Changes in Taxation of Financial Instruments to Take Effect in 2010

Alexei Kuznetsov
Ernst & Young

Recently the President signed the new Federal Law 281-FZ that will introduce long-awaited changes to the taxation of financial instruments. The new law amends profits tax and VAT rules regarding securities trading, derivatives, repurchase agreements and stock lending. It also significantly changes personal income tax rules for operations with these financial instruments. The amendments will come into effect in the most part from Jan. 1, 2010, with some changes taking effect from 2011 or other dates.

The new law also amends the Securities Market Law and other laws by introducing definitions of “derivative financial instrument” and “repo,” which are also to be used for tax purposes. The securities market regulator should issue rules that would be used for transfer pricing purposes for determining reference prices for securities and derivatives.

Of particular note are changes to the taxation of derivative contracts, which had not been amended since 2002 when the profits tax chapter of the Tax Code was first adopted. One of the changes that is likely to have a far-reaching effect on the way that the market operates is the disallowance of tax deduction for derivatives where there is no “court protection.”

This links to a relatively old provision in the Civil Code whereby court protection is not available for corporates where the counterparty is not a bank or professional securities markets participant. Although there are some differing views as to how this provision should be interpreted and what remedies might work, there are practical concerns on the implications for nondeliverable instruments concluded with foreign banks and other entities post July 1, 2009 (derivatives concluded before that date are grandfathered).

Another important development is the abolition of mark-to-market revaluation of derivatives for tax purposes. This has been one of the most complicated areas in the tax accounting, so for many taxpayers this is welcome news. Taxpayers will have the right to elect to revalue some derivatives, which are used for hedging and where the underlying asset is subject to revaluation for tax purposes. Otherwise, the results on derivatives will be recognized on a realized basis.

Technically, under the current rules in the Tax Code, a transfer pricing adjustment may be applied only to sale of securities, although the Ministry of Finance has been trying to argue that the purchase price may need to be adjusted as well. From 2010, there will be a clear requirement to apply transfer pricing rules to both the purchase and sale price of securities. Russian transfer pricing rules remain one-sided (i.e. the adjustment of price to the seller does not translate into an adjustment for the buyer).

Another problem that continues to be unresolved is that the transfer pricing on securities is applied very “mechanically,” i.e. regardless of how illiquid the market might be, the quotes from the stock exchange have to be used without regard for the actual deal parameters. This is exacerbated by the fact that in the absence of trades on an exchange on a given date, when the deal occurs the benchmark quote is to be determined by finding the nearest quote in the preceding 12 month period. Needless to say that such a historical price is unlikely to be representative of the market, especially on the currently volatile markets. There is no progress on this in the new law other than the shortening of the look-back period from 12 months to 3 months to determine the “market quote.”

As for repo, the new law clarifies many technical issues including short sales, the possibility of replacing a security, and so on. The new law also introduces a definition of stock lending transaction for tax purposes and sets rules that are broadly supposed to put the stock loans on an equal footing with repos.

There is an attempt to recognize the economic ownership of income, albeit in very limited cases, i.e. in the repo transaction and in asset management, the Russian party to the transaction, i.e. the buyer on the first leg of the repo, where the seller is a nonresident company, or the asset manager where the beneficiary is a nonresident company, would have the obligation to withhold the tax where the tax was underwithheld at source.

Personal tax rules have undergone significant changes mainly in relation to the possibility of carrying over losses on securities, recognition of tax base on repos, derivatives, etc. These rules are significant not only for individuals but are also relevant to entities operating a stock option plan for employees and for entities acting as agents of individuals on securities/derivatives markets.

There are many other technical changes that in general seem to address certain practical issues and ambiguities in the present tax law, while many provisions are subject to differing interpretations. On balance, one could expect that the new law in many aspects will be positively perceived by the Russian financial markets’ participants, companies and individual investors.