This client briefing discusses the principal tax aspects of the recent amendments to the tax legislation and certain other legislative acts (the "New Law") that were signed into law on 25 November 2009 will become effective on 1 January 2010 (save for certain provisions for which a different implementation procedure is envisaged). The New Law is the result of the combined effort of the Ministry of Finance ("MinFin") and of the Federal Financial Markets Service ("FFMS") and is aiming at aligning the new tax rules with the legal concepts relevant for dealing in financial instruments that will either be introduced or significantly amended as of 1 January 2010, when the majority of the provisions of the New Law will come into effect. For more details on the amendments to the securities market legislation please refer to our client briefing "Regulation of Derivatives and Repos in Russia".
Corporate Income Tax
The key amendments concerning the taxation of derivatives may be summarised as follows:
- as the concept of a "derivative" is being introduced into the Securities Market Law, the Tax Code will also be amended to refer to the Securities Market Law definition. However, for the purposes of corporate income tax, the definition of a derivative is narrower and excludes weather derivatives, emission-reduction linked derivatives and derivates linked to statistical information. In addition to that, the derivatives that do not enjoy enforceability protection as a matter of Russian civil law will not be regarded as derivatives for corporate income tax purposes and any losses resulting from such contracts will not be deductible. Given the existing uncertainty as to whether a cross-border derivative with a Russian corporate would be enforceable, if it were governed by Russian law, it is unclear whether going forward Russian corporate would be able to utilise losses from such trades for their tax purposes (note, though, that the trades executed prior to 1 July 2009 are grandfathered and shall be treated as derivatives for corporate income tax purpose).
- another important innovation envisaged by the New Law is that the currency and mark-to-market revaluations of the derivatives are excluded from the taxable income (save for actually paid or received amounts).
- the New Law clarifies that a tax payer may exercise discretion when it comes to the tax treatment of deliverable derivatives and may choose to classify it for tax purposes as (a) derivative or (b) as a contract with deferred maturity, provided that deliverable OTC contracts may be classified as derivatives only if the contract has been entered on at least T+3 (or more) basis.
- the New Law clarifies that obligations under derivative contracts may be offset against obligations to deliver securities with the same rights and of the same issuer, similar types of securities or investment fund units issued by the same fund as well as monetary obligations in the same currency, and such a set-off would not result in the re-classification of a derivative into disposal of an underlying asset.
- another important amendment concerns the definition of a hedging transaction. By way of a background, a Russian corporate's profit/losses resulting from OTC derivatives must be calculated separately from their trading income, with any ultimate losses being non-deductible against trading income. The only exception exists for the OTC trades qualifying as hedging transactions, but, due to the very restrictive definition of a hedge, historically it has been extremely difficult for a Russian corporate to benefit from this carve-out. The New Law represents a positive step in this regard by clarifying that in order for an OTC derivative to qualify as a hedge the underlying asset is not required to be an absolute match to the commodity(ies) the company generally trades in, and that it is possible to enter into a combination of contracts to achieve hedging purposes (although the documentary requirements to substantiate that a trade indeed represents a hedge, albeit somewhat loosened, remain quite cumbersome).
- An important innovation is provided for the licensed dealers who are now allowed to set off losses resulting from OTC derivatives against their trading income;
- New transfer pricing rules for OTC derivatives are envisaged: as of 1 January 2010 the reference value of a derivative for tax purposes shall be determined either by a taxpayer itself or by an independent appraiser, with the method of valuation being set in the taxpayer's accounting policy. As of 2011 the new rules that are yet to be developed jointly by the FFMS and MinFin shall apply;
- The New Law expressly clarifies that derivatives (including premium amounts, mark-to-market payments, and other periodic or one-off payments) are exempt from VAT, save for the transfer of underlying assets but only if such transfer is subject to VAT.
Sale and Purchase of Securities
The New Law introduces certain amendments to the general tax regime for securities transactions, the most important of which concern the transfer pricing rules for dealing in securities. The New Law reinforces the differentiation of securities into quoted and unquoted ones, modifies the notion of a quoted security for tax purposes, and introduces the changes into the rules on determining the reference prices for tax purposes. In particular, a security will be deemed a quoted security only if the market quote for this security has been determined in accordance with the applicable law at least three months prior to the date of transaction in respect of this security (for securities listed on a Russian exchange the market quote will be determined as the weighted-average price, whereas for a foreign stock exchange this will be a closing price). If a security is quoted, the sale price will be accepted for tax purposes if it falls within the range between the maximum and minimum prices registered on the relevant exchange during the three months prior to the trade (with the previous reference period being twelve months).
As for unquoted securities, the Tax Code will (save for certain minor changes) maintain the rules currently in effect until 2011 by requiring a tax payer to determine the reference price either on its own or with the assistance of an independent appraiser, pursuant to the methods and procedures that have to be laid down in the taxpayer's accounting policy. As of 2011 the benchmark reference price will have to be determined in accordance with the rules that will be developed by MinFin and implemented by the FFMS.
