2010 Tax Update - Key Changes in Russian Tax Legislation and Possible Future Developments

January 2010

After several years of relative stability, the Russian tax system is undergoing some significant changes. This Client Alert summarizes certain important changes in Russian tax law that have become effective in 2010, as well as looking forward to some interesting reforms planned for 2011-2012.

1.          Payroll Taxes in the Form of "Social Contributions"

For the past 10 years, Russian payroll taxes have been imposed in the form of the "unified social tax."  In 2010, the state has reversed gears and returned to the old system of separate contributions by employers to the state pension, medical insurance and social insurance funds (collectively "social contributions"), which are payable in connection with employee salaries.[1]  Payments for obligatory accident insurance remain unchanged.  This system of social contributions also generally applies to payments to independent contractors, inventors and authors of intellectual property, with certain exceptions for contributions to the social insurance fund (specifically, sales-related and lease payments are exempt).  Further, remuneration paid to foreign nationals temporarily residing in Russia is exempted.

The tax base has been broadened, as well.  Formerly, payments to individuals were not subject to unified social tax unless they could be deducted by the employer from its profits taxes.  Starting in 2010, this rule has been abolished, and thus all compensation payments to employees are generally subject to social contributions. [2]

The rates charged for social contributions are now flat, as opposed to the regressive scale used in prior years.  The applicable rate is 26 percent in 2010, and will increase to 34 percent starting on January 1, 2011.  The maximum salary for purposes of social contributions is 415,000 Rubles per year (or approximately $13,700 at current exchange rates); any remuneration paid in excess of this amount is exempt (but remains subject to obligatory accident insurance payments).  However, this cap may be adjusted by the Russian Government on an annual basis.

As a result of these changes, from 2011 the total costs of social contributions will increase for employees with relatively low incomes, and may be reduced for highly paid personnel.  Failure to pay social contributions will be subject to the usual tax penalties (generally up to 20 percent of the underpaid tax, and up to 40 percent in case of intentional breach), plus daily interest at a rate equal to 1/300 of the "refinancing rate" established by the Central Bank.

The compliance procedures have also changed.  From 2010, employers submit reports to the pension fund and social security fund, rather than to the Federal Tax Service.  (However, for 2009 reports must continue to be filed with the local tax inspectorates, in accordance with the old procedure.)  Accordingly, the tax authorities may no longer conduct audits with respect to social contributions; instead, the pension and social security funds may conduct their own separate inspections.  Whether the new rules will reduce or increase the overall administrative burdens on taxpayers remains to be seen.

2.          Other Business Taxes and Anti-Crisis Measures

In response to the global economic crisis, the Russian government introduced certain anti-crisis measures to provide profits tax relief for companies in 2008 and 2009.  Currently, the government has decided to extend some of these measures into 2010, as follows:

2.1.        Interest Deductibility

Russian law imposes certain limitations on the deductibility of interest.  A company is entitled to choose one of several methods for the calculation of deductible interest: one of the most commonly-used is deduction of the aggregate interest paid, up to the maximum interest rate set forth in the Tax Code.  As part of the anti-crisis package, these rates were increased for 2008-2009, and the increase continues to apply in the first half of 2010.  For debt obligations denominated in foreign currency, the current limit is 15 percent per annum.  For debts in rubles, the current limit is two times the "refinancing rate" of the Central Bank (currently nine percent), meaning that the effective maximum deductible rate is 18 percent.  It will be interesting to see what maximum deductible rates will apply for the second half of 2010 and beyond.

2.2.        Depreciation of Capital Investments by Leaseholder

Capital investments made by a leaseholder may now be depreciated based on the useful life of the resulting improvements, when they are not reimbursed by the lessor.  This rule should improve the tax position of lessees.  However, it remains unclear how the "useful life" of the improvements should be determined, and in any case the depreciation period is limited to the term of the lease agreement.

2.3.        Higher Excise Rates

Excise rates have increased on alcoholic products (including beer), tobacco products, petroleum and diesel fuel.  The procedure for making excise payments has also changed.  Excise taxes are now due as a one-time payment before the 25th day of each month, instead of the previous bi-monthly payments.

