The termination of the Russia-Netherlands tax treaty - are you prepared?

The Russian Federation has denounced the tax treaty between Russia and the Netherlands. This means that, as of 1 January, 2022, the tax treaty between Russia and the Netherlands is no longer effective. The termination of the tax treaty can result in a significant increase of the level of taxation for mutual investments and companies in both countries.

Restructuring of cross-border business may be necessary to assure that the tax position is not severely adversely impacted. This news alert provides key insights for companies that are restructuring their Russian-owned Dutch investment structures or Dutch-owned Russian investment structures.

Background

Last year, Russia took the initiative to renegotiate its tax treaty with the Netherlands. These negotiations started after the President of the Russian Federation announced the introduction of minimum withholding tax rates on dividends and interest payments to so-called conduit jurisdictions in March 2020. From the Russian perspective the Netherlands, alongside with Cyprus, Luxembourg, Malta, Switzerland, Hong Kong and Singapore, are considered conduit jurisdictions that are used to shift profits from Russia.

On 9 April 2021, the Government of the Russian Federation announced its intention to denunciate the Russia - Netherlands tax treaty as the Netherlands has not accepted the amendments to the treaty proposed by the Russian Federation. Following the announcement, the Russian Government officially approved the denunciation of the Russia - Netherlands tax treaty and submitted a draft bill to Parliament on 12 April 2021. The draft bill was discussed and voted for by the Russian lower chamber (the State Duma) and the upper chamber of the Russian Parliament (the Federation Council). On 26 May 2021, the President of the Russian Federation signed the law and it was promulgated.

As the Netherlands has been notified about the denunciation before 1 July 2021, it follows from Article 31 of the Russia - Netherlands tax treaty that the tax treaty will cease to be effective per 1 January 2022.

Read our earlier news alert for a more detailed background about the denunciation of the Russia-Netherlands.

Impact termination Russia - Netherlands tax treaty

The denunciation of the Russia - Netherlands tax treaty will result in the following changes as of 1 January 2022.

Withholding tax rates: Dividends, interest and royalty payments will be subject to substantial higher withholding tax rates. Dividend payments made by Russian companies to Dutch shareholders are subject to a withholding tax of 15% (in certain circumstances the domestic exemption may apply). Likewise, interest and royalty payments from Russia to the Netherlands will become subject to a withholding tax at a rate of 20%. Dividend payments made by Dutch companies to Russian shareholders are subject to a withholding tax rate of 15% (the domestic exemption will no longer apply).

Note that withheld Russian withholding tax on dividends, interest and royalties will not be credited against any Dutch corporate income tax due on such income. This means that the only option available for Dutch taxpayers receiving Russian income subject to Russian withholding tax, is to deduct the withholding tax as a cost. This means the withholding tax is deductible from the taxable base as costs as opposed to deductible from the tax payable (which would be the case if there would be a tax credit available).

Capital gains on shares in real estate companies: Capital gain from the sale of shares in so-called qualifying real estate companies (i.e. companies whose assets consist directly or indirectly for more than 50% of real estate property located in Russia) will be subject to Russian tax.

Dual resident entities: The termination of the Russia - Netherlands tax treaty may also impact so-called “dual resident” entities which are tax residents in both jurisdictions. In the absence of the tax treaty, dual resident companies can no longer rely on the tax residency tie-breaker rule and could be faced with double taxation.

Russian domestic issues: Companies should also review the potential implications as a result of the possible inclusion of the Netherlands by the Russian Ministry of Finance on the blacklist of jurisdictions (Order of the Russian Ministry of Finance of 13 November 2007 No. 108n). Inclusion of the Netherlands on this list may result in a denial of various Russian tax benefits for Russian taxpayers, such as (i) participation exemption for dividends received from abroad, (ii) exemption with respect to the property received free-of-charge and (iii) exemption with respect to the sale of shares in Russian entities.

Unilateral prevention of double taxation: Double taxation resulting from the absence of a tax treaty could be mitigated by the application of unilateral tax rules aimed at the avoidance of double taxation. The unilateral Dutch tax rules to prevent double taxation consist amongst others of the Dutch participation exemption for qualifying participations or the Dutch base exemption for qualifying permanent establishments. Furthermore, the Dutch Double Tax Avoidance Decree 2001 can be invoked under certain conditions to prevent double taxation. In particular for individual taxpayers e.g., a Dutch businessperson (natural person) who realizes a profit with the help of a permanent establishment in Russia, or a Dutch employee who receives a salary for work performed in Russia.

