Cyprus Tax News 7 October 2010
Russia-Cyprus Protocol to Tax Treaty signed
Today, 7 October 2010, the Protocol to 1998 Double Tax Treaty between Cyprus and Russia was signed during Russian President Dmitry Medvedev’s official visit to Cyprus.
Most of the changes contained in the Protocol were agreed on 16 April 2009 by representatives of the relevant ministries of the Republic of Cyprus and the Russian Federation. The Protocol was then approved by Order of the Government of the Russian Federation of 2 September 2010 and the Russian Ministry of Finance was instructed to negotiate further with the Cypriot representatives and sign the Protocol on behalf of the Government of the Russian Federation. On 27 September 2010, the Protocol was finalized and approved, after the introduction of small changes, during a visit of the Cypriot Minister of Finance to Moscow.
Most of changes to the articles of the existing treaty which are provided by the Protocol will become effective from 1st January of the year following the year of ratification of the Protocol by both parties. Currently, the expected dates of ratification are not known, and it is therefore not clear whether the changes will come into effect from 1 January 2011, or later.
The Protocol is aimed at continuing to foster and encourage economic relations between Cyprus and Russia. Although at present it may be difficult to assess its influence on Russian groups that have Cypriot companies in their corporate structures, the signing of the Protocol should result in the undeniable benefit of the removal of Cyprus from the Russian blacklist. It means that dividends received by Russian companies from Cypriot subsidiaries can qualify for the Russian dividend participation exemption. This will undoubtedly strengthen the position of Cyprus as being one of the most favorable jurisdictions for Russian investment.
On the other hand, the Protocol establishes new limitations with respect to the application of benefits for transactions involving shares and other corporate rights in real estate property-rich companies, as well as restrictions on the application of benefits provided to mutual investment funds organized primarily for the purpose of investing in immovable property. Furthermore, the Protocol broadens the authority of, and obligations imposed on, the contracting states with regard to the exchange of information and mutual cooperation over the collection of taxes. This is aimed at improving information exchange and greater transparency over the relationship between Cyprus and Russia in the tax sphere as well as enhancing the efficiency of control over tax violations.
Information on the most significant amendments introduced by the Protocol as well as on practical aspects of their implementation are described below.
Key amendments to the Agreement introduced by the Protocol
The Protocol makes changes to 10 of the 30 Articles and introduces a new Article “Limitation of Benefits”.
Importantly, the most significant provisions of the Agreement regarding the taxation of dividends, interest and royalty remain unchanged. In particular, there are no changes in the Agreement to the nil rates of withholding tax on interest and royalties. In respect of dividends, the withholding tax rates remain at 5% or 10%.
Article 4 “Resident”
The provisions of the existing Agreement include a definition of “resident” for the purposes of applying the Agreement. In particular, a legal entity is deemed to be a resident of the Contacting State if it is liable to taxation in that State based in its place of effective management, place of its registration or any other similar criteria. If an entity is a resident of both Contracting States, the place of effective management criterion applies.
According to the Protocol, Article 4 is supplemented by a new paragraph 4 which aims to make the “tie-breaker” test more effective. In particular, if the place of effective management of a legal entity cannot be determined, the Russian and Cypriot tax authorities shall endeavour to determine this by mutual agreement.
These changes are consistent with international practice and based on the principles and recommendations of the OECD.
There is currently no concept of "tax residency" for legal entities in Russia. The basic criterion to determine the status of a legal entity for tax purposes is (Russian) state registration. However, the Russian authorities have stated that they plan to introduce the "tax residency" concept and the criteria for its determination at a future date. It is assumed that place of effective management will be one of the key criteria. If the relevant amendments are introduced in the Russian Tax Code, the problem of "dual residency" of companies of the Contracting States will be resolved, based on the new paragraph 4 of Article 4 of the Agreement.
