The unbearable lightness of offshore being, when offshoring was a simple and rather cheap solution to any problems of any notable business, is gradually disappearing. Cash export and tax optimization schemes are getting more and more complicated and expensive.
— My business is in trouble.
— Call the lawyer, who will prescribe you offshoring. Whatever you want to cure – high taxes, custom duties, antimonopoly regulation or fieri facias.
The effect of the offshoring panacea ends, the “treatment” turns to be more individual, and tax planning – more sophisticated.
Our team picked experts brains to answer the question: what trends are the most noticeable in the offshore world now.
Trend 1. Tasks get more complicated
If you want to know where a market is going to, look at the consumer tastes dynamics. According to legal experts, five years ago almost 90% of the clients asked them “just to provide offshoring service” and did not insist on any advice about international tax planning. It means that they wanted either a personal secret «moneybox» to dump cash, or a “pocket” offshore trader for payments run in export/import transactions. The targets were simple, the needs – unsophisticated. Now such requests have halved. Other requests come from “gourmets”.
They require long-term and reliable schemes, and that on behalf of a registered foreign company they can:• finance their Russian business under the mask of “foreign investor”;• exercise ownership of Russian assets (the most well-known example in mass media – the Dutch Pyaterochka Holding N. V., that owns 100% of the Pyaterochka Group operating divisions).
• register trademarks and intellectual property in order to “structure” royalty payments, etc.
“The clients have started thinking about more complex things, confirms Pavel Romanenko from “Amond Smith”. – They used to be more worried about how to arrange their foreign financial flows. Now I would note stronger interest in proper structuring of holdings. Clients come to us with already existing discrete companies: trading company, management company, sponsor company – all in different places. Their offshore companies are “overloaded” with functions. One company can perform the operating function (and bear the accompanying risks) and the ownership function at the same time, and this is not appropriate. Now it is required to build a proper structure from all these companies: establish an international holding and balance the Russian and the foreign parts”.
Sometimes an entrepreneur has to «dive» into offshoring not to bypass or minimize something, but to make a transaction that would seem pretty well at home, for example, asset securitization transaction.
“This is about the choice of more favorable legal environment. Not our Russian environment with its numerous inaccuracies in laws, where the parties to transaction are not protected properly. The thing is that there is a serious problem of “Kemerovo court” in Russia, i.e. anyone can step in with absolutely “flagrant” judicial definition and crash any agreements between the parties. But the environment based, say, on the English Law, where the administration of such transactions is easy thanks to the completeness and accuracy of laws”, says Valery Tutykhin from John Tiner & Partners.
Trend 2. Image is a priority!
Another trend is becoming more pronounced in the international tax planning sector: Russian people involved in offshoring want to look decently and wear respectable brands with “made (read: incorporated) in Britain”, “made in Netherlands”, “made in Switzerland” lebels. Demand for registration services of European companies in registering firms has grown significantly. The clients even ask to “screw” a company from some respectful non-offshore jurisdiction to the familiar and practiced transfer schemes on import/export. Do we have to deal with reputation losses related to “offshoring” somehow! Take, for example, Cyprus habituated by Russians: it is not at all considered as an offshore area by now (income tax rate is 10%, financial statements presentation is obligatory), but nevertheless the island retains the old offshore image, which nowadays is not always suitable for serious relationships with foreign partners.
Though it is not only the image that matters. For example, you company in Netherlands looks respectable. What’s more, it has a bonus – the agreement to avoid dual taxation between Russia and Netherlands. But what may appear to be more important is that the level of legal protection of its interests would be higher than that of some offshore firm from Nevis Island. It is in the case of problems with Russian law enforcement bodies and competitors concerning you Russian assets “pinned on” the Dutch company. The Nevis authorities have no time to stand up for you: they hardly manage to register the companies at home! And Netherlands does have. As for the dividends, they still may be taken out via a Netherlands Antilles company with minimum losses (the scheme is known as “Dutch sandwich”).
Trend 3.Marginalization of several schemes
Confidentiality citadels are collapsing one be one. Even the intractable Swiss bankers are now under control to be forced to loosen their tongue in the case of money laundering investigation. Business born offshore has to “whitewash” itself, become more transparent.
The problem with “grey” schemes now is that it is often difficult to say on what side of the legal barrier they are: whether it is legal tax optimization or illegal tax evasion. The YUKOS case significantly changed the previous standards: before it the YUKOS schemes were considered as legal.
Gradually narrows the application area of simple schemes, which are used by domestic “grey” importers: when goods at understated prices are imported to Russia on behalf of the offshore company in order to save on customs. They serve as a red flag for the Russian tax and law enforcement bodies.
