Cyprus: Russia-Cyprus (Income And Capital) Tax Treaty

On the 25th June 1999, the Russian Duma approved the "Agreement between the Government of the Republic of Cyprus and the Government of the Russian Federation for the Avoidance of Double Taxation with respect to Taxes on Income and on Capital" (hereinafter referred to as the "Tax Treaty"). The Tax Treaty was signed on the 5th December 1998 and the Council of Ministers of the Republic of Cyprus formally approved it on the 10th December 1998. The provisions of the Tax Treaty will only be effective for taxable years and periods beginning on or after the 1st January 2000. Until that date, the 1982 tax treaty between Cyprus and the former Soviet Union will remain in effect. In general, the Tax Treaty follows the OECD Model with certain modifications. Notable provisions are described briefly below.

In parallel with the OECD Model, Article 1 of the Tax Treaty states that it applies to "persons who are defined under Article 4 of the Tax Treaty as "any person who, under the laws of that State, is liable to tax there by reason of his or her domicile, residence, place of management, place of registration or any other criterion of a similar nature". The definition of residence in Article 4 is in line with the OECD Model but adds in the applicable list of criteria for the taxation of a resident "the place of registration". It is understood this arose because business enterprises in Russia are under an obligation to register with the Russian tax authorities. However, the question is what will be the implications under Russian tax law if a permanent establishment (please refer to section II below) which is registered with the Russian tax authorities and thus qualifies as a resident under the Tax Treaty seeks to avail itself of protection? The Tax Treaty covers taxes both on income and capital. In the case of Cyprus, it covers personal and corporate income tax, special contribution to the defence fund, capital gains tax and immovable property taxes. In the case of Russia, it covers income tax for individuals and corporations and taxes on property of individuals and corporations.

Corresponding with the OECD Model, under the Tax Treaty, the term "permanent establishment" (PE) is defined as a fixed place of business through which the business of an enterprise of one Contracting State is wholly or partly carried on in the other Contracting State(Article 5, para.1). The definition set out in para.1 of Article 5 contains the following conditions for the creation of a PE:- (1) the existence of a "place of business" i.e. a facility such as premises or, in certain instances, machinery or equipment; (2) the place of business must be "fixed," i.e. it must be established at a distinct place with a certain degree of permanence; (3) the carrying on of the business of the enterprise through this fixed place of business which means that the persons who are dependent on the enterprise (personnel) conduct the business of the enterprise in the State in which the fixed place is situated. A building site, construction, assembly or installation project constitutes a PE only if it lasts for more than 12 months (Article 5, para.3).

Under the Tax Treaty, the profits of an enterprise of one State will only be "taxable in that State, unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein". The attribution of profits to the PE should then take place as if the PE were a distinct and separate enterprise, "dealing wholly independently with the enterprise of which it is a permanent establishment" (Article 7, paras. 1 and 2). The force-of-attraction principle thus applies to business income from a PE, except if the enterprise can show that the sales in question were not made in order to derive benefit from the treaty. Royalties and other payments, etc., are specifically excluded from the computation of the income that is attributed to the PE, and so is the interest. Head office overhead expenses will be allowed as deductions in computing the taxable profits of a PE assuming that they can be reasonably attributed to the PE. This treatment is in line with the OECD Model.

Profits from the operation of ships or aircraft in international traffic are taxable only in the country where the residence of the enterprise is located irrespective of the existence or not of a permanent establishment in the other country. "International traffic" is defined in Article 3(1)(g) to cover any transport by ship or aircraft or road vehicles operated by a resident of a Contracting State, except when the transport is operated solely between places in the other Contracting State. In line with the conditions used in the OECD Model, Article 9 of the Tax Treaty requires that transfer pricing between affiliate or related companies must be carried out at arm’s length. Otherwise, an adjustment can be made by the tax authorities.

The dividend withholding tax rate in Russia is, in principle, 15 per cent. This rate is reduced to 5 per cent of the gross dividends if the beneficial owner has invested directly in the capital of the company paying the dividends US$100,000. In all other cases, the rate is 10 per cent (Article 10 of the Tax Treaty). The term "beneficial owner" is not defined in the Tax Treaty; the Commentary, however, to the 1977 OECD Model says that "the limitation of tax in the State of source is not available when an intermediary, such as an agent or nominee, is interposed between the beneficiary and the payer, unless the beneficial owner is a resident of the other Contracting State." It should be noted that Cypriot companies which are owned 100 per cent by non-Cypriots and derive their entire income from non-Cypriot based sources commonly referred to as Cypriot international business companies ("IBCs") are not subject to any dividend withholding taxes by virtue of domestic law. IBCs are subject to corporate tax at the rate of 4.25 per cent on their taxable profits. By virtue of Article 24 ("the Elimination of Double Taxation Article") the Cypriot corporate tax will be credited against the Russian dividend withholding tax with the result that no further Cypriot taxation is suffered.

