For further information on developments in double taxation arrangements, contact Lioudmila Mamet in our Moscow office on (095) 232 5511.
In line with its supervisory function and conscious of the need to introduce conditions designed to strengthen the Russian Banking sector, the CBR's amended banking ratios (introduced at the end of January 1996) became effective as from 1 April 1996.
The amended ratios represent a significant change to those previously required and deal with such areas as:
- increased minimum capital requirements;
- minimum capital adequacy ratios
- increased and improved liquidity requirements
- increased limits of lending exposure limits to single borrowers or groups of connected borrowers
- new maximum limits on lending to shareholders and management
- maximum dependence on single depositors for source of funding
- limits on the extent to which banks can purchase shares in other legal entities.
In recognition of the difficulties which certain banks may have in complying with the new ratios, the CBR have permitted an interim period (up to 1 July 1996) during which time they will not be penalised for failing to comply provided that the ratios do not worsen during the intervening period. The new Instruction also provides for a timeframe for the introduction of tighter requirements up to the year 1999.
The changes will affect banks in different ways depending on their current operations. The new ratios in respect of lending operations are likely to pose some banks considerable difficulty in achieving the required targets in the short term due to the nature of current lending practices. Under the previous rules banks were permitted to lend to individual customers up to a level of 75% of the bank's capital with guarantees from third parties being subtracted from the exposure for the purposes of the calculation. Under the revised requirements the limit is set at 60% with no deduction for guarantees.
In summary, the Instruction is a definite positive step towards the aim of a better regulated and strengthened banking sector. The Instruction should result in ultimately a reduced number of banks with a greater concentration on better capitalised banks. The ratios also favour a reduction in the practice of banks servicing primarily shareholders and should encourage a greater spread of banking activities.
New treaties, new chances
Currently, there are twenty-six agreements on the avoidance of double taxation in force between Russia and other countries, seventeen of which were concluded with Russia's legal predecessor, the Union of Socialist Soviet Republics. In view of the dramatically changed circumstances since the collapse of the Soviet Union, most of the old Soviet treaties are currently being renegotiated and thirty-four new double tax treaties are being prepared.
A multilateral double tax treaty has been in force between all Comecon countries. Unlike many other treaties between former socialist countries, the Comecon tax treaty was repudiated only by Hungary and remains in force between Russia, the Czech Republic and Mongolia. New treaties have been concluded with Poland, Bulgaria and Rumania.
Over the last five years, a combination of restrictive domestic currency legislation and changing tax legislation has inspired a massive capital flight from Russia. The battle against tax evasion and currency law violation is a top priority for Russia's tax and financial authorities, which is reflected in most current treaty negotiations. Tax treaties usually contain a provision on the exchange of information between tax authorities, and the Russian tax authorities are eager to use and expand such provisions in order to facilitate both the identification of foreign companies' ownership and the verification of amounts of income declared abroad.
The current double tax treaty with Switzerland, for example, does not provide for any exchange of information. Obviously, Russia would like to be able to ascertain the ownership of the allegedly billions of old and new Russian dollars sitting in Swiss banks, while the Swiss want to maintain their status as a country where money from all sources is safe and secure. A similar situation exists with regard to Cyprus, where low withholding tax rates and an extensive international treaty network combine with a rather flexible approach by the local authorities vis-a-vis foreign capital. These factors have made Cyprus not only a standard intermediary country for Russia-bound investors but also a popular 'holiday' destination for some Russian business people.
In this respect, a new kind of treaty has recently seen the light. The new tax agreement between Russia and Armenia, for example, deals exclusively with the exchange of information, joint operations and the prevention of tax evasion. The "competent authority" on the Russian side is the tax police, which has recently been upgraded from an operative unit to a Ministry with federal status. More treaties of this kind are said to be in preparation.
A relatively new feature in Russian double tax treaties is a differentiated dividend withholding rate, where dividends from an investment exceeding a certain capital and/or participation threshold enjoy lower withholding rates. For Sweden and Korea, the capital threshold is set at US$ 100,000, whereas the draft treaty with Vietnam stipulates a minimum holding capital of US$ 10 million. For US companies only, a participation threshold exists: dividends from companies that are at least 10% US owned are taxed at 5% instead of 10%.
Without exception, all recently concluded double tax treaties of the Russian Federation contain provisions relating to transfer pricing. The notable absence of any provisions in Russian domestic legislation, which enable tax authorities to correct the income of a Russian taxpayer for tax purposes, has made tax planning relatively straightforward in the past. Within a company structure, purchase prices for transactions between a foreign parent and its Russian subsidiary can be kept artificially high so that only a small profit is made in Russia.
Transfer pricing provisions have not been applied so far by the Russian tax authorities, as this would require additional legislation to be adopted. Practice in other countries shows that successfully challenging prices between related companies requires a thorough understanding of the taxpayer's business, something the Russian tax authorities are currently lacking. In order to prevent double taxation, however, most treaties provide for some form of co-ordination between competent authorities of treaty countries in case the transfer price article is applied.
