The arithmetic of a tighter tax residency policy

In June 2019 the Finance Minister, Anton Siluanov, announced that the Ministry of Finance was working on a change to the criteria for treating individuals as tax residents of the Russian Federation. The initiative may increase the number of foreign legal entities treated as controlled foreign companies (CFCs), and may later increase the fiscal burden both on the individual and on that person's corporate structure.

Background, and an assessment of the "90 days of presence in Russia" criterion

In 2015 the Federal Tax Service of Russia had already tried to change the criteria for the tax residency of citizens. That initiative was not taken further. With the global trend towards deoffshorisation, stricter criteria for determining tax residency, and for taxing the resident, may be introduced in the near term.

Today it is enough for an individual to be outside the Russian Federation for more than 183 days in a year, over 12 consecutive months, in order not to be a tax resident of the Russian Federation (under paragraph 2 of Article 207 of the Tax Code) and not to report the controlled foreign companies (CFCs) referred to in Article 25.13 of the Tax Code. Some taxpayers in this way minimise their CFC obligations to the Federal Tax Service.

The new initiative for treating an individual as a tax resident of the Russian Federation would reduce the number of days of presence in Russia to 90 and would introduce a new criterion, the "centre of vital interests". It will affect the individual's personal income tax and his foreign assets. Foreign legal entities owned by that individual will automatically be treated as CFCs, and the combined administrative and fiscal burden will rise. Questions of tax residency therefore have to be considered in the context of international rules and of the legislation on CFCs.

Background, and an assessment of the "centre of vital interests" criterion

The possibility of determining residency by the "centre of vital interests" criterion is set out in Resolution of the Government of the Russian Federation of 24 February 2010 No. 84 "On the conclusion of intergovernmental agreements on the avoidance of double taxation and on the prevention of evasion of taxes on income and property", but it is not contained in the Tax Code. At present the "centre of vital interests" is used to treat a person as a tax resident where the individual meets the conditions of tax residency in two states at the same time (that is, has a place of residence and spends roughly the same number of days in both countries). Principles of this kind for determining tax residency are applied in Italy, Romania, France, England, China and other countries. In those jurisdictions, particular weight attaches to the individual's family and social ties, to his professional, cultural or other activity, to the place where the business itself is carried on, and to the place from which it is managed.

A family, as the centre of an individual's vital interests, can easily change the territory in which it stays, depending on how comfortable it is to live in the country and on the taxation there. The main source of income usually lacks that mobility. For the most efficient taxation, the fundamental factor is the country of origin of the income, the place where the principal business activity is carried on. The jurisdiction of that centre of interests may therefore become one of the key criteria in determining the beneficiary's tax residency.

It can be extremely risky to scheme in choosing a centre of vital interests that is convenient for tax, while ignoring the laws of the state in which the main source of income is located. According to OECD data, as at 1 June 2019, under the automatic exchange of tax information (CRS), banks in more than 90 countries had passed to the fiscal authorities data on 47 million accounts of individuals, holding 4.9 trillion euros, and all available information on the origin of the funds. If an individual does not give the tax service information on his foreign accounts, the supervisory authorities will be able to obtain that information themselves, without difficulty, by working with their colleagues in other states.

The consequences of the "90 days" rule and of the "centre of vital interests"

Suppose that an individual, the actual recipient of the income, is a tax resident of Cyprus and lives there for more than 183 days a year. He now sets up a Cypriot company with a real economic presence, which owns a profitable subsidiary in Russia. The Russian company is managed, and control over it is exercised, strictly through the Cypriot company, in line with the corporate hierarchy and with the provisions and preferences of the double tax treaty. The nature of the business nevertheless requires a personal presence in Russia of three to five months a year. Under the legislation in force, that individual is not treated as a tax resident of the Russian Federation, and therefore:

• is not obliged to declare the CFC or to report on it in Russia;
• may distribute dividends from Russia at a rate of 5% instead of 13%;
• has practically no exposure to a breach of the currency legislation.

On the transactions described, the risks of being treated as a resident of the Russian Federation and of having an unjustified tax benefit imputed are minimal, provided that every requirement of the current legislation is met.

If the new criteria enter into force, however, the business owner in this example faces the risk of being treated as a tax resident of the Russian Federation. If that risk materialises, his foreign company falls within subparagraph 2 of paragraph 1 of Article 25.13 of the Tax Code and is managed by a resident of the Russian Federation. He would have to apply a tax rate of 13% to the distribution of dividends (instead of 5% under the double tax treaty), declare the CFC, and check all foreign transactions for compliance with the currency legislation of the Russian Federation.

On top of the higher fiscal burden, offences would bring penalties and the risk of an additional assessment:

• from 20% to 40% of the unjustified tax benefit obtained (under Article 122 of the Tax Code);
• from 75% to 100% of the amount of the transactions, for currency offences under Article 15.25 of the Code of Administrative Offences of the Russian Federation;
• if the CFC had transactions with Russian organisations, a risk of an additional VAT assessment.

Now take the same story in figures. Today, for example, a Russian subsidiary that remits 100 million roubles of dividends to its parent company in Cyprus, whose owner spends about 100 days a year in Russia, pays tax of 5 million roubles. If the new rules are adopted, the tax cost of that transaction will be 13 million roubles. The owner will also have to report all foreign companies (CFCs) and transactions to the Federal Tax Service of Russia. A fine of up to 100% of the amount of the transactions is also possible, for example where a further movement of funds from Cyprus to another country is made other than through an authorised bank, together with other variations of the fiscal consequences, depending on the particular circumstances.

In the end, even a structure and a model of doing business in Russia that are transparent today for a non-resident become risky and unlawful after the changes.

Small changes in the criteria for treating an individual as a tax resident can therefore increase several times over the fiscal burden on an entire corporate structure with a foreign element, and not on that person's personal income alone.

If the emphasis is placed on the "source of income", the forthcoming new rule of Russian tax law on the "centre of vital interests" may be quite effective in achieving the main aims: preventing an outflow of capital, and fully taxing at the source of payment the income received in Russia. Court practice under the concept of the actual recipient of income may, for its part, take a new direction.

Overall, the rule will draw a clear line between owners of Russian assets who are domestic beneficiaries and foreign beneficiaries who are very rarely in Russia.

If the business requires the beneficiary to be personally present in Russia on a regular basis, and he does not plan to invest abroad, it will make sense to accept the status of a resident of the Russian Federation, to comply in full with Russian law, and to distribute dividends at the full rate under the Tax Code, and in that way to minimise the risk of fiscal sanctions. If the actual recipient of the income aims to enter the international market and to live outside Russia, and the Russian business can operate effectively without his constant presence, a complete move to another comfortable jurisdiction becomes an effective solution with low tax risk.

To avoid fiscal or even criminal liability for acts that are most often committed through carelessness, business owners need to settle in good time their personal aims and the company's aims over the long term, and to reorganise the corporate structure in line with those aims.

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