Are Tax-Free Dividends for Foreign Investors Possible?

UnknownEvgeny Timofeev Partner, Co-Head of Global Tax Practice Salans
As of this year, Russia alongside many countries with developed tax systems has a participation exemption enabling Russian (but not foreign) companies to receive dividends from Russian or foreign subsidiaries tax-free. Even though the exemption (unlike in other countries) is subject to significant investment requirements, it is still a very effective tool. The requirements are: a minimal investment of at least 500 million rubles (about $21 million), the minimal stake held by the investor -- 50 percent, and a minimal holding period of one year. Additionally, investments into companies resident in "blacklisted" countries are not eligible for the exemption.

The interesting thing is that the Russian government may have inadvertently opened the door not only for outbound tax-free investment, but also for inbound investment free of tax. While historically it was absolutely impossible for foreign investors to achieve the Russian dividend withholding tax rate lower than 5 percent (as the statutory rate is fixed at 15 percent, and none of the about 70 existing Russian double tax treaties provide for a rate lower than 5 percent), it may be possible now.

The trick is that foreign companies from jurisdictions with which Russia has double tax treaties are covered by non-discrimination protection. The nondiscrimination clauses generally provide that companies from the other contracting state must be taxed at least as beneficially as their Russian counterparts. This immediately brings about the hope of getting the exemption on Russian dividends if all the standard conditions are met.

In reality however, it is not that simple. First, not all treaties provide for nondiscrimination clauses applicable to legal entities. Second, some of them expressly (well, in Russian versions sometimes not that expressly) state that the non-Russian residence of the companies breaches the similarity of conditions which in turn makes the non-discrimination clause not applicable. Some of the treaties are silent on this issue but as the OECD Commentary to the Model Tax Convention (even though nonbinding for Russia) provides for the same reasoning, there is still a significant degree of risk involved.

There is, however, a small group of treaties that unlike the others protect the companies based not on the fact that they are registered in a particular state but rather on the fact that they are a tax resident there. Accordingly, the fact that these companies are not a tax resident in Russia should not be an obstacle for them to enjoy the participation exemption. Notably, the list of the countries from which companies may enjoy the zero percent rate on Russian dividends includes Luxembourg -- the most popular European jurisdiction for establishing holding companies (and also Hungary offering a beneficial tax treatment for holdings as well).

However, this does not mean that the same may not be achieved by companies from most of the other treaty jurisdictions. The double tax treaties routinely contain another nondiscrimination clause specifically aimed to ensure that Russian branches (permanent establishments in tax terminology) of the respective foreign companies are not taxed less favorably than Russian companies engaged in the same kind of activities. In this case, the fact that the companies themselves are not resident in Russia is irrelevant.

Accordingly, a foreign investor (other than the portfolio investor) may wish to consider investing into Russian shares through a Russian branch of a foreign company from a treaty jurisdiction. The branch must be properly substantiated with necessary premises and staff (ideally engaged into some other business activities -- such as rendering certain services to the Russian subsidiary in question). Otherwise, the exemption may be withheld as the branch could actually look like it is only there to enjoy the tax benefit of the exemption. To further mitigate the risks the investor may wish to invest through a branch of a company resident in Luxembourg or Hungary -- which would provide them with the argument that the establishment of the branch could not have been aimed merely at achieving the tax economies as they would have been available anyway. To make the picture more complete, do not forget that there is no branch profit remittance tax in Russia, and therefore the dividends may be transferred abroad without any tax leakage at all.

However, there are never free cookies, are there? An investor selling Russian shares is exempt from Russian tax on capital gain (at least unless the Russian company in question owns Russian real estate). Unfortunately, this does not apply to permanent establishments -- as soon as they sell any kind of Russian stock, they get taxed at 24 percent on the gain (in the same manner as Russian companies). Hence, it is a trade-off: either the participation exemption, or the capital gain exemption.

Or, rather, it can be a trade-off but it also can be a double-win. The investor is free to close the branch down and de-register it with the Russian tax authorities at any time. This is not considered to be a tax event in Russia. In case this happens due to bone fide reasons, the Russian stock gets transferred from the balance sheet of the branch to the one at the head office and then can me sold off tax-free. Additionally, there may be nothing preventing the investor from selling the foreign company holding Russian stock itself.

Indeed, every significant development in the tax law is bound to create new opportunities. As there a number of developments in the pipeline (including the tax consolidation concept, the controlled foreign companies rules, and the management and control tax residence test), we will no doubt see more exciting opportunities within the next couple of years.