Stakes in Foreign Companies: What Entrepreneurs and Investors Need to Know About CFC
i-Legal
Business owners and entrepreneurs holding shares in foreign companies often face difficulties when filing tax returns. Our expert helps navigate the practical aspects of applying the "Controlled Foreign Companies Law". As investment culture develops in Russia, an increasing number of individuals are investing their capital in innovative startups and other private companies by acquiring shares in foreign legal entities. Currently, such investments can be broadly divided into two types: investments in foreign public companies and ownership of shares in private foreign companies. Both types have their own regulatory specifics. In the first case, the regulator in Russia has delegated most functions to the brokerage firm through which individuals purchase exchange-listed shares of foreign companies. In the second case, the private investor must independently understand the relevant specifics and ensure compliance with Federal Law No. 368-FZ, concerning the regulation of controlled foreign companies (CFCs) in the Tax Code, also unofficially referred to as the "CFC Law," the latest amendments to which came into force at the end of 2020.
I own shares in a private foreign company — what should I do?
First and foremost, you need to know and remember that when acquiring or participating in the establishment of a foreign company, if the ownership stake exceeds 10%, you must file a notification with the tax authority within three months. Subsequently, you must carefully monitor any changes in the size of your share in the authorized capital. There are cases when, as a result of corporate restructurings, the ownership stake may increase or, conversely, be diluted. Even if your stake was less than 10% at the time of the initial investment, it may increase in the future. In the event of a change in ownership stake, a change in the manner of participation without a change in ownership stake, or upon termination of participation, the tax authority must be notified within three months of the date of the relevant event. If your ownership stake in a foreign company exceeds certain thresholds established by law, additional obligations will arise, which we will discuss below.
What is a CFC?
CFC, or controlled foreign company — is a term referring to a company incorporated under the laws of another country but fully or partially controlled by Russian persons. Such companies are quite often established, for example, by major Russian entrepreneurs and startup founders for operations outside of Russia, at the request of one of the investors (more often of foreign origin), in the presence of foreign divisions, for the benefit of a favorable tax regime, or even to protect their business from political or other risks. Let us examine what a CFC is from a legal standpoint, who qualifies as a "controlling person" of a CFC, what obligations this imposes, and how to bring your investments in private foreign companies into compliance with existing requirements.
The CFC Test
CFC status applies to companies controlled by tax residents of the Russian Federation (controlling persons), as the controlling person holds a legally established share of direct or indirect participation (participation criterion), or exercises control over a foreign company (control criterion). Under the participation criterion, a controlling person is recognized as a Russian tax resident whose direct or indirect ownership stake in a foreign company exceeds 25%. A controlling person is also recognized as one whose stake is less than 25% but exceeds 10%, provided that Russian tax residents collectively hold more than 50% of the participation in such a company. Under the control criterion, a controlling person is one who has the ability to influence the distribution of profits of the relevant foreign company. For instance, if the company's documents stipulate that dividend distribution is possible only with the consent of a particular shareholder, despite that shareholder holding just 1%. In practice, this is possible, for example, when the relevant shareholder holds an active option to acquire a controlling stake in that foreign company, or when ownership is registered under a nominee shareholder with a trust declaration. It is important to note that controlling person status in Russia is determined on the basis of tax residency, not citizenship. If an individual is not a Russian tax resident, the "CFC Law" does not apply to them. Currently, such status in Russia is determined based on the individual's actual presence on the territory of Russia for at least 183 days per year. There may be nuances here. For example, in our practice there was a case involving an individual who, under Russian Federation rules, was a tax resident of Russia, and simultaneously was a tax resident of Estonia under Estonian law. In such cases, the provisions of double taxation avoidance agreements are typically applied, provided that such an agreement has been concluded between the Russian Federation and the relevant jurisdiction and ratified by both parties. However, as noted above, each case has its own nuances — for example, there is no such agreement with Estonia. When determining the aggregate share of control by Russian persons, not only direct but also indirect participation is taken into account. This is because a person may own foreign companies not directly but through participation in other companies. For example, a Russian citizen who is a tax resident of Russia owns 11% of shares in a Cypriot company. The remaining shareholders are foreign individuals and legal entities. It seems everything is fine — we have not exceeded the thresholds. But, for instance, one of those shareholders who owns 60% of shares is an offshore company whose shareholder is another Russian tax resident, and this completely changes the situation. From this, another important practical conclusion can be drawn: to avoid breaking the law, you need to thoroughly study information about your partners.
CFC Test Is Positive
So, it has been determined that you are a controlling person of a CFC. In this case, in addition to the requirement to notify about ownership of shares in a foreign company mentioned above, the law establishes the following obligations: First, you must file an annual CFC notification. Individuals must do so by April 30 of the year following the year in which the individual recognizes income in the form of CFC profits. According to legislative provisions, the controlling person recognizes income in the form of CFC profits in the tax period following the CFC's financial year. For example, if the CFC's financial year is January 1, 2020 — December 31, 2020, the individual recognizes income in the form of CFC profits in 2021 based on the CFC's financial statements for 2020, and accordingly, the CFC notification must be filed no later than April 30, 2022. There are also a number of nuances in calculating CFC notification deadlines that should be considered in each individual case. Second, together with this notification, you must submit documents confirming the amount of profit, the absence thereof, or the CFC's loss. Such documents are typically the company's financial statements (or, in their absence, other supporting documents) and an audit report, if an audit is mandatory for the company. The necessity of an audit is determined by the rules of the country of incorporation but may also be conducted voluntarily. The tax authority "prefers" to receive audited financial statements — they always inspire greater confidence, especially in disputed situations. Third, in addition to the above, the tax authority has the right to request any additional information, and you are required to provide it within one month. In practice, this is an extremely important point, the violation of which may result in the imposition of a substantial fine. In this regard, we try not to let it come to such a request and proactively provide the maximum number of documents: for example, if the basic document package does not clearly indicate the amount of the CFC's profit or loss. It is also useful to remember that, if necessary, you can approach the tax authority for clarifications — this may be relevant, in particular, for clarifying legislative requirements or determining the format for submitting reports in your specific situation. At present, not all tax inspectorates have specialized experts in this area, but their number and qualifications are growing with each reporting period.
