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New tax regime for IT assets in Russia

  • Russia

    28-10-2020

    Possible solutions and risks in business restructuring

    The development of information technologies and the growth of the IT sector of the Russian economy has been one of the priorities of the economic policy of the Russian Government for several years. For example, companies developing and maintaining computer programs have been using reduced rates of insurance premiums for more than ten years. In addition, VAT exemption for the transfer of software rights based on license agreements has long been valid.

    In 2020 against the background of an economic decline due to coronavirus the Government of the Russian Federation decided to conduct an IT maneuver in the Russian IT industry. Its main features are enshrined in the Federal Law No. 265-FZ[1], of 31 July 2020, which amends the Tax Code of the Russian Federation (hereinafter referred to as “the Law”). Key provisions of the Law come into force on 1 January 2021.

    Even more significantly the Law reduces the rates of insurance premiums for IT companies (from 14% to 7.6%) and establishes a reduced income tax rate of 3% for them decreasing the overall tax burden of IT companies and making them more competitive than other tax jurisdictions. At the same time, these tax benefits for IT companies are of indefinite nature and allow IT businesses to build long-term financial and tax business models.

    At the same time Russian IT companies or deeply integrated and localized businesses with foreign capital will be able to benefit from new regulations even more by means of use of a new format of VAT exemption for the transfer of rights to software and databases, which is now applicable only in case such software and databases are registered in a special Russian software register.

    It is also important to understand that such a preferential tax regime creates certain fiscal and strategic expectations for financial regulators. Thus, the Ministry of Finance of Russia notes in its press release: “The IT sector will not only be the driver of the economy now, but also in the future will act as insurance in case of a repetition of unforeseen situations that the whole world faced, for example, during a pandemic”.[2]

    Nevertheless, we are convinced that the Law provides good opportunities for developing and increasing the financial liquidity of the business of a wide range of companies involved in the IT sphere, which will allow those companies to gain competitive advantages.


    1. Companies that will be able to take advantage of preferences for income tax and insurance premiums

    The new tax regime applies equally to two main and interrelated areas of the IT industry, namely:

    • companies providing software development
    • companies providing hardware development and design

    Moreover, while for IT companies, in fact, only the income tax rate and insurance premium rates are being reduced, and the criteria in this sector are well known, for hardware developers this regime is being introduced for the first time.

    It is necessary to notice that due to the digital transformation of business, many manufacturing and trading groups of companies have created their own IT intragroup companies developing and supporting the use of software.

    These IT divisions can also apply the new tax regime if they meet the regime requirements and undergo the necessary restructuring (see paragraph 3 of the Alert).

    (a)  Requirements for software developers

    The requirements for applying reduced insurance premium rates  have been known and some IT companies have been applying them for over 10 years. Therefore, for this category of companies, the main positive news will be the indefinite duration of such measures and the reduction of the tax burden on income tax to 3%. For companies that think about starting to apply preferential treatment, the actual criteria will be applied, complicated in some cases by existing controversial issues and risks.

    For the purposes of applying the new regime, the following Russian companies are recognized as “IT companies”.

    90% “IT income”

    In particular, there are three main groups relating to “IT income”, namely income from:

    1)   transfer of rights to developed software and databases

    2)   provision of services (execution of works) for the development, adaptation and modification of software, databases, programming features and information products of computer technology

    3)   provision of services related to installation, testing and maintenance of software and databases that were developed by the organization or adapted / modified by it

    However, several important questions remain open today related to the qualification of income as IT income for the purposes of applying the benefit. For example, in accordance with the civil law, software or database development can be carried out by re-development of existing (original) software or database. Although it is not known how the tax authorities will characterize income from such “re-developed sources” for the purpose of benefit application, especially if the sources are of foreign origin or derived from a related party.

    The question also remains open as to whether the list of IT income is closed or it may include income from other services, for example, if the service or activity is an integral part of a directly named service.

    Based on our practice of structuring contracts and activities within groups of companies, the range of income taken into account as “IT income”, can be successfully and reasonably expanded considering the peculiarities of a particular business activity, and such an approach will most likely be applied in practice in 2021.

    Accreditation in the Ministry of Digital Development, Communications and Mass Media

    To get accreditation, it is required to check the formal features of the company's activities (Russian Classification of Economic Activities (OKVED) codes, Charter requirements, etc.) for compliance and send a package of documents to the Ministry of Digital Development, Communications and Mass Media of the Russian Federation. It should be taken into account that after adoption of the Law the number of applications for accreditation has significantly increased, which in practice may lead to an extension of the monthly period for making an accreditation decision.

    Personnel requirements

    The average number of employees for the reporting (tax period) should be at least seven people. The Law does not contain any other requirements for staff, but based on our practice of applying the existing edition of the IT benefit, the structure and qualifications of staff are important, for example, the ratio of IT and other specialists, the compliance of the qualifications of IT specialists with the developed software or database, etc. Individual discrepancies may result in tax risks of making claims against the reality of the received IT income.

    In this regard, before applying the preferential tax regime, it is necessary to analyze the company's employment documents (employment contracts, job descriptions, etc.), as well as clearly define the structure and nature of the activities of subcontractors.

