Tax on payments to foreign organisations: hope for the best, prepare for the worst?

As expected, the end of 2023 has produced a rich crop of changes to Russian tax law. On 8 November 2023, for instance, came the publication of the second draft of a bill[1] which, among other things, makes substantial changes to the tax rules governing income received by foreign organisations from sources in the Russian Federation (“the Bill”).

If passed, the Bill is expected to take effect from 1 January 2024.

The key potential changes to the Russian Tax Code are highlighted below.

1. Expansion of the range of income which is taxable at source in Russia

Under the Bill, payments made to a related entity for the performance of work (rendering of services) in the territory of the Russian Federation would be treated as Russian source income which is subject to withholding tax (clause 9.4 of Article 309 of the Tax Code). For these purposes, the place of supply of the services/work would be considered to be the buyer’s location, i.e., the location of the Russian organisation which pays the income.

Income of this kind would be subject to the tax rate applicable to dividends, i.e., 15%.

The current version of the Bill does not lay down any transitional provisions or any exceptions for agreements concluded in the past. Nor does it make any exceptions for particular kinds of work/services. This means that it is not only typical intra-group services (such as consulting, legal, accounting services, etc.) that would be hit, but also various business-related services, such as brokerage, banking and depositary services. Moreover, the changes would also affect situations where, in the current environment, services are purchased from independent entities by foreign related entities and then wholly or partially “recharged” to a Russian organisation.

Historically, fees for services (other than certain types of services specifically mentioned in clause 1 of Article 309 of the Tax Code) were not considered as income from sources in the Russian Federation and were not, therefore, subject to withholding tax. At the same time, over the last few years the tax authorities have been paying close attention to payments for intra-group services, examining whether the prices charged for them are at arm’s length for tax purposes, whether the Russian organisations have a genuine need for them, whether they constitute shareholder activities, etc., as a result of which, in a number of cases, they have recharacterized remuneration for services (in whole or in part) as a disguised dividend distribution and required the amounts concerned to be assessed to withholding tax at the 15% rate prescribed for dividend income. To a certain extent, therefore, these provisions of the Bill serve to formalise the approach that has been taken by the tax authorities over the last few years.

In those cases where payments of this kind are made to related entities from friendly jurisdictions, the 15% tax rate may potentially be lowered based on applicable double taxation treaties, provided that the recipient of the income provides proof of its eligibility for the relevant benefits.

The question arises of how the changes to the provisions of Article 309 of the Tax Code will correlate with the planned amendments to Article 105.3 of the Tax Code, which provide for tax to be charged at 15% on the difference between the market price and the price actually used in the transaction with the foreign related entity. In the long run this would lead to the double charging of withholding tax on the amount by which the cost of work/services deviates from the market price.

2. Exemption from tax agent functions to preserve the tax treatment in effect prior to the suspension of certain provisions of international tax treaties of the Russian Federation

The Bill provides for exemption from the functions of a tax agent and the application of lower rates of withholding tax in the Russian Federation in the case of the payment of certain types of income to foreign organisations based in “unfriendly” states which were previously eligible for tax treaty benefits (prior to the suspension of certain provisions of tax treaties by Presidential Edict No. 585 of 8 August 2023 (“the Edict”)).

It is planned that these rules will be temporary in nature and will apply to the period from 8 August 2023 to 31 December 2025.

The exemption from withholding functions would apply in relation to the following types of income provided that the relevant conditions are met:

It is worth noting that the above changes and requirements for exemption from the performance of tax agent functions or for the application of reduced tax rates based on international tax treaties apply only to payments made to organisations that are tax residents of jurisdictions with which tax treaties have been partially suspended. The provisions in question do not, therefore, affect payments made to residents of “friendly” jurisdictions (such as China, India, Brazil, etc.).

The changes do not cover a range of other transactions which were previously exempt from tax based on applicable double taxation treaties. The benefits do not, for instance, cover payments of interest income on intra-group credits and loans, payments on derivatives and, for example, royalty payments to related entities. Further analysis is needed as to how the independence requirements would be applied, such as whether they would apply to persons who are beneficial owners of income.

3. Setting of a 0% withholding rate for income under agreements on the settlement of insurance and/or contractual claims under lease agreements

The Bill provides for the setting of a 0% rate of withholding tax for income received by foreign organisations under agreements on the settlement of insurance and/or contractual claims arising from agreements concluded with foreign lessor companies on the rent/lease of aircraft (including auxiliary power units and aircraft engines).

The applicability of the 0% tax rate depends on the following conditions being met:

• The rent/lease agreement with the foreign lessor was concluded before 5 March 2022;
• The aircraft has been registered or is to be registered in the State Register of Civil Aircraft of the Russian Federation;
• The agreement on the settlement of insurance and/or contractual claims provides for ownership of the aircraft (including auxiliary power units and aircraft engines) to pass to a Russian organisation;
• The foreign organisation receiving the income is not a related party of:

1. the Russian organisation to which ownership of the assets concerned passes in accordance with the agreements on the settlement of insurance (contractual) claims, or
2. the lessor organisation in accordance with the agreement on the rent/lease of the aircraft (including auxiliary power units and aircraft engines).

The zero tax rate is applicable provided that the foreign organisation receiving the income provides to the tax agent the confirmations provided for in clause 1 of Article 312 of the Tax Code.

*  *  *

The changes described above introduce fundamentally new taxation principles in the Russian Tax Code. In the initial stages, therefore, the way in which they are interpreted and applied might not be entirely consistent, and it is possible that differences of interpretation might arise between taxpayers and tax authorities. Since the Bill does not abolish the liability of tax agents for failure to withhold tax as appropriate, taxpayers should take care in assessing whether the new benefits are applicable in their situation.

It may also be expected that the tax authorities will pay close attention to any changes in the structure, payment terms, pricing, etc., of transactions to check for the occurrence of unjustified tax benefits and other matters once the Bill has passed into effect.

We will continue to monitor the Bill and will keep you informed of any further changes and the progress of its approval as and when news is received.