By Roustam Vakhitov, International Tax Partner, Crowe Expertiza, Moscow
On June 7, the Dutch government received the Russian government’s notice of intent to terminate the double tax treaty between the two countries, following a failure to reach agreement on a revised treaty. The negotiations marked Russia’s fourth recent attempt to revise the terms of its existing tax treaties and its first failure to do so.
The years 2020–2021 will be remembered in Russia not only as years of the pandemic, but also years marked by the radical revision of the Russian agreements on the avoidance of double taxation with Cyprus, Luxembourg, Malta and the Netherlands. These are relatively small countries by Russian standards, at least by size, although the Dutch GDP is close to two-thirds of the Russian GDP. But they are associated with a large volume of foreign investment into the Russian economy.
The list continues: Singapore, Switzerland, and Hong Kong are next in line. It is difficult to predict where this process will end and whether the next round of tax treaties will require revision, but one can try to make reasonable assumptions.
New tax treaty policy
In a memorable speech on March 25, 2020, President Vladimir Putin announced the necessity to revise a number of Russian tax treaties. Soon the parameters of the revision were announced – an increase in the dividend withholding rate to 15%, while retaining a reduced 5% withholding tax for public companies, and an increase in the interest rate from zero to 15%. Negotiations began, which were not always easy. In the end Malta, Cyprus and Luxembourg agreed to the Russian terms. The Netherlands did not.
Some commentators say there are not many real Cypriot and Luxembourgish businesses independently investing in Russia. Often this is about taxation of Russian investments passing through these countries.
The situation with the Netherlands is different: there are many real Dutch businesses operating in Russia. The Dutch newspaper NRC has estimated the amount of real investments of Dutch businesses in Russia in recent years at a level of EUR 10–20 billion (approximately USD 11.8–23.6 billion). This is without taking into account the “transit” companies. It was unacceptable to triple the dividend withholding tax rate for such businesses in Russia, at least from the Dutch perspective, especially taking into account that the Netherlands would normally not tax dividends paid to Russian corporate shareholders.
For the Dutch budget, the absence of a tax treaty is technically advantageous. Russian recipients of Dutch dividends will start paying 15% tax on dividends in Holland after the agreement is terminated. And it was unacceptable for political reasons to accept rather harsh conditions, unilaterally beneficial to Russia. At the hearings in the Dutch parliament, members were surprised by Russia’s intention to keep reduced rates for large and state-owned companies and increase taxes on medium and small companies, which, from the Dutch tax policy perspective, should be the primary recipients of benefits and support measures. Further, the Dutch newspaper NRC has wondered why it would make sense for Russia to increase the tax rate on dividends to 15% for groups such as Yandex, X5, Veon, and a number of others. After all, this will reduce the income of Russian investors by exactly these amounts.
Reference to possible abuse is not entirely convincing, as both countries may use a wide range of measures to combat tax evasion, under the multilateral instrument of BEPS.
A technical solution that satisfies the interests of both parties could be the maintenance of preferential rates for Dutch residents, subject to the fulfillment of the so-called limitation of benefits test. This would grant benefits to a company if it can prove that its real owners are Dutch residents. This option appears to have been rejected by the Russian side as well. Following the notice of termination in early June, the termination of the tax treaty takes effect as of 2022.
The most important question arises: will the declared goals be achieved – closing the channels of withdrawal of money from Russia to low-tax jurisdictions?
To answer this question, just look at the blossoming offers to move companies from the Netherlands to jurisdictions with double tax treaties with Russia with beneficial withholding rates.
What’s next?
Perhaps negotiations with Singapore and Hong Kong could be conducted according to the Cypriot scenario, but Switzerland, for example, has serious investments in Russia. For this country, like the Netherlands, there will be issues of raising withholding tax rates for genuine Swiss businesses. And if the tax agreement is terminated, Russian investors will be subject not to a 15% Dutch dividend withholding tax rate, but to a much heavier 35% Swiss tax on dividends.
And termination of the Swiss double tax treaty for Russia, according to many commentators, would be like a shot in the second leg. The cost of terminating the Dutch tax agreement in terms of image and investment losses – stability and predictability of business conditions for foreign investors, predictability of the investment climate – is quite heavy already.
In any case, tax treaties with a large number of countries with the 5% dividend withholding tax rate are unlikely to be quickly renegotiated – starting from Germany and not ending with Austria and Montenegro. Obviously, the “circuit “designers” will focus on a number of such beneficial tax treaties conventions.
At the same time, the question will inevitably arise: why Lithuanian, Swedish, Austrian, Finnish, Qatari and investors from a couple of dozens other countries will be entitled to a 5% Russian withholding tax rate on dividends, while Dutch and Swiss pay 15%.
Strictly speaking, even now there is no legal possibility of applying reduced rates in the absence of real business and real investments; this is just about enforcing anti-avoidance measures. Therefore, the solution is not with raising rates under double tax agreements, but in building a system for detecting and combating tax abuse. The Russian tax authorities already have the necessary tools within the framework of both national legislation and international agreements (BEPS, etc.).
But these measures need to be enforced, and raising tax rates – either through revising tax treaties or terminating them – does not help to reach this goal. For years, dozens of other agreements with low withholding rates will remain, and tax dodgers will jump from one to another, transferring “holdings” from the Netherlands to, for example, Montenegro and Latvia, and from there further on. Real Dutch businesses though will face a decrease in profitability due to increased tax rates and may be less interested in investing in Russia while tax incentives for investing in neighboring Belarus, Ukraine and Kazakhstan are much more attractive.
Therefore, such measures as increasing tax rates in double tax treaties or terminating them will be counterproductive – not solving key problems but giving rise to new ones.
The Russian tax authorities have experience in effectively solving the problems of massive tax avoidance and tax evasion, e.g., in respect of VAT, artificial splitting of businesses to obtain tax benefits for small and medium enterprises, and fighting the shadow economy. If the purpose of preventing the abuse of international tax agreements is set, I am sure it can be solved without punishing real investors – which in the meanwhile have already started suffering negative consequences (e.g., Gazprom already closed its businesses in the Netherlands).
Cross-border businesses need to be patient for a couple of years, carefully evaluate the impact of the changes and not make rash attempts to “resolve the situation” through migration solutions. Such attempts are easily tracked, can be easily challenged and will not be effective. It is wiser to wait for a new Russian-Dutch double tax treaty, which, hopefully, will be signed in the not too distant future.
—Roustam Vakhitov is an International Tax Partner at Crowe Expertiza, Moscow.
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