Tax manoeuvre for the Russian it sector

Following the speech by the President on 23 June 2020 about far-reaching support measures for the Russian IT sector, in little less than a month, the Government prepared and introduced to the State Duma draft law No. 990337-7 “On Amending Part Two of the Tax Code of the Russian Federation (to the Extent Related to Supporting Organisations Doing Business in the Area of Information Technology”.

On 31 July the federal law No. 265-FZ was signed by the President and officially published.

Reduction of the profits tax rate and insurance contributions

Key Changes

The law provides for the following tax incentives to stimulate and support the IT sector:

• a reduced rate of profits tax from 20% to 3%;
• a reduced rate of insurance contributions from 14% to 7.6%.

Qualifying Activity

Russian IT companies may be entitled to the reduced profits tax rates and rates of insurance contributions, if they carry out certain qualifying operations carried out either on a stand-alone basis or in combination. Specifically, the qualifying activity covers the business activity by the companies operating in the area of information technology that are engaged in:

• developing software and databases (SW and DB);
• selling SW and DB they developed (own SW and DB);
• rendering services related to the development, adaptation, modification, installation, testing and maintenance of SW and DB; and/or
• performing operations related to the research and development of electronic component based products and electronic (radio-electronic) hardware.

As to operations related to the transfer of rights to SW and DB, it is necessary to take into account that only companies that sell access to their own SW and DB will be entitled to the offered benefits. Operations involving the resale or (sub)licensing of SW and DB of third party developers may not enjoy these benefits.

Eligibility Criteria

The following requirements must be simultaneously met:

• IT accreditation. A company that carries out R&D and SW and DB Maintenance must be granted IT-accreditation with the Ministry of Communications. For R&D centres operating in the area of microelectronics and radio-electronics, inclusion on the register administrated by the Ministry of Communications is needed;
• Qualifying Income threshold. At least 90% of the total income must be earned from:
  • the sale, transfer (including through granting remote access) of exclusive rights and rights to use SW and DB developed by the company independently, including their updates and additional functionality; and/or

  • services related to the development, adaptation and modification of SW and DB and those related to the instalment, testing and maintenance of SW and DB.

    Such income threshold will be calculated on the basis of the amount of all income of the company for the reporting (fiscal) period according to tax accounts (net of FX differences and income generated as a result of the assignment of receivables relating to the developed IP assets);

• Minimum headcount. The average headcount of the relevant IT company for the reporting (fiscal) period is at least seven employees.

Advertising as an Excluded Activity

Income generated from granting rights to use SW and DB are excluded when calculating the threshold compliance, to the extent the rights relating to the functionality of such SW and DB consist of providing online advertising services. This includes the following operations:

• distributing advertising information and granting access to it,
• posting seller's/purchaser's offers in respect of goods, work and services,
• searching for information on potential purchasers /sellers and making transactions.

Use of the Rights to Software and Databases

The law provides for quite an extensive list of grounds for the application of the tax incentives. It is set out by the law that SW and DB may be made available for use and application on a material medium or provided electronically irrespective of the legal contract type.

Revising the approach to the software vat exemption benefit

VAT Exemption for the Transfer and Licensing of Rights to SW and DB

The VAT exemption of operations related to the transfer of exclusive rights to and licensing of SW and DB in the Russian Federation has been revised and the scope of it has been significantly narrowed. It applies only if both requirements are met:

• such SW and DB are included on the Unified Register of Russian Computer Software and Databases (https://reestr.minsvyaz.ru/reestr/), which currently includes more than 6,800 companies; and
• the functionality of such SW and DB does not consist of providing online advertising services as defined above.

After the law was read for the first time, the reference to a licence agreement as the only form serving as the basis for the transfer of rights to SW and DB was excluded from the provisions of paragraph 26 of Article 149 (2) of the Tax Code of the Russian Federation. Actually, the possibility to grant rights to SW and DB based not only on a "conventional" licence agreement, but on other forms of agreement as well, (including, for example, a sublicence agreement) was available earlier (as confirmed by numerous letters from the Ministry of Finance and the Federal Tax Service), however it was not expressly provided in the Tax Code of the Russian Federation, which caused controversy.

In addition, now rights to SW and DB and to their updates and additional functionalities can be transferred via cloud technologies, ie under so called SaaS and DaaS models.

