Protocol to Russia-Cyprus Double Tax Treaty Signed

April 2009

On April 21, 2009, the Russian Federation and the Republic of Cyprus signed a Protocol amending the Double Tax Treaty between the two countries, which has been in place since 1998. The new version of the treaty will come into force once the Protocol is ratified by both states, and will generally be applicable to tax periods beginning on or after January 1 of the year following ratification.

1. New Taxes on Indirect Sale of Russian Real Property and Inbound Investment

The core changes in the Treaty remove a prior exemption for taxation of capital gains from the indirect sale of Russian real property.

Currently, capital gains from the sale of shares in a Russian subsidiary by its Cypriot parent company are tax exempt in both jurisdictions, even if the subsidiary owns real property in Russia. The amended Treaty will remove this benefit for sales of shares in Russian subsidiaries where more than 50 percent of total assets consist of Russian real property.

Such a significant change in taxation will definitely have an impact on existing structures. The positive news, however, is that the new treatment will not come into effect until 2014 at the earliest, so that during the transitional period investors may develop new exit and restructuring strategies. For example, a typical strategy may involve creating, and selling at, a higher tier in the corporate holding structure.

Other important changes relate to mutual equity funds investing in real property situated in Russia. The intention seems to be to reserve to Russia the right to tax distributions by such funds out of their rental income and disposal gains, and to counter the argument that such distributions are exempt from tax in the hands of Cypriot members of such funds (in reliance on the "Other Income" Article in the Treaty). However, the Russian tax treatment of such situations remains unclear, both because Russian domestic law does not specifically address such matters and because one of the relevant changes introduced by the Protocol refers to funds which invest only in real estate, whereas the assets of Russian mutual real estate funds may, and in practice do, legally include (a) assets and rights that are related to real estate, but not formally classified as such (e.g. rights under investment, shared construction and/or construction contracts, design documentation, etc.) and (b) other assets (e.g. money, debt instruments, etc.). These changes will come into effect immediately, rather than in 2014.

2. Exchange of Information Article

The Protocol introduces an expanded Article on Exchange of Information between the competent authorities of the Contracting States. It complies with international standards set by the Organization for Economic Cooperation and Development (OECD).

Some commentators predict that the new provisions are likely to be used by the Russian authorities as a powerful tool to obtain information about the beneficial owners of companies incorporated in Cyprus and, thus, the beneficial owners of many Russian businesses.

In our view, the potential impact of the Protocol may turn out to have been somewhat exaggerated. The information exchange is restricted in various ways by the terms of the Protocol itself, and by the domestic laws of the Contracting States. For example, under Article 26.3 of the amended Treaty, Cyprus is not required to supply information which is not obtainable under its own laws or in the normal course of administration. Moreover, the new transparency requirements should not adversely affect legitimate tax-efficient structures.

As an immediate, positive consequence of the revised Article, Cyprus will be removed from the so-called "black list" of non-compliant countries issued by the Russian Ministry of Finance two years ago.

The black list was part of the new Russian holding company regime, introduced in 2008, which provides a tax exemption for dividends from foreign subsidiaries of Russian companies under certain circumstances. The exemption did not apply to dividends paid from subsidiaries in countries on the black list.

As a result of removal from the black list, it is expected that Russia will treat dividends from Cyprus as tax-exempt (provided the other conditions are satisfied).

The signing of the Protocol should also improve relations between Cyprus and the Russian tax authorities in general.

3. Limitation of Benefits

The Treaty has also been amended by the insertion of a new Article on "Limitation of Benefits."

The operating principle of this new Article is that the benefits provided by the Treaty to Russian and Cypriot residents will not be available if the main purpose (or one of the main purposes) for establishing residence in one of the Contracting States is to obtain such tax benefits, which would not otherwise be available. This appears to be an aggressive new "anti-treaty shopping" provision, especially as it is not based purely on an objective test as to ultimate beneficial ownership of any intermediate entities, but depends on a determination reached as a result of consultations between the two tax authorities.

On the other hand, the rule seems to have a relatively narrow application, as its scope is limited to companies that are not registered in either Contracting State but are nevertheless claiming Treaty benefits. So, it appears that this anti-avoidance rule would not apply to a Cypriot incorporated company or a Russian incorporated company.

4. Withholding Tax on Dividends and Interest

Finally, it should be noted that the Protocol does not change other important benefits provided by the Treaty, such as the reduced rate of dividend withholding tax and the tax exemption for interest payments. These benefits are still fully available to investors.

For more information, please contact Judith Harger at +44 20 7459 5185 or jharger@dl.com, or Anna Lessova at +7 495 737 5114 or alessova@dl.com, or your Dewey & LeBoeuf relationship attorney.