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Doing Business in the Russian Federation 2006*


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General Country Information ..............................................................................................................................3 Political System ......................................................................................................................................................3

Chapter 1. Doing Business........................................................................................................................4

The Russian Economy ..........................................................................................................................................4 Leading Sectors .....................................................................................................................................................5 Mergers & Acquisitions ........................................................................................................................................7

Chapter 2. Legal Framework ......................................................................................................9

Types of Business Entities ..................................................................................................................................9 Formal Registration Requirements .................................................................................................................10 Tax Litigation .........................................................................................................................................................10 Taxation...................................................................................................................................................................11 Intellectual Property Rights ...............................................................................................................................11 Privatization...........................................................................................................................................................12 Subsoil Legislation..............................................................................................................................................13 Real Estate ...........................................................................................................................................................13 Mergers & Acquisitions ......................................................................................................................................15 Capital Markets.....................................................................................................................................................16 Licenses ................................................................................................................................................................17 Currency Regulations .........................................................................................................................................17 Regulatory Structures for the Russian Financial Sector ...........................................................................18

Chapter 3. Accounting and Audit ..........................................................................................20

Accounting Principles and Practices .............................................................................................................20 Audit Requirements and Practices .................................................................................................................23 Appendix 1. Differences Between Russian Accounting Rules and IFRS ..............................................25

Chapter 4. Taxation ..........................................................................................................................27

Tax System ............................................................................................................................................................27 Tax Administration...............................................................................................................................................27 Principal Taxes ......................................................................................................................................................28 Tax Treaties ............................................................................................................................................................32 Industry Specifics................................................................................................................................................33

Chapter 5. Customs........................................................................................................................36 Chapter 6. Labour Relations and Social Security ..........................................................37

Employment Relations .......................................................................................................................................37 Stock Options and Other Equity Based Compensation Plans ................................................................38 Foreign Personnel ...............................................................................................................................................38

Chapter 7. Corporate T ransparency ............................................................................................40 PricewaterhouseCoopers in the Russian Federation .............................................42

General Country Information
Territory (million km2): 17,075 Capital: Moscow Population (million): 142.7 GDP (USD billion): 766 GDP per capita (USD): 5,320 Language: Russian Main religions: Russian Orthodox, Muslim Government type: Federal republic Currency: Rouble Average exchange rate in 2005: RR 28.3 US$1 There are 13 cities with a population of over 1 million people: Moscow, St. Petersburg, Novosibirsk, Nizhni Novgorod, Ekaterinburg, Samara, Omsk, Kazan, Chelyabinsk, Rostov-on-Don, Ufa, Volgograd and Perm

Political System
Doing business in the Russian Federation 2006

Russia is a federative presidential republic. According to the Constitution established in 1993, the President of the Russian Federation sets basic domestic and foreign policy. The President is also Commander-in-Chief of the Armed Forces. Vladimir Putin was re-elected president on 14 March 2004. The Federal Assembly consists of two legislative chambers: the Federation Council (upper chamber of parliament) and the State Duma (lower chamber). The majority of deputies in the State Duma are members of the pro-presidential party, United Russia. On the whole, the political situation in Russia is stable.

Chapter 1.

Doing Business
The Russian Economy
Economic Performance
The Russian economy, displaying positive new trends, was very successful in 2005. Real GDP increased by 6.4% and industrial production was up by 4%. Record volumes and prices on main exports in the energy sector, first and foremost, conditioned a steady balance of payments. Export revenues increased by 33.9% to US$245.3 billion. As a result of Russia's strong economy, Standard & Poor's Ratings Service raised its long-term sovereign credit rating for Russia to BBB+ on 4 September 2006. Moody's Investors Service left Russia's investment-grade rating at Baa2 with an outlook of Stable. The Fitch rating agency upgraded Russia's rating to BBB+. In 2005, CPI inflation was 10.9%, down 0.8% from the previous year. One of the most important components of inflation in 2003 to 2005 was the rise in the tariffs levied on the housing and utilities services, which more than doubled between January 2003 and December 2005. In 2006, the government is planning to bring down the inflation rate to 8%. In 2005, the growth in direct foreign investment was 38.9%. The share of such investment in the total amount of foreign investment increased to 24.4%, compared with 23.3% in the previous year. The total amount of foreign investment made in the non-financial sector was US$53.65 billion, an increase of 32.4%. Luxembourg, the Netherlands, Great Britain, Cyprus, Germany, the US and France remain the main investors in the Russian economy. As of 30 June 2006, the amount of gold and foreign exchange reserves had reached US$250.6 billion. In April 2006, unemployment totaled 5.5 million people, or 7.5% of the economically active population. The economically active population numbered 73.9 million people, or 51% of the total population of Russia.

Russia's well-educated workforce is an important asset for long-term growth. Russia's relatively low-cost and generally highly skilled workers are one of the main attractions for investors. The resident population of the Russian Federation as of 1 January 2006 was 142.7 million people, down 0.7 million from 2004. Russia's population will continue to fall in the mid term.

Indices of Basic Macroeconomic Indicators in 1999-2005 (% against the preceding year)

2001 Gross domestic product (GDP) Fixed capital investments Volume of industrial production Trade balance (US$ billions) Gold and foreign exchange reserves (US$ billions) 105.1 108.7 104.9 48.1 37 2002 104.7 102.6 103.7 46.3 48 2003 107.3 112.5 107 59.9 77 2004 107.2 110.9 106.1* 85.8 125 2005 106.4 110.5 104* 118.3 182

*The dynamics of industrial production is given by kinds of economic activity. Source: Rosstat, Central Bank of Russia

Leading Sectors
Energy, Utilities & Mining
Russia's energy industry includes oil, gas, coal, shale and turf production. It also includes electricity generation, oil refining, centralized heating supply systems and power transmission networks. Accounting for a quarter of GDP, the energy industry is currently one of the most important and sustainable sectors in Russia. Its activity amounted to a third of industrial output and half of the federal budget, export, and hard-currency revenues. Currently its energy, utilities, and mining sectors (especially in electricity and gas) face major reforms to encourage continued domestic and foreign investment and to solve such crucial challenges as high market energy demands and export restraints. Russia is an important player in the international energy trade, possessing a share in global primary energy production of over 12%. Russia's energy reserves are among the world's largest; a country with less than 3% of the world's population, it controls around 13% of the prospected oil reserves, 34% of the natural gas, around 20% of the coal, 32% of the brown coal, and 14% of the uranium in the world. The oil and gas sector remains the principal sector of the Russian economy. It plays a leading role in generating state budget revenues and secures a positive trade balance for the country. Russia is third on the list of the world's largest oil producing countries, after Saudi Arabia and the US, and is the second-largest exporter. In 2005, Russia's oil production grew 2.5% on the year to 9.4 million barrels per day (470.2 million tons). LUKOIL, TNK-BP, Rosneft, and Surgutneftegas extracted the highest volumes of crude oil in 2005. Russia is the world's leader in reserves of natural gas (48 trillion cubic meters). In 2005, gas production rose 1% on the year to 640 billion cubic meters. Gazprom, Russia's state-run natural gas monopoly, produces 85.5 % of Russia's natural gas and operates the country's natural gas pipeline. Russia's total coal reserves are around 157 billion metric tons. After China, the US, India and Australia, Russia is the world's fifth-largest coal producer. Its fast-growing national coal production reached 296 million tons per year in 2005. In 2005, coal production rose 5.8% (compared with 2004) to 296 millions tons. Coal exports increased by 6% on the previous year. Russia's top coal-producing areas, accounting for more than 95% of its total coal output, are the Siberian, Far East, and Northwest federal districts. In the electricity sector, Russia relies on a 216.7-GW generating capacity of over 700 power plants and on a power transmission network of 2,500,000 kilometers (1,500,000 miles). RAO UES of Russia, the national electricity leader, operates around 90% of these assets. In 2005, electric power output in Russia rose 20.3% on the year to 952.2 billion kilowatts per hour (kWh). Electric power consumption increased 15.9% on the year to 940.1 billion kWh. Russia's hydro-power plants generate 45.7 GW, which accounts for nearly 21% of the overall generating capacity, while 10 nuclear power plants with 32 generating units provide 10% of the overall generating capacity (23.3 GW). The utilities sector is in the process of restructuring. A reform program has been launched that aims to dismantle the monopoly and create competition in the market in order to attract investment and induce mergers and acquisitions activity.

Along with oil and gas production, metallurgy is one of the key industrial activities of the Russian economy. Russia ranks first in the world in nickel production, second in aluminum production and export after the US, and fourth in steel production after China, Japan and the US. According to official statistics, in 2005 the metal industry accounted for over 16% of Russia's total industrial production and around 10% of total foreign investment. In 2005, metal industry production increased by 2.2%, compared with 2004. The share of investments in the fixed capital of metal production was 5.4%. Exports of metals and metal products increased 12.8% on the year to US$34.252 billion in 2005, including exports of ferrous metals and products, which rose 11.4% to US$20.948 billion. Exports of non-ferrous metals and products rose 17.3% to US$12.356 billion. An expanding domestic demand for metal products on the part of machine building and construction resulted in dynamic growth in metallurgy. In 2005, Russian ferrous metals companies increased finished steel production by 1.6% to 54.575 million tons. The largest ferrous metals holdings are Mechel Steel Group, Evrazholding, Severstal Group, Magnitogorsk Iron & Steel Works (MMK), Novolipetsk Ferrous Metal Factory (NLMK), and Tube Metallurgical Company (TMK). The non-ferrous sector is strongly export oriented: up to 70% of the country's non-ferrous metal production is exported. The largest non-ferrous metals holdings are Russian Aluminium,

Doing business in the Russian Federation 2006


Chapter 1. Doing Business SUAL-Holding, UMMC, Norilsk Nickel, and VSMPO-AVISMA. The process of privatization and asset consolidation in the metals industry is largely complete. Most metallurgical companies are vertically-integrated holdings, conducting exploration and extraction as well as refining and sales activities. Overall, relatively low production costs, proximity to raw materials, an improving technological base and increasing international integration are the key positive features of the Russian metallurgical industry. are Unilever, Procter & Gamble (including Gillette), L'Oreal, Oriflame, Avon, Mary Kay and Henkel. The main challenges faced by the retail and consumer sector in Russia are a lack of space in the major cities, poor logistics, insufficient infrastructure, and bureaucracy. However, given an increasing demand following the strong, sustainable growth in personal disposable incomes and intensifying competition in the market, some of these problems should be overcome in the future.

