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Traps and Pitfalls of Foreign Business in Russia

In spite of all current difficulties, Russia is still attractive for foreign investors. However, doing business in our country is distinct of certain particularities and, sometimes, connected with serious risks. So, how could a foreigner start conquering Russian market in a legally seamless way and what pitfalls one may encounter?

Choosing Bona Fide Contractors

First of all, a foreign investor should bear in mind that Russia in the years of Boris Yeltsin, the first RF President, and Russia of Vladimir Putin are absolutely different countries in terms of their legal nature. Russian people are already well aware of private property, while the state understands the importance of maintaining transparent relations with business and does it best to make the companies work legitimately and pay all taxes imposed by applicable legislation.

However, we need to realize that certain risks still exist. Primarily, they are connected with the fact that some entrepreneurs in Russia thirsty for earning more money whatever it takes, including those evading taxes. This is the point, where, perhaps, the main hazard for a foreign businessman lies. One might wonder, why should a civilized foreign investor be aware of questionable techniques of doing business by Russian mala fide entrepreneurs? The matter is that contemporary business community in Russia is still not accustomed to pay absolutely all taxes. However, Russian fiscal authorities, in their turn, do not pursue an informal goal of applying additional charges against the companies that ignore payment of taxes, but they do care about real pumping up the state budget, i.e. actual collection of tax debts from companies that are able to pay.

So, here is the first inference that we could draw: a foreign investor needs to work only with those Russian contracting parties that do pay taxes, i.e. bona fide taxpayers.

At the same time, a foreign businessman should be also aware of one more “but”: Russian legislation does not prescribe the notion of “bona fide contractor”, it was merely washed out in the course of multitudinous precedents of judicial practice. That is why it is essential for a foreign investor to elaborate, either personally or with assistance of professional consultants, a methodology of contracting parties’ screening to avoid problems in future, inter alia, in terms of relations with Russian tax and law enforcement authorities. So, what are the goals of such screening?

  • Setting the stage for rejection of all potential claims from the part of fiscal and law enforcement authorities, connected with exclusion of costs on the profit tax and non-deductibility of value added tax (hereinafter VAT) from amounts paid to mala fide suppliers;

  • Preparation of evidentiary base in case of potential tax controversy for the purpose of confirming the fact of interaction with “problematic” contracting parties;

  • Prevention of potential negative civil law consequences, connected with supplies of commodities (works or services) from mala fide contracting party.

By the way and besides, it is worthwhile to elaborate and deploy at the enterprise the methods of accounts receivable management. Unfortunately, in Russia, promises to pay in due time, given by a contracting party, may actually result in budget-unfriendly lawsuits and, due to stepped-up bankruptcies of legal entities, you might not be paid at all by a contracting party, to which you delivered goods (works or services), and you might not get your goods back too. As you may imagine – these are direct losses for you.

Beneficiaries Under Siege

Nowadays, the country has plotted the vector for bringing the ultimate beneficiaries to tax liability, i.e. individuals, who in fact run business and do adopt strategically important decisions, rather then those nominal directors or owners of established companies.

For instance, the RF Criminal Code directly foresees exemption of nominal managers from liability, in case such managers disclose ultimate beneficiaries, i.e. actual owners of the business. Russian bankruptcy laws are being adjusted towards prioritized satisfaction of tax authorities’ requirements and application of subsidiary liability to the companies’ beneficiaries. What is it done for? The answer is straight - the state understands that only certain individual (beneficiary) will be searching for money, in order to repay the debt to the state and avoid imprisonment. Only these individuals may have enough assets to discharge the claims of fiscal agencies.

By the way, if any beneficiary is not capable of paying debts, then in such a case the Federal Law dated 29.12.2014 № 476-FZ “On introduction of amendments to the Federal Law “On insolvency (bankruptcy)” and certain legislative acts of the Russian Federation in part related to regulation of rehabilitative procedures applicable to the debtor individual” introduced relevant amendments to the Federal Law dated 26.10.2002 № 127-FZ “On insolvency (bankruptcy)”, which allowed acknowledging physical persons bankrupt.

It is important that bankruptcy mechanisms are being currently applied not only by fiscal authorities, but mala fide contracting parties too, who consider bankruptcy as a tool for forcible business takeover. For a foreign businessman, who is not familiar with Russian realities, it is vital to know that if you don’t have a majority creditor in bankruptcy proceedings, then your business in 90% of cases will be lost forever and, even more, in case your company is involved bankruptcy, which incorporates all of your (fixed) assets, then it will be not feasible to recover them at all without a kind of control over such bankruptcy proceedings.

