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New amendments in double taxation between Luxembourg and Russia

  • Russia

    09-02-2021

    Current status of the double tax treaty

    Luxembourg-Russian DTT[1] has a long-lasting history dating back to January 1, 1998 when the DTT started to be applied by the countries. Certain provisions have long stayed unchanged. For example, the DTT has always provided exemption from taxation at source for the party paying interest income. However, as for the dividends, the DTT has not always provided parties with the most favorable 5% tax on dividend payments. Before 2014, the most profitable tax rate possible to achieve was 10% in case of 30% participatory interest and a 75 thousand EUR investment criteria were met. Later on, upon adoption of the first Protocol amending the DTT (further herein, – the 2011 Protocol), starting in tax periods following January 1, 2014, it was possible to apply a 5% tax rate on dividends.

    Also, both Luxembourg and Russia joined MLI. Starting January 1, 2021, MLI will be applied to tax at source in relations between Luxembourg and Russia. This primarily means additional attention to the principle purpose test (further herein, – the PPT) of the transaction. A 365-day-holding-rule is retained by the MLI for dividend payments.

    Thus, to date, the Luxembourg-Russian DTT has provided a 5% reduced tax rate in case of a dividend payment when 10% participatory interest and 80 thousand EUR investment criteria are met and exemption at source in case of interest payment.

    What has changed?

    On March 25, 2020, the President of Russia, Vladimir Putin, in his speech to the nation has raised an initiative to increase tax rates for dividend and interest income in double tax treaties (further herein, – the DTTs) with transit countries, through which sufficient resources of Russian origin pass. Following the issuance of the initiative, the Russian Ministry of Finance has addressed Luxembourg with a proposal on DTT’s amendment. On November 6, 2020, a new Protocol amending the Luxembourg-Russian DTT (further herein, – the 2020 Protocol) has been signed by the parties to the treaty.

    Based on Article I of the 2020 Protocol, a 5% reduced tax rate in case of dividend payment is only applicable in respect to the following recipients:

    • entities with a special status: (i) insurance institute or pension fund, (ii) the Government, a political subdivision or a local government administration, or (iii) the Central Bank
    • public companies, i. e., companies whose shares are traded on a registered stock market, provided than no less than 15% of the shares that provide the right to vote in the company are in freely circulation and that the annual 15% participation criterion in the Russian company paying dividends is met

    In all remaining cases, when paying dividends, withholding tax is withheld under the Luxembourg-Russian DTT at a rate of 15%. According to Article II of the 2020 Protocol, exemption from the source when paying interest is applicable in similar cases:

    • the recipient of the interest is an entity with a special status: (i) insurance institute or pension fund, (ii) the Government, a political subdivision or a local government administration, (iii) the Central Bank or (iv) a bank
    • interest is paid in relation to the following securities, which are traded on a registered stock market: (i) government bonds, (ii) corporate bonds and (iii) Eurobonds

    In the event interest is paid to a public company, the source withholds the tax at a rate of 5%.

    In all remaining cases, when paying interest, withholding tax is withheld under the Luxembourg-Russian DTT at the rate of 15%.

    It should be noted that the exemption from taxation at source in case of Luxembourg has not been entirely cancelled (for example, as in the case with Malta). With Malta, the maximum permissible benefit is the withholding tax rate in the amount of 5%, which is applicable in defined cases.

    When do changes take effect?

    In Article III of the 2020 Protocol, it is directly stated that the new changes take effect only upon receipt of the latest of the notifications of one of the contracting states confirming completion of domestic procedures mandatory for the 2020 Protocol to enter into force. Actual application of the 2020 Protocol takes place starting next year when such notification has been received. In Russia, the respective domestic procedures have been completed at the end of 2020 by means of respective law ratification. In this regard, as new changes are applied starting next year upon Russia's receipt of the notification from Luxembourg, the 2020 Protocol should take effect not earlier than January 1, 2022 in case such notification is received during 2021. Taking into account prolonged periods of time needed for the Luxembourg-Russian DTT itself and the 2011 Protocol to be applied (up to five years), we see the possibility of the 2020 Protocol taking effect even later.