Article 5 “Permanent establishment”
The meaning of permanent establishment is extended by a new paragraph 4, according to which provision of services by a resident of one State in the other State might lead to the recognition of a permanent establishment in that other State, provided the following conditions are met:
a) The services are provided by an individual who is present in that other State for a period (or periods) exceeding 183 days in any 12-month period, and during this period (or periods) more than 50% of gross income attributable to the active business activities of the resident of the first-mentioned State are received for the services rendered in the other state through this individual; or
b) The services are rendered during a period (or periods) exceeding 183 days in any 12-month period/ and these services are rendered as one project or related projects by one or more individuals who provide such services and are present in the other State.
The new paragraph follows the wording prescribed by the OECD Model Agreement Committee in the Commentary to the latest Model Agreement in respect of the determination of a permanent establishment, and in particular means that business activity carried out by a resident of one Contracting State in the other Contracting State can create a permanent establishment in that other Contracting State even if there is no a “fixed place of business”.
This provision may affect the business of Cypriot companies operating in the services sector (for example, consulting services) through individuals who spend a long period of time in Russia. Please note that the current Russian Tax Code does not provide a similar definition of the term "permanent establishment". In Russia, a foreign organization may be recognized as having a permanent establishment if it carries out business activities on a regular basis in Russia through a “permanent place of business” or through a dependent agent. If the relevant amendments are introduced in the Russian Tax Code, the permanent establishment of a Cypriot company in Russia could be recognized on the basis specified in the new paragraph 4 of Article 5 of the Agreement..
Article 6 “Income from Immovable Property”
The amendment to Article 6 provides for the taxation of income received by participants in mutual investment funds established for the purposes of investing mostly in immovable property. In accordance with a new paragraph 5, such payments are taxable in the same way as immovable property. Thus, taxing rights belong to the State where such immovable property is situated.
This means that the income paid by Russian mutual investment funds whose assets consist mostly of immovable property, in favor of participants who are Cyprus tax residents, will be subject to Russian withholding tax at the rate of 20%. One of the possible reasons for this construction is the special concern of the Russian authorities in respect of real estate investment funds which have adopted corporate structures facilitating possible “double non-taxation?, i.e. the income received by foreign participants of the funds is not liable to taxation in either country. Due to the above-mentioned change, the tax treatment of interim distributions in respect of investments in mutual funds mostly investing in immovable property is clear. However, the following questions should be considered:
- There is no clear understanding of what is meant by “mutual investment funds established for the purposes of investing mostly in immovable property” and “mutual funds mostly investing in immovable property” as well as how the “major part” of investments should be calculated;
- Taxation of the proceeds received by the participants in such funds on the redemption of its shares.
Article 8 “Income from International Traffic”
According to the existing Article 8 of the Agreement, the taxing right for income from international traffic (i.e. shipping and aircraft) belongs to the country in which the person deriving such income is resident.
The Protocol changes this Article to the OECD Model Agreement principle of the taxing right belonging to the country where the effective place of management of the person deriving such income is situated, and not to the country of such person’s residence.
The consequence of this change will be the necessity of providing evidence that the place of effective management of a company (the international carrier) is located in Cyprus. Currently, a similar concept in the Russian Tax Code requires additional clarification from the Russian tax authorities regarding the criteria for determining the place of effective management. Increasing substance in Cyprus may be necessary for organizations which use companies registered in Cyprus for the purposes of international transportation.
Article 10 “Dividends” and Article 11 “Interest”
The Protocol introduces changes to the conditions for eligibility for the 5% rate of withholding tax on dividends. Under the new version of Article 10 of the Treaty, the application of this rate requires a minimum EUR 100,000 investment in the capital of the company paying dividends rather than USD 100,000 under the current version of the Treaty.
The Protocol also amends the definitions of dividends and interest. The definitions of these types of income are substantially aligned with the wording of the latest OECD Model Treaty.
Thus the amendments add, to the definition of dividends, payments on shares in mutual investment funds and similar collective investment vehicles (other than investment funds mostly investing in immovable property), as well as depository receipts over shares.
In addition, the changes to the definition of dividends allow the Russian tax authorities to apply the domestic “thin capitalization” rules to reclassify “excessive? interest payments as dividends and tax such amounts in Russia at source, albeit at the reduced dividend withholding tax rates under Article 10 of the Treaty. Corresponding changes are made to the definition of interest contained in Article 11 of the Treaty.