Communications and IT
The Russian communications and information technology sectors are developing rapidly and represent 5% of the country's GDP. According to the Ministry of Information Technologies and Communications, revenues of the Russian communications industry grew by 22%, reaching US$23.17 billion in 2005. By the end of 2005, mobile telephone penetration exceeded 86%, compared with only 50% a year before. In 2005, the total amount of mobile subscribers was 130 million. Mobile penetration is growing particularly fast in the regions, stimulated by sharp competition among the three major national operators (Mobile TeleSystems, Vimpelcom, and Megafon). They are vying to buy up regional operators and develop new networks across the country. Russian mobile operators are actively expanding in the CIS and Europe. The most intensive annual growth was shown by mobile communications, new generation services and IP-telephony. IP-telephony operators' sales reached US$260 million in 2005, which is a 53% increase. The fixed-line segment is dominated by state-controlled Svyazinvest. Privatization of Svyazinvest has already faced several delays. The market for alternative operators is also developing rapidly in Russia. Market leaders, including Comstar United Telesystems, Peterstar, and Golden Telecom, are growing fast and focusing on high-margin corporate and high-income household sectors. The government has begun liberalizing the long-distance market by granting alternative operators licenses for international and inter-city calls. The key emerging competitors to Rostelecom, the former state monopoly, are T ranstelecom, Golden Telecom and MTT. This process of liberalization is accompanied by a wholesale change in access and interconnection rules. National internet penetration rates are rather low, with most estimates putting the rate somewhere around 15%. In 2005, the number of internet users

Retail & Consumer

The increasing purchasing power of the population is the main driver behind the dynamic growth in recent years of Russia's retail and consumer sector. The retail and consumer sector is one of the fastest-growing markets in Russia and attracts 38% of all foreign investment. The retail industry's turnover in 2005 was around US$240 billion. Russia is the fastest-growing retail food sales market in the world, with the potential to redouble in size by 2008. In 2005, Russia was ranked the second most attractive retail market in the Global Retail Development Index. Hence, Russia has emerged as a big retail opportunity. Major international chains are expanding their presence in the food market, including Auchan, Metro, Rewe and Ramstore. However, Russian retail giants such as the Pyaterochka-Perekrestok, Kopeika, Sedmoy Continent, and Magnit chains continue to represent a significant share of the market. In spite of the extensive growth of modern retail chains, both Russian and international, street markets and kiosks still account for almost two-thirds of Russia's retail turnover. Their share of the market is steadily declining, however. Estimates of the volume of the consumer goods market in Russia differ substantially. While the Federal Service on State Statistics (Rosstat) gives a figure of US$130 billion, independent research agencies believe that the volume is much higher, up to US$190 billion. Around 40% of Russians' income is spent on food, but income spent on household amenities, goods and services, medicine and medical services, recreation, education and cultural services is increasing steadily. Multinational companies are already either market leaders or significant players in many segments of the Russian consumer sector. The food and beverages industry is dominated by companies such as Danone, Sun Interbrew, Nestle, Pepsi and CocaCola. Strong international players in the personal care, cosmetics and household products markets

was 22 million people. Revenue from internet services reached US$1 billion in 2005. Hardware is the major IT segment, accounting for more than 80% of the sector's revenue according to official statistical data, and is growing rapidly. The volume of hardware sales grew by 20% and totaled US$6.5 billion in 2005. The software industry is also on the rise, with a growth rate of around 20% and sales reaching US$1.2 billion in 2005. In 2005, the Russian government initiated a pilot program in IT-park creation. Parks are to be built in Tyumen, Novossibirsk, Nizhniy Novgorod, Kaluga and Kazan regions. The IT sector accounted for 5.3% of Russia's GDP in 2005. Despite positive developments in the IT sector, software piracy remains very high in Russia.

The sector is highly segmented. The top 24 banks control 65% of assets. Over the past few years, major Russian banks have attempted to reposition themselves as retail banks. Banks currently offer only a limited range of commercial and retail products (compared to those in the EU and the US), but new financial products are being introduced to the market. In January 2006, consumer loans reached US$38 billion and increased by 91% from 2004. Insurance According to results for 2005, the share of insurance premiums in GDP was less than 3%.The reported volume of the Russian insurance market was US$17 billion, an increase of 4% from 2004. The insurance market portfolio is comprised of the following segments: Property 37.83%, Liability 3.30%, Obligatory Medical Insurance 28.68%, TPML 10.95, Life Insurance 4.75%, Personal Lines 13.05% and Other Obligatory Lines 1.44%. As of 1 January 2006, there were 1,075 insurance companies in Russia. Some of the top companies are Rosgosstrakh, Ingosstrakh, RESO-Garantia, Sogaz, and Rosno. The top 100 insurers controlled 83.5% of the market in 2005. Throughout 2005, insurance companies developed regional networks to reach customers in more remote areas of Russia. As a result, insurance has become popular not only in major centres, but throughout the country. Companies have to comply with international standards to expand their operations beyond the local and to the worldwide community. Foreign customers prefer their insurers to possess a rating that indicates the financial stability and solvency of the enterprise. At present, seven companies in Russia have international ratings such as those set by Standard & Poor's and Fitch: Ingosstrakh (S&P rating BB+), Moscow Re (S&P rating B+), ProgressGarant (Fitch rating B-), Reso Re (S&P rating B+), Neftepolis (S&P rating B+), T ranssib Re (Fitch rating B+), and Russian Insurance Center (Fitch rating B).

Financial Services
Securities The Russian securities market is represented by two major stock exchanges: the RTS Stock Exchange and the MICEX Stock Exchange. T raditionally, RTS accumulates shares trading, while MICEX accumulates bonds trading. More than 400 securities, including 70 bonds, are listed on the RTS Stock Exchange. In 2005, the total turnover on the exchange was US$57.7 billion. The RTS Stock Exchange also calculates the RTS Index, actively used as an indicator for the Russian securities market. Daily trades on MICEX are held in stocks and bonds of about 350 issuers. More than 550 professional participants in the securities market trade on the MICEX Stock Exchange. In 2005, the estimated volume of transactions totaled US$226 billion, including stocks transactions totaling US$142 billion. Moreover, MICEX organizes foreign exchange trading and is developing the derivatives market. Banking There are over 1,200 banks in Russia. State-owned Sberbank has a significant competitive advantage over other banks due to its size and extensive branch network about 1,000 branches throughout the country. As a result, Sberbank dominates the Russian banking sector with a market share of 62% in deposits, 50% in retail lending, 32% in commercial lending, and 29% in aggregate assets. The Russian banking sector is one of the fastestgrowing and most attractive segments of the Russian economy. In 2005, the sector grew even faster than the economy. The banks' total net assets increased by 43% and totaled US$320 billion.

Mergers & Acquisitions

The year 2005 saw encouraging developments in mergers and acquisitions (M&A): over 700 M&A transactions were completed in Russia. The Russian M&A market grew by 73%. Domestic (72%) and inward (19%) transactions represent 91% of the total deals closed. Most transactions were made in the manufacturing, financial services and energy and utilities sectors, the last accounting for 42% of the estimated total Russian market value. The average size of private deal transactions

Doing business in the Russian Federation 2006


Chapter 1. Doing Business in Russia was US$174.5million in 2005. The oil and gas industry maintains a leading position in terms of the volume of deals completed. The largest deal in the history of M&A in Russia was registered in October 2005: Gazprom's redemption of 72.663% of the shares of Sibneft for US$13.09 billion. In 2005, there was a sharp decrease in the volume of deals in the transport and finance industries. Russia had the highest proportion of domestic deals among CIS countries in 2005, about 70% of the total. In terms of the number of inward transactions, Russia was the most attractive among CEE countries with 137 transactions in total. With 63 outbound deals closed in 2005, compared to 26 in 2004, Russia remained active outbound investor, targeting mainly Ukraine (with 14 deals), but also neighboring countries such as Armenia, Uzbekistan, Latvia and Azerbaijan and favored European countries Germany, Austria, and Italy. Russian companies set a precedent by establishing outward transactions in such distant locations as China, Australia, the UK and the US.

Chapter 2.

Legal Framework
This section summarises for investors Russia's general legal framework. Familiarization with these basic principles of Russian law may save considerable time and expenses later if a contemplated business structure (which is a commonly accepted structure in western countries) is not advisable or even possible in Russia. limited and additional liability companies also limit the liabilities of investors to the extent described below. Full Partnership A full partnership is similar to the American general partnership in which partners bear (full) joint and several liability for the partnership's obligations. A participant in a full partnership may not be a full partner in any other partnership. Limited Partnership A limited partnership, which is closer to the European kommandit partnership, has both full partners and partners whose liability is limited to amounts equal to their contributions. A full partner in a limited partnership may not be a full partner in another partnership and its liability is the same as for full partners described above. Partnerships under Russian law and for tax purposes are generally regarded as separate legal entities and are taxed accordingly. Contractual agreements for joint activity do not have legal personality, and share some of the characteristics of a tax transparent general partnership, with special rules governing their tax treatment. Limited Liability Company In this company, the liability of each participant is limited to the value of its contribution. Each equity holder in the limited liability company has the right to withdraw from the company at any time and to receive an amount equal to its pro rata share of the net assets of the company, provided the company is solvent. For foreign investors contributing significant amounts of time and money to a joint venture at the start-up phase, this aspect can be worrisome. The minimum charter capital of a limited liability company is 100 times the minimum monthly wage*. Additional Liability Company In an additional liability company, a participant's liability is limited to the value of its contribution multiplied by a factor set forth in the company's charter.

Types of Business Entities

Foreign investors can choose from a number of different forms of business representation in Russia, from Russian legal entities to representative offices and branches of foreign legal entities. Russian legal entities may be established in various forms, including joint-stock companies, limited liability companies and partnerships. Representative offices of foreign entities are strictly limited to conducting only liaison and support functions. Branch offices are nowadays only allowed to be involved in commercial activities, though they were allowed a much broader range of activities in the past. Many investors opt for branch offices at the outset because these entities are able to engage in almost any kind of commercial activity, are easier to establish and are subject to less onerous reporting requirements. At the same time, for many investments, including joint ventures, production plants, licensing, customs or privatisation issues, a Russian legal entity may be better suited to an investor's needs. Currently, the following forms of commercial legal entities (for-profit) may be incorporated in Russia: Full Partnerships; Limited Partnerships ("kommandit" partnerships); Limited Liability Companies; Additional Liability Companies; Production Co-operatives; Joint-Stock Companies (Open and Closed); Unitary Enterprises (State-owned legal entities not available to foreign investors). Of the above, only the joint-stock company resembles a corporation, but the limited partnership and the

*The term "minimum monthly wage" is used by the government as a ratio when calculating different payments, fines, penalties etc. and does not reflect the real minimum wage. As of 1 January 2006 the minimum monthly wage (for calculating different payments, fines, penalties, etc.) was 100 roubles (i.e., approximately US$ 3.7).

Doing business in the Russian Federation 2006


Chapter 2. Legal Framework Production Co-operative A production co-operative (or cartel) is deemed to be a voluntary association of citizens united on the basis of membership for joint production or other economic activity, and through their personal labour and other participation combining their property share contributions. Joint-Stock Company Russian law provides that only joint-stock companies may issue stocks which are regarded as securities and subject to registration. Russian legislation defines open and closed joint-stock companies, which are broadly equivalent to public and private companies, respectively. Public companies must make certain financial and related information public each year. The minimum charter (share) capital for open and closed joint-stock companies is 1,000 and 100 times the minimum monthly wage, respectively. are filed by the CEO or Director of the founding company as described above. Shelf companies are generally not available, and the incorporation process can take from two to three months. Preliminary approval from the Federal Anti-monopoly Service or subsequent notification is required in certain cases. State duty for registration of a Russian legal entity as of 1 January 2006 is RR 2,000 (equivalent to approximately US$75). No processing fee is charged for the registration of a Russian legal entity. Registration is also required for a branch or representative office of a foreign legal entity (FLE). However, in contrast to Russian legal entities, the process of registering a branch or representative office of an FLE involves various federal and local authorities. Registration of a branch or representative office of an FLE generally includes the following steps: Accreditation through federal and local bodies (accreditation bodies). Accreditation is effectively compulsory, since the local banks and administrative authorities may not recognize the branch/representative office without this form of accreditation; T registration; ax Registration with State statistics authorities and acquisition of statistical codes; Registration with extra-budgetary (Pension and Social Security) funds; Opening bank accounts. For the accreditation of a representative office, accreditation bodies charge a processing fee ranging from US$1,000 to US$2,500 depending on the period of accreditation from one year up to three years, respectively. The state duty for branch accreditation as of 1 January 2006 is RR 60,000 (approximately US$2,200). In addition, accreditation bodies charge a processing fee ranging from US$500 to US$2,000 depending on the period of accreditation from one year up to five years, respectively. The registration and accreditation procedures are rather complex but can normally be completed within four to six weeks.

