The growing tax exposure linked to the usage of foreign conduit companies is one of the most pressing issues relating to tax planning in Russia.
What is a Conduit Company?
A Conduit Company is a company used for the transfer and transformation of revenue for purposes of reduction of its tax obligations in the field of international economic transactions.
Usually, conduit companies are set up in low tax jurisdictions (tax havens) or in jurisdictions, which enjoy relevant double taxation avoidance treaties (DTA), enabling them to transfer revenue from the place of doing business at the reduced rates.
Consequences of a classification as a Conduit Company
In order to demonstrate the negative consequences of a company being classified as a conduit, we may consider the most simple and widespread scheme of Russian business entity ownership: a chain of Cyprus – British Virgin Islands (BVI) companies, wherein the Cyprus entity acts as a transmitter of revenues to the actual recipient entity in the BVI.
In this case, the Agreement between Russia and Cyprus on the avoidance of double taxation with respect to taxes on income and on capital should be applied. This Agreement provides significant benefits, lower tax rates and tax relief for revenues originating from Russian sources.
Nevertheless, according to Russian case law (e.g. Interdistrict Inspectorate of the Federal Tax Service for Major Taxpayers No. 1 vs Naryanmarneftegas Ltd, Case No. А40-1164/11, where the definition of “Conduit Company” was given; the famous case No. А40-1164/11 of InterdistrictInspectorate of the Federal Tax Service for Major Taxpayers No. 1 vs JSC “UK” Severny Kuzbass”, which became a tacit court precedent for Russian courts thereafter, where the tax consequences of the use of “Conduit Companies” were formulated and the taxpayer was penalized and charged with additional tax; and finally gained momentum in “Nestle Russia” LLC vs Interdistrict Inspectorate of the Federal Tax Service No. 48 for Moscow, Case No. А40-16883/15, where the tax consequences and approach were entrenched), the aforementioned fiscal benefits would not be applied to the revenues of Russian sources, if the latter are transferred within the framework of one or more transactions carried out with the goal of a foreign entity claiming benefits and then forwarding these revenues to another entity, which would otherwise not be entitled to claim these benefits had the revenues been transferred directly. In other words, the benefits are not accorded if the Cypriot entity is used merely as a transmitter between the Russian and the BVI companies, thus annulling the positive effect of the DTA. Benefits, low tax rates and tax relief for revenues paid from Russian sources apply only if a company resident of a foreign state, which has concluded a DTA with Russia, is the actual recipient of the revenue.
This construction thus jeopardizes the right to claim benefits of the Cypriot entity, risks the application of thin capitalization and transfer pricing rules and could lead to an additional charge of tax on the Russian entity.<br>
A further negative consequence ensuing from the usage of conduit companies in tax planning is an additional tax charge for Russian companies, for instance on revenues paid to Luxemburgish, Cypriot and Swiss entities qualified as conduits, notwithstanding the double taxation avoidance treaties concluded with these states.
Thus, in our understanding, the use of “Conduit Companies” will no longer provide the desired fiscal benefits and could even lead to increased tax liability and penalties for Russian business entities, as demonstrated by the foregoing remarks on the tendencies in Russian case law.
Nowadays this approach is being implemented under the Russian Federation Government Decree No. 84 of 24.02.2010 “On conclusion of international agreements on avoidance of double taxation and prevention of tax evasion on income and property taxes”.
Hong Kong will provide a competitive opportunity for tax planning in doing business in Russia, since the advantages of the Russia-Hong Kong DTA can be obtained without difficulty, given the easy access to compliance in Hong Kong with the criteria for avoiding conduct classification as set out below.
Indeed, according to the Russia-Hong Kong DTA, a company, which is a resident of both jurisdictions by virtue of their local legislations, is considered to be resident where it has its place of “effective management”. If the latter should be Hong Kong, then, in general terms, only a 5% tax would be levied on dividends transferred from a Russian to a Hong Kong entity and interests and royalties transferred in such manner would only be taxed in Hong Kong. Concerning the 5% tax on dividends, a further major advantage for the usage of Hong Kong companies is the fact that the only precondition for this reduced tax rate to apply is that the Hong Kong-resident company hold directly at least 15% of the capital of the company paying the dividends. This makes Hong Kong a much more competitive jurisdiction compared to many others, given, for instance, the needed 100,000 EUR investment to profit from reduced tax rates in the case of Cyprus.
At the same time, it must be noted that benefits under the Russia-Hong Kong DTA will be available to any company either Russian or Hong Kong, unless it is classified as a conduit. The Russia-Hong Kong DTA contemplates strong defensive mechanisms against using it for treaty-shopping purposes.
How to avoid Conduit Classification
In general terms, for a company to avoid to be considered a conduit, the following criteria must be met:
– Substance: the company must have self-sustained economic expediency, its own assets and not be used for tax optimization or ‘treaty shopping’ purposes exclusively;
– Place of management: Management of the company must be carried out from the place of its incorporation and not from Russia;
– Actual recipient of revenue: the company must be the actual recipient of revenue and have a right to dispose of the latter;
– Ultimate beneficiary: the ultimate beneficiary of the company must pay taxes on the income received from such a company in accordance with the Local Tax Code and CFC Rules if applicable.
With our extensive experience in the industry, we are ready to provide you with more detailed legal advice on the issue and assist you with this and any other queries pertaining to business structuring in Russia.
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