Cyprus: Cyprus - A Window To Russia

Last Updated: 23 October 1998
Article by David Fox
Cyprus is currently used as a place where intermediary investment/holding, finance and licensing companies are located for the purposes of conducting business transactions in the Russian Federation and other CIS countries. This is due to many reasons such as the geographical location of Cyprus but primarily to the existence of a favourable agreement for the avoidance of double taxation between Russia and Cyprus.

Another important reason is the existence of a regime in Cyprus by virtue of which significant tax incentives are granted to Cypriot companies which conduct business activities out of Cyprus.

Russian companies and the Russian economy in general currently need a large injection of capital which cannot come from Russian investors but from international investors mainly institutional investors. Institutional investors currently use Cyprus as a low tax springboard into Russia. The fact that Cyprus has certain historic links and cultural affinities with Russia is also an important consideration to such investors.

RUSSIAN FEDERATION - ECONOMIC OVERVIEW

Russia gained independence from former Soviet Union on 24 August 1991 and adopted its constitution in December 1993. To move away from a centrally planned economy towards a market based economy, a radical reform package was adopted in January 1992 focusing on economic liberalisation and privatisation.

The reform process has had a pronounced effect on Russian economic data as is demonstrated by table 1.

Table 1

                        1991    1992    1993    1994    1995    1996

REAL GDP (% CHANGE)       13      19      12      15     4.0     1.6
Rbl/US$ exchange rate
(annual average, %)      1.7     222     930    2212    4565      na
Inflation (annual 
average, %)               93    1354     896     302     190      80
Non-CIS exports (excl
gold) (US$% change)     19.8    16.7     9.0    10.6      25      na

During 1995, the Rbl/US$ exchange rate increased from a 1994 year end level of 3.550 to 4.640 at the end of 1995 and is currently approximate 4.825. The Rouble/US$ exchange rate at present operates in a corridor established by the Central Bank of the Russian Federation of 4.000 to 5.100. The International Monetary Fund in February 1996 released the final US$1.05 billion instalment of a US$6.3 billion loan for Russia agreed in 1995 and expressed its satisfaction with Russia's track record in 1995 of full implementation of the economic stabilisation and reform programme. Understandings are believed to have been reached upon most aspects of the 1996 economic program, directed at a further reduction in inflation, recovery in economic growth and deepening of institutional changes.

COUNTRY RISK - RUSSIA

Companies conducting operations in Russia face significant political, social, economic, currency and legal risks. Certain of these risks are set out below:-

Political Uncertainty

Russian politics are characterised by considerable instability and uncertainty. The institutions of the government and the relations between them, and governmental policies and the political leaders who formulate and implement them, are subject to rapid and not necessarily peaceful change. The civil war in Chechnya has heightened concerns about Russia's political stability and highlighted the existing tensions between the Central Government in Moscow and some of the regions within Russia on the one hand and the armed forces and the political establishment on the other. Moreover, the return of the Communist party as the largest parliamentary party in the elections of December 1995 as well as the President's ill health could result in further political and economic instability or uncertainty.

Social Risks And Business Culture

The political and economic changes in Russia in recent years have resulted in significant turbulence, as existing structures of authority have collapsed and new ones have begun to take shape. The local and international press have reported that significant organised criminal activity has arisen, particularly in large metropolitan centres. This activity is reported to involve demands for protection money, requirements to work with specific entities controlled by organised crime, damage or destruction of property belonging to businesses unwilling to co-operate with organised crime and physical violence directed against the employees of such businesses. In addition, the local and international press have reported high levels of official corruption in Russia.

The existing business culture in Russia continues to be influenced by attitudes formed in the period of the Soviet Union's centrally - planned economy, in which survival often depended on finding ways to avoid arbitrary laws and arbitrary application of laws and agreements. As a result, the commitment of local business people, government officials and agencies to abide by legal requirements and negotiated agreements is still uncertain.

Civil Unrest

Companies operating in Russia may also be subject to the risk of civil unrest resulting from, among other things:-

  • attempted or actual changes in government through extra-constitutional means;
  • popular unrest associated with demands for improved political, economic and social conditions;
  • succession of regions;
  • hostile relations with neighbouring countries and regions; and
  • civil wars.

