Cyprus has long been the main springboard for both inbound and outbound investments and other transactions in Russia.  But its inclusion on the Russian offshore ‘blacklist’ has meant that income arising from dividends received from Cypriot subsidiaries was not eligible for the zero rate profits tax enjoyed by Russian parent companies on dividends from foreign subsidiaries.

The Protocol harmonises the DTT between the two states with the OECD model agreement and, as a result, lifts general legal and practical restrictions on the issue of exchange of information while at the same time retaining the favourable withholding tax rates between the two countries.

The new Protocol, signed by Russian President Dmitry Medvedev at the beginning of March 2012 and adopted by the Russian Duma less than a month earlier, is expected to enter into force on 1 January 2013.  It reaffirms the reputation of the DTT between the two states as one of the best (if not the best) that Russia has with any other country.

While the terms of the Russia–Cyprus treaty had originally been agreed in October 2010 and ratified by Cyprus in August 2011, concerns on information disclosure had led to delays in ratification by Russia.  Cyprus was one of 42 countries on Russia’s ‘blacklist’ (officially the List of States and Territories Which Grant Preferential Tax Treatment and (or) Do Not Require the Disclosure and Provision of Information in Relation to Financial Operations Carried Out (Offshore Zones)) deemed to be ‘uncooperative territory’ and excluded from provisions under the Russian Tax Code allowing a tax exemption on the repatriation of dividends from subsidiaries of Russian companies. 

This has now been resolved through the introduction of a revised Exchange of Information article, consistent with article 26 of the OECD Model Tax Convention on Income and Capital – a move, moreover, which affords a degree of protection in requiring certain safeguards for the exchange of information: ‘fishing’ enquiries are not allowed, with tax authorities required to demonstrate detailed prior knowledge of any company under investigation.

The removal from the list has now essentially removed any tax-adverse implications in the use of a Cyprus company by Russian nationals: a Russian company can now receive a dividend from a Cyprus subsidiary company without that dividend being taxed at the level of the Russian parent company.

Other positive measures include the retention of current (highly attractive) withholding tax rates – specifically a rate of five per cent on dividends (where investment is in excess of €100 000, otherwise 10 per cent), and nil rates on interest and royalties.

The Protocol also makes clear that distributions from mutual investment funds (or similar collective investment vehicles) can benefit from these reduced dividend withholding tax rates.  However, the revised Protocol stipulates that distributions from mutual investment funds investing only in immovable property will be treated as ‘income from immovable property’, thereby allocating taxing rights to the source country. 

The term ‘shares’ is given a wider interpretation within the provisions of the Protocol in relation to dividends, thus extending the application of the favourable withholding tax provisions on dividends to rights being in the form of depositary receipts.

The revised Protocol does introduce new provisions on the taxation of capital gains, however, expected to come into force four years after its adoption (i.e. 2017).  The taxation of capital gains on the sale of shares of companies which derive more than 50 per cent of their value from immovable property assets situated in either Cyprus or Russia will now be taxed at the rates applicable in the country in which such immovable property assets are situated (a measure again consistent with the latest OECD Model Tax Convention).

The revised Protocol also clarifies that the decisive factor of whether a company or entity is tax resident in either Cyprus or Russia is the place of ‘effective management’.
A further new provision is also introduced whereby the benefits provided under the DTT will not be allowed (the so-called ‘limitation of treaty benefits’) if, following consultations between both countries, it is established that the main purpose (or one of the main purposes) of the creation or existence of tax residency in either country was to obtain the benefits of the DTT.  However, this limitation of benefits provision applies only to non-Cyprus incorporated companies that move their tax residency in Cyprus.

The meaning of permanent establishment is extended to allow, under certain conditions, the taxing of profits from services performed by a company incorporated in either country (i.e. Russia or Cyprus) through individual(s) who are present in the other country for more than 183 days in a 12-month calendar year.
Income from international traffic (i.e. of ships or aircraft) is replaced by giving the taxing right for such income to the country in which the effective place of management of the person deriving such income is situated (as opposed to the residency of the person deriving such income).  This change, again, follows the OECD Model Tax Convention.

These measures have been widely welcomed by investors in both countries, and are expected to further boost Cyprus’s standing as an offshore investment destination.  The authorities are to be further commended in allowing a four-year grace period prior to the introduction of new regulation on capital gains: investors would be wise to utilise this opportunity to put effective tax planning strategies into place now.