Requirements for Inclusion on the Unified Register

In order to apply the benefit, the SW and DB must be included on the Unified State Register of the Ministry of Communications. The rules for the formation and maintenance of the register are regulated by Article 12.1 of Federal Law No. 149-FZ of 27 July 2006 “On Information, Information Technology and the Protection of Information”. For these purposes it is required that:

• the exclusive rights to SW and DB belong either to a Russian citizen, or, if this refers to a company which is not partially owned by state, more than 50% of shares in this company are directly or indirectly owned by Russian citizens;
• SW and DB are released into civil circulation in the Russian Federation;
• total payments under licence and other agreements on granting rights, R&D and SW and DB maintenance to foreign entities/individuals and to Russian companies controlled by them, and to agents or representatives of foreign entities/individuals and Russian companies controlled by them represent no more than 30% of the right holder's revenue for a calendar year.

To be included on the Unified Register of the Ministry of Communications, a number of documents should be submitted, in addition to the application and a copy of the SW. The list of necessary documents is not exhaustive, therefore the experts of the Ministry of Communications may request other documents, including those not expressly listed in the instructions on how to apply (https://reestr-minsvyaz.ru/instrukciya-po-podache-zayavlenij-v-reestr).

Timeframes of the New Tax Incentives

Article 3 of the federal aw provides for a standard approach to the codification of these changes. The suggested changes are scheduled to enter into force on 1 January 2021, and at present it is proposed that these measures will remain in place indefinitely. Accordingly, they should not be limited by any timeframes stipulated in relation to certain support measures under the National Economic Recovery Plan.

Practical Issues and Additional Questions

Although this law describes the terms and conditions for the application of these measures in sufficient detail, some issues remain unclear and trigger a discussion from the perspective of their practical implementation, namely:

• First, given that stringent eligibility criteria are set for IT companies and R&D centres operating in the area of microelectronics and radio-electronics to qualify for these support measures, will the tax authorities treat a corporate spin-off or de-merger or the establishment of a new entity for such purposes as a business split which is tax-driven and lacks a business purpose?
• Second, where foreign parties pay remuneration to an affiliated Russian service provider, will such foreign companies, for withholding tax not to be imposed on them, need to have confirmation that the Russian service provider has the necessary economic substance, other than the minimum headcount, to carry out SW sales and provide SW development, implementation and maintenance services? In what scope and how elaborately will the risks and functions of the Russian service provider be analysed? Could such commercial relations be deemed to have no business purpose and be necessary only for shifting profits to a low-tax jurisdiction (meaning the Russian Federation in this case) and will it be deemed that a Russian company does not effectively have sufficient DEMPE functions to carry out such operations?
• Third, given that changes to the VAT benefit did not affect the operations related to the licensing and transfer of exclusive right to inventions, utility models, industrial designs, integrated circuit topographies, and importantly, know-how, and these intangible assets (intangibles) were moved to a newly introduced separate paragraph 26¹ of Article 149(2) of the Tax Code a question arises: how should the operations involving the transfer of rights to SW and DB and other intangibles under one single contract be classified if SW and DB and other intangibles are all bundled together as part of the combined rights to know-how?
• Equally important to take into account how these support measures will affect innovation centres and technology and development special economic zones (SEZ) and their residents. In particular, may, for example, a Skolkovo resident company take advantage of these incentives or will, for example, innovative centres and technology and development SEZ be offered new benefits (and, if so, what benefits) to retain / attract residents? This is worth considering because, due to the restrictions set by the regimes of the SEZ and innovative centre, applying for the proposed benefits may in fact turn out to be a simpler solution.

• And last, but not least, as the President said in his speech (and as it is specifically emphasised in the Explanation Note to the law), the proposed rate of profits tax "will be effectively one of the lowest tax rates in the world", but considering the Federal Tax Service's intentions and active steps towards strengthening their presence on various international platforms jointly with the tax administrations of other countries, how will the proposed measure be treated, for example, by the Organisation for Economic Cooperation and Development ("OECD") and would it not be qualified as a measure allowing aggressive tax planning?

  To be more specific, according to the Global Anti-Base Erosion (GloBE) Proposal that was put forward for discussion by the OECD in 2019, in order to prevent the taxation of profits of international companies below the permitted level, it is suggested under Pillar Two of the proposal that a minimum corporate income tax rate should be set and that profits of international companies should not be taxed at a lower rate. If a Russian company of an international holding structure is subject to taxation in Russia at a rate below such a minimum rate (which is under discussion now), can the payments made by the foreign related entity to such related Russian company be not recognised as tax non-deductible or, in the case of royalties and licence fees, attract withholding tax in the source country?

Conclusion

Despite its uncertainties and perceived complexities and setting aside the downsides of the VAT exemption for cross-border transactions, it is believed that the new law, which is in general quite favourable, should definitely be strongly sought after by Russian business, as it grants massive tax opportunities for both domestic and international tax structuring in a way allowing one to take advantage of the offered benefits in the best possible manner. However, an extensive analysis of these opportunities from the perspective of tax and non-tax factors needs to be conducted - including subject to intellectual property protection issues - for such structure to be effective for a long term.