Economic Risks

Confronted with the collapse of the centrally-planned economy and the resulting economic crisis, the Government of Russia has been attempting to implement policies of economic reform and stabilisation. These policies have involved freeing prices from central control, reducing defence expenditures and subsidies for state owned enterprises, privatising state-owned enterprises, creating a tax system, a banking system and a securities system, introducing legal structures designed to facilitate marked based activities, and encouraging foreign trade and investment.

There can be no assurance that the economic measures taken by the government will continue to be effective in improving economic conditions. Moreover there is a lack of political consensus as to the scope, content and pace of economic reform particularly since the December 1995 parliamentary elections. There can be no assurance that the government would not take actions detrimental to foreign investors which might include discrimination against private sector and/or foreign-owned enterprises, expropriation, re-nationalisation or consficatory taxation. Currency fluctuations may add a further element of uncertainty to the business environment.

Currency Convertibility

Roubles are not convertible outside Russia and although, the Rouble is currently convertible within Russia, the currency exchange markets remain relatively illiquid compared to those of other nations and therefore, may not permit the exchange of currencies at favourable rates. Russian currency regulations are extremely complex and fines for breach can be very heavy. Currency regulations change frequently and their interpretation by the regulatory authorities may also be subject to considerable change. Currency regulations, subject to adherence to formal procedure, currently permit free repatriation, for foreigners, in foreign currency, of interest, dividends, profits, payments for goods and services, capital gains subject to payments of all applicable taxes, duties and levies. Considerable delays may be experienced in the exercise of the right to repatriate while obtaining clearance from the tax authorities. There can be no assurance that restrictions on the repatriation of foreign currency will not, at some future time, be re-imposed.

Uncertain Tax Law And Practice

Russian tax law and practice is at an early stage of development and is subject to frequent changes which often have an uncertain legal effect and are subject to varying interpretations. It is possible that the current interpretation of the law or understanding of practice may not apply in the future, and any changes could apply retroactively. Russian laws impose steep penalties for late payment of taxes. Generally, Russian enterprises (including foreign-owned subsidiaries) must withhold and remit a withholding tax of 15% on payments of dividends, interest and profits from shares, bonds and other securities issued in Russia, and certain other Russian-source payments. Foreign legal entities without a business presence in Russia are subject to a withholding tax of 15% on dividends and interest received from Russian enterprises, and 20% on royalties, rentals and other income. Capital gains realised from the

sale of Russian real estate, securities and debt may be subject to Russian withholding tax at a rate of 20%. The applicable withholding tax rates as set out above are considered to be a major disincentive for foreign investment in Russia.

Legal Uncertainty

Many laws may have been enacted in Russia without clear constitutional or legislative authority and in many instances are contradictory and leave issues unclear. The absence of a tradition in Russia of judicial and regulatory decision making in the context of private commercial transactions adds a further element of uncertainty.

SATELLITE STATES

Large countries (referred to as "target countries") tend to utilise smaller countries, whose infrastructure and laws are more flexible and developed in a way that legitimate business is not hindered by unjustifiable bureaucracy to attract business. The existence of such satellite states which offer tax and other incentives, facilitates foreign investments in the target countries. The Channel Islands (the Kingdom of Jersey and Guernsey and the Isle of Man) currently perform this role for investments in the United Kingdom and France. The United States of America use most of the Caribbean Islands, Bermuda and the Netherlands Antilles. Intermediary companies set up in Hong Kong, Singapore and Labuan offer unique advantages for investments in Asian countries such as China, Malaysia, Vietnam, Indonesia etc. Offshore companies in Mauritius are the natural vehicles effecting investments in India because of Mauritius' favourable internal tax rules and double taxation treaty with India. Another example is Madeira which is considered to be the natural stepping stone for investments in Brazil and other South American countries again because of Madeira's geographical position, internal taxation regimes and applicable double taxation treaties. The examples are indeed numerous and may only prove the necessity of using an intermediary/auxiliary jurisdiction to boost foreign investments in a target country. Such a jurisdiction, other than tax incentives through normally reduced withholding tax rates, affords the foreign investor with the required degree of comfort, which is perhaps not available in the target country but is necessary for the realisation of the investment.

