Cyprus – Russia Protocol Signed

In an era when the business world is seeking ways to restore financial balance, the relationship between Cyprus and Russia, two strongly affiliated countries, is improving steadily. Following the signing of the treaty for the avoidance of double taxation (DTT) back in 1998, Cyprus was and still is amongst the largest investors in the Russian market while Russia constitutes one of the pioneers in the area of foreign investments in Cyprus.

On a global scale, innovation and transformation of the business sector challenge the traditional business relations between the two countries calling for a re-adaptation of these relations. This re-adaptation is reflected in the recent commitment by the Presidents of the two countries to further their mutual cooperation, sealed in October 2010 in Nicosia with the signing of the amending Protocol to the current DTT. Under the amending Protocol to the DTT, various changes in line with the OECD Model Tax Convention on Income and on Capital have been introduced. This signifies that both countries are willing to improve their reputation on an international level.

It is considered a great achievement for Cyprus to be able to maintain the existing withholding rates with the current DTT in relation to dividends, interest and royalties with only limited differentiating clauses and clarifications adopted. In line with this, dividends will maintain the five per cent withholding tax rate at source if the beneficial owner has directly invested the equivalent of at least €100,000 in the capital of the company paying the dividends. The current provision has been amended only with regards to the currency of the investment, switching from US dollars to Euro.

The definition of ‘dividends’ of the Protocol now further clarifies that payments on shares of mutual investment funds or other similar collective investment vehicles will be subject to the withholding tax rates applicable to dividends. In contrast, distributions by real estate investment trusts and real estate investment funds will be treated and taxed as income from immovable property instead of being treated as dividends or other income. Additionally, the definition of ‘dividends’ now extends to include the distributions from shares held in the form of depositary receipts which will also be subject to the relevant taxation.

The withholding tax on interest will continue to be at the rate of zero per cent. The definition of ‘interest’ is now fully in line with the OECD Model Tax Convention to cover income from debt-claims of every kind, whether or not secured by mortgage and whether or not carrying the right to participate in the debtor’s profits. Under the new definition, no penalty charges are included concerning late payments or interest regarded as dividends. Such reclassified interest will be subject to the existing withholding tax rates of dividends. Royalties will continue to enjoy the zero per cent withholding tax rate with no further clarifications or amendments being brought about by the new Protocol.

A clarification has been introduced in relation to the treatment of residency under which a higher level of cooperation between the relevant tax authorities of Cyprus and Russia is required. The clause provides for both the aforementioned authorities to consult with each other and reach a mutual decision concerning the cases whereby the ‘effective management’ cannot be determined.

An improvement has also been added with regards to the permanent establishment treatment provided under the DDT. A new paragraph has been inserted in order to clarify the provision of services by individuals in a contracting state. Under the Protocol it is now clear that a permanent establishment may arise from administration or business activities executed through service providers who will be deemed to be present in a contracting state for more than 183 days in a period of 12 months.

Provisions relating to income deriving from International transportation underwent a replacement, and now provide for the taxation of such income only in the contracting state in which the place of effective management of the persons deriving the transportation income is situated.

Despite the significant changes outlined above, the interest of the business community focuses on the major changes being brought about in relation to the capital gains treatment, the exchange of information and the introduction of a limitation of benefits clause.

The capital gains article has been amended to permit a contracting state to tax capital gains derived by a resident of the other contracting state from the alienation of shares or similar rights which derive more than 50 per cent of their value from immovable property situated in the contracting state. Capital gains resulting from the disposal of shares, the value of which does not derive for more than 50 per cent from immovable assets remain taxable in the alienator’s country of residence. The new provisions adopted do not affect gains deriving from the disposal of shares in the course of a corporate re-organisation, the disposal of listed shares on a recognised stock exchange and, finally, the disposal of shares derived by a pension fund, a provident fund and the government of either of the two countries.

The Protocol provides for a four-year grace period from the date of ratification of the Treaty for implementation of the new provisions of the capital gains article. This grace period has been interpreted as a ‘catching up’ period for other investing countries in the Russian market, which currently seem to be negotiating their existing treaties. In line with this, Russia has undertaken that by the implementation date of the capital gains clause incorporated in the Protocol with Cyprus, the same capital gains treatment will be adopted in all its treaties concluded with its main foreign investors.

Another important change lies with the exchange of information article, which has been revised to adopt the exact OECD Tax Convention on Income and Capital under which the relevant tax authorities of both contracting states are under obligation to permit exchange of information by utilising and mobilising their national mechanism in order to collect the required information. According to the Protocol, the exchange of information is not limited in scope to taxation covered by the DTT but it can also extend to include indirect taxation. Such information, once obtained by the competent authorities, shall be treated with confidentiality; however, it may be disclosed, if needed, in court proceedings. In order for a contracting state to obtain the desired information, it is obliged to proceed in line with the national legislation and collection of information mechanism in place at the other contracting state. The mechanism currently in place in Cyprus is outlined in the following paragraphs.

In 2000, Cyprus signed a commitment letter provided by the OECD along with other countries with regards to the elimination of harmful tax practices and the embracing of the international standards of transparency and the exchange of information. This commitment resulted in the amendment of the Cyprus national legislation (Assessment and Collection of Taxes Law, 72 (I)/2008) in 2008 providing for the exchange of information as well as the procedure to be followed for the collection of the required information.

The right for the initiation of the national mechanism for the collection of information rests with the Director of Inland Revenue who may request evidence regarding a person under investigation and must provide the justification for such a request. Upon the provision of satisfactory justification the Attorney General of the Republic may grant his written consent in order for the collection of information to take place. It is important to mention that both contracting states are not expected to go beyond the powers granted by their national legislation in order to obtain information, but remain under the obligation to obtain the data that is available and is possible to collect.

Lastly, the limitation of benefits is a new clause added to the Protocol aimed at the prevention of treaty abuse. The tax authorities of both contracting states reserve the right to refuse the tax benefits of the Treaty to any company created for the specific purpose of obtaining the Treaty benefits and provided that it is neither registered in Cyprus nor Russia. Companies incorporated in Cyprus or Russia are excluded from such limitation but this may apply to companies not registered in Cyprus but tax resident in Cyprus (ie, having their management and control in Cyprus). The decision for the application of this clause shall be the result of mutual consultation between the two relevant authorities, aimed at the elimination of ‘treaty shopping’.

The Protocol itself was signed in October 2010 and was expected to come into force from the 1 January 2011. However, Russia is seeking parliamentary ratification of the treaty, which is ongoing today, whereas the Council of Ministers in Cyprus have already ratified the Treaty.

It is true that Cyprus has been expecting the ratification by the Russian parliament prior the end of the year 2010 but despite the determination of Mr Medvedev back in October 2010 in Nicosia, the treaty did not come into force as initially expected. The Russian president committed upon his recent visit to Cyprus that the enforcement of the Treaty will result in the removal of Cyprus from the Russian ‘black list’ of uncooperative jurisdictions. As a result, dividends received by Russian shareholders from equity participations in Cyprus subsidiaries may be able to qualify for the Russian ‘participation exemption’ and will not be taxed in Russia. For obtaining this tax benefit of non-taxation of dividends from abroad the Russian government requires amongst other provisos that the dividends are received from countries or territories which do not provide a ‘preferential’ tax (offshore) regime.

With the ratification of the Treaty by the Russian Parliament and the removal of Cyprus from the Russian ‘blacklist’, it is expected that the investment opportunities will be boosted in an environment inspiring greater confidence, clarity and professionalism.