Russia's tax legislation and practice will inevitably be influenced by the more than fifty new treaties that are to be concluded in the near future. Hopefully the growing international exposure will change the focus of the Russian tax system and encourage not only foreign investment but also business originating from Russia. They should also increase the Russian authorities' knowledge of a taxpayer's business so that they may use the legal powers at their disposal on a more selective basis.
Focus on the Pension Fund
Payroll costs are a favourite target, not only for the Russian tax authorities, but also for the `non-budgetary funds'. These are special purpose funds established by law but which function independently from the tax authorities. Payroll expenses are subject to contributions to six different funds, resulting in an aggregate liability of 40.5%. Originally, the contribution base - the definition of payroll expense - for each fund was similar, but these have now begun to diverge. In this issue we focus on the State Pension Fund which has a special position not only due to its size, but also due to the political importance of the pension issue.
As a rule, pension fund contributions are made on the basis of gross salary: 28% contribution for the employer and just 1% for the employee. However, pension fund contributions are clearly not value for money given the minimal pension which bears little relation to the salary once earned, and which is usually only paid after a considerable delay. Whilst pensions are calculated broadly by reference to the statutory minimum wage, this has not kept up with inflation and thus pensions are effectively unindexed. Some employers - and employees - are beginning to recognise the benefits of private pension fund schemes, where there is a direct correlation between contributions and benefits, but most individuals are generally not yet ready to plan for the future in this way, and prefer the cash alternative.
In order to avoid exposure to pension fund contributions and other payroll taxes, various indirect remuneration schemes have emerged: examples include generous business trip allowances, payment in kind and insurance schemes under which `salaries' are paid as premiums to insurance companies and then subsequently paid out as `insurance benefits' to the employee.
A recent Instruction of the Pension Fund has imposed a liability to contributions on these alternative remuneration schemes. In particular, all voluntary insurance premiums for the benefit of employees are now subject to contributions, thus blocking not only the more aggressive insurance schemes but also creating a considerable disincentive to employer contributing to private pension schemes.
Whereas the tax authorities impose interest on late tax payments of 0.7% per day, the Pension Fund charges 1% per day and is thus perhaps the most feared creditor in the Russian Federation. Naturally, enterprises in financial difficulty prefer to pay off any pension fund debt first, and fortunately the Pension Fund has considerably more flexibility than the tax authorities to defer debts or collect them instead from creditors of the enterprise.
Impact of new Land Code on agriculture
Introduction In Spring, one of the most discussed topics in Russia is usually agriculture. And it is now a widely spread point of view that the problematic agricultural sector poses one of the main threats to future economic growth in Russia. Last year's national agricultural production declined by 8 % to 63.5 million tonnes (the lowest level for last thirty years). This year's estimates are not optimistic (70 million tonnes). Last year's grain imports declined by 35% to 2.3 million tonnes.
The decline of the agricultural sector is linked to two key issues: price disparity and land ownership. Between 1992 and 1994, industrial prices increased 1035 times whereas agricultural prices only increased 228 times. In 1989 one tractor was equal to 18 tonnes of wheat. In 1994 it was worth 40 tonnes of wheat. The main obstacle for further agricultural development is a current resistance to private ownership. While the adoption of a decree legalising private land ownership is an essential element of Boris Yeltsin's election platform, Communist leader, Gennady Zuganov, shares the traditional and strong belief in collective property (that is, most lands should belong to the state and foreign citizens should not be allowed private ownership of land - the so called "national leasing" concept).
Until a new federal land code is adopted, most of the Russian regions will remain reluctant to initiate land reform despite the recent Presidential decrees. One of the key obstacles for attracting foreign investments into the country is therefore unlikely to disappear in the near future.
Private agricultural enterprises At the beginning of the year, there were, in Russia, only 280,000 private farmers. They own only 6.1% of the total cultivated land in the country. Last year they produced 3 million tonnes of grain (4.7% of the total production of grain), 517 thousand tonnes of sunflower seeds (12.3% of the total production), 160 thousand of meat (1.7% of the total production), 596 thousand tonnes of milk (1.5%). More than half of the Russian farmers' plots of cultivated land do not exceed 20 hectares in size and only 8% of the farmers have more than 100 hectares of land. Relatively large farmer's households are operating in the regions of Astrakhan, Volgograd, Saratov, Orenburg, Amur and Altai.
State-owned agricultural enterprises
State-owned agricultural enterprises (SOE) are not necessarily inefficient. They need, however, to be restructured. Technical assistance is particularly required to improve the marketing of domestically produced foodstuffs and to strengthen production organisation. Russian agriculture also urgently requires the development of effective rural banking and credit systems, the establishment of a nation-wide management information system, and the implementation of an efficient social security system. Investments and technical assistance are also needed to acquire modern post-harvesting technologies and agroprocessing capabilities.
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