Formal Registration Requirements

The introduction on 1 January 2004 of a one-window registration procedure for Russian legal entities has not, in practice, proved sufficient to simplify the process. The Moscow Registration Authorities have even complicated the process of setting up a new company in Russia by introducing on 1 January 2006 a new procedure for filing an application for the State Registration application under which the CEO or Director of a founding company has to file the application for the state registration and receive the registration certificates no representation by proxy is allowed. Such practice has been challenged, however, by the Russian Supreme Court's recent decision (Ruling GKPI06-735 of 1 August 2006) to allow application for state registration by proxy. As this ruling has just recently been published, it remains to be seen how it will be implemented in practice. The new procedure has significantly increased the time it takes to set up a company; if the CEO or Director of the founding company can not personally come to Russia to file the application, it must be sent by registered (not express) mail to the Russian registration authorities which will process the application and return registration certificates by regular mail either to the address of the founding company or the local address of the entity being incorporated. It is obvious that under the above circumstances the registration process may take several weeks or even months to complete. There are no alternatives available at the moment except for the personal filing of the application by the CEO or Director of the founding company, especially when time is of the essence for investors. Therefore, registration may be completed within 3-4 weeks through local tax authorities, who can handle registration procedures provided the documents

Tax Litigation
T disputes in Russia are heard by arbitrazh courts, ax which are regular state courts having jurisdiction over disputes related to business and economic activity, including tax litigation. Such courts can be likened to financial courts such as Germany's Finanzgericht and the like. The arbitrazh court system is divided into four levels: first-instance arbitrazh courts, arbitrazh appellate courts, courts of cassation and the Supreme Arbitrazh Court (SAC) of the Russian Federation.


The first level is made up of the federal arbitrazh courts of Russian federal constitutive entities; altogether there are eighty-one first-instance arbitrazh courts. Arbitrazh appellate courts have jurisdiction over several constituent entities of the Russian Federation; altogether there are twenty arbitrazh appellate courts. Arbitrazh appellate courts fully re-examine cases whose first-instance court rulings have been appealed but have not yet come into force. Each of the ten federal district arbitrazh courts, which form the third level of the system, functions as a court of cassation with regard to a group of arbitrazh courts making up one court circuit. These courts of cassation check the legality of the decisions in force passed by the first-instance arbitrazh courts and arbitrazh appellate courts in their district. The superior judicial body is the Supreme Arbitrazh Court of the Russian Federation. Very few cases are brought before the Supreme Arbitrazh Court, which chooses at its own discretion the cases it hears. It is also important to note that while a general case may be decided at any judicial stage, tax disputes always go through a full court cycle of the first three court levels and, less often, the fourth at the instigation of the tax authorities. On average, cases last from ten to twelve months, from the moment of filing an application until the final ruling of the arbitrazh court of cassation, but may take eighteen months or longer due to the circumstances and complexity of a particular case. Non-regulatory acts (e.g., decisions, requests, etc.), actions and omissions of the tax authorities can be challenged in arbitrazh courts. The deadline for making such a challenge is three months from the moment the taxpayer becomes aware of the violation. Most tax disputes up to 70% according to non-official statistics are related to export VAT recovery, either set-off or refund.

T reform has been a major step in improving ax the investment climate in Russia and has led to the overall systematization and simplification of the laws and tax administration. T reform introduced a 13% ax flat rate for personal income tax, reduced corporate tax from 35% to a uniform 24%, reduced VAT from 20% to 18% and introduced some other significant changes. The last several years have seen the gradual replacement of a variety of tax laws on separate taxes with the equivalent Chapters in the T Code. The ax introduction of the T Code eliminated loopholes and ax concessions, liberalised business expense deduction, and expanded and clarified many important definitions and procedures. All this has made the Russian tax system clearer to foreign investors. The T Code does not contain many anti-evasion ax provisions. A major development in this area was the introduction of new transfer pricing rules (in effect since 1 January 1999) and thin capitalization rules (effective since 1 January 2002). The tax authorities generally tended in the past to follow the form rather than the substance of a transaction, which encouraged aggressive tax evasion techniques. More recently, however, they have shifted their attention to the substance of a transaction when justifying it for legal or tax purposes, and the concept of a 'bona fide' taxpayer is currently being developed in Russia. Form continues to be important, and documentary support critical. The best recipe for success in such an environment is to keep transactions simple, properly documented and administered, be responsive to change in all aspects of business operations, and have strong tax and legal assistance.

Intellectual Property Rights

Russia is a party to all major international agreements and conventions concerning intellectual property, including: the Patent Cooperation T reaty, the Madrid Agreement Concerning the International Registration of Marks of 14 April 1891 and the Madrid Protocol of 28 June 1989 thereto, and the Nice Agreement Concerning the International Classification of Goods and Services for the Purposes of the Registration of Marks. Russian patent law regulates the legal protection and use of inventions, utility models and industrial designs. Its provisions correspond to international treaties on the harmonization of patent legislation and the Patent Cooperation T reaty, to which Russia is a party. Therefore, many of its provisions are similar to those in force in the majority of industrialized countries. In Russia, an examination of merits is conducted to confirm the patentability of an invention. Discoveries, scientific theories and mathematical methods, methods and rules of playing games and solutions consisting only of the presentation of information do not fall within the scope of Russian patent law. Russian law grants exclusive rights to an original

The present tax system is relatively new, and many tax issues encountered in longer-established systems have not yet arisen or been resolved in Russia. Therefore, many concepts familiar to Western business people and tax specialists are not reflected in the tax legislation and as such are not widely known in Russia. As new concepts are introduced or discovered by the Russian authorities, they are in some cases applied differently than in the West.


Doing business in the Russian Federation 2006

Chapter 2. Legal Framework method, which are supplemented by the rights to a product directly made using the patented method. Under the Federal Law "Concerning T rademarks, Service Marks and Appellations of Origin of Goods" legal protection of a trademark is provided on the basis of its official registration or under international treaties or conventions to which Russia is a party, including the Madrid Agreement Concerning the International Registration of Marks of 14 April 1891 and the Madrid Protocol of 28 June 1989 thereto. Russia is still in the process of implementing rules to give formal recognition to famous or well-known trademarks. It is a statutory obligation of the trademark owner to actually use the trademark in its business activities (i.e., the manufacture, export and sale of goods bearing the trademark). If the trademark owner fails to comply with this obligation, the trademark may be prematurely deregistered by decision of the Chamber of Patent Disputes under the respective claim of an interested person or legal entity. Protection is also provided to topologies of integrated circuits, plant varieties, copyright and related rights. Know-how is not considered intellectual property, but confidential information under Russian legislation. Company names are not the same as trademarks in Russia and cannot be protected under Russian law. Currently, Russian legislation only partially regulates domain names and the procedure for registering and assigning them. According to Russian legislation, all intellectual property rights may be transferred and/or granted under either the assignment or the license agreement, accordingly which must be duly registered with the Federal Service for Intellectual Property, Patents and T rademarks of the Russian Federation in order to take effect. Without a license agreement, the trademark may be used with respect to goods bearing the trademark that are put on the market by the trademark owner or with his consent. Distribution agreements granting rights to a whole set of exclusive rights including firm or trade name, know-how and confidential information, trademarks, etc. should be registered with tax authorities and the Federal Service for Intellectual Property, Patent and T rademarks of the Russian Federation. is regarded as the key element of the government's privatization policy. The Privatization Program sets forth the priorities, restrictions and principles of the privatization process. The Privatization Law requires that the State Duma (Russian Parliament) approve an annual privatization program submitted by the Russian government. Having already divested itself of nearly all of its large property holdings, the Russian government now faces the arduous task of unloading the lion's share of some 9,000 federal unitary enterprises and about 3,800 other companies owned by the state in full or in part, while somehow managing the ever-increasing number of state institutions. The plan is to keep only those enterprises that are deemed strategically important or that create products for public consumption. The government is hoping to complete this process by 2008. Recent Changes in Privatization Regulation In accordance with the Land Code Enforcement Law, buildings, premises and other structures, as well as the land plots beneath them, shall be privatized concurrently. However, if the owner of a building or other structure acquired such property prior to the Land Code's taking effect, the owner has the right to acquire ownership of the underlying land plot or lease it, except in cases where privatization is prohibited. As of 1 July 2006, the concept of delimitation of state-owned land between federal, regional and municipal ownership levels has changed. Its legislative refinement makes privatization of land more transparent. On 24 March 2005 the Plenum of the Supreme Arbitrage Court of the Russian Federation ruled that if the owner of a building or structure concludes a contract to lease the underlying land after the Land Code took effect, such owner is recognized to have exercised its exclusive right of lease and forfeited its right to purchase the land plot.

Subsoil Legislation
A great number of regulatory acts are presently in effect in Russia that directly or indirectly apply to subsoil use. The most important of these acts is the Law on Subsoil , passed in 1992. Until a new subsoil law is adopted, the Subsoil Law will continue to regulate subsoil use. It applies to foreign as well as Russian entities and individuals. The Subsoil Law establishes the legal framework for the use of subsoil, categories of subsoil use and the grounds for creating or terminating subsoil use rights. It also briefly describes the scope of a license for subsoil use and the core rights and obligations of subsoil users, as well as the mechanism of governmental regulation of subsoil use, and liability for non-compliance with the Law.

The principal laws regulating the privatization process in the Russian Federation are the Civil Code, the Law on the Privatization of State and Municipal Property, the Land Code, the Law on Land Code Enforcement and various other laws dedicated to specific types of assets subject to privatization. Of these laws, the Privatization Program, defined in the Privatization Law,


To implement the Subsoil Law, governmental agencies (including subsoil use licensing agencies) have adopted a large number of regulatory acts. Under the Subsoil Law and in accordance with general practice, a subsoil user must comply not only with the provisions of the Subsoil Law and associated regulations, but also fulfil the requirements of other legal and regulatory acts (on the environment, industrial safety, labour and tax legislation). Thus, other branches of law also directly affect the subsoil use process. In addition: Many provisions of the Subsoil Law are of a generic nature, unclear, or ambiguous; The Subsoil Law and regulations adopted to implement it have numerous gaps and fail to address some aspects of relations between the state and the subsoil user; Many aspects of relations between the subsoil user and the state are based on existing practice rather than on regulatory acts. The administrative nature of relations in subsoil use in the Russian Federation means that there is no peer partnership between the state and the subsoil user; rather, they represent a superior and a subordinate party. Some investors have the misconception that in the area of subsoil use the state and the subsoil user are on the level of partners. This misconception is due to the fact that a subsoil use license includes a license agreement that is signed by the licensing agency and the subsoil user when the license s issued. However, even though this document is called a license "agreement", implying a civil contract, it is an administrative act that dictates the conditions of the license and the obligations of the subsoil user. It is important to note that: The licensing agency takes decisions on the termination, suspension, or restriction of a license independently and without having to obtain a court order; The right to use subsoil cannot be freely transferred or used as collateral; The fact that a subsoil user received a license for geological exploration of subsoil, prospecting and discovery of a subsoil deposit does not guarantee that it will receive a license for production of the same subsoil area, since the Subsoil Law does not provide for mandatory issuance of a license in such circumstances. The Subsoil Law does not restrict foreign entities from directly or indirectly holding subsoil rights. Despite the absence of any legal basis for discrimination, however, in practice very few foreign entities have directly received a license from the licensing authorities.

