New Protocol to Cyprus-Russia Tax Treaty
On April 16, 2009, representatives from the relevant Ministries of the Republic of Cyprus and the Russian Federation signed a Protocol to the 1998 tax treaty between the two countries. The Protocol is expected to be ratified by both countries in 2009 and to become effective as from January 1st, 2010.
The Protocol, which is the result of over one year of negotiations, will benefit international business and will continue to promote and encourage financial relations between Cyprus and Russia. It is one of the most favourable tax treaties ever agreed by the Russian Federation.
Removal of Cyprus from the Russian “Blacklist”
The Russian Federation has agreed to remove Cyprus from its blacklist. The outcome of this has significant results for Russian businessmen since dividends received by Russian companies from Cypriot subsidiaries will now qualify for the Russian dividend participation exemption.
Dividends, Interest and Royalties
Tax on Interest and Royalties - No major changes
It is important to note that there are no changes to the nil rates of withholding tax on interest and royalties. With regards to dividends, the withholding tax rates of 5% or 10% remain unchanged. The only change to the conditions for eligibility for the 5% rate is that instead of a minimum of USD 100,000 investment in the capital of the company in whose shares are held, the minimum investment is now EUR 100,000.
Amendments to Definitions
The definitions of dividends and interest have been amended to be aligned with the wording of the latest OECD Model Treaty definitions. An addition was made to the definition of dividends to include payments on shares of mutual investment funds and similar collective investment vehicles (see Section E: Distributions from Mutual Investment Funds), as well as, depository receipts over shares. However, the new definitions of dividends and interest will not prevent the Russian tax authorities from applying 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 the treaty.
Taxation of Capital Gains
The Major Change - To be Effective in 2014
The major change to the existing treaty is the taxation of capital gains on the sale of shares in real estate property-rich companies. Currently, the treaty provides for the country of residence of the selling entity to have the taxing right (e.g. Cyprus for Cypriot companies selling shares in Russian property-rich companies). The Protocol moves to the latest OECD Model Treaty principle where such gains should be taxable in the country where the real estate is situated.
The taxing right will remain with the country of residence of the selling entity when that entity is:
· A pension fund
· A provident fund
· The government of Cyprus or the Russian Federation
Or when the gains come from the disposal of shares in a listed company or in the course of a corporate reorganisation.
This amendment to the treaty is not expected to apply until January 1st, 2014, because the Protocol provides for this amendment to become effective on the first day of the calendar year following four years after the Protocol as a whole enters into force. In the meantime, planning opportunities are likely possible to mitigate any negative implications of this change.
The Perceived Limitation of Treaty Benefits
New article introduced
A new limitation of benefits article has been introduced. It denies benefits of the treaty to entities that are not registered in Cyprus or Russia and that were created with the main purpose of benefiting from a reduction or exemption in tax.
Therefore, this limitation should not apply to companies incorporated in Cyprus or Russia. Since a Russian resident company is one that is always incorporated in Russia, the limitation will most likely only apply to companies that are incorporated outside Cyprus but that are tax residents in Cyprus by virtue of the exercise of their management and control in Cyprus.
This denial of treaty benefits does not apply automatically by virtue of the new article, but it offers a mechanism to the tax authorities of both Cyprus and Russia to oppose some perceived treaty abuses, and only as a result of consultations between the tax authorities.
Distributions From Mutual Investment Funds
Amendments to Existing Articles
Dividends – The dividends article has been amended to provide that dividends shall include payments on shares of mutual investment funds so that such distributions would have a maximum tax of 10% withheld by the paying entity. Under Russian domestic law, such distributions are currently subject to 20% withholding tax. As a result, the uncertainty under the existing treaty on whether such distributions could be classified as “other income” is removed.
Income from immovable property – This article has been amended to allocate taxing rights to the source state with respect to income of a mutual investment fund investing only in immovable property. The possible reason for this construction is a potential concern of the Russian authorities with regards to structures created where income from real estate contributed into such real estate investment funds lead to a possible “double non-taxation” effect within those structures.
We expect that the breadth of application of these amendments, especially in respect of distributions from Russian real estate funds, will be clarified by the tax authorities in the coming months.
Other changes to the existing treaty brought about by the Protocol include:
· The definition of resident - Under the existing treaty, residence is determined by the entity’s place of effective management. A new paragraph has been added by the Protocol with the objective of making the “tie-breaker test” more effective. When the place of effective management cannot be determined, the Russian and Cypriot tax authorities shall endeavour to determine this by mutual agreement.
· The meaning of permanent establishment – Has been extended to allow for the taxation of profits from services performed in one country by an entity of the other country through an individual or individuals present in the other country for more than 183 days in a 12-month period, in certain circumstances. The new paragraph follows the wording circumscribed by the OECD Model Treaty
Committee in the Commentary to the latest Model Treaty for countries that wish to include such a provision.
The article on exchange of information – Has been replaced by the latest OECD Model Treaty
equivalent. The difference from the current article is largely understood to be clarifications of existing obligations and powers.
ConclusionIt is hereby suggested that the amendments pending to be introduced to the current Treaty between Cyprus and the Russian Federation do not adversely affect Cyprus as an advantageous centre through which investment into Russia may be challenged and in addition, by the removal of Cyprus from the black list of the Russian Ministry of Finance, which will take effect upon the ratification of the Protocol by the Russian Federation, Cyprus would come the most suitable location for the channeling investment out of Russia as well.