized by a foreign entity that does not have a permanent establishment in Russia is taxed at 20% withheld at source, unless relief applies under a tax treaty, e.g. the Israel-Russia tax treaty. There will also be tax consequences in Israel.
As for individuals, there is a 13% flat rate of income tax for Russian tax residents. If a person is not a resident in Russia for the tax purposes, a 30% rate applies. Social security payments are made by the employer (Russian company or a registered branch of a foreign company) at a rate of around 26%.
The current general rate of VAT is 18% on taxable supplies, which include the majority of domestic sales of goods and services. The Tax Code contains "place of supply rules" which determine whether the supply is subject to VAT in Russia. The VAT regime in Russia has been amended recently. The cash method of accounting has been abolished and only the accrual method is permitted for VAT purposes.
There is no separate registration for Russian VAT purposes; instead a company registers for all corporate taxes. If a foreign entity (e.g. Israeli entity) that is not registered for tax purposes in Russia sells goods, work or services and the place of supply is Russia, the tax base is determined by the Russian purchaser acting as tax agent. The tax agent must calculate, withhold from the foreign taxpayer and pay the Russian government the appropriate amount of VAT.
Special Economic Zones: Russia has introduced special economic zones that offer preferential tax treatment for investors and provide assurance against unfavorable changes in tax legislation.
Financial reporting: The Russian accounting system differs from the accounting principles generally accepted in the US (US GAAP) and International Financial Reporting Standards (IFRS). Furthermore, financial accounting is separate and distinct from tax reporting in Russia and investors carrying on business in Russia should apply both systems to comply with the requirements.
The Russian Ministry of Finance is formulating a program for Russia's transition to International Financial Reporting Standards (IFRS).
The overall trend: Russia is in a state of transition. Although the Russian tax system and business environment have been significantly improved, the tax reform process in Russia continues and the Russian Tax Code still contains some controversial provisions. The guidelines issued by the tax authorities and other authorized state bodies are not always sufficient.
There are still rapid changes, making long-term tax planning difficult. The position of the tax authorities may differ from region to region and also over time. Lately, the Russian tax authorities have begun to pay close attention not only to the formal side of a transaction but to the economic substance behind it and apply business purpose tests.
In addition, the "political risk" in Russia must be assessed. High-level officials proclaim developments aimed at protecting the investor's position, but practical issues remain and must be checked out.
How will Russian taxes interact with Israeli taxes for Israeli investors? This will depend mainly on individual circumstances; see, for example, our article "Tax issues to consider when investing abroad" (The Jerusalem Post, October 18, 2006). Key issues typically may include: the entity structure; the business model; intellectual property and research and development; finance aspects; income repatriation; exit strategy; management and employees; double-tax relief; tax planning and anti-avoidance rules.
Under the Israel-Russia tax treaty, Russia generally withholds 10% tax at source from dividends, interest, royalties, paid to Israeli residents if they are not deemed to have a permanent establishment (primarily, a fixed place of business or branch) in Russia. Russia has strict withholding tax and income source rules, so each case must be checked out in advance.
Subject to this, if an Israeli company with no permanent establishment in Russia simply trades from Israel with an unrelated Russian company, it should only pay tax in Israel.
If an Israeli company has a permanent establishment in Russia it will report the resulting profit or loss to the Israel Tax Authority as well as the Russian authorities. Israel generally will tax the Israeli company on its worldwide profits, including Russian source profits, at the regular rate - 29% in 2007. There will be an Israeli company tax balance to pay after crediting the Russian tax (24%) on the Russian source profits (e.g. 29%-24%=5% anticipated Israeli company tax balance in 2007).
If an Israeli resident company or individual invests in the shares of a Russian company, it may be able to defer Israeli tax until it receives a dividend from the Russian company. At that time, the Israeli tax would generally be 25% of the gross dividend less a credit for the Russian dividend withholding tax of 10% under the Israel-Russia tax treaty, resulting in a net Israeli tax liability of 15% of the dividend.
Alternatively, if an Israeli company (not individual) holds at least 25% of a Russian company, the Israeli company may choose to pay the regular rate of Israeli company tax (29% in 2007) on its share of the pre-tax profit of the Russian company and claim a credit for the corporate and dividend withholding taxes paid in Russia - this should eliminate altogether the Israeli company tax altogether.
Capital gains, loan interest, royalties, management and technical fees and so forth may be taxable in both countries - specific advice should be obtained - especially if income or gains are to be re-invested abroad.
Russia has a system of foreign exchange control, so its formalities should be followed.
The above is only a brief overview. As always, consult experienced tax and legal advisers in each country at an early stage in specific cases.
Leon Harris is an International Tax Partner at Ernst & Young Israel
Ekaterina Dokhlova heads the Russian Tax Liaison Desk at Ernst & Young Israel
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