Finally, the New Law seems to introduce the requirement for downward adjustment of the purchase price of securities for the purchaser if the purchase price exceeds the maximum market price as determined in accordance with the Tax Code.
Similar to the tax treatment of derivatives, for tax purposes the Tax Code adopts Securities Market Law definition of a 'repo transaction' (although in order to qualify as a repo for tax purposes and not to be treated as a taxable disposal, the tenor of a trade must still be under one year). As the amendments to the Securities Market Law contain and recognise concepts incidental to cross-border repo transactions (such as, substitution and set-off), the amendments to the Tax Code rather helpfully recognise these concepts without triggering any reclassification of a repo into a taxable disposal.
The New Law also eliminates the historical residual uncertainty as to whether the rules on taxation of repos also apply to a foreign entity entering into a cross-border repo with a Russian counterparty, by confirming that where a foreign entity with no presence in Russia is a buyer under the first leg of the repo the amount received under the second leg of the repo in excess of the amount paid under the first leg of the repo shall be taxed in a fashion similar to interest.
The New Law further provides that if there is any dividend on shares sold under the first part of a repo by a foreign entity to a Russian buyer, the latter must prior to the transfer of that dividend to the foreign seller, deduct the portion of tax that the issuer has failed to withhold. While this rule addresses the situations where the rate of withholding tax applicable to foreign shareholders is higher than the rate of tax applicable to Russian shareholders, it fails to address the opposite situation where a foreign entity may, by virtue of a double tax treaty, be entitled to taxation at a rate lower than the rate applicable to Russian shareholders. It is somewhat unclear, how (if at all) the treaty benefits in such circumstances should be claimed.
While generally repo transactions are exempt from VAT based on Section 3 Article 149 of the Tax Code, a tax payer may waive this exemption. Hence, it may be appropriate to include a specific representation as to absence of such waiver into the repo documentation.
The new Article 2821 introduces a new concept of stock-lending transactions into the Russian Tax Code, which are broadly similar to the regulations provided for repo transactions (as historically the stock loans were taxed under the rules established for general lending).
A positive innovation is that stock-lending transaction may be governed by the Russian or foreign law which reduces the recharacterisation risk of a stock loan into a taxable disposal of shares in situations where the parties enter into an English law governed cross-border stock-loan that provides for the delivery of the cash collateral by the borrower. However, in order to qualify as a stock loan, the tenor of the stock loan should not exceed one year and interest must be paid in cash. These two restrictions may have an impact on how certain types of capital markets, M&A or derivative transactions utilising stock-lending concepts will be structured going forward. Should the borrower fail to return securities within one year, both the lender and the borrower would have to record a sale and purchase of the securities.
Dividends, interest and other manufactured payments are treated in a similar fashion to manufactured payments on securities sold under repo transactions.
The New Law also addresses the residual uncertainty as to whether interest on a stock loan (or any similar charge) is subject to VAT by extending the rules applicable to VAT treatment of repos also to stock lending.
Taxation of Individuals
The rules on taxation of individuals dealing in securities and derivatives (which are relevant not only for individuals themselves, but also for brokers and asset managers providing financial services to some individuals and liable for withholding of relevant taxes) have also been substantially amended. The main changes being as follows:
- the definition of a derivative for the purposes of personal income tax, while based on the new definition of a derivative in the Securities Market Law, is narrowed down to specifically exclude not only weather-linked and emission-reduction-linked derivatives and derivatives linked to statistical information, but also to exclude credit derivatives.
- the New Law has substantially modified the rules for the determination of financial result from transactions with securities and derivatives, and eliminated certain uncertainties and inconsistencies existing under the current law. In particular, the margin payments (or other payments made under a derivative contract) are expressly recognised as expenses, the losses from dealings in listed securities may be deducted from the listed derivatives that are linked to listed securities or stock indices, etc.
- from January 2010 loss-carry-forward will be available not only to corporate tax payers but also to individuals. This would however be limited to losses only in respect of listed securities and derivatives and the loss carry-forward will be possible only over a 10 years period. Taxpayers would need to keep documents confirming the amount of loss incurred in previous periods.
- the concepts of stock lending (from 1 January 2010) and repo transactions (from 1 January 2011) will be introduced for the first time into the regulations on taxation of individuals, with the rules broadly corresponding to those established in respect of taxation of corporations as discussed above.
- from 1 January 2010, any material benefit gained from the acquisition of derivatives at a price below the fair market value will also be subject to taxation. The fair market value of the derivatives shall be determined pursuant to the same rules that are established for corporate taxpayers (see above).
- an important change is that material benefit arising upon the purchase by an individual of unquoted securities will also become subject to taxation, with the material benefit being the difference between the reference price determined pursuant to the Tax Code and the actual purchase price. While it is not quite clear from the wording of the New Law, how should the reference price be determined in 2010 (which gives rise to a question as to whether the material benefit may be effectively taxed in 2010), starting from 1 January 2011 the reference price will be determined pursuant to the rules that are yet to be jointly established by the FFMS and MinFin.
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.