The application of such schemes gradually will fall to “background” levels. The problem of “black” market and “grey” import (for example, alcohol, tobacco) exists in many countries. But in the USA, UK, and continental Europe it is not a large sector. And people involved in such business do not hurry to say in public: “I’m in alcohol and tobacco business”, they prefer stay in the shadow. And we will gradually change, we already do! Yes, some entrepreneurs will continue to use American and British companies, register them for homeless people, understanding from the very beginning the criminal nature of their actions. But everybody will know what they are really doing.
Escaping, hiding in different islands, changing one by one legal statuses in the form of one-day offshore companies becomes very risky and unworthy of a respectable entrepreneur. In fact, such behavior was a norm during the unforgettable 90s.
Trend 4. Tax optimization appreciation
We can’t say, that cost of registering companies services has increased somehow. The thing is that proper optimization schemes are much more expensive. Because if you do quick and dirty then you could easily become a participant of a demonstrative beating in the form of additional charge of taxes and prosecution. For example, ingredients for a “Dutch sandwich” (a Netherlands firm and an offshore company on the Antilles) will cost you at least $14-15 thousands, including business support during the first year. And a “sandwich” with “Switzerland+Gibraltar” – roughly $16-18 thousands. But this is not all expenses. The call of the times, vigilant fighters with money-laundering and tax bodies sounds like that: firms must not exist simply in the form of a set of documents, which, in turn, is only a supplement to a bank account. For the purpose of security an entrepreneur has to do his/her best in order that his structure will not look sham: open an office, pay fee to a CEO and a secretary (in many foreign jurisdictions this is often obligatory for setting up a company), simulate the economic feasibility of the business, and it involves higher and higher expenses. There they are: our industrial and financial groups rush to open up real offices on Bahamas and Bermudas, and Russian managers hurry up to pack their bags — to manage business processes in the shadow of palms.
Later comes simple mathematics. The results of the optimization at least must cover the expenses to support the crafty structure of offshore and non-offshore companies. There are plenty of entrepreneurs who went far ahead of themselves or bought an offshore company that is hardly useful.
In 90s a simple formula was determined by consultants and registrars: If your private fortune exceeds half a million dollars then it’s time you turned to offshoring. How does this formula look now?
“I would say in other way: If you turnover reaches a certain level, then it’s not time for you to turn to offshoring — it’s time you paid taxes. This is a more real wording, says Vlery Tutykhin from John Tiner & Partners. – At some point of time it is better to leave offshoring, or “thrust out your head” at least. Because business with a turnover of “x” million dollars, which is totally dependant on the offshore schemes, is a non-sense”.
A scheme is called “Dutch sandwich”, because it consists of a company in Netherlands and an offshore company on Netherlands Antilles. The scheme is benefited from an agreement to avoid dual taxation: Russia-Netherlands, Netherlands-Antilles.
View from the outside:
A Netherlands company (2) holds assets of a Russian company (1) (no less than 25%), takes part in management, and receives dividends. In turn, the Netherlands company is a 100% subsidiary of the Antilles company (3).
If the dividends were paid out to the Russian owners, the tax rate would be 15%. When the dividends are transferred to the Netherlands company’s account, the source pays a tax of only 5% under the agreement to avoid dual taxation. The income tax in Netherlands is high (31.5%), that’s why the Netherlands company immediately pays out dividends to the Antilles company, and pays a tax of 8.3% under the agreement to avoid dual taxation.
Result: • Saving on taxes by 1.7% of the amount of dividends paid out by the Russian company, cash is transferred and accumulated abroad. • The scheme is legal.
• Higher protection of the Russian assets.
Set-up, backing and real filling of the resident company in Netherlands. Use of intellectual property
A transit scheme, consisted of Cyprus as a lower tax center that has an existing agreement to avoid dual taxation with Russia, and an offshore company.
View from the outside:
A Russian company (1) pays out royalty for the use of intellectual property (trademark, patent, etc.) under the sublicensing agreement in Cyprus (2).
The royalty payment to Cyprus by the RF source is subject to 0% of tax under the agreement to avoid dual taxation. The Cyprus company charges the received funds to the account of a company on the British Virgin Islands under the licensing agreement, retaining a 1-3% commission (this commission is subject to the income tax at 10% in Cyprus, thus the real tax expenses in Cyprus fall to tenths of one percent of the transferred amount from Russia). For the transfer of funds the Cyprus source pays 0% of tax.
Result: • The funds are transferred from Russia with minimum losses and accumulated in the offshore company.
