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Tax and Immigration Considerations When Employing Expatriates

Ernst & Young Peter Reinhardt, Partner, Ernst & Young, Human Capital Services

One of the questions most frequently asked by employers is which structure they ought to use for the employment of their expatriates. This is unfortunately a question with no single easy answer. Employment of expatriates is everywhere an exceedingly complex exercise in Human Resources management. Frequently the best answer will depend in part on the corporate structure and the specific industry to which the employer belongs.

Russia significantly adds to the usual challenges by requiring most employers to perform a delicate balancing act between numerous bodies of Russia law which are often in contradiction with each other.

To complicate matters further, relevant law and practices in Russia are highly dynamic, meaning that a perfectly acceptable employment structure at the start of an expatriate's assignment may end up being wholly inappropriate within months. In the last year or two, immigration rules have been the main culprit behind many companies' having to reevaluate how they deploy foreign workers to Russia.

The good old days

A brief walk through the history of the development of relevant laws in Russia in the last 10 years or so may be helpful towards understanding how we find ourselves where we are today.

The legal environment of the 1990s was generally supportive of the kinds of structures which most multinational companies normally seek to use for their internationally mobile employees.

Specifically, that is continued employment and delivery of pay in the home country, in order to facilitate uninterrupted participation in social security, pension and other benefits programs there, and in order to maintain a continued employment link into the home country to ease the eventual process of repatriation.

This arrangement also makes it considerably easier to pay expatriates at home in the currency they are used to. Finally, it helps to maintain confidentiality concerning expatriate pay levels in countries where there are partic- ularly large differences between expatriates' and local nationals' compensation, such as was the case in Russia in the 1990s.

To explain the basis on which those expatriates are working in the country of assignment and to allow the business to charge the costs of the expatriates to the foreign subsidiary, secondment agreements have been typically used, according to which the home country employer invoices the subsidiary a lump-sum amount which compensates for the total payroll costs associated with the expatriates.

Then there was tax In the 1990s Russia posed no serious challenges to such secondment structures. Immigration issues were of little concern back then, with many expatriates exempt from work permit requirements thanks to being personally accredited. Even where work permit requirements were applicable, it essentially made no difference in practice whether the expatriates were employed and paid locally in Russia or remained on an offshore payroll. Although the tax laws in effect at that time were silent about secondment arrangements, the tax authorities quickly became familiar with them and, as long as they were properly structured and documented, they could be used without any adverse tax consequences for the business.

Indeed, for quite some time Russia's tax system strongly incentivized the use of such structures as opposed to locally employing expatriates. Russia's social security rates were close to 40 percent of wages and uncapped.

Further, the mid-1990s saw the misguided attempt to stamp out wage inflation in the country by the introduction of an "excess wages tax," which required employers in Russia to pay a 35% tax on an employee's earnings in excess of an extremely low threshold, i.e., most of the compensation which would typically be paid to an expatriate. However, that tax was avoided when the local business paid not salary but rather secondment fees.

Predictably, the excess wages tax not only helped to keep expatriates' pay offshore, but also exacerbated the problem of employers' shifting the pay of Russian employees offshore as well, or using "gray" schemes to deliver pay in Russia in forms other than salary.

Rampant tax avoidance and non-compliance under that system was the key driver behind the dramatic reforms ushered in by the new Tax Code in 2001. It was then that Russia adopted the famous 13 percent flat rate of personal income tax for tax residents, and also slashed employer social tax rates by introducing a regressive scale bottoming out at 2 percent.

That bold move was indisputably a spectacular policy success, with personal income tax receipts to the federal budget approximately doubling in the first year alone, followed by a significant jump in revenues in each subsequent year as well.

Still, expatriates generally continued to be paid offshore. Why? For one thing, the Tax Code requires individuals working in Russia to pay tax on their earnings irrespective of where they are paid, so payment onshore or offshore in most cases makes no difference to an individual's tax liability. The profits tax chapter of the new Tax Code also specifically recognized secondment structures for the first time, in effect blessing them.

Ultimately, however, the answer as to why this practice continued can be found in the same HR imperatives that have always been behind such an approach: the utmost importance of ensuring that the expatriate's home country social security, pension and similar benefits are not adversely impacted by a foreign assignment.

Practically speaking, initially all was fine with continuing that approach. However, before long a slow but steady assault on secondment structures began, not through tax legislation, but through other bodies of law.

Spiraling downward

One could consider the first blow to have been the new Labor Code which Russia adopted in early 2002 and which can be interpreted as implying that there is an employment relationship between an expatriate and the local host entity in Russia even in a secondment arrangement.

The Labor Code requires employment relationships to be documented by employment agreements, so the implication of such an interpretation of the Labor Code is that local employment rather than secondments should be used when bringing expatriates into Russia. However, this implication was soft enough that few multinational employers were driven by it to drop their long-held preferences for secondment structures.

The much more serious blows have been dealt by changes in immigration legislation and its evolving interpretation by the authorities. Towards the end of 2002 Russia adopted a new law concerning the status of foreign citizens (Law No. 115-FZ), which all but completely replaced the previous body of immigration regulations.