    In Luxembourg, a bill of law[2] approving the 2020 Protocol has been issued on November 27, 2020 and is currently under discussion in the Luxembourg parliament. It is pertinent to note that according to the opinion of the Luxembourg Council of State[3], the 2020 Protocol does not deserve any special observation. It has also been clarified that the 2020 Protocol will only be applicable in Luxembourg after January 1, 2022 (at the earliest), once the notification process will be completed, and only if such 2020 Protocol has also been regularly published in the Luxembourg official gazette.

    Who is affected and what to do?

    1.    Income payment from Russia to Luxembourg

    Russian businesses paying income to Luxembourg will be heavily affected by the 2020 Protocol. Based on the mentioned complications in the process of enacting the 2020 Protocol, general tax treatment from the perspective of Luxembourg-Russian DTT should not fundamentally change in 2021. However, such changes could take place in 2022 or later.

    Tax changes regarding the most popular transactions are summarized in the Table No. 1 below.

    Table No. 1. Main changes in tax treatment of different types of income paid from Russia to Luxembourg starting January 1, 2022

    No.

    Transaction (type of income paid)

    Changes starting January 1, 2022

    Restructuring options / Areas of attention

    i

    Dividend payment incl. cases of tax re-qualification of interest into dividends (e. g. thin capitalization regarding intra-group loans[4])

    Affected

    5% reduced tax rate on dividend payment can be applied to payments to public companies only.

    Restructuring of a private Luxembourg company to a public company.

     

    ii

    Intra-group interest payment to affiliated parties

    Affected

    Loans issued by structures other than Luxembourg banks are usually not exempted based on 2020 Protocol rules.

    a) Restructuring of a private Luxembourg company to a public company – allows 5% tax rate at source application.

    b) Issuance of loans in form of corporate bonds or Eurobonds for interest exemption application – allows exemption application.

    iii

    Interest payment based on bank loans, incl. fiduciary loans[5]

     

    Not affected

    If a loan is issued by a Luxembourg bank, its payment is not affected.

    Attention to PPT should be paid. Contract documents should reflect real business processes of a company. Otherwise, restructuring is needed in case there is a risk of failing PPT.

    iv

    Royalty payment, i. e. payment based on use of IP rights owned by Luxembourg companies, i. e. trademarks[6]

    Not affected

    Royalty payment is exempted at source.

    v

    Transactions related to property located in Russia, i. e. sale of shares in Luxembourg property owning structures

    Not affected

    In case Russian property prevails in assets of a Luxembourg company (more than 50%), upon the 2011 Protocol income from sale of shares in such companies can be taxed in Russia.

    Attention to share of Russian property in the assets of a Luxembourg company should be paid. Russian Ministry of Finance has issued clarifications[7] on property share, which is calculated on the latest booking date.

    vi

    Payment of interim income by Russian property funds

    Affected

    Interim income paid by a property holding fund is generally treated as dividends. Based on the 2020 Protocol rules, a 5% tax rate can be applied in limited conditions.

    Structuring of a real estate investment fund in Luxembourg (as return may be distributed to investors free of withholding tax regardless of the fact that the fund is financed by way of debt or equity). Note, however, that most of the Luxembourg funds do not benefit from DTT access.

    2.    Income payment from Luxembourg to Russia

    In case interest or dividends are paid by a Luxembourg tax resident company to recipients in Russia, the 2020 Protocol should also have, in practice, a limited impact in Luxembourg based on exemptions provided by the national legislation of Luxembourg.

    Indeed, according to Luxembourg income tax law, dividends distributed by a Luxembourg resident fully taxable company should in principle be subject to a 15% Luxembourg withholding tax rate. However, a full domestic exemption is available under the Luxembourg participation exemption regime for a Luxembourg fully taxable resident company distributing dividends to its Russian parent company, provided that:

    • the Russian parent company is fully subject to income tax comparable[8] to the Luxembourg corporate income tax, and
    • the participation amounts to 10% (or EUR 1.2m for dividends) and is held for at least 12 months on the date the income is allocated or realized for tax purposes. A commitment to hold the minimum shareholding for an uninterrupted period of at least 12 months satisfies this condition. The test applies to the participation in general and not on a share-by-share basis

    Also, according to Luxembourg income tax law, arm’s length interest payments are not subject to withholding tax. It is only in case of a requalification of interest on the excess debt as a hidden profit distribution, that the Luxembourg 15% withholding tax should apply (unless an exemption applies e. g. under the Luxembourg participation exemption).