New Russian Subsoil Legislation A draft Subsoil Law developed by the Ministry for Natural Resources (MNR) was approved by the government in March 2005 and submitted to the State Duma the following month. The draft was examined in the first reading in October 2005 and then returned to the government in November 2005 for further development and amendment. At the moment, the status of the draft Subsoil Law is quite unclear. The new Subsoil Law: Introduces a contractual system for relationships between the state and the subsoil user. Contracts shall be governed, in general, by civil legislation. Licenses issued before the introduction of the new Subsoil Law shall remain in force but licensees will be entitled to change them to contracts. Recognizes subsoil use rights as property rights which can be transferred, pledged, etc. Entitles companies holding exploration rights to receive production rights if they make a commercial discovery (it is not applicable to foreign investors who discover strategic fields). Provides that a subsoil use contract can be terminated by a court order only (but the licensing authorities will still be able to terminate a license without a court order and in certain cases the contract can be terminated by the state unilaterally and out of court). Limits grounds for the termination of subsoil use rights. Makes no guarantees of the renewal or extension of the subsoil use right. While the new Subsoil Law improves the business environment in the subsoil sector in some ways, it also places a number of potentially onerous demands on foreign investors, which should be dealt with carefully. For instance, it does not allow foreign companies to obtain subsoil use rights and provides that the government introduce bidding restrictions on companies with foreign participation in certain auctions. Furthermore, any disputes that arise shall be resolved in Russian court proceedings only. The license regime, while significantly restructured, remains in place and requires new implementing regulations. It is yet unclear how the new system of civil subsoil use contracts will work in practice.

Real Estate
This section provides a general overview of Russian real estate law. General Provisions of Russian Law Russian law permits private ownership of land and other real property. The Constitution, together with the Civil Code, Land Code and other laws, uphold and protect the right to own private property. Currently, most land is not privately owned, but is still held by the


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Chapter 2. Legal Framework Russian Federation, Russian regions and municipalities. The rights to real property such as ownership, lease and servitudes (easements) have to be recorded in the State Register of Rights to Real Property and T ransactions Therewith, as explained below. Russian law provides that significant technical and legal information about land plots, such as their measurements and boundaries, must be recorded in a state land cadastre. All land is categorized on the basis of its permitted use into one of the following land categories: agricultural land; settlement land; land for use by industrial enterprises, power companies, transportation companies and communication companies; security zones; forestry land; waterfront land; or reserved land (i.e., land which is owned by the state or municipality and is subject to reclassification into one of the other land categories). Land must be used in accordance with its category and, to the extent that urban construction regulations apply, in accordance with zoning requirements. The main principles for changing the category of a given plot of land are set forth in the Land Code. The Federal Law "On Reclassification of Land and Land Plots from One Category to Another" of December 2004 regulates the procedure for such reclassification in more detail. Under the Land Code, state and municipally-owned land plots may be sold or leased to Russian and foreign persons or legal entities. However, Russian law bans the sale or lease of certain types of land, the most common examples of which are nature reserves and land used for military purposes. Some land plots that may not be transferred to private ownership may nevertheless be leased, such as forestry land and nature reserve land. In general, Russian law neither imposes major restrictions on foreigners nor makes distinctions between foreigners/Russian legal entities with foreign interests and Russian legal entities/citizens in relation to the ownership of land except for agricultural land, land located at the Russian border, and certain other territories yet to be specified. Agricultural land plots have high priority and are subject to special protection. Regions of the Russian Federation and, in some instances, municipal authorities have the right of pre-emptive purchase of agricultural land plots offered for sale, except where the land is offered for sale through public auction. To use land in the agricultural category for a purpose other than agricultural production, a landholder must first have the land reclassified in accordance with its proposed intended use. The main principle of the reclassification of land from the agricultural category to another is that only land which cannot be used for agricultural purposes can be reclassified. The Land Code calls, in principle, for a unified approach to land and the facilities located on it. At the present time, however, land and facilities located on it are treated as separate legal interests under Russian law as it is still possible for them to be owned by different persons even though a building and the underlying land cannot be sold separately if they are owned by the same person. Obtaining Land Plots for Construction Purposes Russians and foreigners may acquire land held by the state or municipalities for development and construction. The Land Code allows the state or municipal authorities to refuse to grant land if the land in question may not be alienated or privatised, if the land is reserved for state or municipal needs, and in some other cases specifically stated in the law. There are two principal procedures which must be complied with in order to grant state or municipalityowned land for construction purposes. These procedures are known as "granting land with prior approval for the location of the construction" and "granting land without prior approval for the location of the construction". Construction on an allocated land plot may only be carried out after obtaining a construction permit. A construction permit is granted to the landholder the owner or tenant of the land plot. Obtaining a construction permit is a multi-stage process. It involves approvals and registrations of the project documentation by a number of governmental bodies, including architectural and urban development agencies, environmental management and protection agencies, and governmental bodies for public health supervision. State Registration of Rights to Real Property and Transactions Therewith The rights to real property (including land plots and buildings) and certain transactions therewith are subject to state registration in the Unified State Register of Rights to Real Property and T ransactions Therewith as provided by the Civil Code and Federal Law "On State Registration of Rights to Real Property and T ransactions Therewith". Registration is required for the right of ownership to newly-erected buildings and facilities, the right of ownership to land plots, the disposal of real property pursuant to a trust, servitudes (easements), sale and purchase agreements of real property, mortgage agreements, and land plot and building lease agreements concluded for a term of at least one year. Such rights to real property only arise at the time of their state registration. Rights to real property and transactions therewith are registered by the


regional branches of the Federal Registration Service at the location of the real property. In the event of failure to register a transaction with real property that requires state registration within the prescribed period of time, the transaction is deemed unconcluded or, in certain instances, null and void. Any transaction involving real property rights must be registered. Urban Construction Code The new Urban Construction Code adopted on 29 December 2004 introduces clearer and more transparent regulations governing the issuance of construction permits and permits for putting facilities into operation, although it remains to be seen how this legislation will be implemented in practice. As a general rule, a permit is issued for the period of the construction stated in the project documentation, but it may be extended. The new Urban Construction Code has also introduced a more definite procedure for commissioning a completed facility, although numerous implementation rules have yet to be adopted. Under the new procedure, upon completion of the construction, the landholder has to obtain a commissioning permit which certifies that the completed construction conforms to the project design documentation and statutory rules. To file an application for obtaining a commissioning permit, the landholder has to prepare certain statements and acquire, among others, approvals of the state construction supervision and state fire safety authorities (unless the type of facility concerned does not require these kinds of supervision). When such a commissioning permit is granted, the rights to the completed building may require state registration. After registering the rights to the facility constructed on the leased land plot, the owner of such real property obtains the exclusive right to acquire the title to such land plot or to obtain it on a long-term lease. As a general rule, the lease term applicable to state-owned land plots cannot exceed 49 years. Construction of Residential Property Prior to the adoption of the Federal Law "On Participation in Construction of Multi-Apartment Houses and Other Real Property and On Amending Certain Legislative Acts of the Russian Federation" of 30 December 2004 ("Law on Shared Participation in Construction"), construction funded or managed by multiple parties was regulated by the Russian Civil Code and other laws. The Law on Shared Participation in Construction created a more comprehensive and explicit legal basis for individuals and legal entities to invest money in the joint construction of multiapartment houses or other types of real estate.

Despite the legal go-ahead on this key point, the Law on Shared Participation in Construction does not present an unambiguously market-friendly framework for multi-party real estate investments. A number of its provisions have not been tested in practice, others are unclear or contradictory, and some call for urgent amendment as they are onerous to developers and financing banks and so prevent market growth. For that reason, most of the players (developers) tend not to use the regulatory framework introduced by the law, making the market less transparent. In response to numerous requests from the construction industry to make this strongly proconsumer law less burdensome for developers, the lawmakers are now considering amending the Federal Law "On Participation in Construction of MultiApartment Houses and Other Real Property" to make the law less stringent for developers and the market more transparent.

Mergers & Acquisitions

In Russia, the term "acquisition" is understood to mean a transaction where one party gains control over the other. A "merger" is defined as a type of corporate reorganization where one company ceases to exist and transfers all its assets and liabilities to another company by means of legal succession. Mergers are mainly used for intra-group restructuring. The most common options for acquisition of a business of a Russian company: Acquisition of shares (either existing or newly issued shares); Acquisition of assets. Though Russian law recognises acquisitions of businesses, they are very rare on the Russian market.

Foreign Ownership Restrictions

Ownership of Shares Generally, a foreign company is permitted to own 100% of a Russian company. Russia has a few sectors in which foreign ownership is limited: banking, insurance, military production and supplies, media, space exploration, aviation and agriculture. Currently, the authorities are considering introducing limitations in the oil and gas sector. Ownership of Assets Except for a limited number of restrictions, a foreign company may own or lease buildings, structures, land plots (except for agricultural land) and other assets, including intangible assets such as patents and trademarks.

Acquisition of Shares: Issues to Consider

Title to Shares A buyer should make sure that: the seller holds the title to the shares; the shares have been duly


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Chapter 2. Legal Framework authorised, validly and properly issued and distributed in accordance with all Russian laws and the foundation documents (this issue is the most critical for a privatized acquiring company); the shares are fully paid; and the seller has received all necessary corporate approvals. When acquiring newly issued shares, a subscriber should monitor the process of share issuance, including share registration with the Federal Service for Financial Markets. Corporate Law Requirements If a buyer (together with its affiliates) acquires more than 30% of voting shares in an open joint-stock company, the buyer must make a public offer to the remaining shareholders of the company to acquire their ordinary shares at the fair market value. If, as a result of such acquisition, the buyer (together with its affiliates) purchases more than 95% of the company's voting shares, the buyer must, at the request of the remaining shareholders of the company, purchase their shares in the company at the fair market value. Anti-trust Approval In accordance with Article 18 of the Law on Competition and Restriction of Monopoly Activity on Commodity Markets, prior anti-trust approval is required when more than 20% of ordinary shares in the company are acquired and the combined book value of the acquirer (its affiliates) and the target company exceeds RR 3 billion. Registration of Shares Transfer T ransactions with shares of a joint-stock company require registration in the shareholders' register in order to ensure their transfer. The register can be maintained either by the company or professional registrar. Registration of transfer usually takes from one to three days. T ransactions with participatory shares of a limited liability company require amending the foundation documents of the company and subsequent state registration. This procedure may take from seven to ten days. Anti-trust Approval Prior anti-trust approval is required when assets for purchase comprise more than 10% of the book value of all the seller's fixed and intangible assets and the combined book value of the assets of the acquirer, its affiliates and the seller exceeds RR 3 billion. Registration of Transactions with Real Property T ransactions with real property (acquisition, lease, mortgage and others), patents and trade marks require state registration. It normally takes twenty to thirty days for the registration of a transaction and subsequent transfer of rights to assets.