Obviously the changes to the definition of dividends are introduced, in particular, in order to broaden this definition with respect to the Russian „“thin capitalization? rules and tax in Russia at source the amount of reclassified interest without the possibility of exemption under Article 11 “Interest” of the Treaty.
Article 13 “Gains from alienation of property”
The major change to the existing Treaty made by the Protocol is the taxation of capital gains on the sale of shares in real estate property-rich companies.
Currently, the Treaty grants the taxing right to the country of residence of the selling entity.
The Protocol aligns Article 13 with the latest OECD Model Treaty principle that provides that such gains should be taxable in the country where the real estate is situated (provided that “more than 50% of the value of shares (or other corporate rights) is represented by immovable property situated in the other state”). However, if the income is derived from alienation of shares listed on a registered stock exchange, or as the result of a reorganization of the company, the income should be subject to taxation in the country of residence of the company selling the shares.
Since the Protocol provides for the amendment to come into force only on 1st January of the fourth calendar year following the year the Protocol as a whole enters into force, the earliest possible date is 1st January 2015 (provided the Protocol is ratified before the end of 2010). In the meantime, there are likely to be planning opportunities available for mitigating any negative consequences from this change. It provides companies which invest in real estate and owning or conducting operations with shares and other property rights of companies in the real estate sector with additional time for tax planning and potential restructuring of activity.
The issues to be considered:
- unclear wording “more than 50% of the value of shares (other corporate rights) is represented by immovable property situated in the other state“ and uncertainty in respect of the application of this provision to operations connected with the alienation of shares and other corporate rights of the company, which indirectly (e.g. through a subsidiary) owns immovable property in Russia. If the relevant amendments are introduced in the Russian Tax Code, income from such operations could be taxable in Russia at the 20% tax rate;
- application of Article 13 to income from the alienation of shares in mutual investment funds:
- the tax collection mechanism in cases where the transaction relating to the alienation of shares (other property rights) of a company owning immovable property in Russia is conducted by two foreign companies.
Article 25 “Mutual agreement procedure”, Article 26 “Exchange of information” and Article 27 “Assistance in collection”
Amendments introduced to articles 25, 26 and 27 of the Agreement generally concern administrative matters and adopt the latest OECD Model Treaty equivalent articles.
Major changes to Article 26 “Exchange of information” largely clarify existing obligations and powers of the contracting states. Besides, under the new version of the article, the exchange of information will cover taxes of all types and substance, i.e. not only direct taxes which are within the scope of the Treaty.
It should be noted that the changes introduced do not assume the automatic exchange of information. To obtain information from the Cypriot tax authorities the Russian tax authorities will have to follow certain procedures, and in particular, in considering the possibility of information provision, the requirements of Cyprus legislation have to be taken into account.
The proposed changes follow international practice and are aimed at expanding the exchange of information between the Russian and Cypriot tax authorities. Similar changes have been introduced in several double tax treaties concluded by Russia, in particular, with Germany and the Czech Republic and may be added to treaties with other states in future.
The new wording of Article 27 “Assistance in collection” is almost identical to the latest OECD Model Treaty equivalent. The application of this article will be possible only when Cyprus introduces changes to its domestic legislation allowing for the provision of such assistance.
Article 29 “Limitation of benefits”
The protocol introduces a new limitation of benefits article that seeks to dis-apply the benefits of the treaty that would otherwise provide a reduction or exemption in tax, to an entity that was created with the main purpose of obtaining such benefits.
It should be noted that the limitation will not be applied to companies incorporated in Russia or Cyprus. Most likely this provision concerns only companies incorporated outside Cyprus but which are tax resident in Cyprus by virtue of the exercise of their management and control in Cyprus.
Meanwhile, the denial of treaty benefits does not apply automatically by virtue of the new article, but rather offers a mechanism to the tax authorities of both Cyprus and Russia to counter some perceived treaty abuses and only as a result of consultations between the tax authorities.
|Pieris M. Markou