    Could a look-through approach to Luxembourg income recipient be applied?

    To ensure that the tax residency and the beneficial ownership of a Luxembourg company will not be challenged by Russian or any other foreign tax authorities, the substance requirements listed in the circular issued by the Luxembourg tax authorities on intra-group financing activities[9] should be observed (in addition to an arm’s length remuneration and sufficient equity at risk in case of a financing activity). Indeed, in absence of any further administrative guidance, the substance requirements foreseen for intra-group financing activities in the circular on intra-group financing activities (e. g. board composition, effective management, employees, infrastructures, etc.) are considered as general guidelines under domestic law as to the recognition by the tax authorities of a resident company, including for beneficial owner test purposes. In an international context, the necessary business substance for the recognition of the Luxembourg tax residence by foreign tax authorities must also be considered from the tax perspective of the foreign jurisdiction(s) involved.

    In case such adequate substance is lacking in Luxembourg, the Luxembourg-Russian DTT benefit could be denied and the Luxembourg company disregarded for DTT purposes. This is an approach a Russian entity can use in order to apply benefits based on a DTT other than Luxembourg-Russian DTT in application of a “look-through” approach. In such case, restrictions related to a Luxembourg company will not be applied. This means application of a DTT with the jurisdiction of a Luxembourg entity’s parent company or of the entity which is treated as the beneficial owner of income. From a practical viewpoint, such approach makes sense in two main situations:

    • beneficial owner of income is another European/US jurisdiction and there are no restrictions regarding income type: given income ends up at the accounts of another European/US company having favorable DTT provisions with Russia, such approach could be used for such income. For purposes of a “look-through” approach, indirect participation is considered equal to direct participation. However, as more and more DTTs fall under the scrutiny of the Russian Ministry of Finance, use of such approach is already limited with Cyprus, Malta and potentially the Netherlands
    • beneficial owner of income is another Russian company and the income paid to the Luxembourg company is dividend income: in such case, according to amended legislation, a 0% tax rate to dividend payment can be applied, if the 50% participatory interest criterion is met and dividend income or passive income of another type is received by Russian company within half a year from initial dividend payment

    The main points of attention in case of a look-through approach application should be the consistency of such an approach with the tax treatment used by a company in previous tax periods as well as the general presence of a business purpose in changing the income “centre”.

    Eversheds Sutherland tax support

    In case your business in Russia is structured through Luxembourg, we recommend you to analyse the tax burden increase risks of the current structure and elaborate potential restructuring models as well as explore the opportunity to apply a look-through approach. Our tax team will be happy to assist you with this.


    [1] Convention between the Grand Duchy of Luxembourg and the Russian Federation for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital on June 28, 1993

    [2] Luxembourg Bill of law n°7725 dated November 27, 2020

    [3] Opinion of the Luxembourg Council of State dated January 26, 2021 regarding the Luxembourg Bill of law n°7725

    [4] Scania Leasing case, No. А40-149755/2015, Nestle case, No. А40-16883/15

    [5] Oriflame case, No. А40-138879/14

    [6] Moskommerzbank case, No. А40-8065/2018, Intesa Bank case, No. А40-241361/2015

    [7] E. g. see Letter dated December 3, 2019 No. 03-08-05/93884

    [8] A minimum tax rate of 8.5% should satisfy this requirement and the taxable basis should be determined according to the rules and criteria similar to those applicable in Luxembourg. As standard corporate income tax rate in Russia is 20%, this condition should be met in the majority of cases

    [9] Circular LIR n°56/56bis of December 27, 2016

    This information is for guidance purposes only and should not be regarded as a substitute for taking legal advice. Please refer to the full terms and conditions on our website.

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