Capital markets
General The capital market and transactions with securities transactions within the Russian Federation are primarily regulated by the Federal Law "On the Securities Market" ("the Securities Law") of 22 April 1996 and the Federal Law "On Protection of Investors' Rights and Interests on Financial Markets" of 5 March 1999. The offering of corporate securities is regulated by the Federal Law "On Joint Stock Companies" and by a number of regulations issued by the Federal Service for Financial Markets ("the FSFM") a Russian securities market watchdog. Securities in Russia Under Russian law, an instrument may not be considered security unless it is specifically recognized as such in the Russian Civil Code or other relevant laws. The Civil Code recognizes shares, bonds, promissory notes, cheques, deposit and saving certificates, bills of lading and options on shares. Most corporate securities should be registered with FSFM before their placement and allotment. Registration of issue usually takes approximately thirty days and requires disclosure and filing of certain information and documents with FSFM. In a limited number of cases, the Securities Law requires the issuer to register a prospectus of an issue. Companies that have at any time registered a prospectus are subject to capital markets disclosure requirements. Fundraising A Russian company may raise funds through the issue of equity or debt securities. Equity securities may be offered to the general public only by open (public) joint-stock companies. Shares of closed jointstock companies and limited liability companies may not be offered to the general public. In 2006, the procedure of public offering of shares on Russian stock exchanges was simplified and new amendments to the legislation were aimed at bringing

Acquisition of Assets: Issues to Consider

Title to Assets A buyer should perform thorough due diligence on the seller's title to target assets, especially when such assets were privatized in the past. This should not be limited to a search of real property registers, patents and trade marks, but should be extended to a review of supporting documents: agreements, acts of acceptance, permissions etc. A buyer's solicitor should also conduct a careful review of encumbrances associated with the target assets being acquired.


public offering rules in line with international standards. Under the new rules, the number of shares to be floated on foreign exchanges was capped at 35% of the overall issued shares in the company. The issuance and trading of bonds is governed by the Securities Law, which distinguishes between secured and unsecured bonds. Secured bonds must be fully secured with a third-party guarantee or suretyship, or with a pledge (or mortgage) over the issuer's and/or third party's securities or immovable property. Only companies which have existed for a minimum of two years may issue unsecured bonds. The issue of bonds should be registered with FSFM. Russian joint-stock companies may also issue bonds convertible into shares. Together with bonds, Russian companies make extensive use of promissory notes for debt financing. The Russian Federation is a party to the Convention Providing a Uniform Law for Bills of Exchange and Promissory Notes.

Licensing requirements for travel agency services as well as structural engineering survey and construction are slated for cancellation on 1 January 2007 . Licensing requirements for certain other activities will be withdrawn as soon as the government bodies regulating them adopt more detailed regulations to set out strict operating standards. Unfortunately, Russian law does not provide any deadlines for adopting these regulations, and so it is hard to predict when each particular licensing requirement will be abolished. For example, regulations on the maintenance of medical equipment and its production were expected to come into force in the summer of 2006, but up to the present moment these regulations have not been enacted and the licensing requirement remains in force.

Currency regulations
Federal Law No. 173-FZ "On Currency Regulation and Currency Control" ("the Currency Law") establishes rules for performing currency operations in the Russian Federation. Under the Currency Law, currency transactions include transactions involving currency valuables (i.e., foreign currency and foreign currency securities) and transactions between residents and non residents involving roubles and domestic securities. All currency transactions may be classified into three major groups: Currency transactions between residents and non-residents; Currency transactions between residents in Russia with currency valuables; Currency transactions between non-residents in Russia. Currency transactions between residents and non-residents On 1 July 2006, it became much easier to perform currency transactions between residents and non-residents. Until then, certain currency transactions between residents and non-residents (e.g., loan transactions, transactions with Russian or non-Russian securities, etc.) were restricted, required the use of special bank accounts and were subject to reservation requirements. The above restrictions have been abolished by the Central Bank of Russia and the Government of the Russian Federation. The respective amendments in currency legislation are aimed at liberalizing the currency market and simplifying the process of transactions between Russian residents and their foreign counterparts. Currency transactions between residents Currency transactions between residents are prohibited, except for certain transactions specified by the Currency Law. Specifically, the following types of

Certain activities requiring special expertise may be carried out by either a legal entity or a licensed individual. Nowadays, a wide range of business activities in such areas as finance, banking and investment services, building and construction, the handling of hazardous wastes, pharmacy, education, weapons production, energy and mining, transportation and others are subject to various licensing requirements. The basic legal framework for licensing is set forth by the Federal Law of the Russian Federation of 8 August 2001 "On Licensing of Several Activities". This act provides a list of activities to be licensed as well as general guidelines for licensing procedures. It is worth mentioning that licensing in such industries as, for instance, alcohol production and trade, telecommunications and cryptography, banking, and international road transport is governed by other laws and regulations. At the moment, licences are granted by a number of different state bodies and agencies responsible for specific industries or businesses. As a rule, licences are granted for a term of not less than five years, which may subsequently be extended. In the event of violation of the licence requirements, the licence can be cancelled or revoked by decision of the licensing bodies or by court ruling. Carrying on business activities subject to licensing without the proper permission or licence may result in administrative or even criminal liability under Russian law. Russian law has made provisions for the eventual abolishment of an extensive number of licences.


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Chapter 2. Legal Framework currency transactions may be performed freely between residents: T ransactions between agents (commission agents) and principals (commission principals) where the agents render services that involve the conclusion and performance of contracts with non-residents for the transfer of goods, the performance of work or services, or the transfer of information or intellectual property; T ransactions between a resident and an authorized bank involving the receipt and repayment of loans, or the payment of interest or penalties under respective contracts; T ransactions relating to mandatory payments (e.g., taxes, fees and other such payments) in foreign currency to the federal budget, a budget of the constituent entities of the Russian Federation, or a local budget, as required by Russian legislation; T ransactions involving a resident's acquisition of promissory notes from an authorized bank issued by this or another authorized bank, the presentation of such notes for payment, the receipt of payment for such notes, or a resident's alienation of such promissory notes to an authorized bank. Currency transactions between non-residents in Russia T ransactions between non-residents in foreign currency are free from restrictions. Non-residents may freely carry out among themselves transactions involving Russian domestic securities in the territory of the Russian Federation. The only potential restriction is that the Russian Central Bank may require non-residents to use special accounts, but so far this has not been introduced. Accounts of residents opened with foreign banks Residents have a right to open without restriction accounts in foreign currency with banks located in foreign states that are members of the OECD or the Financial Action T ask Force on Money Laundering (FATF). Residents must notify tax authorities of the opening of accounts abroad. A resident legal entity and a resident individual may also open foreign accounts in countries that are not members of OECD or FATF which requires advance , registration of the account with Russian tax authorities. The above requirement is effective until 1 January 2007 when residents will be allowed to open without , advance registration bank accounts in any foreign bank, and will only be required to notify tax authorities upon opening the accounts. stock exchange activity, and issues the relevant regulations. It also regulates the investment of pension savings. The main objectives of FFMS are to maintain stability in the financial markets, make the markets more efficient and attractive to investors, reduce investment risks, and increase market transparency. The FFMS performs the following tasks: Regulate the issuance and trading of securities, as well as state registration of security issues, and report on the results of security issues; Register security prospectuses; Control and supervise the activities of issuers and professional market participants; Promote public understanding of the laws and their practical application; Synthesize the practice of legislation use and make proposals to the federal government to improve existing laws and develop draft laws and other regulations; Organize analysis of issues relating to the development of the financial markets; Maintain information disclosure in concordance with Russian legislation. The FFMS has fourteen regional divisions: in Moscow, St. Petersburg, Yekaterinburg, Novosibirsk, Nizhni Novgorod, Rostov, Vladivostok, Oryol, Krasnoyarsk, Omsk, Chelyabinsk, Samara, Saratov, and Irkutsk. The main federal laws regulating the activities of issuers are Law No. 208-FZ of 26 December 1995 "On Joint-Stock Companies"; Law No. 39-FZ of April 22 1996 "On the Securities Market"; and Law No. 14-FZ of 8 February 1998 "On Limited Liability Companies". Additionally, FFMS has issued many regulations for all securities market participants.

Banking and Finance

The operations of commercial banks are regulated by the Civil Code; the Federal Law "On Banks and Banking Activities" of 2 December 1990; and Central Bank of Russia (CBR) regulations. Banks are issued different types of licenses which permit them to carry out a range of banking activities depending on the type of license held. Typical services offered by commercial banks include lending, settlement operations, foreign exchange operations, trade finance, and operations with securities, including bonds, shares, and bills of exchange. In December 2003, the Federal Law "On Insurance of Bank Deposits of Individuals" was adopted. The law stipulates the legal, financial, and organizational framework for mandatory insurance of bank deposits of individuals; the powers, procedure for establishment, and operation of deposit insurance institutions; and the procedure for deposit compensation payments.

Regulatory Structures for the Russian Financial Sector Securities Market

The Federal Financial Markets Service, or FFMS (formerly the Federal Commission for the Securities Market), is the federal executive body that controls and supervises activity in the financial markets, including


Since 1 October 2004, all Russian banks have been preparing their financial statements in IFRS format in addition to using Russian statutory reporting forms. In December 2004, the government passed the new Federal Law "On Credit Histories." The main objectives of this law are to decrease credit risks, improve timeliness of fulfillment of engagements by borrowers, and increase the efficiency of credit organization activity by creating credit bureaus.

performs the role of supervisor in the field of insurance activities. The main functions of the Federal Service for Insurance Supervision are as follows: Making decisions about the issue or denial of licenses and about the cancellation, limitation, suspension, recovery of operation, or withdrawal of licenses; Issuing and withdrawing the certificate of competence; Compiling a common state register of an insurance company's employees; Monitoring observance of insurance legislation; Receiving, adapting, and analyzing accounting, which is provided by the employees of an insurance company; Issuing instructions to the employees of an insurance company on the exposure of a breach of the insurance legislation. The Federal Service for Insurance Supervision has territorial branches in all seven federal districts. The Federal Law "On Insurance" of 27 November 1992 establishes the legal framework for insurance transactions between buyers and sellers of insurance. In addition, the law allows the use of insurance intermediaries, sets accounting and solvency rules for insurance companies, and establishes a supervisory authority. Chapter 48 of the Civil Code, which is devoted to insurance issues, reinforces the Law "On Insurance" on a number of matters, but there are some areas where the two conflict. Since Chapter 48 contains some all-inclusive but nonspecific principles concerning licensing, supervision, and nonspecific deregulation, it will continue to act as a brake on the progress of reform efforts until appropriate amendments to the Civil Code are enacted. In January 2004, "On Insurance" was enacted, which significantly tightened the rules, including imposing requirements for charter capital of newly created insurance companies of between US$1 million and US$4 million depending on the type of license (non-life insurance, life insurance or reinsurance license). The Federal Law "On Mandatory Third-Party Auto Insurance" took effect in July 2003. With this law on the books, insurance companies collected US$1.8 billion in insurance premiums in 2005. In July 2005, new amendments to the Federal Law "On Mandatory Third-Party Auto Insurance" were adopted. Changes in legislation aim for recovery of damage to insured persons even in the event of bankruptcy or withdrawal of the license of the insurance company.

Central Bank of Russia

The main law for the banking system is the Federal Law "On the Central Bank of Russia" of July 2002, which declared the CBR a legal entity and the main bank of Russia. The law specified the functions of the bank in organizing money circulation, monetary regulation, foreign economic activity, and regulation of the activities of joint-stock and cooperative banks. The CBR enjoys independent status. The structure of the CBR includes 59 central administrative boards, 19 national banks and 924 calculation cash centers. The chairman of the CBR is nominated by the President of the Russian Federation and approved by the parliament. The new law has extended the scope of the State Duma's control over the bank. The CBR owns a controlling stake in Sberbank, also used to implement monetary policy, and in a number of foreign institutions, including Ost-West Handelsbank in Frankfurt. CBR also owns stakes in Intergovernmental Bank (Moscow), Moscow Interbank Currency Exchange and the National Depository Center. In April 2005, CBR and the Russian government adopted the Banking Sector Development Strategy for the period to 2008. The document was set as the main objective during that period. The main goals in the development of the banking sector are as follows: Increase the effectiveness of the banking sector's activity in attracting household and enterprise sector funds; Enhance the competitive ability of Russian credit institutions; Increase the protection of interests of depositors and creditors of banks; Develop a competitive environment and maintain the transparency of credit institutions; Prevent dishonest commercial practices and illegal activities in the banking sector; Strengthen investor, creditor, and depositor confidence in the Russian banking sector

The main body for insurance regulation is the Federal Service for Insurance Supervision of the Ministry of Finance. It is a federal body of executive power that


Doing business in the Russian Federation 2006

Chapter 3.