Corporate restructuring may be needed

The termination of the tax treaty between Russia and the Netherlands has invoked uncertainty for businesses as double taxation may arise, considering no tax treaty protection will apply. Although, unilateral relief of double taxation via application of the participation exemption or possible tax credit may be sufficient for certain specific structures, restructuring is needed for most companies to prevent double taxation.

Commercial considerations and objectives are paramount when revising the corporate structure. Companies also need to examine the legal and tax considerations beforehand, to prevent potential business disruptions due to legal or tax constraints. By acting accordingly a commercial restructuring plan can be achieved that works from a legal and tax point of view.

What are the tax implications of restructuring your business?

The key Dutch tax considerations are:

Disposal of subsidiaries: The Netherlands is a well-known holding jurisdiction due to its participation exemption. Therefore, it is most likely that corporate restructurings also consist of transferring the ownership of (Russian) subsidiaries held by a Dutch holding company. Capital gains income related to the transfer of qualifying subsidiaries should be fully exempt from Dutch corporate income taxation on the basis of the participation exemption.

Distribution in kind (of business assets): In principle, dividend distributions made by a Dutch company are subject to 15% dividend withholding tax. Reduction of the dividend withholding tax to 5% is still possible on the basis of the Russia-Netherlands tax treaty. A full exemption of dividend withholding tax is possible under the domestic dividend withholding tax exemption. One of the main conditions of the exemption is that the shareholder is a treaty resident of a jurisdiction that has concluded a tax treaty (that includes a dividend article) with the Netherlands. As this is still the case, Russian shareholders are in principle still eligible to claim the full domestic exemption until 1 January 2022. Note that the exemption does not apply if the interest in the Dutch entity is held with (one of) the main purpose(s) to avoid Dutch dividend withholding tax and an artificial arrangement is in place.

Read our news alert about the dividend withholding tax exemption.

Debt forgiveness: Corporate restructuring usually includes restructuring of outstanding intra-group loans. For a Dutch debtor company, generally, any waiver of existing debt as a result of a restructuring should result in a taxable profit at a corporate income tax rate of 25% (2021 rate). However, a specific exemption may apply to the extent that the cancellation took place as a result of a genuine non-recoverability risk of the debt. In regard to a Dutch creditor, he is allowed to take a tax deductible write-off on any non-recoverable part of an outstanding receivable as part of any debt restructuring.

Winding up Dutch company: Reorganizations that lead to winding up of a Dutch company via a liquidation leads to a tax settlement for its tax obligations. In general, the winding up of a Dutch company that merely functions as holding or financing company should not trigger a (significant) tax settlement.

Transfer pricing aspects: A business restructuring could entail a cross-border transfer of valuable assets (e.g. intangibles) or the termination or substantial renegotiation of existing arrangements (e.g. manufacturing arrangements and distribution arrangements). Such business restructuring may have transfer pricing consequences, such as whether the business restructuring would lead to a form of compensation payment/indemnity to the restructured entity and, if so, what would constitute an arm's-length compensation payment. Companies need to properly document and describe the business restructuring activities within the group to avoid potential discussion with the tax authorities.

Reportable transaction (DAC6): The transaction process of a corporate restructuring may qualify as a reportable scheme under the EU Directive on European Mandatory Disclosure rules (MDR). The main tax features of a cross border restructuring may fall into Hallmark E2 covering arrangements involving the transfer of hard-to-value intangibles and/or hallmark E3 covering arrangements involving an intragroup cross-border transfer of functions, risks or assets resulting in a decrease of 50% of the EBIT of the transferor. Although the reporting requirement primarily lies with intermediaries, there are many scenarios in which companies also have filing obligations. Companies need to actively manage their reporting obligations in relation to their corporate restructurings.