• The taxes of the Russian company fall to a minimum..
Requirements: • Licensing agreements must be registered in the RF.
• The Cyprus company must have a formally confirmed resident status.
Tax planning for non-residents
In any country the issues of tax planning for non-residents and effective business are closely related. That’s why these questions always arise in foreign trade activities both in the case of commercial relations with partners and planning and development of the effective structure of companies within the single group with its elements located in different countries with different tax rates, including income tax rate, and with different taxation methods.
Tax planning inevitably led to saving on tax payments and to solving of the related problems in business of some countries. There are lots of examples. They include not only well-known offshore jurisdictions like Panama, Seychelles, Belize, or Dominican Republic, but also many large and small European countries that want either to support such business, or make it one of the biggest components of GDP (Cyprus, Liechtenstein, Luxemburg, Malta, Netherlands, etc.).
For example, British Virgin Islands (eastern part of the Caribbean Sea) earn about $100 mln per year, or about 60% of GDP from state duties for registration and backing up of special International Business Companies (leave alone other types of income related to the operations of such companies).
In Luxemburg earnings of the financial sector where work about 70–75% of the population, including immigrants, amount to 70%.
International tax planning will exist until tax systems of different countries are different. Regular discussions about tax schemes problems or potential problems of offshore companies undoubtedly spark interest to this theme, stimulate to examine mixed information once again, particularly, for making right business decisions.
What is tax planning for non-residents?
First, remember globally approved general principles of income taxation. Almost any country imposes a tax on income depending on where it was received. If an entrepreneur receives income on the territory of the RF, then it will be taxed as the RF resident (local company, permanent representation of the non-resident in the RF), or based on the taxation principles of specific types of the non-resident income (in the form of dividends, interests, royalty, import/export operations stipulated in the Article 106-112, Chapter 25 of the Tax Code of the RF).
But is there any point in using non-resident companies with low or zero income tax rate (offshore companies), if taxes are anyway paid according to the place of business activities?
Typically offshore companies and offshore territories should protect legally received and declared incomes for their subsequent use as investments or simply holding in countries with more stable political or banking system.
In this case an offshore company plays a role of investor who invested profit in some country, paid out all taxes and received income in the form of dividends (and also paid an additional tax on received dividends. Dividends and dividends tax do not belong to company expenses for the purpose of income tax calculation and payment).
However in practice this scheme fails in the competition as other investors appear to be more creative. They prefer to receive income that may be charged to expenses of a company, doing business in some other country. It includes payment of services, interests on loans, and other payments. In this way they usually kill two birds with one stone – do business in the country with good investments prospects and high taxes and lower taxation base in order to get much lower effective tax rate.
It should be mentioned that tax bodies in many countries are surely aware of such methods of tax optimization, and very often these methods that limit their application either have already been developed, or are being developed, or tax bodies have already been using them. There is no secret that Russian tax bodies applied “insurance wage schemes” for wage payments, and British Tax Service purchased property on behalf of offshore companies for private use.
So the question arises about the legitimacy of these methods of tax optimization. I think a tax consultant is able to answer my question. Obviously the most civilized way to solve this problem is to improve tax laws. In this case the work of the tax consultant would be limited to monitoring or forecasting. However, in practice the situation is always much more complicated as the government often does not catch up with new tax schemes, nor has time to struggle effectively against the old ones. In particular, it is confirmed by the struggle against “wage schemes” within arbitrage or even criminal procedure, which, however, brought no result. Anyway a bill separating tax planning and tax evasion was worked out. If a federal law based on this bill will eventually be passed, rules of the game surely will change, though the game itself won’t be over.
So, the first method of tax planning for non-residents is the organization of various payments to non-residents, which ideally match the following criteria:• they are charged to company expenses for the purpose of income tax calculation and payment;• they are not subject to other taxes (VAT, tax on non-residents incomes);
• they do not bring about additional obligatory procedures or their additional reservation.
These payments can be divided into two subgroups:• income subject to benefits under the Treaties (agreements) to avoid dual taxation;
• other types of income.
The first subgroup involves payments of interests on received loans. This is a wide-spread method of tax planning that allows quickly receive loans in a country and as quickly withdraw loans out of the country. Besides it allows charging interests to the company expenses.
This method is quite popular in Europe and the RF, because according to the Agreements with many countries the tax rate on interest payments form our country is zero.