Accounting and Audit

Accounting Principles and Practices
Investor Considerations
Russian Accounting Rules (RAR) are not yet in line with International Financial Reporting Standards (IFRS, previously known as International Accounting Standards), although Russian accounting reforms based on IFRS have been introduced. Inflation accounting is underdeveloped. Consolidated financial statements are treated as secondary to the stand-alone statutory financial statements of a company and are often not prepared. The accounting profession is still in the formation stage. assets. Nor is there a specific rule for business combinations. The main differences between national accounting rules and IFRS are presented in Appendix 1 below.

Accounting Principles and Practices

Russian accounting practice has already moved a long way from the central-planning model towards a market-economy model and, consequently, towards international accounting practice. In 1998, the Russian Government adopted a Programme for Reform of Russian Accounting in Accordance with IFRS. In line with this programme, new Russian Accounting Standards (RAS) are being introduced. These standards regulate major aspects of accounting, as well as the presentation and disclosure of information (such as accounting policies, fixed assets, intangible assets, inventories, income and expenses, related parties, segment information, government grants and others). The new RAS have introduced fundamental accounting assumptions and requirements, such as going concern, consistency of accounting policies, accrual basis, prudence, substance over form, cost-effectiveness and others, thus bringing Russian practice closer to international practice. Practical interpretation of the requirements and assumptions under RAR may be different from IFRS (e.g., RAR are often form-driven).

Accounting and Its Regulation

One of the major differences between Russian accounting and international practice lies in the understanding of the term "accounting" itself. In Russia, the term has a primary meaning of bookkeeping and a secondary connotation of financial reporting. Therefore, Russian Accounting Rules give extensive coverage to bookkeeping procedures, rather than financial reporting rules. Accounting in Russia is regulated by state authorities. The regulatory framework for Russian accounting has three levels. The first level includes the Federal Law "On Accounting," the Civil Code, the Federal Law "On Joint-Stock Companies", etc. The second level of the regulatory framework consists of Russian Accounting Standards, the Chart of Accounts and other accounting regulations. The Central Bank of Russia is responsible for setting standards for banks and other credit institutions, while the Ministry of Finance performs this function for all other companies. The accounting policies of a given company are developed based on the legislation and regulations of the first two levels. Each company keeps its accounting books and prepares its financial statements in accordance with its approved accounting policies. Although accounting procedures are gradually becoming more harmonized with IFRS, there is still a long way to go. Some significant differences continue to exist and in some cases there are no specific Russian Accounting Rules (RAR) that cover certain areas. For example, there are no rules for accounting for the impairment of some

Form and Content of Statutory Financial Statements

The only financial statements acceptable for filing purposes are statutory financial statements. The structure, presentation, procedures for preparation and other aspects of statutory financial statements are stipulated in the Russian Accounting Standard "Financial Statements of a Company". Statements should be prepared in Russian roubles and in the Russian language, and a company must submit its annual statutory financial statements to: The stockholders of a legal entity in accordance with its foundation documents; The state statistics authorities; The state tax authorities. Basic annual statutory financial statements include: a balance sheet, a profit and loss account, and notes to both (for example, the cash flow statement and the


statement on changes in equity constitute a part of the notes). For qualifying small businesses, a simplified set of accounting rules is allowed. The reporting year of a Russian company is the calendar year.

value if (1) the price of inventory decreased during the reporting year, or (2) if inventory became obsolete or partially damaged. Provisions for impairment of inventories are created at the reporting year-end. In the balance sheet, inventories are shown net of the provision. Investments Investments should be initially recorded at the cost incurred by the investor, including amounts paid to a seller under a contract, fees paid to intermediaries in relation to an acquisition and other similar items. Short-term foreign currency securities are shown at the exchange rate of the given foreign currency in terms of RR established by the Central Bank of Russia as of the balance sheet date. Long-term foreign currency securities are not revalued. Investments in publicly listed stocks should be revalued at their market value on a regular basis. A provision is created at the reporting year-end for financial investments in non-listed stocks if they are steadily declining. Property, Plant and Equipment Property, plant and equipment shall be recognized at historical cost. To offset to a certain extent the effect of inflation on the fixed-asset base, a company has the right to perform the revaluation of the historical value of fixed assets and accumulated depreciation once per year (at the beginning of the year) or less often, but still on a regular basis. The depreciation of fixed-asset items may be carried out by one of the following methods: the straightline; diminishing balance; sum-of-the-years-digit; or sum-of-the-units. The useful life is determined by a company according to its accounting policy. Intangible Assets The categories of intangible assets are defined by the relevant accounting standard. Amortization of an intangible asset shall be charged over its useful life by one of the following methods: straight-line method; sum-of-the-units method; or diminishing balance. An asset without a specified useful life may be amortized over twenty years, but not longer than the life of a company. Positive goodwill is included in the intangible assets and amortized on a straight-line basis over twenty years. Amortization of negative goodwill is accounted for as operational income and is written down to the financial results of a company evenly over twenty years. Legal Reserve A legal reserve is created by a company in accordance with its foundation documents and may be used for a limited number of purposes (e.g., to

Chart of Accounts
The main categories of the Chart of Accounts are shown in the Table below. The Chart of Accounts must be applied in the Russian Federation by all commercial companies (except banks and state-financed companies) using double-entry accounting. Main Categories in the Chart of Accounts Account Category Non-current assets Inventories Costs of production and work-in-progress Finished goods and goods for resale Cash and investments Accounts receivable and payable Equity Financial results Off-balance sheet accounts

number 01-09 10-19 20-39 40-49 50-59 60-79 80-89 90-99 001-011

Some Important Aspects

Balance Sheet On the face of the balance sheet, all assets and liabilities should be classified into current and non-current depending on their maturity date. Assets and liabilities should be classified as current if their maturity date is within twelve months of the balance sheet date or within the operating cycle if the latter exceeds twelve months. All other assets and liabilities should be classified as non-current. Receivables Provisions for trade receivables that have not been settled on the due date and are not secured by appropriate guarantees (under Russian legislation such receivables are classified as doubtful) are created at the reporting year-end. In the balance sheet receivables are shown net of the provision. Inventories Inventories are initially recognised at cost. The cost of inventories (by type) can be assigned by using different cost formulas in the event they are transferred for production or otherwise are disposed of. The following cost formulas are allowed: specific identification; average cost; first-in, first-out (FIFO); or last-in, first-out (LIFO). Finished goods are valued at actual cost, standard cost or direct costs. Work in progress can be valued at standard cost, direct costs, cost of raw materials and semi-finished goods, or actual cost (for unique production only). For reporting purposes, inventories should be measured at the lower of cost and net realizable


Doing business in the Russian Federation 2006

Chapter 3. Accounting and Audit

cover the loss of the reporting year). The year-end balance of the legal reserve is carried forward into the next reporting period. Finance Lease Russian legislation stipulates that risks related to assets held under finance lease are borne by the lessor, unless the lease contract provides otherwise. For accounting purposes, the finance lease contract must define whether the lessor accounts for and depreciates an asset held under finance lease and the lessee accounts for such an asset off-balance sheet, or vice versa. Business Expenses All regular business expenses for accounting purposes are taken in full into the calculation of the profit (loss) for the reporting year. Such expenses include, for example, business travel expenses, advertising expenses and payments made under insurance contracts. For some of these expenses, adjustments are needed in order to calculate profit for tax purposes. Consideration should be given to differences between treatment of expenses for statutory accounting and tax accounting purposes. Borrowing Costs Interest on loans is generally either recognized as an expense and taken in full to the profit and loss account or capitalized. Russian accounting requires the capitalization of borrowing costs during the construction of a non-current asset. Interest costs relating to intangibles and securities can also be capitalized up to the moment the asset is recognized in the books. Cash Flow Statement Russian rules do not define the term "cash equivalents" and, therefore, cash balances per cash flow statement are reconciled to cash, rather than to cash and cash equivalents. Only the direct method is allowed. Explanatory Notes The explanatory notes to the annual statutory financial statements must contain essential information about the company and the financial status thereof, comparability of the information for the accounting year and the preceding years, significant accounting policies and other significant information for potential users of financial statements. Any instances of non-compliance with the accounting rules must be reported in the explanatory notes with an appropriate explanation and discussion of the effect on the statutory financial statements. The notes must also announce changes in accounting policies for the following accounting year. The regulations prescribe rules of disclosure that are in many respects comparable with international practice. These include post-balance sheet events,

contingencies, related parties, earnings per share, segment information, government grants, etc. However, the practical implementation and details of these rules may differ. Generally, the scope of disclosure in RAR financial statements is lower than in IFRS financial statements, but is increasing from year to year. Consolidated Financial Statements There is a requirement in Russian accounting to prepare consolidated financial statements, but they are still treated as secondary to the stand-alone statutory financial statements and are often not prepared. Consolidated accounts can be prepared under IFRS or RAR. A decision to prepare consolidated financial statements under IFRS instead of RAR is made by the management of the parent company or its owners/shareholders. IFRS consolidated financial statements that are prepared instead of consolidated statutory financial statements must be provided to the owners/shareholders of the parent company. Although the Russian consolidation rules introduce a procedural framework similar to IFRS, specific rules may differ (for example, in exceptional cases investments in subsidiaries and affiliates can be carried at cost) or may not address a number of practical issues. Publication of Financial Statements According to the Federal Law "On Accounting", a company's annual statutory financial statements must be accessible to all interested users, including bankers, investors, creditors, buyers, suppliers, etc. Such users can receive copies of the annual statutory financial statements upon payment of copying costs. The Accounting Law also establishes a requirement that statutory financial statements for certain categories of companies (for example, open jointstock companies, insurance companies) be published. Such companies should publish their statutory financial statements in newspapers and magazines that are accessible to the users of statutory financial statements, or distribute (among the users) a brochure containing their statutory financial statements, and also submit the statutory financial statements to regional state statistical authorities in accordance with the company's registration for further presentation to interested users. The publication procedure for open joint-stock companies requires that balance sheets, income statements and audit reports be published. Prior to publication, statutory financial statements must be approved by an AGM and audited. Depending on the volume of operations and the size of the


company, it may publish a balance sheet and income statement in short form or in full. The deadline for publication is 1 June of the year following the reporting year.

Accounting at Branches and Representative Offices of Foreign Companies

The Federal Law "On Accounting" is applicable to branches and representative offices of foreign legal entities in Russia, unless otherwise stipulated under international agreements concluded by the Russian Federation. In setting up and maintaining an accounting function (including the preparation of financial statements), foreign legal entities, branches and representative offices in Russia may choose one of the following: Rules existing in the Russian Federation (RAR); Rules existing in the country where a foreign legal entity is located if such rules do not contradict IFRS, as issued by the IASB. The choice of accounting rules by a foreign entity must be documented as an accounting policy. If a foreign legal entity decides to apply RAR, it should fully comply with the requirements and procedures stipulated by the Federal Law "On Accounting", as well as other statutory regulations and instructions on accounting. Under this approach, accounting can be maintained under the rules adopted by the foreign company in addition to maintaining accounting under RAR. If a foreign legal entity decides to apply rules other than RAR, it should comply with the requirements and procedures in effect in the country where the given foreign legal entity is located. Irrespective of their choice of accounting rules, branches and representative offices of foreign legal entities must maintain tax accounting under the rules prescribed by the Russian Tax Code.