The introduction of this new law had a number of immediate effects, such as making it clear that personal accreditation would no longer be sufficient to exempt an expatriate from the general work permit requirements (except for accredited journalists), and requiring the same lengthy work permit application procedures for all job positions, no matter how senior in the organization. Thus, a huge swathe of the expatriate population, which had previously been exempt in practice, was caught up in the requirement to obtain work permits, and the process itself was made significantly more complex and time-consuming for even the highest executives.

As far as secondments are concerned, there was initially no impact. The immigration authorities were in practice equally happy to accept a local employment contract or a copy of a secondment agreement as the basis for a work permit application. However, all that changed sometime in early 2004 when the Federal Migration Service quietly started interpreting the law differently, such that only direct employment contracts with the corporate entity in Russia would serve the purpose.

This had the effect of bringing many work permit applications to a screeching halt. Among more conservative employers, that in turn put a number of expatriate assignments on hold until new employment structures could be put in place that would allow work permit applications to go forward.

The final straw

Things then went from bad to worse in January 2005, when the Federal Migration Service narrowed its interpretation of the main immigration law even further, adopting the curious and, at best, legally dubious view that foreign companies operating through branches or representative offices in Russia had no "right" under that law to apply for the work permits required by their expatriate employees. In effect, the immigration authorities were saying not only that expatriates must be employed and paid onshore, but that their employers had to incur the enormous expense of setting up Russian subsidiaries to employ them if they didn't already have them.

As a result of this "moratorium" on accepting work permit applications from foreign companies, once again work permit applications came to a sudden halt. Large numbers of expatriates and their employers found themselves without the necessary permits, not for lack of trying, but because they were being prevented by the authorities from fulfilling their obligations to apply for them.

To add insult to injury, the fines for working in Russia without a permit had been substantially increased by new legislation which had just come into effect at the end of 2004, and the immigration authorities were not coupling this moratorium with any cessation of their willingness to impose those fines in cases where expatriates did not have work permits for which their employers were no longer "allowed" to apply.

This moratorium was the last straw. The ensuing outcry and flurry of lobbying from the foreign investment community quickly got the Prime Minister's office involved, with the end result that in late April the Federal Migration Service resumed recognizing the equal "right" of both foreign companies and Russian companies to apply for work permits. It is difficult not to find this whole discourse about a "right" to apply for work permits somewhat surreal in the context of a law which defines not who has a right to apply for work permits, but rather who has an obligation to do so.

Serious hurdles

This victory against the moratorium did not however resolve the previously standing problem of companies' not being able to apply for work permits except where there was a local employment contract with the expatriate.

Needless to say, there has been strong resistance from many expatriates as well as their employers against this regulatory pressure to simply move their employment onshore, irrespective of whether it is a Russian subsidiary or a representative office in which they are working.

Apart from the psychological issues associated with becoming a local employee, such a move typically severely threatens the expatriate's social benefits, pension benefits and seniority rights in the home country. It complicates and makes more expensive the delivery of expatriate pay. It potentially raises confidentiality concerns in an organization with respect to pay levels.

The seriousness of these problems should not be underestimated. If they are not solved, it can be enough to prevent expatriate assignments and the investments into Russia which accompany them.

Not surprisingly, therefore, most companies which have tended to use secondment agreements in the past have tried to find compromise solutions which address these concerns while at the same time meeting the formal requirements necessary to push work permit applications through.

The most obvious idea which springs to mind is to use a dual employment structure, whereby the expatriate is issued a local employment contract, so as to facilitate the work permit application, but keeps an offshore employment contract for a substantial portion of total compensation, so as to maintain continuity of home country benefits.

Alas, things are not that simple, however. Dual employment can have exceedingly negative tax consequences for a business, meaning that one must carefully review whether this really is the best solution and, if so, be extremely careful in any case as to how one implements it. Ultimately, short of full local employment in Russia, which many companies and expatriates consider simply unacceptable, no solution is wholly without risk in the current Russian legal environment.

Unfortunately, that places many employers of expatriates in the unenviable position of having to choose whatever is - for their particular facts and circumstances - the lesser of two evils.

A glimmer of hope

All is not yet lost, however. There is some hope that the immigration rules may be amended to be more accommodating of common international practices for employing expatriates. Specifically, the Ministry of Internal Affairs has been collaborating with a number of other interested ministries on drafting amendments to the main immigration law which could be considered by the Duma as early as this fall.

Among the amendments which have been discussed is one which would expressly recognize secondment arrangements for immigration purposes, much as the Tax Code already does. In addition, the ministries have been debating amendments which would reinstate the old exemption from work permit requirements for all those expatriates who are personally accredited, irrespective of their profession (i.e., not just journalists).

Finally, there has been discussion of amending the law to bring back a quicker and simpler procedure for applying for work permits for "key personnel," meaning most top executive positions.

Which of these amendments will ultimately make it into the draft bill submitted by the Government to the Duma is yet to be seen. However, one can be sure that the foreign business community will be watching closely as this next chapter unfolds in the never ending saga of legislative developments affecting the employment of expatriates in Russia.