As its name indicates, Russian Federal Law No 409-FZ dated 28 December 2010 "On Making Amendments to Certain Legislative Acts of the Russian Federation in Respect of Regulation of Dividend Payouts (Profit Distribution)" is principally concerned with dividends paid by companies. However, one of its provisions creates attractive opportunities for financing Russian limited liability companies (OOOs) and joint-stock companies (AOs) on a tax-free basis.
Companies whose capital has been depleted by operating or other losses have difficulties in obtaining finance and, if the depletion is severe, may require the injection of further capital or "soft" loan finance by shareholders. Paragraph 11 of Article 251.1 of the Tax Code encourages this by providing that contributions in cash or in assets by a majority shareholder are tax exempt as long as the assets (other than cash) are held for at least one year. Contributions by minority shareholders or holders of smaller shareholdings were therefore not eligible for tax exemption in Russia.
Law 409-FZ amends Article 251 of the Russian Tax Code by adding a new exemption from taxation of income or assets contributed to an economic entity or partnership by its shareholders or participants with a view to increasing its net assets, including the introduction of additional capital. Such income includes property, proprietary rights as well as non- proprietary rights (including IP rights) which can now be transferred to the Russian company by any of its shareholders for the purposes of increasing the former’s net asset position either through the increase of its capital or by funding its reserves.
This exemption is available irrespective of the size of holding of the contributing shareholder in the capital of the company. This amendment is of a great importance for Russian commercial businesses which are owned by several investors, none of which holds a majority share of the charter capital.
Cancellation of a debt owed by a company to a shareholder which (forgiveness or waiver) is effected for the purposes of enhancing the company's net asset position also falls within the scope of the exemption. The same applies for undistributed dividends or profits of Russian companies which are not claimed by the owners and are credited to reserves.
The new provisions have retroactive effect and extend to legal relationships established on or after 1 January 2007. They create a very attractive environment for the enhancement of the net asset position of Russian companies, and significant additional benefits can be obtained by involving Cyprus holding or finance structures.
Following the abolition of the 1% minimum participation threshold under Cyprus law, all holdings by Cyprus companies in the share capital of Russian companies (including OOOs and AOs) are tax exempt in Cyprus; this is so both in respect of dividends payable to Cyprus from such entities as well as a sale of any shares or participatory interest by a Cyprus company in such Russian entities.
As such, a Russian business can have as many investors as it wishes investing through Cyprus resident companies. The shareholders may -irrespective of the size of their shareholding- now contribute any assets they wish to the Russian company for the purpose of enhancing the financial and net asset position of the underlying Russian company. Any contribution by the Cyprus shareholder to the share capital of the Russian company will be tax exempt in Cyprus. The Cyprus company may also proceed to finance the Russian subsidiary for the purpose of funding its reserves without increasing the latter’s share capital. Under certain circumstances and depending on the case the funding may be considered as part of the investment in the subsidiary in which case there will be no Cyprus taxation. In all other cases the funding will be treated as a loan from the Cyprus shareholder.
Moreover, an eventual exit or alienation of any participatory interest in the Russian entity (including an increased participatory interest in light of Law 409-FZ) will be tax exempt in Cyprus, and also in Russia if the Cyprus-Russia double tax treaty (“DTT”) applies. Disposals of shares in property-rich companies will no longer be exempt from Russian tax with effect from 2016.
Russian companies may also be financed from Cyprus by debt rather than by finance. As long as the arrangement does not fall foul of the Russian thin capitalization rules, interest payable on the debt will not suffer any withholding taxes in Russia. Care should also be taken to stay within the thin capitalization rules so as not to risk disallowance of the interest for Russian tax purposes. This requires consideration on a case by case basis in the context of the DTT. The question of substance is of crucial importance in determining whether the Russian tax authorities will accept that a Russian enterprise is be eligible for relief under the anti-discrimination provisions set out in Article 24(3) of the DTT for the purposes of assessing the question of interest deductibility.
In summary, by careful and prudent tax planning, and by ensuring that the structure has the necessary degree of business substance in Cyprus and in Russia, the shareholders of Russian commercial companies can now improve the financial position of the companies in a commercially optimal and tax efficient manner by a combination of actions including the effecting of contributions of property as well as raising cross-border finance through Cyprus.