It is expected that the procedure for preparing consolidated financial statements will be established by a special Federal Law "On Consolidated Financial Statements", a draft of which is being discussed by the State Duma. In accordance with the new Law, consolidated financial statements of public companies will be prepared solely under IFRS whose recognition and translation into Russian will be approved by the government. Consolidated financial statements shall be subject to audit and publication. The new Law is expected to be introduced for 2005 financial statements while companies that prepare financial statements in accordance with US GAAP will receive a grace period of up until preparation of 2008 financial statements.

Audit Requirements and Practices

Investor Considerations
An annual statutory audit is mandatory for all companies meeting certain criteria set by Russian legislation. New Russian Auditing Standards (RSA) are currently being developed. Russian standards on auditing are close to international practice. Licensing is mandatory for audit firms and auditors working independently In order to conduct audit activities, auditors should hold an audit certificate.

Companies Subject to Statutory Audit

In accordance with Russian auditing legislation, some companies are obliged to have their annual statutory financial statements audited. Commercial non-governmental companies whose annual statutory financial statements are subject to statutory audit include: All open joint stock companies; Banks and other credit institutions, insurance companies, commodity and stock exchanges, investment funds, charitable and other (non-investment) funds, etc.; Other companies with annual sales exceeding 500,000 times the average official minimum monthly wage for the reporting year and companies with total balance sheet assets exceeding 200,000 times the average official minimum monthly wage for the reporting year (currently RR 50 million and RR 20 million, respectively). In addition, annual statutory financial statements subject to publication must be audited by independent auditors prior to their publication. Consolidated financial statements are not subject to mandatory statutory audit.

Implementation of IFRS
In 2004, the new Accounting Development Concept was adopted, outlining fundamental changes to be introduced in accounting regulations and their schedule. The Concept envisages mandatory preparation of consolidated financial statements by public and other public interest companies in accordance with IFRS. Stand-alone accounts will be prepared by companies in accordance with Russian accounting rules, to be developed on the basis of IFRS. The Concept also includes certain measures to develop the accounting profession, in particular delegating the development of accounting standards to professional organisations while state authorities still make the decision of whether to adopt them or not.

Auditing Standards/Legislative Framework

The Federal Law "On Audit Activity", enacted in 2001, is still in force. It defines audit services,


Doing business in the Russian Federation 2006

Chapter 3. Accounting and Audit establishes the rights, obligations and liability of auditors and audit firms, discusses confidentiality and independence, and sets forth substantial compliance regulations. In May 2005, the State Duma adopted in the first reading amendments to the Law "On Audit Activity" which introduce significant changes to the audit profession. It proposes to replace the licensing of audit activity with mandatory membership of audit firms in self-regulated professional associations, to introduce mandatory quality control and to toughen the requirements on auditors' independence. Auditing standards in Russia are expected to be in line with international standards. Work on preparing such standards began in 2002, and as of 1 July 2005 the government had approved 23 Russian standards on auditing. RSA cover the most important audit issues and can generally be compared to international practice.

While significant progress has been made in the area of accounting reform over recent years, Russia still lacks a full and comprehensive set of accounting and auditing standards. The government recognises this and is working on further accounting and auditing reforms.


Appendix 1. Differences Between Russian Accounting Rules and IFRS

The table below is based on the results of "GAAP 2001 A Survey of National Accounting Rules", conducted by seven leading accounting firms, including PricewaterhouseCoopers, and updated to include the latest developments in both RAR and IFRS.

Russian accounting may differ from that required by IFRS because of the absence of specific Russian rules on recognition and measurement in the following areas: provisions in the context of business combinations accounted for as acquisitions consolidation of special purpose entitiesthe the restatement of financial statements of a company reporting in the currency of a hyperinflationary economy in terms of the measuring unit current as of the balance sheet date the translation of the financial statements of hyperinflationary subsidiaries the treatment of accumulated deferred exchange differences on disposal of a foreign entity de-recognition of financial assets the recognition of operating lease incentives accounting for defined benefit pension plans and some other types of employee benefits accounting for an issuer's financial instruments accounting for derivative financial instruments hedge accounting accounting for long-term assets held for disposal IFRS 3 SIC 12 AS 29 AS 21 AS 21 AS 39 IAS 17, SIC 15 IAS 19 AS 32, IFRS 2 AS 39 IAS 39 IFRS 5

There are no specific rules requiring disclosures of:

the fair values of financial assets and liabilities the fair values of investment properties certain segment information (e.g., a reconciliation between the information by reportable segment and the aggregated information in financial statements, significant non-cash expenses, other than depreciation and amortization, that were included in segment expense and, therefore, deducted in measuring the segment result for each reportable segment) summarised financial information on associates extensive disclosures on business acquisitions/disposals significant management judgements made in the process of applying the entity's accounting policies and key sources of estimation uncertainty

IAS 32 IAS 40

IAS 14

AS 1, IAS 36


Doing business in the Russian Federation 2006


Chapter 3. Accounting and Audit There are inconsistencies between Russian rules and IFRS that could lead to differences for many enterprises in certain areas. Under Russian rules:

goodwill is calculated by reference to the book value of acquired net assets proportionate consolidation may be used for subsidiaries in which the parent holds 50 percent or less of the voting shares the useful life of property, plant and equipment is usually determined using periods prescribed by the government for tax purposes finance leases are generally defined in legal terms and the right of capitalization is given to a lessor or a lessee by a contract the completed contract method can be used for the recognition of revenues under construction contracts when the outcome of a construction contract can be estimated reliably trading, available-for-sale and derivative financial assets are not recognized at fair value trading and derivative liabilities are not recognized at fair value any financial investments are not required to be carried at fair value provisions can be established more widely or less widely than under IFRS, and there is no requirement for discounting the correction of errors is included in the determination of the net profit or loss for the reporting period, but separate disclosure revenue recognition rules do not differentiate between exchanges of goods of a similar nature and value and exchanges of dissimilar goods, and do not discuss adjustment for the amount of cash or cash equivalents transferred in exchanges for dissimilar goods

IFRS 3 IAS 27 IAS 16 IAS 17 IAS 11 IAS 39 IAS 39 IAS 39 IAS 37 IAS 8

IAS 18

In certain enterprises, the following issues could also lead to differences from IFRS:

some parent companies do not prepare consolidated financial statements under IAS in the definition of control, it is not required that the ability to govern decision making be accompanied by the objective of obtaining benefits from the entity's activities certain subsidiaries may be excluded from consolidation beyond those referred to in IFRS a subsidiary that is a bank may be excluded from consolidation if it is dissimilar from the rest of the group certain set-up costs that have been paid by a company's founder can be capitalized nternally generated brands and similar items can be capitalized if the enterprise has an exclusive legal right inventories are generally carried at cost rather than at the lower of cost and net realizable value the realizable value of inventories can be measured without deduction of selling costs

IAS 27.10 IAS 27 IFRS 3 IAS 27 IAS 38 IAS 38 IAS 2 IAS 2


Chapter 4.

Tax System
Introduction As mentioned earlier, the Russian tax system is relatively new. The Tax Code, which took effect on 1 January 1999, lays down general principles aimed at rationalizing the tax system. Currently the Tax Code consists of Part 1, establishing the basic principles and procedures of the tax system, and Part 2, which contains seventeen chapters on specific taxes. There are a number of significant taxes in Russia charged in relation to sales and property, and taxes specific to certain industries or activities (gaming/gambling, for example). There is a simplified system of taxation established for small enterprises, which may pay a unified tax on income and a reduced number of other taxes; regional authorities have the right to introduce a tax on imputed income within their jurisdictions for legal entities and individual entrepreneurs carrying out activities in certain industries. Enterprises, farms and individual entrepreneurs producing agricultural products may have to pay a unified agricultural tax instead of most other taxes if this activity represents at least 70% of total revenues for a certain period. International treaties prevail over domestic legislation and many double taxation treaties signed by Russia provide for more favourable treatment of various transactions than under domestic law. The Russian tax system continues to be in a state of flux the profits tax and VAT chapters of the Tax Code were updated beginning on 1 January 2006, and some important changes with respect to tax administration are expected soon. Tax Year The tax year in Russia is the calendar year. Different fiscal year-ends are not permitted.

Tax Administration
Administration of the Tax System
Taxes, duties and fees are enacted by law and may be changed only by new legislation. The Federal Tax Service, which is responsible for collecting taxes, closely coordinates its activities with the Ministry of Finance, which has overall responsibility for collection of Russian state budget revenues and for establishment of taxation policies. Other law enforcement bodies include, in particular, the Federal Agency for Economic and Tax Crimes under the Ministry of Internal Affairs, which is responsible for investigating tax crimes. Tax administration rules continue to be modified. Recent amendments to the general part of the Tax Code are seen in many parts as tightening the tax environment, although they do appear to introduce more order and certainty in many areas, including tax audits.

Corporate Taxpayers
Registration Requirements Every legal entity must register with the tax authorities in its main location as well as in each tax district in which it has a branch, a representative office, other separate subdivisions, or real property and transport vehicles. A foreign legal entity is required to register with the tax authorities in each tax district in which it conducts business for more than thirty days in a calendar year (regardless of whether the activity is taxable or business-type activity), or where it has real property or transport vehicles. A simplified registration procedure is available to foreign legal entities that do not carry out activity in Russia, but have movable property subject to taxation in Russia or wish to open accounts with a Russian bank. A foreign legal entity must notify the tax authorities in each tax district in which it has a source of income. Notification should also be sent to the tax office which is responsible for the territory where a foreign legal entities' movable property is located.


Doing business in the Russian Federation 2006

Chapter 4. Taxation Tax Returns and Assessments Companies are required to file tax returns with the tax authorities on a monthly, quarterly or annual basis, depending on the particular tax and the company's line of business. T axes are paid in monthly, quarterly or annual instalments, and a final adjustment made when annual tax returns are submitted. The tax authorities do not issue tax assessments to enterprises. Instead, the company must pay the amount of tax indicated in the tax return. Tax Audits T returns are desk-audited by the tax authorities ax upon submission. In addition, the tax authorities have the right to perform regular field audits of companies. Under current tax law, field audits may not last for more than three months, and may cover only three calendar years prior to the year of the audit. Once audited, the tax authorities may not audit the same period again, except upon reorganization or liquidation of a taxpayer, or as part of a superior tax office review. Spouses Spouses are liable for personal income tax separately and are required to submit their own tax declaration, where applicable. Exit Permits When an expatriate individual ceases his/her activities in Russia, a final tax return must be submitted within one month prior to departure. A formal exit permit is not required.

Tax Administration for Foreign Nationals

Foreign nationals are generally treated in the same way as Russian nationals. In Moscow, tax returns of foreign individuals are processed centrally (by a dedicated local tax office).

Penalties and Interest

The law stipulates a variety of tax violations with various penalties for each violation. For example, a 20% or 40% penalty is charged for underpayment of taxes. The late filing of a tax declaration carries a penalty of 5% to 10% per month of the unpaid tax. A number of fixed penalties are imposed on a taxpayer for failure to register, and failure to supply the tax authorities with required information, etc. Failure to withhold tax due results in a 20% penalty for the tax agent. Interest for late payment is charged at a rate not in excess of 1/300 of the Central Bank of Russia re-financing rate (12% from 26 December 2005 and 11.5% from 26 June 2006) per day. The amount of underpaid tax and interest for late payment can generally be collected by the tax authorities without the consent of the corporate taxpayer or a court ruling. However, collection of penalties requires the ultimate consent of the taxpayer or a court ruling.