Furthermore, withholding tax on interests is, in principle, 15 per cent in Russia. Under the Tax Treaty, this withholding tax is reduced to nil (Article 11). This agrees with the OECD Model. The term "interest" in Article 11 includes income from bonds, debentures and securities. Royalty withholding tax is levied in Russia at a rate of 15 per cent. This is reduced to nil under the Tax Treaty (Article 12). The definition of the term "royalties" concurs with the OECD Model. It is defined as "payments of any kind received as a consideration for the use of, or the right to use, any copyright or literary, artistic or scientific work including cinematograph films and recordings for radio and television broadcasting, any patent, know-how, computer programs, trade mark, design or model, plan secret formula or process, or for information concerning industrial, commercial or scientific experience". Articles 11(5) and 12(5), following the basis of the OECD Model, contain an anti-avoidance, arm’s length rule: where, by virtue of a "special relationship" between the payer and the payee of the interest and royalties, the amount of interest or royalties exceeds that which would be payable between parties at arm’s length, Articles 11 and 12 will only apply to such amount as would have been paid between unrelated parties. Cyprus does not levy withholding tax on either interest or royalty payments by IBCs.

The general rule [contained in Article 13(4)] is that gains from the alienation of property are only taxable in the state of which the alienator is resident: to this rule there are exceptions for immovable property [Article 13(1)] and the property of a permanent establishment or fixed base [Article 13(2)]. Article 13(3) unlike the other two exceptions to the general rule, grants the exclusive right to tax gains from the alienation of ships, aircraft and related property to the state where the alienator is resident (in line with the taxation of income from shipping, aircraft, etc., in Article 8). Income derived by a resident of a Contracting State in respect of professional services, etc. may only be taxed in the state of residence unless he has a fixed place regularly available to him in the other state or the stay in the other Contracting State exceeds 183 days in any 12-month period which begins or ends in the fiscal year in question (Article 14 of the Tax Treaty). Article 15(1) provides that the state of residence of a taxpayer should have the exclusive right to tax income from employment, unless the employment is exercised in the other Contracting State in which case the state where the employment is exercised may also tax such remuneration as is derived therefrom.

However, remuneration in respect of employment exercised in the other Contracting State is exempt there (and therefore taxable only in the state of residence of the employee) if three requirements are all met: (1) the employee is present in the other state for a period or periods not exceeding 183 days in the fiscal year concerned; (2) the remuneration is paid by, or on behalf of, an employer who is not resident in the state where the employment is exercised; and (3) the remuneration is not borne by a permanent establishment or fixed place of the employer in the state where the employment is exercised. In accordance with Article 19 pensions and other similar remunerations are only taxed in the country where they are paid from.

Double taxation is eliminated by giving a credit of the tax withheld in the other state against the tax payable in the country of the recipient of the income. However the tax credit cannot exceed the amount of the tax payable in the country of residence of the recipient. In the case of Cyprus, in respect of dividend income from Russia, in addition to the Russian withholding tax, tax credit is also given for the underlying tax on the profits out of which the dividends are paid. Moreover, tax paid in Cyprus on income or capital which is also taxable in Russia is deducted from tax payable in Russia on the same income or capital. In Russia, the credit method has been adopted as the method of choice to eliminate double taxation. Article 23(3) contains tax sparing credit provisions which allow for a credit to be granted in Cyprus in respect of Russian taxes which Russia could have imposed but which the Russian tax payer has been spared due to incentive legislation. Article 24 of the Tax Treaty corresponds substantially with the non-discrimination article of the OECD Model. Article 24(1) prevents nationals of one Contracting State from being subjected to any taxation which is more burdensome than that imposed on nationals of the other Contracting State in the same circumstances. Article 24(2) concerns the situation where an enterprise of one Contracting State has a permanent establishment in the other Contracting State-taxation is to be not less favourably levied on that permanent establishment than is levied on enterprises of the first state carrying on the same activities. Finally, Article 24(3) provides that interest, royalties and other disbursements paid by an enterprise of one Contracting State to a resident of the other Contracting State should be deductible in calculating the taxable profits under the same conditions as if they had been paid to a resident of the same Contracting State as the enterprise.

The mutual agreement procedure under the Tax Treaty is similar to that of the OECD Model (Article 25, paras. 1-4). However, the Tax Treaty contains a time limit of two years (as opposed to the three year time limit of the Model) within which the mutual agreement procedure is to commence. The exchange of information under Article 26 of the Tax Treaty is identical to the OECD Model. Hence, any information received under the Tax Treaty is to be treated confidentially, as under domestic laws. Moreover, Article 26(2) provides that no state is obliged to provide information if the provision of such information will contravene local laws or reveal industrial/ trade secrets.

The Tax Treaty is generally based on the OECD Model and continues the process of bringing Russia’s tax regime closer to western models, with increased emphasis on anti-avoidance. Cyprus’ current role as an important gateway for foreign investments into Russia is maintained and strengthened. The Tax Treaty will remain in force for at least five years after the 1st January, 1999 (as per Article 30 of the Tax Treaty).

This note is intended to provide general information about a recent development which may be of interest. It is not intended to be comprehensive nor to provide any specific legal advice and should not be acted or relied upon as doing so. Professional advice appropriate to the specific situation should always be obtained.