“Surprise” for the Bank and Tax Inspectorate

You should also account for substantial risks, connected with amendments introduced in the end of 2016 to the Federal Law dated 07.08.2001 № 115-FZ “On counteractions against legalization of criminal proceeds (money laundering) and financing of terrorism” (hereinafter the Law № 115-FZ), which allowed credit institutions to suspend banking transactions and block certain accounts. In practice, it looks like this.

For example, your company needs to make payment to a foreign entity or transfer dividends. However, as soon as such payment order is received by the bank’s front office, in fact, in 90% of all cases the bank’s security service will promptly block transactions on such accounts. Thereafter, the bank’s client will have to explain and evidence that the payment is purported for legally sound purposes and that such cross-border transfer is not for the purpose of legalization of criminal proceeds (money laundering). Moreover, most of the top banks have already introduced the traffic light system for Russian legal entities too. That is why you may be surprised by your accounts being blocked with reference to the Law № 115-FZ, inter alia, in relation to your Russian contracting parties in case such contracting party is filed in the black list due to suspicious transactions regulated by the norms of the Law 115-FZ.

In addition to the banks, this practice was deployed by tax authorities too. Effective from this fall, tax inspectorates started practicing a new approach by issuing orders for blocking of bank accounts, suspension of registration formalities with legal entities owing to non-conformance of the legal entity’s address. In case the legal address specified by the company in the Uniform State Register of Legal Entities (hereinafter the USRLE) is not confirmed, then fiscal authority makes a record in the USRLE stating non-conformity of its actual address. I.e. in case a legal entity is just registered at a certain address, but is not actually located there, then such a record will be definitely made in USRLE with all ensuing consequences. This will ultimately complicate operations with contracting parties, because in such a manner it represents the company unreliable for them.

Get Protected Comprehensively

Well, could it be really the only option for a foreigner to forget about doing business in Russia? Of course not! Russian economy develops at accelerated pace. At the moment, there are all necessary prerequisites for a foreign businessman to occupy an adequate niche in relevant business by having invested knowledge, skills and experience of work in more economically developed countries. The only thing is to know local risks and take timely measures required for their avoidance.

How to avoid the abovementioned risks? The answer is quite simple: when building a business in Russia, you need to shape-up the legal structure in a an intelligent way jointly with experienced consultants, in-building the mechanisms of tax optimization allowed by applicable laws, that is to do everything within the framework of legislative environment.

The best piece of advice – “don’t put all eggs in one basket”, clearly separate you business activities from your assets portfolio in order to protect the latter. Why doing this? Let me explain.

Collection of tax debts from a company, which has zero cash or liquid assets, is the ground for bringing of inter-dependent entity to liability (spp. 8 and 9 sp. 2 p. 2 Article 45 of the RF Tax Code, hereinafter the RF TC).

Tax authorities are insisting on inter-dependence in case they establish that a company transferred its business activities to a controlled legal entity. They will examine kin relations between the founders and employees of given companies and recognize the entities dependent on such grounds.

At present, most of the courts enforce tax debts against formally independent legal entities.

The courts use to acknowledge entities as dependent ones for the purpose of sp. 2 p. 2 Article 45 of the RF TC and satisfy the claims on enforcement of debts on VAT, penalties, fines on the profit tax, due to the audited taxpayer failure to fulfill its obligations related to payment of additional amounts of tax.

That is why, when building legal structure of a group of companies, it is very important to account for their inter-relations.

Unfortunately, there are no predefined criteria defining inter-related companies according to Russian legislation. All of such signs were formed in the course of judicial practice. However, some of the “distinctive features” may be highlighted: common personnel, common (the same) actual address, the same IP address, consistent exchange of loans between the companies aimed at elimination of cash gaps, etc.

In such cases, only professional consultants will protect a foreign businessman against getting frizzled. Starting business in Russia without consultants, in practice, is more expensive and burdensome than with them. Indeed, incorrect first move in chess may tip the beam of the entire game. Therefore, only elaboration of the most efficient format of the legal structure of the business and assets’ holding will allow the owner to ensure control over business processes in Russian jurisdiction without the risks of assets’ loss, accounting for the most comfortable taxation system, i.e. by way of introduction of the most efficient structure of tax planning.

Only the business structure built in the right way, when deciding on the form of incorporation, whether joint stock company or limited liability company, will allow shaping-up the business system of investment and reinvestment in the very beginning.

It is not enough to have a legal structure in place, you will need to set-up the managerial control, elaborate and implement adequate personnel motivation system. This is also an important task for foreign investors in Russia, which should be dealt with by consultants only.