    (b) Requirements for software developers

    For Russian organizations engaged in the design and development of electronic component base products and electronic (radio-electronic) products, the preferential tax regime provided by the Law is an innovation. Not all the conditions for its application have been detailed at the level of by-laws now. At the same time, the approach is largely based on the experience of the application of benefits on insurance premiums by IT companies, in particular, the following similar requirements are imposed:

    90% of the income consists of the development and design of “hardware”

    In particular, the amount of income from services (work) realization for the design and development of electronic component based products and electronic (radio-electronic) products according to the results of the reporting (tax) period should be at least 90% of the total income. It should be noted that the Law does not provide for any restrictions in relation to the customers of such services and the origin of equipment, therefore, income from the development and design of electronics for a foreign customer should also be taken into account.

    Inclusion in the register of the Ministry of Industry and Trade of the Russian Federation

    At the moment, a regulatory framework is being developed for the formation and administration of the register of companies that provide services for the development and design of hardware. In particular, the Draft Decree of the Government of the Russian Federation has been published, which establishes the procedure for forming a register of hardware developers[3]. Inclusion in the register assumes limitation of foreign investments into the developer company, however, it does not exclude the possibility of applying a preferential tax regime by companies that design and develop foreign products (hardware). Also, the Draft Decree of the Government of the Russian Federation in fact expands the list of products, services and the income from which should be taken into account in order to apply the benefits within the framework of the concept of the “Electronics Design Center”. However, it is not clear to what extent such an expansive approach will be perceived by the tax authorities in practice.

    Personnel requirements

    The average number of employees for the reporting (tax period) should be at least seven people. As well as for an IT company, the Law does not establish any additional requirements for employees, their qualifications, etc. In this regard, before starting to apply the preferential tax regime developers and designers of “hardware” should make sure of the correct execution of the workforce and the structure of subcontractors.

     

    2. Change in VAT exemption: who will win, who will lose?

    In 2021 VAT taxation exemption for transfer of exclusive rights and rights to use software and databases stipulated by Subclause 26 of Clause 2 of Article 149 of the Tax Code of the Russian Federation will undergo a significant change. In particular, the said exemption will be subject exclusively to the transfer of rights to software and databases included in the special Unified Register[4] (hereinafter – “the Register”) administered by the Ministry of Telecom and Mass Communications of Russia. The main requirements for inclusion in the Register are as follows:

    • restrictions on foreign participation in a Russian company that owns an IT asset;
    • lawful introduction of IT assets into civil commerce on the territory of the Russian Federation;
    • a sufficient degree of localization in the development of an IT asset (not more than 30% of a foreign element)

    In 2021 the transfer of rights to software and databases from foreign suppliers in practice will be subject to VAT at a rate of 20%. If the products (part of the products) of a foreign company are closely related to the Russian market the management is ought to think about restructuring the supply chain in order to be included in the Register and localize key IT products.

    For Russian companies starting from 2021 the inclusion of software and databases in the Register will be a question of not only participating in public procurement, but also exemption from VAT in order to maintain a competitive price.

    We believe that the issue of the inclusion of software and databases to the Register should be decided by the company's management based on the status of customers, the structure of VAT in the company and current business needs.

    Use of software for online advertising and websites

    The new preferential treatment for IT companies does not apply to the transfer of rights to software and databases that are used to distribute advertising information over the Internet and (or) gain access to such information, as well as for the operation of websites. In particular, proceeds from the sale of these products are not included in the company's “IT revenues” and are subject to VAT taxation that cannot be exempt.

    For this reason, it is very likely that from 2021 the monetization of IT products through advertising or the freemium model will become less commercially attractive for some companies.


    3. Restructuring for the purpose of applying a preferential tax regime

    A significant reduction in the tax burden on income tax and insurance premiums as well as changes in the VAT taxation of the transfer of software products can be a trigger for the start of restructuring of the group's divisions that have accumulated IT assets.

    The most common and cost-effective way to combine IT assets today is to create an IT hub in the Russian Federation. Based on our experience IT hubs created as a Center of Excellence, Shared Service Center or their hybrid version will fall under the preferential tax regime in 2021.

    It is important to consider the general tax anti-evasion rules provided in Article 54.1 of the Tax Code of the Russian Federation, in particular the requirement for a reasonable business purpose as the main goal pursued in the implementation of any restructuring. Therefore, the absence of a correctly formulated and documented concept that reflects the business goal of restructuring IT assets may lead to refusal of the tax authorities to apply a preferential tax regime and recalculating of the company's tax liabilities.

    The restructuring of IT assets is a complex procedure that should be carried out subject to the rules of corporate, tax, labor and commercial legislation taking into account the peculiarities and procedures for the transfer of intellectual rights.

    The legal practice of Eversheds Sutherland in Russia successfully provides its clients with such complex solutions with the involvement of lawyers from different practices, which allow them to restructure IT assets in the most complete and efficient way.


    [1] The Federal Law № 265-FZ of 31 July 2020 “On amendments to the second part of the Tax code of the Russian Federation”

    [2]  https://minfin.gov.ru/ru/press-center/?id_4=37115-o_nalogovom_manevre_v_it-otrasli

    [3] Draft Decree of the Government of the Russian Federation “On maintaining the register of organizations providing services (performing work) for the design and development of electronic component base products and electronic (radio-electronic) products”

    [4] https://reestr.minsvyaz.ru/reestr/

    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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