Russia Tightens Tax Loophole as Kremlin Seeks to Plug Budget Gap

By Georgi Kantchev

MOSCOW -- The economic crisis sparked by the coronavirus pandemic is pushing the Kremlin to clamp down on tax avoidance and close an offshore loophole popular with Russian business, as the government scrambles to plug holes in its budget.

Starting in January, Moscow says it will begin taxing at higher rates profits that companies transfer to lower-tax jurisdictions such as Cyprus, Malta and Luxembourg, marking some of the most aggressive steps taken by Moscow in recent years to claw back tax revenue.

Until now, companies based in Russia that sent profits -- in the form of dividends or interest income -- to holding companies domiciled in those jurisdictions paid only an average of 2% tax to Russian tax authorities.

That rule originally sought to encourage foreign companies to set up business in Russia by lightly taxing profits they returned to their home countries. However, Russian companies have long used the loophole to lower their tax bill at home.

In Russia, most interest and dividend income is taxed at 20% and 13% respectively. In Cyprus, for instance, tax rates on such income can be as low as zero. The Russian government will now raise the tax on most dividend and interest transfers to Cyprus, Malta and Luxembourg to 15%. Officials expect to earn over $2 billion a year.

"We had been watching this process for a long time," said Alexey Sazanov, Russia's Deputy Finance Minister. "Of course, this situation doesn't suit us."

The changes are part of a long-term drive by President Vladimir Putin to combat financial outflows and bring Russian capital back home. The combination of coronavirus lockdowns and low oil prices hit budget revenues and plunged the country into a deep recession this year, creating "such a catalyst that pushed us to take decisive action," said Mr. Sazanov.

The cash is needed to shore up state coffers. Russia ran a budget deficit of $23 billion in the first nine months of the year as the downturn hit revenues while spending rose with increased handouts to businesses, families and the poor. The economy is expected to shrink by 4.1% this year, according to the International Monetary Fund.

"We are interested not in diverting cash flow to some other country, but in keeping these funds with us -- again, either taxed fairly or invested in development," Mr. Putin said at a government meeting in August.

The Russian move could be a precursor of similar efforts around the world, as governments will eventually need to raise new revenues to pay for the huge economic and social programs now supporting their populations during the pandemic.

Companies in many countries use profit shifting and exploit gaps and loopholes in tax rules to lower their tax bills. Rich people sometimes use offshore havens to lower their tax bill, as well as protect their wealth from political risk and capital controls, hedge against currency fluctuations and diversify their asset base.

But such practices cost $100 billion to $240 billion a year in lost tax revenue globally according to the Organization for Economic Cooperation and Development.

"What Russia is doing amounts to a hammer tactic. It's a unique approach, " said Daniel Bunn, vice president of global projects at the Tax Foundation, an independent tax policy nonprofit group based in Washington-D.C.

The changes could raise tax obligations for some major Russian businesses.

Hundreds of Russian companies are registered in Cyprus, for example. Among them are farming conglomerate Rusagro and internet group Mail.ru as well as payments provider Qiwi. O'Key Group, which has more than 160 supermarkets across Russia, is registered in Luxembourg. Russia's largest technology company, Yandex, and X5 Retail Group, the largest retailer, are both registered in the Netherlands.

Mail.ru, Qiwi and Yandex declined to comment. The other companies didn't respond to requests for comment.

"Some company clients are looking into options to change their corporate structures, move jurisdictions or return to Russia," said Rustem Ahmetshin, senior partner at Moscow-based law firm Pepeliaev Group. "But such changes are costly and take time."

The country's wealthy could also be indirectly impacted since they are often major shareholders or own such companies. However, the new law doesn't affect the large flows of Russian personal wealth that are stashed in low-tax jurisdictions, particularly in Cyprus.

The government has been trying to persuade Russian firms to return home in recent years by creating special administrative regions in Kaliningrad and Russky Island in the Far East. Known as Russian offshores, these locations offer favorable tax regimes and administrative mechanisms allowing companies to move to Russia quickly and cheaply.

The uptake so far has been slow. Some 30 to 40 companies are currently in the process of redomiciling, Russia's Deputy Economy Minister Ilya Torosov told Russian news agency Interfax last month. "Will there be hundreds of them -- yes. Will there be thousands of them -- we do not know," Mr. Torosov said.

Russian officials say they are looking to improve conditions further to stimulate more companies to come back.

"We are striving to create more attractive conditions in the special administrative regions than in Cyprus or the Netherlands after the revision of [the tax] agreements," said Mr. Sazanov, the finance official, by improving the tax and legal frameworks of these regions.

"In this case, Russian companies will have what is called a 'carrot' that will attract them, and, perhaps, they will be interested to return. We are counting on it," he said.

Write to Georgi Kantchev at [e-mail]

(END) Dow Jones Newswires

11-05-20 0714ET