CYPRUS/RUSSIA DOUBLE TAXATION AGREEMENT

A foreign investor would need to choose a location where from his investment in Russia shall be channelled. Ideally, the holding vehicle should be located in a jurisdiction that reduces the Russian withholding tax on outgoing dividends and at the same time be vested with the protection of a double taxation agreement which enjoys superior force over domestic law.

Cyprus might be an ideal place for the location of an investment vehicle. The Cyprus/Russia double taxation agreement of 1982 provides for a nil Russian withholding tax on outgoing dividend, royalty and interest payments and also contains a beneficial permanent establishment clause. In view of the provisions contained in the Cyprus/Russia double taxation agreement, Cyprus has emerged as the main gateway for foreign investment in Russia. Indeed joint ventures, privatisation bidders, collective investment schemes, industrial groups of many types, pension funds, merchant banks and securities houses etc have structured their investments and business activities in Russia via Cyprus.

It should be noted that prospective investors consider entering into investment transactions in many countries where investment possibilities exist. The risk factors attached to investments in Russia (as these have been set out above) constitute a major drawback adversely affecting any investment decisions. Such risk factors are in effect mitigated by Cyprus' role as underlined above. It is respectfully submitted that should there be a change in the current Cyprus role the level of investment funds flowing into Russia shall be affected.

Cyprus shall soon be introducing legislation permitting the establishment on the island of collective investment schemes and other types of investment pooled vehicles, which shall be accumulating investors' funds, for the purposes of investing same in countries with which Cyprus has concluded double taxation agreements. If withholding taxes are to be introduced in respect of dividends and/or interest, flowing from Russia to Cyprus, proposed fund managers and sponsors utilising Cyprus shall be reluctant to invest funds under management. In this respect it is of the essence that the new double taxation agreement (if any) between Russia and Cyprus does not impose any withholding tax on dividends and/or interest especially if the respective loan is granted by a bank or other financial institution or a collective investment scheme such as a fund. Moreover, the new double taxation agreement should exempt from taxation profits arising from the disposal or sale of movable property such as shares. This is very important because financial institutions, banks and collective investment schemes shall only participate in the Russian Securities market provided that the capital gain arising on the sale of the shares in Russian companies is exempt from taxes by virtue of the terms of the relevant double taxation agreement. In this respect it should be noted that such exemption is provided in almost all of the double taxation agreements entered into by Cyprus.

Cyprus is a respectable and well regulated jurisdiction. All types of business in and/or from the island are well supervised and regulated to the effect that Cyprus enjoys a very good reputation internationally as a prime business and financial centre. European Union directives and other international conventions in respect of economic crime, money laundering etc have all been ratified by Cyprus. Illustrative of the attitude of the Cypriot authorities to guard well against any misuses of the island is the recent enactment of the Law on the Concealment, Investigation and Confiscation of the Proceeds of Certain Crimes whose aim is to deprive criminals of the proceeds of their crimes. It should also be mentioned that in view of Cyprus' imminent entry in the European Union, Cyprus has or is in the process of harmonising its legislation with that of EU. Cyprus is also in the process of passing new legislation whose major aim is to adopt all EU Directives.

CYPRUS: A "WINDOW" TO RUSSIA

Russia is at present more eager to attract foreign investment and capital in its territory rather than be concerned with how its exported after-tax income will be dealt with in the hands of its treaty partner. This lies at the crux of the matter as Russia should focus its efforts in arranging for the existence and implementation of an effective taxation system in Russia as opposed to being concerned in respect of the flow of income which has already been taxed in Russia to a treaty partner.

Cyprus, for all the reasons set out above has played a very constructive role as a satellite state whereby capital is routed in Russia.

If the terms of any renegotiated double taxation treaty between Russia and Cyprus adversely affect Cyprus' current role, Russia itself shall be closing the window it opened for itself to the western world and to the free market economy.

For all the reasons stated above, it is respectfully submitted that any amendment to the Russia/Cyprus double taxation agreement at this stage will not serve the best interests of Russia and its efforts to encourage the flow of foreign investments into the country. At the same time any amendment which will affect the rates of the withholding taxes on dividend, interest and royalties will adversely influence the beneficial role of Cyprus.

This information was correct in June 1997.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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