The key Russian tax considerations are as follows:

Corporate restructuring: There are currently no unified solutions allowing one to restructure Russian investments owned by a Dutch group in order to mitigate the negative effect of termination of the double tax treaty. None of the existing tax opportunities are effectively risk-free. From a Russian tax perspective, potential measures may, inter alia, include the following:

• Moving a parent company from the Netherlands to another jurisdiction, which may be more favorable in terms of taxation for relations with the Russian Federation. However, aside the Dutch exit tax, compliance with the Principal Purposes Test (PPT) must be carefully reviewed ahead of time as Russia joined the MLI and must follow minimum standards, including the PPT test for the purposes of applying double tax treaties with other jurisdictions.
• Tax migration (transfer of the effective management of a company from the Netherlands to another jurisdiction, resulting in a change of tax residence while the company legally remains incorporated in the Netherlands). This option appears to be challenging from a Russian tax perspective, as, in addition to the double tax treaty compatibility for tax residency requirements, the Russian tax authorities may exercise a onerous view on where the effective management is arranged, and in complex situations disallow benefits of the “migrated” treaty on arbitrary grounds. It appears that this opportunity may be more attractive for companies that receive their main income from specific passive income activities (provision of SaaS services, licensing, etc).
• If the company receives income from active business in Russia, the entire income flow can be transferred to a branch office with the idea to replace the subsidiary with a branch in the Russian Federation. This option should be carefully reviewed, as for passive income it would not provide a substantive tax advantage.
• Application of a “look-though” approach to the distribution of passive income is another option, whereby a Dutch company would waive the beneficial ownership status on dividends and/ or other passive income (as the case may involve) from a Russian subsidiary in favor of its upper corporate tier or other group entity in the country with the effective double tax treaty. This option should be carefully analyzed subject to all practical circumstances and history of the corporate and contractual set-ups, as self-initiated “look-through” strategies have been very difficult in Russia as a practical matter.

The existing tax environment in Russia suggests that for the options described there is no ”one-size-fits-all” restructuring solution. However, it is worth thinking about financial flows and transactions for future years and review opportunities now to be prepared, before the treaty is formally ineffective.

PPT Impact: In all restructuring scenarios businesses should consider the Principle Purpose Test (PPT) under the MLI. According to PPT, all restructuring steps and the choice of the new jurisdictions shall be dictated by sound business reasons.

This is particularly relevant in light of the recently re-enforced Russian GAAR which assumes, inter alia, that if Dutch companies continue to receive income from Russian sources indirectly through companies in the EU or other jurisdictions with effective double tax treaties with Russia, a treaty relief and reduced withholding tax rates will be challenged under beneficial ownership rules.

Actions for dividends to be taken in 2021: If there are accumulated, retained earnings on the balance sheet of a Russian company, then it is worth accelerating dividend distribution by the end of 2021.

License restructuring: With respect to license structures, parties may consider the change of the rights holder and/or economic owner of the license income of a Dutch entity to some entity of a group that may be considered a beneficial owner of income. It is necessary to ensure that new entities perform the DEMPE functions in relation to an IP object. This should allow parties to avoid 20% withholding tax on license payments in Russia. This may be relevant for regular license agreements or electronic services and SaaS arrangements.

Restructuring of debt financing: Similarly to license transactions, parties may consider restructuring their debt financing agreements in order to be excluded from 20% withholding tax on interest remitted from Russia to the Dutch entity - recipient. In this case parties need to confirm that the new lender shall be viewed as the true beneficial owner of interest income in the eyes of the Russian tax authorities.

CFC implications: Another important change will follow for the preparation of documents necessary for reporting to controlled foreign companies in the Russian Federation. Previously, financial statements of a Dutch company would not have to be audited (unless required by the company's domestic regulations). Now auditing of the financial statements of a Dutch company will become mandatory, as only those controlled foreign companies, registered in countries that have a double tax agreement with the Russian Federation, are exempt from the audit opinion as part of their CFC reporting. This may not be a particularly important change for certain CFC controlling persons, as in practice Russian taxpayers prefer to provide the Russian tax authorities with audited financial statements in all cases.

That said, as a result of the treaty denunciation certain Russian CFC profits exemption rules would not apply to the profits of a Dutch company treated as a CFC for Russian purposes (e.g. effective tax rate exemption, financial institute exemption).

Should you have any question or would like to discuss the impact of the termination of the Russia - Netherlands tax treaty on your business, please contact one of the authors of this article or your regular contact within DLA Piper.