Taxes
There is a comprehensive set of rules for taxing controlling persons. As a general rule, tax must be paid to the Russian budget on CFC profits if the amount of such profits for the financial year exceeds 10 million rubles. It is critically important that in this case, tax is paid on the entire amount of the CFC's profits in proportion to the controlling person's ownership, and not just on the amount exceeding the specified threshold. The tax rate for a controlling individual is the standard rate, which currently stands at 13% or 15% depending on their total income for the corresponding year. To simplify, taxation applies to profits of companies whose primary source of income is passive income, such as dividends, loan interest, royalties, as well as income from activities such as advertising and consulting services. Profits of so-called active foreign companies are exempt from taxation. In addition, if a foreign company is registered in a non-low-tax jurisdiction with which Russia has a double taxation avoidance agreement, or if the foreign company is established under the laws of a EAEU member state, it also does not fall under CFC taxation. At the same time, for tax purposes, CFC profits do not include, for example, dividends paid by the CFC, and tax paid in a foreign state on the CFC's profits, in proportion to the controlling person's ownership stake. Losses of prior years (according to financial statements) may also reduce the taxable base; however, it is critically important that prior-period losses can only be carried forward for the purposes of determining CFC profits if the controlling person filed a CFC notification for the financial periods in which such losses were recorded. There is also the option of paying tax on a fixed CFC profit. Upon voluntarily transitioning to this scheme, the controlling person pays personal income tax on a fixed amount of 34 million rubles (38.46 million rubles for the 2020 tax period), regardless of how many CFCs the controlling person holds that status in. In this case, the assessed tax amount is also fixed at approximately 5 million rubles. It should be noted that paying personal income tax on fixed profits does not exempt one from the obligation to annually file CFC notifications; however, there is no need to attach the CFC's financial statements to such notifications. A more detailed description of the principles for forming the taxable base for CFCs can be found in the explanations and diagrams on the Federal Tax Service website, where they are quite well described. From a practical standpoint, several additional points are worth noting. When calculating CFC profits in rubles for the purposes of submitting information to the tax authority, it is necessary to correctly determine the foreign currency exchange rate against the ruble. This becomes especially important when the CFC's profit level is near the 10 million ruble threshold, as was the case with one of our clients. The rate should be determined as the arithmetic average of the foreign currency-to-ruble exchange rate set by the Central Bank of the Russian Federation for all days in the corresponding period for which the financial statements were prepared. It is also worth noting that the financial year in various jurisdictions may differ from the financial year established in Russia. In this case, if the deadline for calculating corporate income tax on the foreign company in the foreign state falls later than the deadline established by the Russian Tax Code for the controlling person to pay tax on CFC profits, such tax may be taken into account when calculating the tax due from the controlling person on CFC profits for the tax period following the year in which the foreign company's income tax was assessed in the foreign state.
What If... Fines and Other Nuances
Until 2021, failure to file a CFC notification on time was penalized with a fine of 100,000 rubles. However, this year it was increased to 500,000 rubles (Article 129.6 of the Tax Code). The same amount must also be paid for financial statements not submitted on time (Clause 1.1 of Article 126 of the Tax Code). Despite the relatively modest amount (50,000 rubles for each foreign company), it is important to remember that a separate fine is imposed for failure to notify about participation in a foreign company (not to be confused with the CFC notification mentioned above!). This fine also applies to each instance of failure to notify the tax inspectorate about a change in the size of the share, the manner of participation, or termination of participation in a foreign company. The largest fine is imposed for failure to provide additional information requested by the tax inspectorate within 30 days (Clause 1.1-1 of Article 126 of the Tax Code). In this case, a fine of 1 million rubles must be paid, which once again confirms the value of advance preparation and submission of the most complete set of documents to the Federal Tax Service. Finally, the tax itself must be paid by July 15. If this is not done on time, the CFC shareholder is fined 20% of the income received, but no less than 100,000 rubles. Clearly, failure to submit a notification or financial statements for just one company during a single reporting period can result in the violation of several obligations simultaneously, with a very substantial total penalty. And if you hold the required number of shares in several foreign companies, the total damages may reach several million rubles.
Nobody Will Find Out About Me
Many entrepreneurs used to think, and some continue to think, that the tax inspectorate will not discover their ownership stakes in foreign companies. However, many of our fellow citizens holding such stakes have already received and continue to receive "letters of happiness" from the Federal Tax Service. It is worth remembering that in addition to the large number of international legal assistance agreements Russia has with other countries, since 2018 the Federal Tax Service has been automatically exchanging tax information with 75 countries and 13 territories worldwide. The full list can be viewed here. Accordingly, the Federal Tax Service has sufficient sources of information, and data from them reaches the tax authorities very promptly. In addition, tax authorities can exchange information on the basis of individual requests. It is noteworthy that it is not only the Federal Tax Service that monitors compliance with Russian CFC legislation. Recently, a Swiss bank asked the shareholders of one of our client companies to provide evidence that the Russian tax authorities had been duly notified by the beneficiaries about the CFC serviced by that bank. So far this is the first such case in our practice, but it may well not be the last.