2.4.        Simplified VAT Refund

A simplified procedure for VAT refunds has been adopted for large taxpayers.  Such taxpayers are now entitled to offset input VAT, as recorded in their tax returns, at any time before completion of the obligatory "desk audit" of these tax returns.  Generally, a taxpayer may use the new simplified procedure if:

• the aggregate taxes (including profit tax, excise tax, mineral extraction tax and VAT, but excluding import/export VAT and VAT withheld by tax agents) paid within the previous three years exceed 10 billion Rubles (or approximately $333 million at current exchange rates); and
• the taxpayer provides a bank guarantee in the amount of the refund, in case it is later disallowed.

The law sets forth the requirements to be met by the bank issuing the bank guarantee.

3.          Possible Future Developments

Based on steps taken by the Russian Government last year, the following reforms are expected to become effective by 2011 (although there are no guarantees, as policies may change quickly):

3.1.       Proposed Changes to Transfer Pricing Rules

The Russian Ministry of Finance has published a revised version of a proposed draft law on transfer pricing.  The key changes include the introduction of:

• an "arm's length" concept as opposed to the existing rules, which are based on more than a 20 percent deviation from market prices;
• amendments to existing pricing methods to bring them in line with internationally-accepted transfer pricing principles;
• "functional analysis" as a key method for determining which transactions are relevant for comparison purposes;
• new sources of information which may be used to determine the range of market prices;
• new transfer pricing documentation and reporting requirements, as well as penalties for non-compliance; and
• the possibility of "advance pricing agreements" with the tax authorities, to avoid disputes and increase certainty.

The activities subject to the transfer pricing rules would be limited to transactions between related parties, transactions with third parties enjoying certain tax preferences (including companies registered in low-tax jurisdictions), and certain types of cross-border transactions (including trading in oil, gas or metals).

3.2.        Consolidated Group Treatment

One of the biggest surprises for foreign investors working in Russia - and headaches for large Russian corporate groups - has been the lack of consolidated tax treatment for companies under common control.  To address this problem, a new tax regime has been proposed which will allow major Russian corporate groups to consolidate profits and losses earned by different subsidiaries, and thus to minimize the profit tax burden within the group as a whole.

Under the proposed concept (which is still in draft form), a single "consolidated group" may be established by agreement between its participants.  The group will be recognized solely for the purposes of profits tax.  The losses of one member of the group may be offset against the profits of another, and transactions between group members may be excluded from the consolidated tax calculation.  Further, it is expected that asset sales and financial transactions between group members will be excluded from transfer pricing regulation.  

Such groups may be created only between companies in the same industry sectors; for instance, banks may form a consolidated group only with other banks.  Companies enjoying certain tax benefits would not qualify for group treatment.  The new regime would contain special anti-abuse provisions, as well.

3.3.        Substantial Shareholding Exemption

A recent amendment to Article 284.3(1) of the Tax Code seeks to address the inefficiency of dividend flows between parents and subsidiaries in Russia.  The new regime will come into force in 2011, and will remove one of the current requirements for exemption from dividend withholding tax for "substantial shareholders".

Presently, there is a nine percent tax on dividends paid from a Russian subsidiary to its direct Russian parent company, and this tax may not be offset against withholding taxes on corresponding dividends payable to an ultimate foreign parent, unless the Russian parent qualifies for tax-free treatment of dividends under the "substantial shareholding exemption".  The key requirements for the substantial shareholding exemption are currently (1) at least 50% shareholding in the company paying dividends, (2) a minimum 365-day ownership period, and (3) an equity investment of at least 500 billion Rubles (approximately US$16.6 million at current exchange rates). 

To improve matters, starting in 2011, the third "investment" requirement will be abolished, which will make the exemption more widely available.  As a result, the use of holding companies in Russia may become somewhat more feasible.  

3.4.        Protocol to Russian/Cyprus Double Tax Treaty

Cyprus remains a frequently-used jurisdiction for foreign holding companies that invest in Russia.  In 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. 

Among other impacts, the changes to the treaty will affect Russian real estate projects structured through corporate vehicles in Cyprus.

The new version of the treaty will come into force once the Protocol is ratified by the Cyprus House of Representatives and the Russian Duma, and will generally be applicable to tax periods beginning on or after January 1 of the year following ratification.  The Protocol is still awaiting ratification in Russia, and it remains unclear when the new provisions will become effective.  (For more details, see our Dewey & LeBoeuf Client Alert dated April 30, 2009.)