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New Developments in the Cyprus-Russia Double Tax Treaty
Following clarifications provided in December 2009 regarding the term "directly invested", the Moscow Department of the Russian Federal Tax Service under the Russian Ministry of Finance and the Ministry of Finance moved a step forward to provide further clarifications concerning the definition of the permanent establishment, the treatment of the liquidation proceeds and the re-characterised interest (to dividends) with respect to the application of the Double Tax Treaty (DTT) between Cyprus and the Russian Federation. These clarifications are not binding on taxpayers or courts, but may indicate how the tax authorities in Moscow may be interpreting the tax treaty, especially in respect of the treatment of permanent establishment as well as interest payments. Taxand Cyrpus and Taxand Russia review the new treaty and its impacts.
In March 2010 The Moscow Department of the Russian Federal Tax Service clarified the scope of the term "Permanent Establishment" with regards to the application of the Cyprus - Russia Double Tax Treaty.
In line with the circular, the provision of management services by Cyprus company shall give rise to a permanent establishment in Russia. The clarification is based on the assumption that a Cypriot Company can not provide management services without the presence of its representatives in Russia. The presence of representatives in Russia constitutes a permanent establishment hence taxed in Russia
Accordingly, a Cyprus company which provides management services and issues the relevant invoices to a Russian Company shall be deemed to have a representative in Russia, thus giving rise to a permanent establishment therein. Respectively, profits attributed to the Russian permanent establishment shall be taxed accordingly under the provisions of the Cyprus - Russia DTT.
Although at present there is not case law on this subject and the interpretations appears to be rather broad, it is useful to keep in mind that the Russian tax authorities may regard provision of management services as resulting in a permanent establishment in Russia.
The more recent clarification of the Ministry of Finance of 10 June 2010 No 03-08-05 concerns the tax treatment of liquidation proceeds both under the Russian tax perspective and their treatment under the Double Tax Treaty. Respectively, considering the fact that the Cyprus - Russia Tax Treaty is in the spotlight, specific rules were laid down having application to the taxation of liquidation proceeds realised by Cyprus corporate shareholders of Russian subsidiary companies.
Accordingly proceeds from liquidations of Russian Companies realised by Cyprus Corporate shareholders shall not be taxed in Russia to the extend that such proceeds are not in excess of the share capital contribution of the said shareholder.
Any income exceeding the amount of the share capital contribution is seen as an undistributed profit and shall be treated as a dividend distribution and will be taxed accordingly under the provisions of the existing Cyprus - Russia Double Tax Treaty at the rate of 10%, or 5% if direct investment of the parent into subsidiary is at least USD 100,000.
On 14 May 2010, the Russian Ministry of Finance provided further clarifications with regards to excessive interest payments via a new circular. According to the clarifications an amount of interest paid by a Russian Company to its foreign parent / domestic affiliated to the parent Company may be re-characterised into Dividends. This rule applies when the Russian Company exceeds the debt to equity ratio provided under the Russian legislation (3:1). In such cases, the amount of interest in excess of the ratio is considered a non-deductible expense and accordingly re-characterised as Dividends. The provisions of Article 10 of the Treaty between Cyprus and Russia shall apply in such an event.
The result will be the imposition of Russian Withholding tax at the rate of 10%, or 5% if the shareholder receiving the dividends has directly invested an amount equal or higher than $100000 in the share capital of the paying Company.
It must be noted that the Russian thin cap rules apply only to Russian companies directly or indirectly held by non-residents. Under certain interpretation this approach is discriminatory and is contradicting to non-discrimination provisions in Russia-Cyprus tax treaty. The Moscow Commercial Court of Cassation, which is the second highest court in the country, found Russian thin cap rules contradictory to Russia-Cyprus tax treaties in case of Field Invest on 23 September 2009 and Gidromashservis on 12 July 2010. Hence the clarifications of Ministry of Finance will be not necessarily upheld by court. At the same time taxpayers should be prepared to face challenges by tax authorities following the interpretations above.
Careful consideration of the risks involved is key factor for long-term tax planning of business operations in Russia via Cyprus.
It is expected that the pending Protocol to Russia Cyprus tax treaty will be signed in Cyprus in early October 2010, opening. Amendments to the tax treaty may affect positions of current structures, hence tax audit and re-evaluation of existing structures may be required.
Your Taxand contacts for further queries are:
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T. +357 22 699 222
T. +7 495 967 0007 (Ext. 281)