Menu
Tax Notes logo

Politics, Not Economics, Driving Russian Tax Reform

Posted on Sep. 7, 2020
Natalia Pushkareva
Natalia Pushkareva

Natalia Pushkareva is a PhD candidate in global studies at the University of Urbino in Italy and a Frederic Bastiat Fellow at the Mercatus Center at George Mason University in Arlington, Virginia.

In this article, the author analyzes several recently announced tax policies aimed at helping Russia recover from the economic effects of the COVID-19 crisis and considers how they may affect the business environment and the Russian economy as a whole in the long term.

On June 23 — one week before a national referendum on amendments to the Russian Constitution that would remove the limitation on the number of terms an individual could serve as president and (officially) make the legislature subordinate to the president — President Vladimir Putin addressed the nation.1 Not only did Putin, who has held the presidency for 20 years,2 use the opportunity to encourage participation in the referendum, he also introduced several major changes to the country’s tax policy.

A Progressive Income Tax?

One of the biggest news items in the speech was the announcement that Russia is bringing back progressive income tax rates — albeit in a limited form — for the first time since 2001. Starting in 2021 all taxpayers whose annual income exceeds RUB 5 million (approximately $68,400) will pay income tax at a rate of 15 percent instead of the general 13 percent rate. The higher rate will only apply to income in excess of the threshold. Putin vowed that the revenue from this tax, which he projects will be around RUB 60 billion, will be spent only on treating children who have serious diseases and purchasing medical equipment.

The reform raises multiple questions. First, one new tax rate set only two percentage points higher than the general rate can hardly be called progressive, especially in a country with as high a level of income inequality as Russia has today.3 The stated threshold is equivalent to the salary of a Moscow-based senior manager. While there is nothing wrong with classifying those individuals as rich, there are people who control much more wealth and receive incomes many times higher than the stated threshold. Thus, it would be fairer to create several tax brackets with income tax rates that increase significantly from one bracket to the next. Without including more brackets, the announced plan does not make much sense economically or politically.

Second, the mechanics of the new policy are also far from clear: Although the income tax is considered to be a federal tax, no revenue collected from it goes to the federal budget. Eighty-five percent of income tax revenues go to regional budgets, and 15 percent goes to to local budgets. The government has yet to explain how the tax authorities will distinguish the revenue from the extra percentage points so that they can transfer it to a different destination. In his address, Putin mentioned that decisions about how exactly to spend the additional revenue should be made by benefactors and charitable nongovernmental organizations, but he did not specify exactly how the system will work. Will the authorities set up some type of special-purpose account for the 15 percent payers? This is just one of the many unanswered questions.

At this point, the income tax measure seems to be a fairly spontaneous political move and an effort to gain the electorate’s sympathy rather than a carefully crafted tax policy change. In recent years, the Russian government has banned the import of several medications that are vitally important for sick children despite not having adequate Russian-made generics, instituted similar bans on the import of much-needed medical equipment, and fired several talented and highly specialized children’s surgeons and oncologists for speaking out about problems in the healthcare system. This seems to indicate what economists might call the government’s “revealed preferences.”

Controlled Foreign Corporation Tax

Another novel tax policy that Putin introduced in his June 23 speech is the option for Russian beneficiaries of controlled foreign corporations to pay a fixed RUB 5 million corporate tax without providing any paperwork. The measure seeks to stimulate the development of modern, responsible business in the country. According to Putin, Russian businesses operating abroad “must have an opportunity to pay their taxes at home, in Russia in a comfortable and civilized manner.”

Since 2015, Russian tax residents who are shareholders of 25 percent or more in a CFC must pay Russian income taxes at rates of 13 percent for individuals and 20 percent for corporate owners. The tax also applies to shareholders of 10 percent or more in a foreign company if Russian citizens own 50 percent or more of the company. The procedure for paying these taxes is far from straightforward: The CFC taxes are usually due one or two years after the end of the relevant reporting period, losses can be carried forward eternally, and a significant amount of paperwork is required. The reporting scheme for CFCs controlled by Russian residents is so complicated that taxpayers often need to seek the assistance of professionals from the Big Four accounting firms to fully comply.

The new policy is intended to give those who control significant sums of money through CFCs relief from these headaches and encourage them to pay taxes in Russia even if that means Russia must accept a significantly lower effective tax rate than would otherwise apply. As Putin explained in his speech, this and other policy changes seek to increase trust in and support of the Russian business climate while also demonstrating “that it is possible to work in Russia profitably, safely and reliably, and do this legally, openly, and honestly.”

According to tax practitioners, only those who control $10 million or more through CFCs (assuming 5 percent profitability) will benefit from the new rule. Market experts report that it usually does not make financial sense to invest less than $5 million in a CFC and that those with between $5 million and $10 million invested in CFCs will be best served by continuing to report in the old-fashioned manner. Thus, only those with more than $10 million invested in CFCs will benefit from the new rules. Obviously, the more the taxpayer controls through CFCs, the larger the benefit obtained by paying a fixed sum of tax.

Not only will the new rule benefit taxpayers with significant sums invested in controlled entities abroad, the ability to pay a fixed amount of tax without any reporting responsibilities will also benefit tax authorities who will not need to analyze complex schemes and huge bundles of documents. Some businessmen have said that the CFC tax compliance documentation that they provided to the authorities in the past has sometimes weighed more than 100 kilograms (about 220 pounds).