The next payment from this subgroup is royalty payment, which is quite popular, but has more restrictions than interest payment. First, a trademark (service mark) must be registered in the Federal Service for Intellectual Property, Patents and Trademarks in order that payments for its use will be considered as royalty payments in the accounting. Second, a very important question is the determination of the licensing (sublicensing) agreement price that generally should not deviate from the market price by more than 20% (Article 40 of the Tax Code of the RF). Otherwise tax bodies are authorized to check the accuracy of the transaction prices. Third, the Ministry of Finance and the Tax Service have recently agreed on the necessity to impose VAT tax on royalty payments in favor of non-residents.
Payments of the second subgroup include a payment for non-resident services, payment to reinsurer – non-resident under the reinsurance contracts. The payment to non-residents under the reinsurance contracts also implies the participation of a Russian insurance company (reinsurer). This type of payment was legally simplified compared to many other payments. Since the Chapter 25 of the RF Tax Code (paragraph 2, clause 2, article 309 of the RF Tax Code) was adopted, reinsurance payments to a foreign partner are not considered as income from the RF sources.
The next method that allows effective using of tax planning for non-residents can be called situational. In other words it is applied only in specific situations that can be quite numerous. One of the examples is the case when an organization plans to do or does business of securities purchase and sale on the territory of the RF. If the work is done by the Russian organization on its own account and at its own expense (broker), all received profits are subject to taxation at 24%. In the case when the work is done by a company registered in a country that entered with Russia into the Treaty (agreement) to avoid dual taxation, then all received profits can be charged to this company’s account (net of brokerage) without additional taxes on the territory of the RF.
Another example, when an organization plans to carry out foreign trade activities on import/export in different countries. For example, goods are bought in a European country and are sold in an African country. If the activities are limited to import and export, no representative office is set up in any of these countries. If the activities are carried out by a Russian company it will pay tax on received profits. But if the operations are carried out via offshore company the income tax is not paid.
The third method of the offshore companies use implies a use of benefits stipulated by local taxation system (for us – the RF). For example, the Chapter 30 of the Tax Code of the RF exempts foreign companies that don’t do business in the RF via permanent representatives from tax on property not relating to real estate. Taking into account the above mentioned, there is point in considering on which balance the property is accounted, if the property, for example, was transferred under the lease agreement between non-resident and the RF resident.
One more example – joint venture agreement with foreign organization (simple partnership agreement, according to the Chapter 55 of the Civil Code of the RF). As the simple partnership is not a legal entity, there is a question of how the received income will be distributed among the parties. The foreign organization as one of the parties has the right to receive its portion of income defined by the simple partnership agreement. But if the foreign organization does not have a permanent representative in the RF, then its income is subject to taxation (articles 106–112 of the Tax Code of the RF). In the case of a Treaty to avoid dual taxation with the country where non-resident company is registered this company may not pay tax on its part of income. However in practice it’s quite difficult to implement such scheme.
The thing is that in the case of any suspicions tax bodies may attempt to admit the appearance of the permanent representation of the non-resident in the RF, given the nature of the joint venture, or simple partnership agreement simulative and as a cover for other transactions, for example, receipt of a loan from the non-resident (if its investment into the simple partnership has only financial purpose), or for any other reasons. However the risks do not mean that this type of tax planning is inappropriate in business. There are lots of examples of legally appropriate scheme implementation that lived through all claims from tax bodies in courts, including senior courts.
There are many facts of using non-resident companies in tax planning. Because of their diversity there is obviously no, and won’t be, a complete list of these methods. I would like to draw the reader’s attention to the other aspect of the theme – prospects and trends in the future.
So, tax planning for non-residents will always exist. Similarly as always will change (improve) the rules of the game, what can be seen in general lowering of income tax rate in many countries of the world. The European experience also points to the inevitable problem of tax competition. Nowadays tax competition in Europe continues to flourish, despite the consistent related policy of the EU. As Jonathan Todd from EC notes, “it [Europe] does not intent to advance the initiative concerning income tax rates, as EU governments have the right to set any income tax rate”. There are examples of countries setting zero income tax rate for any types of companies, or single low tax rate in order to dismiss all EU claims on bad tax competition. Besides, many countries provide various additional reductions of payments passing through the companies in these countries (Denmark, Netherlands, Cyprus).
Note that earlier in the era of «wild capitalism» offshore companies were steadily associated with the word “illegal”. Certainly it was justified in the times when the country received 60% of the currency earnings refund on exported goods at best. However we have seen a lot changes since then. This economic sector became much more controllable, which naturally reverses the “pendulum movement”.
Governments of many countries have come to the conclusion that too tight regulation of offshore companies activities negatively affect the sound investment climate. Even the RF Government once discussing the bill “About the peculiarities of the legal status of offshore companies in the RF” agreed that prohibitive measures towards offshore companies did not bring the desired effect.