Using the Hong Kong Double Tax Treaty with Russia

The Russia-Hong Kong Double Tax Treaty (DTA) has been in effect since April 1, this year, and has begun to prove itself as a useful tool for foreign companies investing in Russia. Our firm, Dezan Shira & Associates has successfully implemented business structures in Russia, using Hong Kong corporations as an ownership vehicle for a foreign owned company in Russia.

The background and benefits of the DTA are that such agreements are concluded by and between two states (in this case, Hong Kong and Russia) and are aimed at eliminating taxation-related obstacles to the movement of capital, goods or income, at preventing tax evasion and discrimination, and also at establishing procedures for interaction between the states when collecting taxes.

DTAs concluded between Russia and other countries and regions are based on the Model Agreements on Avoidance of Double Taxation of Income and Property, approved by resolutions of the Russian Government in 1992 and in 2010. In turn, these model agreements reproduce to a significant degree the Model Tax Convention on Income and on Capital by the OECD (hereafter the “Model Convention”). Despite the fact that Russia does not participate in the OECD, the Convention and the Commentary on it are used by Russian courts when making decisions in disputes involving the application of DTAs.

The majority of the DTAs signed off by Russia are applied in relation to such Russian taxes as corporate profit tax (including income from business activities, income from real estate, interest, dividends, and royalties), as well as personal income tax (including income from independent activities, from work for hire, fees of directors, artists, and athletes, and from real estate). The DTAs include taxes on the property of enterprises and of individuals among the taxes excluded from double taxation. The DTAs do not extend to indirect taxes like value-added tax (VAT).

In most cases, the essence of the mechanism for preventing double taxation consists in the fact that taxes on income or capital to be paid in one country may be partially or completely deducted from the amounts of tax (or counted towards payment thereof), which are subject to payment in another country in regard to that income or capital. Income received under certain conditions may also be exempt from taxation or taxed at rates lower than the rates applied to taxpayers not falling under the operation of the DTA.

Below, we look at some matters related to application of DTAs concluded by Russia in regard to types of income most characteristic for business, for instance, profit from business activity, dividends, interest, royalties, and income from real estate (capital gains).

Residents

DTAs extend to parties that are residents of Russia or of a state that is a party to a relevant agreement. Normally, DTAs do not apply when a party is not a resident of any of the participating states. For DTA purposes, resident is any individual or legal entity (such as a Hong Kong company) that, under the legislation of that state, is subject to taxation there based on dwelling place, permanent residence, place of registration, place of management, or place of foundation of a company, or any other similar criterion. If the taxpayer is a resident of both states, additional criteria for determining residency status for DTA purposes are applied. 

Permanent establishment

Under the majority of DTAs concluded by Russia, profit tax is not levied on the profit of foreign companies obtained from business activity in Russia, except in cases when a company is engaged in business activity via a permanent establishment set up in Russia. The DTAs set certain thresholds above which a Hong Kong or other foreign organization is recognized as having a permanent establishment.

The term “permanent establishment” includes specifically:
a) place of management;
b) branch;
c) office;
d) factory;
e) workshop; or
f) mine, oil or gas well, quarry, or any other place for extracting natural resources.

In case the national legislation sets higher thresholds for recognizing the existence of a permanent establishment (that is, ones less favorable for the taxpayer), the provisions of the appropriate DTA are applied (more favorable ones). For instance, in Russia, a construction site is regarded as a permanent establishment, irrespective of how long it has actually existed, whereas according to the Russia-Hong Kong DTA, a construction site leads to a permanent establishment if the length of its existence exceeds 12 months. This makes them attractive for construction and other projects taking more than one year to develop.

The Russia-Hong Kong DTA also states that PE status may be claimed if the provision of services, including consultancy services, through employees or other personnel engaged for such purpose that continue (for the same or a connected project) is for a period or periods aggregating more than 183 days within any 12-month period, and as such, is applicable to architects and other consultants engaged in projects taking more than six months in any year to execute.

The profit received through a permanent establishment is taxed only for that portion which the permanent establishment could have received if it had existed as an independent entity under similar conditions.

Treatment of dividends

Dividends paid out by a Russian company to a foreign company may be taxed both in Russia and in the country of which the foreign company is a resident. Dividends to which the DTA might apply may be taxed at rates lower than those set by national legislation. That said, the DTA may set certain requirements for the amount of interest from shares and the size of the investments of the recipient of the dividends.

Treatment of interest on loans

Interest payable to a foreign resident is taxed at the source of the payment in Russia. The Hong Kong DTA stipulates an exemption from tax in Russia or a reduced tax rate at the source. Exemption and a reduced tax rate do not apply to interest related to the permanent establishment of a foreign resident in Russia.

In a situation where companies are interdependent, interest is exempt from taxation only to the extent which would be agreed to between independent entities; for the remaining excess portion, the accrued interest is taxed as profit tax in accordance with Russian law.

Royalties

Income from royalties paid by a resident of Russia to a Hong Kong or other company is subject to Russian taxation at the source of payment. That said, DTAs may envisage tax exemption in Russia or a reduced tax rate at the source. Exemption and a reduced tax rate do not apply to royalties related to the permanent establishment of a foreign resident in Russia.

In the event that the payer of royalties and the recipient have special (dependent) relations, then the amount of income paid in the form of royalties is not taxed only on the portion that would have corresponded to the amount of royalties paid under similar conditions between independent entities.

Beneficial owner

As a rule, DTAs grant exemption or a reduced tax rate for dividends, interest, and royalties provided that the recipient of the income acts as a beneficial owner. A beneficial owner is recognized to be any individual or legal entity enjoying benefits of receipt of income. The concept of beneficial owner is intended to limit the application of DTAs in cases when an agent or nominee acts as the recipient of the income, as well as to prevent tax evasion with the help of conduit companies.

The protocol to the DTA signed by Russia and Hong Kong specifically contains an amendment prohibiting the use of conduit arrangements, whereby income paid to a resident of a state that is a party to the DTA and which is taxed on preferential terms subsequently is transferred entirely (or almost entirely) to another party which would not be able to take advantage of similar tax benefits if that income were paid to it directly. However, Russian law does not require mandatory disclosure of the end recipients of the income.

Non-discrimination

DTAs contain provisions aimed at ruling out discrimination. Taxation on foreign citizens or companies from a foreign country in Russia should not be more onerous (discriminatory) in comparison with taxation of Russian citizens or companies in the same circumstances. This rule also extends to the activity of foreign entities which creates a permanent establishment in Russia. The prohibition on discrimination also means that Russian companies whose capital directly or indirectly belongs to (or is controlled by) residents of a foreign country should not be subjected in Russia to more onerous taxation in comparison with the taxation of other similar Russian companies.

It should be noted that the Russian tax authorities, applying rules on non-discrimination, believe that taxation of Russian companies owned by residents of one foreign country are subject to comparison (non-discrimination) with taxation of companies owned by residents of other foreign countries. Russian court practice follows the path of not applying the provisions on non-discrimination in cases of tax abuse practice (for example, when applying thin-capitalization rules).

Capital gains

Russian profit tax is levied on income received by a foreign resident from alienation of real property (capital gain) located in Russia. This rule extends likewise to income arising from the sale of shares or other corporate rights in Russian companies whose assets principally consist of real estate located in Russia. The Hong Kong DTA allows one to avoid paying profit tax in Russia in connection with a foreign resident’s sale of shares or other corporate rights in Russian companies whose assets principally consist of real estate located in Russia.

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