The measure is clearly aimed at enticing high-net-worth individuals to return to Russia. After Russia introduced CFC rules in 2015, the tax authorities noticed that wealthy individuals became highly mobile. According to the law firm Egorov Puginsky Afanasiev & Partners, about 40 percent of CFC beneficiaries gave up their tax residency in Russia when the CFC regulations entered into effect.4 Others sought tax amnesty or tax-free liquidation. Ultimately, only about 1,000 Russians self-reported as CFC beneficiaries. The added tax revenue from making CFC beneficiaries pay taxes in Russia was a modest RUB 3.8 billion for 2018 — nine times less than what the budget will receive if every CFC beneficiary pays the RUB 5 million tax.

Putin’s speech reveals that the government, realizing how mobile CFC beneficiaries are and how easy it is to manipulate residency rules in a globalized world, has decided to try to attract wealthy taxpayers with lower effective tax rates, thus dragging itself into global competition for wealthy residents. However, the tax rate is not the only factor that defines a country’s business climate. The latest constitutional amendments do not offer much hope for the development of democratic institutions or the rule of law in Russia any time soon.

Another purpose of the CFC legislation in Russia is to decrease the use of artificial schemes for investing in Russia through companies located abroad. From this point of view too, the RUB 5 million tax on CFCs is not the best response: For many investors, it will be much cheaper to use CFCs to invest and pay the fixed RUB 5 million tax than to operate directly through Russian legal entities.

IT Sector Changes

Finally, Putin used his speech to introduce a dramatic decrease in the corporate income tax rate for the Russian IT sector. Starting in 2021, Russian IT companies that generate at least 90 percent of their income from the sale of software and services for its development, implementation, and support will pay corporate tax at a 3 percent rate, a sharp decrease from the 20 percent they pay today. And their insurance contributions will decrease from 14 percent to only 7.6 percent. In his address, Putin emphasized that the insurance contribution reduction in particular is a permanent move — not just a short-term measure aimed at helping businesses recover from the recession. The plan also includes some other, relatively minor tax benefits.

The intent of these policies is to bring Russian IT companies back from other jurisdictions where some have formally registered, attract international high-tech start-ups to Russia, and stimulate the export of software from Russian companies. The problem is, of course, that this is a textbook example of a race to the bottom rather than a sustainable policy. The 3 percent corporate income tax rate is one of the lowest rates in the world, and it is six times lower than the standard rate. As Putin explained in his address, the rate:

is not only comparable but even better than in such attractive jurisdictions for IT business as India and Ireland. In fact, this will be one of the lowest tax rates in the world.

This is exactly the sort of tax competition that the international tax community is trying to avoid. While major international organizations and NGOs are calling for international cooperation and the introduction of a universal minimum tax to prevent harmful tax competition, Russia is ignoring the widely held sentiment and giving the IT sector unprecedented tax benefits as a last resort to stop companies from relocating abroad.

While it is true that evidence shows that international businesses still respond to tax incentives, the corporate tax rate would hardly make a list of the top five concerns of those who do business in Russia. No tax benefit can make up for the risk of being held criminally responsible or the risk of a business being taken over by the state. To compete internationally, Russia needs to enact more fundamental, structural, and institutional reforms that offer businesses stability and promise that the rules of the game will be fairly and consistently enforced.

The Russian IT sector agrees with this analysis. A few weeks after Putin’s address, the Association of Computer and Internet Technologies — an association comprised of some of the largest IT companies operating in Russia, such as Yandex and Kaspersky Lab Inc. as well as representatives from the Russian offices of Google, Microsoft, and Apple — issued a statement indicating that Russian IT companies feel endangered and threatened.5 They cited the recent arrests of several IT entrepreneurs and government searches targeting IT industry companies such as the National Computer Corporation, Merlion, Jet Infosystems, I-Teco, TechnoServe, and Maykor. The association warned the government that the hostile business environment might give IT companies an incentive to leave the country. The companies made it very clear they are concerned about the prospect of doing business in Russia. To address these issues and ensure Russia’s digital development, the associations suggested executing not only tax reforms but also legal reforms “that will ensure that all the branches of legislative, executive and judiciary powers are as friendly to law-obeying entrepreneurs as possible.”

These requests make sense. The tax policy changes seem like chaotic, poorly considered, and almost desperate attempts to regain the loyalty of high-net-worth individuals and businesses rather than efforts to ensure Russia’s long-term economic development. However, it is becoming increasingly clear that in a world of (almost) perfect mobility, simply lowering your tax rates is not enough to make a country internationally competitive. In fact, doing so without considering the long-term implications may result in negative economic consequences such as growing inequality.

FOOTNOTES

1 Vladimir Putin, “Address to the Nation” (June 23, 2020). All quoted language from the address is based on the translation available on the Kremlin’s website.

2 The total includes the term of President Dmitry Medvedev when Putin was the actual decision-maker but not the formal officeholder.

5 Vladimir Kozlov, “Russian Tech Industry Faces Coronavirus Brain Drain,” The Moscow Times, June 17, 2020.

END FOOTNOTES

Copy RID