On 14 February 2023, the Council of the EU (the Council) voted to add Russia to the main EU list of non-cooperative jurisdictions for tax purposes (the EU Tax Blacklist) (as well as the British Virgin Islands, Costa Rica, and Marshall Islands). The EU Tax Blacklist is part of the EU’s external strategy on taxation and aims to promote good tax governance worldwide. The Council added Russia to the EU Tax Blacklist due to non-fulfilment of certain tax-related commitments combined with the fact that the dialogue with Russia on tax matters came to a standstill following the Russian aggression against Ukraine.
Whilst the addition of Russia to the EU Tax Blacklist should not have any immediate and/or direct legal consequences at EU level, it is expected to lead to significant German tax implications for taxpayers with business relationships with Russia – from as early as 2024 – as a result of the application of the German Tax Haven Defence Act (Steueroasen-Abwehrgesetz; the THDA).
The THDA was adopted in 2021, based on suggested measures by the Council, with the aim of putting pressure on blacklisted tax jurisdictions outside the EU to implement and comply with international tax standards. To this end, specific tax law measures were implemented that seek to discourage German taxpayers from entering into or carrying on with business transactions with counterparties based in such jurisdictions.
Under the THDA, the German Ministry of Finance is entitled to incorporate the amendments to the EU Tax Blacklist into national law by way of a regulation that is usually adopted once a year. The German Ministry of Finance is expected to reflect the updated EU Tax Blacklist in a corresponding regulation by the end of 2023, i.e. Russia is expected to become a non-cooperative jurisdiction for purposes of the THDA as of 1 January 2024. Assuming this timeline is met, certain defensive measures against German taxpayers with business relations with Russian counterparties will apply, along with special tax compliance and cooperation obligations for such taxpayers. This is the position regardless of any potential protection available under the tax treaty between Germany and Russia (referred to as a ‘qualified treaty override’).
German defensive measures and tightened tax compliance
The THDA provides for four defensive measures which are applied in stages over time (if Russia is not removed from the EU Tax Blacklist again in the meantime) as summarised below:
- As of 2024, stricter controlled foreign company (CFC) rules will apply. Controlled companies domiciled in Russia will be deemed to be intermediate companies subject to German CFC rules with their entire – not only passive – income if and to the extent such income constitutes low-taxed income within the meaning of the German Foreign Tax Act (Außensteuergesetz), i.e. in principle, income subject to an effective tax rate of less than 25%. Certain exemptions from German CFC rules (i.e. motive test and de-minimis threshold) will no longer apply with respect to Russian resident companies.
- Equally as of 2024, the German non-resident tax liability regime will be extended to income received by Russian resident individuals or companies from financing relationships, insurance and reinsurance services, the provision of other services, trade, and royalties or capital gains relating to German-registered IP. Relevant remuneration debtors would be required to withhold and remit German tax at a rate of 15% from relevant payments to Russian counterparties.
- As of 2026, German participation and capital gains exemption rules will be denied with respect to dividend or capital gains income derived from Russian subsidiaries; exceptions may apply if and to the extent the taxpayer can prove that the distributions result from amounts that have already been subject to domestic withholding tax or that the deduction of expenses has already been denied for the respective amounts under the THDA.
- Finally, as of 2027, tax deductibility of business expenses paid to a Russian resident recipient will also be denied unless the corresponding income is subject to taxation in Germany or covered by the (extended) CFC rules.
With respect to tax compliance and cooperation, as of 2024, the THDA requires taxpayers to prepare extensive documentation regarding the type, content, and scope of the transactions involving counterparties residing in Russia, which must be made available to the German tax authorities within one year from the end of the relevant calendar or fiscal year. In addition, the update of the EU Tax Blacklist may trigger disclosure obligations regarding specific cross-border arrangements with Russian counterparties under the German DAC6 rules.
In response to the wider Western sanctions imposed to date, Russia has implemented various counter-measures including, among other measures, approval requirements regarding distributions from or divestments of Russian subsidiaries held by certain foreign (including German) shareholders. In light of the recent addition of Russia to the EU Tax Blacklist, on 15 March 2023, the Russian Ministry of Finance and the Russian Ministry of Foreign Affairs published a press report stating that the Russian President will be asked to adopt a decree that will suspend Russian tax treaties with all ‘unfriendly’ countries. Since Germany qualifies as an ‘unfriendly’ country for these purposes, if the Russian President upholds this proposal, the tax treaty between Germany and Russia will be suspended (although the precise details and timing of such suspension remain unclear at this stage).
Impact on German businesses and M&A activity linked to Russia
German corporations that are currently considering a divestment of any Russian subsidiaries (subject to the relevant Russian counter sanctions approval process mentioned above) should keep a close eye on the anticipated timing of such transactions given the potential suspension of (i) German participation and capital gains exemption rules and (ii) benefits under the Germany/Russia tax treaty (such as a reduction of Russian withholding tax on dividend payments). It may also be necessary to review the envisaged deal structure from a tax perspective and to analyse the potential for additional DAC6 reporting requirements.
As for German majority shareholders in Russian subsidiaries who are considering continuing their business operations in Russia beyond 2023, it will be necessary to carefully consider the tax effects resulting from the application of the extended German CFC rules as of 2024 (as the effective tax rate at the level of the Russian subsidiary is typically less than 25%). In some cases, German corporate shareholders may be forced to explore options to limit or exclude exposure to German CFC rules (e.g. via an intra-group share transfer or trade sale depending on the ultimate ownership structure of the group).
Even German groups that have already exited the Russian market following the Russian aggression against Ukraine in early 2022 may be affected by the recent developments if business relationships with Russian resident counterparties continue beyond 2023. For example, questions around certain purchase price arrangements in the relevant M&A agreements may arise if and to the extent capital gains have not yet been recognized at the level of the relevant Seller entity, and in instances where German sellers were granted repurchase options with respect to the Russian business, thorough tax analysis will be necessary prior to exercise of such an option right. As always, however, the specifics will depend on the circumstances of each individual case.
If you would like to discuss the issues raised in this blog post, please get in touch with the authors or your usual Freshfields contact.