There is arguably no greater obstacle to foreign investment in Russia than the tax system.


The climate for all forms of investment in every sector of the economy is affected by such mainstays of the Russian fiscal system as galloping tax rates, the ever-shifting contours of taxable income and transactions, and the vagaries of interpretation by local officials.


At the same time, lawsuits brought and won by taxpayers throughout Russia in the past two years indicate the willingness of the courts to review critically the actions of the State Taxation Service and, where these are not consistent with an objective interpretation of the legislation, to invalidate them.


The Supreme Arbitration Court recently issued two separate letters that are intended to be of guidance to litigants and to the lower courts, summarizing recent decisions of arbitration courts.


The documents include a reference to a simple case that has potentially broad significance in determining whether or not officials can impose capital gains tax on passive foreign investment in Russian securities.


In the case in question, the State Taxation Service fined a komissionny magazin, or consignment store, for its failure to withhold income tax from the proceeds of sales that it pays out to individual clients. Consignment stores are commonly used to earn extra cash by selling family trinkets or items bought abroad.


Little of the extra cash that people earn through consignment store sales finds its way onto their individual income tax declarations, therefore the State Taxation Service attempted to collect the tax from the consignment store itself as the only easily accessible entity involved in the transaction.


The arbitration courts, however, reversed the decision of the tax service by ruling that the law on individual income tax levies a tax on income and not on revenues. More importantly, it does not oblige consignment stores to study each client's costs and expenses to determine the amount of income tax that is applicable.


While the relevance of this case to foreign investment is only by implication, it indicates that the tax service will find it difficult, if not impossible, to impose capital gains tax on passive foreign investment in Russian securities.


For example, a recent tax service letter attempts to tax capital gains received by foreign investors not operating through a permanent establishment.


Russian taxes on foreign investors not operating through a permanent establishment are collected by means of withholding, which is effected by the Russian enterprise making the payment to the foreign investor.


What is not clear is how the Russian enterprise is supposed to calculate the capital gain of the foreign investor without information as to the foreign investor's costs and expenses. In a transaction between two foreign investors in respect of Russian securities it is even less clear who will be obligated to withhold tax.


The consignment store case is instructive on both points and suggests that the State Taxation Service is not free to impose withholding obligations in addition to those provided for in the law and without sufficient information accessible to the payor as a matter of law.





Leonid Rozhetskin is a graduate of the Harvard Law School and a native of St. Petersburg, now in private practice in Moscow.