COVID-19: PRESSURE POINTS: WITHHOLDING TAX – UNEXPECTED LINKS, UNUSUAL MECHANISMS (RUSSIA)

On 25 March 2020 president Putin in his television speech addressing Russian citizens¹ announced a set of support measures to be provided to the poorest citizens and small and medium businesses in the context of the spread of COVID-19. At the same time, in addition to these measures, the President announced an increase in the rate of a number of taxes. The change which is most relevant for businesses  is a sharp increase in the withholding tax applicable to dividends and interest payments payable to recipients abroad.

The president said that the dividends and interest “flowing out of Russia to offshore jurisdictions must be taxed appropriately”. The president also made a comment which is not fully clear to the experts that “currently two-thirds of such funds [...]are subject to a real tax rate of only 2 percent as a result of application of various kinds of schemes of the so-called optimisation”. The president said that a withholding tax rate on dividends of 15% should apply. The president acknowledged that this would require amendments to be made to the double taxation treaties (the “DTT/DTTs”) and instructed the government to make such amendments. Finally, the president said that if the countries with which DTTs are in place did not agree to such amendments, Russia would unilaterally terminate such DTTs. Russia will prioritise terminating DTTs with countries “through which significant resources of Russian origin are passing, being the most sensitive for our country” (there are no doubts that Cyprus would be the first on the list, the UK and the Netherlands are prime candidates too, taking into account the political tensions).

What are the specific measures described by the president?

Firstly, it is evident that, contrary to what was said, this is not about offshore jurisdictions – Russia has no DTTs in place with any offshore territories (i.e., low-tax jurisdictions) such as the BVI or the Seychelles. Secondly, speaking about dividends, the proposed measures refer to full cancellation of the currently available withholding tax benefit, since the dividend tax rate under the Russian Tax Code is exactly 15% while the tax rate under various DTTs is 5-10%. Thirdly, although this point was described rather unclearly, it is assumed that the withholding tax rate applicable to the interest would be increased too; however if it is introduced at the level of 15%, it would be lower than under the Russian Tax Code (20%). Finally, the president acknowledges that it is impossible to introduce new rates without amendment of or withdrawal from the DTTs.

It is interesting that the  reference to “foreign experience” commonly made by the Russian leadership in substantiation of any prohibitive or pro-fiscal measures was omitted this time. This is not surprising – development of international tax law has been, for many decades, moving not towards total cancellation of any withholding tax benefits but towards restriction of abuse of the available withholding benefits.

Let’s look at how quickly the tax increase plans could be implemented.

Certain DTTs are amended very rarely, however, the process of making amendments to the DTTs to which Russia is a party is ongoing continuously and, based on prior experience, it can be predicted that even with strong political backing, it usually takes no less than a year to agree upon amendments to one DTT. Separately, there is an issue of the willingness of the other party to amend the DTT in principle. Russia has recently joined the Multilateral Instrument (MLI) which has introduced amendments to the treaties of the joining countries. This may have reduced the appetite for further amendments to be made to certain treaties by the countries generally. Presumably, this is why the president threatened to entirely withdraw from the treaties if the relevant counterparties do not cooperate.

Withdrawal is possible either in accordance with the procedure envisaged by the DTT itself or in accordance with the general procedure set out in the Vienna Convention on the Law of Treaties, which requires providing a 12-month notice of withdrawal to the other party. However, DTTs normally contain a shorter notification period – for the most part, treaties cease to have effect starting from the year following the year in which a withdrawal notice is sent and in some instances a notice has to be submitted no later than six months before the year end. Consequently, even if the Russian Government decides not to spend time on re-negotiation of the terms of the DTTs and withdraws from those at once, there will be no legal grounds to impose 15% withholding tax until 2021. Therefore, the link between tax increase and financing of the urgent and short-term support measures benefitting those suffering from COVID-19 does not appear to be so obvious.

As a result of the factors discussed above, it is reasonable to expect a significant increase in dividend payments in 2020. However, it is important to remember that the tax authorities can already apply a 15% rate for dividends (and 20% rate for interest). In particular, in order to apply lower tax rates for dividends and interest, DTTs normally require the income recipient to be its beneficial owner. The concept of the income beneficial owner is complicated and multi-faceted, while the Russian case law has been for many years showing the trend towards interpretation of this concept not in favour of the tax payer. That is why we do not rule out that any attempt to try and pay dividends at a lower rate by the end of the year would face increased scrutiny on the part of tax authorities and courts in terms of whether a DTT could be applied to such incomes in principle.

Such increase in the taxes applicable to dividends and interest is likely to have great negative impact on foreign investments in the Russian economy.

If dividends are distributed to Russian owners through a chain of foreign companies, then, because of the de-offshorisation campaign and foreign controlled companies legislation adopted a few years ago, the proposed measures represent another blow to Russian businessmen using foreign holding entities.