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New Developments in Russia Regarding Cyprus Structures



As the international tax community waits patiently for the ratification of the Cyprus-Russia protocol (click here for details regarding the content of the protocol), and following clarifications provided in December 2009 regarding the term “directly invested”, the Moscow Department of the Russian Federal Tax Service and the Ministry of Finance recently provided important clarifications with respect to the application of the Double Tax Treaty (DTT) between Cyprus and Russia. These clarifications are as follows:

  • The definition of permanent establishment;
  • The treatment of liquidation proceeds;
  • The re-classification of interest (to dividends) with respect to the application of the Double Tax Treaty (DTT) between Cyprus and Russia.

Although these clarifications are not binding on either taxpayers or courts, they certainly indicate how the tax authorities in Moscow may be interpreting the relevant tax treaty, particularly the treatment of a permanent establishment and interest payments.

Scope of the term “Permanent Establishment”

In line with the said circular, the provision of management services by a Cyprus company shall give rise to a permanent establishment in Russia. The clarification is based on the assumption that a Cypriot Company cannot provide management services without the presence of its representatives in Russia. The presence of representatives in Russia constitutes a permanent establishment hence taxed in Russia.

Although at present there is no case law regarding the above, caution should be taken if your Cyprus structure involves such supply of services from Cyprus to Russia.

Tax treatment of liquidation proceeds

A recent clarification from the Ministry of Finance of 10 June 2010 (No. 03-08-05) prescribes the tax treatment of liquidation proceeds both under the Russian tax perspective and their treatment under the Cyprus-Russia DTT. Specific rules were outlined as having application to the taxation of liquidation proceeds distributed by a Russian subsidiary to its Cyprus corporate shareholder.

Accordingly, proceeds from the liquidation of Russian Company received by a Cyprus Corporate shareholders shall not be taxed in Russia to the extend that such proceeds are not in excess of the share capital contribution of the Cyprus shareholder.

Any income exceeding the amount of the share capital contribution is viewed as an undistributed profit, treated as a dividend distribution, and taxed (namely withholding tax) accordingly under the provisions of the existing Cyprus – Russia Double Tax Treaty at the rate of 10%, or 5% if direct investment of the parent into subsidiary is at least USD 100,000.

Excessive interest payments

On 14 May 2010 the Russian Ministry of Finance provided further clarifications with regards to excessive interest payments via a new circular. According to the clarifications an amount of interest paid by a Russian Company to its foreign parent (or domestic company affiliated to the parent Company) may be re-classified as dividends. This re-classification would apply when a Russian Company exceeds the debt to equity ratio provided under the relevant Russian legislation. In such cases, the amount of interest in excess of the permissible ratio is considered a non-deductible expense and accordingly re-classified as dividends.

The result, applying the Cyprus-Russia DTT, will be the imposition of Russian withholding tax at the rate of 10%, or the reduced rate of 5% if the shareholder receiving the dividends has directly invested an amount equal or higher than US$100,000 in the share capital of the paying Company.

It is important to note that Russian thin cap rules apply only to Russian companies held directly or indirectly by non-residents. Under certain interpretations this approach is discriminatory and is contradictory to non-discrimination provisions in the current Cyprus-Russia DTT. The Moscow Commercial Court of Cassation, being is the second highest court in the country, found Russian thin cap rules contradictory to the Cyprus-Russia DTT tax treaty in the cases of Field Invest on 23 September 2009 and Gidromashservis on 12 July 2010. As a result, the clarifications of Ministry of Finance will not necessarily be upheld by the courts.

Ensuring you are prepared

Savva & Associates are at your disposal to assist in preparing for potential challenges by tax authorities following the interpretations above. Careful consideration of the relevant risks involved is a key factor for long-term tax planning of business operations in Russia via Cyprus.

On a final note, it is expected that the pending Protocol to the Cyprus-Russia DTT will be signed in Cyprus in early October of this year, slightly prior or during President Medvedev’s pending visit to Cyprus. As such, amendments to the tax treaty may affect positions of current Cypriot/Russian structures, hence a tax audit of existing structures is strongly recommended.

Further Assistance

S&A Cyprus are at your disposal for any assistance you may require in relation to the above. We look forward to helping you better understand how these changes may affect your business or create new opportunities, and working together to offer you practical and reliable solutions.

Contact

Vision Tower
67 Limassol Avenue,
2nd floor,
2121 Nicosia,
Cyprus

Office: +357 22 516 671
Telefax: +357 22 516 672

Mr. Charles Savva
Director, International Tax
c.savva@savvacyprus.com


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