Individual Taxpayers
Tax Residence An individual is considered a Russian tax resident if physically present in the Russian Federation for 183 days or more in a calendar year. Employer's Withholding Obligations Income tax should be withheld at source, by an employer who is deemed to be a tax agent, on all remuneration paid to individuals (employees and individual contractors, except for those who are duly registered individual entrepreneurs). Under current rules, responsibility to act as a tax agent lies with Russian entities, individual entrepreneurs and permanent establishments of foreign legal entities in Russia. In addition to withholding obligations, employers must provide information to the tax authorities on income paid and tax withheld, and notify the tax authorities about the amounts of income received by individuals from whom tax could not be withheld. Tax Returns An individual is required to file an annual tax return with the Russian tax authorities if he/she: is self-employed; received income from which Russian tax was not withheld by a tax agent; is a Russian tax resident and received income from sources outside Russia; or is entitled to and intends to take an income tax deduction provided for under Russian law. Personal income tax withheld by a tax agent is credited against the final tax liability for the year.

In the event of an overpayment of tax, the taxpayer may apply for a refund or offset of the amount overpaid against other taxes or future tax liabilities. Appeals contesting decisions of the tax authorities may usually be made to the next highest tax authority or through the courts. While the overall statistics suggest that taxpayers prevail in court in more than half of all cases, there is an emerging trend of courts ruling more often in favor of the tax authorities, especially in VAT refund disputes.

Principal Taxes
The structure of the Russian tax system provides revenues for three budgetary tiers: federal, regional and local. All taxes are legislated at the federal level, although regional and local governments have the power to set rates and establish procedures for those taxes that are specifically designated as regional or local. Generally, the lower-tier authorities cannot grant concessions with respect


Major Taxes Currently Payable by Businesses and Individuals in Russia Profit tax Value-added tax (VAT) Excise taxes Personal income tax Unified social tax Mineral resources extraction tax Payments for the use of natural resources Water tax Stamp duty Tax on property of organizations (property tax) Transport tax Gaming tax Land tax Individual property tax

Federal Taxes

income generated from the sale of goods, work or services, the sale of property and any other income (receipts), unless it is specifically exempt from taxation. Sales income for tax purposes may be computed using only the accruals basis; only smallscale taxpayers are still allowed to use the cash basis. Since the introduction of Part 1 of the T ax Code, tax in relation to branches is not calculated separately, but instead a portion of the overall tax liability should be distributed to the regional and/or local budget where the branches are located. The accounting year is the calendar year. Expenditures are generally allowed on an accruals basis. The Profit T Chapter of the T Code has ax ax made a significant step forward with respect to improving deductibility rules for tax purposes. The new rules have significantly broadened the list of deductible expenses now the main criteria for deductibility is that the expense should be incurred for the purpose of carrying out activities aimed at deriving profits, be economically justified and supported with relevant documentation. The T Code ax establishes a list of non-deductible expenses (or partially deductible, such as entertainment expenses, certain types of advertising expenses, interest on loans and other expenses) and defines certain expenses subject to amortization. Depreciation is usually tax deductible within norms (straight line or reduced balance depreciation method). Intangibles are amortized over the life of the asset (or ten years if the useful life of the asset cannot be ascertained). T losses may be carried forward for ten years. In ax 2006, the deduction is allowed to be up to 50% of the tax base for 2006 before deduction. From 2007 this limitation will be abolished. Profit tax is payable on a year-to-date basis. Companies may choose between paying profits tax monthly, on the basis of actual profits, or quarterly with monthly advance payments, calculated on the basis of the profits of the previous quarter. The final payment for the year is due by 28 March of the following year. The quarterly and annual returns should be filed within the same deadline as the payment due dates. VAT Payments Sales of goods, works and services within Russia, and imports of goods into Russia, are subject to value-added tax (VAT). VAT is payable at a standard rate of 18% on most goods, including imported goods, and services. A 10% reduced rate applies to a limited range of basic food items, children's goods, medicines and some mass media products. VAT is accounted for by vendors of goods or services and importers of goods. Some items are exempt from VAT (insurance and banking operations with some exceptions, circulation

Regional Taxes

Local Taxes

to taxes allocated to a higher authority (i.e., regional authorities cannot grant concessions on federal taxes). The regional authorities have the right to reduce original profits tax rate by no more than four percentage points for certain groups of taxpayers. They can also introduce lower property tax rates, as well as grant property tax exemptions. Above is a summary of the major taxes currently payable by businesses and individuals in Russia. Please note, however, that this list is not all-inclusive and that there are a number of other federal, regional and local government fees on certain activities, including various stamp duties and license and registration fees. Apart from the taxes listed above, a company may be liable to certain obligatory pension and social insurance payments and pollution charges. Customs duties are governed separately by the Customs Code.

Taxation of Corporations
Corporations and their shareholders are taxed separately. Starting 1 January 2002, the profit tax rate for all taxpayers does not exceed 24% (federal portion of 6.5%, regional portion of up to 17 .5%, but no less than 13.5%). The corporate income tax system distinguishes between resident legal entities which pay tax on their worldwide income, and foreign legal entities which pay profits tax on income derived through a permanent establishment (at the rate of 24%) and are also subject to withholding tax on income from Russian sources not related to a permanent establishment (at rates varying from 10% to 24% depending on the type of income and the mechanism for its calculation). Russian Entities Profit Tax A Russian legal entity is taxable on worldwide profits. Legal entities are generally subject to profit tax on


Doing business in the Russian Federation 2006

Chapter 4. Taxation of securities, certain medical equipment/services, etc.), but recovery of input VAT may be restricted. Exemptions are available from import VAT for technological equipment, related components and spare parts contributed to a company's charter capital. Export of goods and provision of certain export-related services are subject to VAT at the zero rate. Exports to and imports from CIS countries are considered exports and imports for Russian VAT purposes. For cross-border services, there are special rules (similar to those of the EU's Sixth Directive) determining whether they are provided within or outside of Russia. In particular, services of a consultancy nature, or certain services related to patents, licences or similar rights, rendered to an entity which has a place of activity in Russia are subject to VAT. Services related to property located in Russia are also subject to Russian VAT. VAT on expenses incurred in connection with the performance of activities subject to VAT, as well as VAT on purchased or imported fixed and intangible assets, is creditable provided the goods/services are actually received. Credit for input VAT with respect to certain business trips, entertainment and advertising expenses is limited by reference to the same limits as for the profit tax deduction. If sales are exempt from VAT as a general rule the input VAT is not credited but is added to the cost of relevant expenses. VAT on capital construction can now be credited. Branches are not independent VAT taxpayers. A legal entity should calculate VAT as a whole, declare it in a single VAT return to be submitted and subsequently paid to the tax authority where it is registered (normally, where the head office is located). VAT is generally paid on a monthly basis. For taxpayers with quarterly revenues of less than RR 2 million, the tax period is a quarter. The deadline for submitting tax returns and payment of VAT is the 20th day of the month following the expired tax period. Excise Taxes Excise taxes apply to the production and importation of cars, tobacco, alcohol, petrol and lubricants. Transport Tax Regional authorities are entitled to introduce a transport tax. The tax is in most cases based on a vehicle's engine capacity. The exact tax rate is established by the regional authorities within the allowed limit. Property Tax From 1 January 2004, the property tax base has been significantly reduced and currently includes only the net book value of fixed assets reflected on the taxpayer's balance sheet. Intangible assets, inventories and work-in-progress are now excluded from the property tax base of a legal entity. The maximum property tax rate is 2.2%. Regional legislative bodies can introduce lower property tax rates, as well as grant property tax exemptions. Foreign Entities (specifics) The basic rules of taxation described above are equally applicable to overseas companies present in Russia, with certain specifics briefly summarized below. Profit Tax Specifics Foreign legal entities pay tax on profits attributable to a permanent establishment (PE). A PE is broadly defined as "a branch, division, office, bureau, agency, or any other place through which a foreign legal entity regularly carries out its business activities in Russia". Russia's various double taxation treaties could define a PE differently, which could mean tax relief in some cases. Conducting business through an agent may also create a taxable PE in Russia. Profits of a PE are computed on substantially the same basis as Russian legal entities, including composition of tax deductible expenses. The T ax Code does not specifically provide for deductibility of expenses incurred abroad by a head office with respect to its PE in Russia, though most double tax treaties provide for such a possibility. If a foreign legal entity conducts free-of-charge preparatory and/or auxiliary services for third parties, a PE is considered to have been formed, and the tax base is calculated as 20% of its expenses relating to such activities. Foreign legal entities operating in Russia through a PE are to follow broadly the filing and payment schedules as established for Russian legal entities, although they do not make monthly advance payments and pay profit tax on a quarterly and annual basis only. Where a foreign legal entity does not create a PE in Russia and is not protected by a double taxation treaty, withholding tax rates are as follows (withheld at source): 15% in relation to dividends and income from participation in Russian enterprises with foreign investments; 10% in relation to freight income; 20% in relation to some other income from Russian sources, including royalty interest, capital gain (special procedure for disposal of immovable property and shares in Russian subsidiaries where the major assets are immovables). The income tax withholding rates may be reduced under the terms of a relevant double taxation treaty, and its provisions may be applied based on a confirmation of tax residence to be provided by a


foreign company to the Russian tax agent (no advance permission from the Russian tax authorities is required). VAT Specifics Non-tax-registered suppliers of works and services are subject to Russian VAT collectible via a reversecharge withholding mechanism. The VAT reverse charge is withheld at source by a resident taxregistered agent at the rate of 18/118 (or 10/110) of the amount of income paid inclusive of Russian VAT. This VAT may normally be credited by the agent as input tax, provided certain requirements are met.

Taxation of Shareholders
Domestic Shareholders Dividends Dividends received from Russian companies by a Russian company or Russian individual tax resident are taxed at 9% at source. Dividends received by a Russian company from a foreign entity are taxed at 15% on receipt. Capital Gains Capital gains of a resident business entity must be included in its worldwide income, which is subject to corporate income tax. Losses from the sale of securities are deductible only to the extent of gains earned on the same class of securities (although certain exceptions apply for banks, brokers and other financial institutions). Losses from the sale of fixed assets may be deducted for profit tax purposes in equal installments during the remaining economic life of the asset sold. There is no separate capital gains tax. The capital gains of tax resident individuals are taxable in Russia at 13% personal income tax. Specific property deductions may be applied to the taxable income. Foreign Shareholders Dividends A 15% tax is levied on all dividends paid by Russian subsidiaries to non-resident corporations, 30% for non-resident individuals. These taxes can be reduced or even eliminated under the provisions of a relevant double tax treaty. Capital Gains Foreign shareholders are subject to Russian taxation with respect to income from the disposal of shares if this income is attributed to a PE, or if the value of immovable property located in Russia represents more than 50% of the total asset value of the investee. With respect to the second case, relief is available under many tax treaties.

in the calendar year a person is physically present in Russia. An individual is considered resident if physically present in Russia for 183 or more days in a calendar year. Starting from the reporting period for 2007 the wording "calendar year" is to be changed to , "twelve consecutive months", but interpretation of this amendment has not been introduced yet. Russian residents are liable to tax on their total worldwide income received during the calendar year at a flat rate of 13% (except for dividends and other minor exceptions). Non-residents are taxed at 30% on income received from Russian sources (including income attributable to work in Russia, dividends from Russian companies, etc.), though it may be possible to apply a relevant double tax treaty to exempt certain types of income from Russian taxation. Different rates are established for dividends received by resident taxpayers (9%) and certain income gained from receipt of prizes, insurance benefits, excessive interest on bank deposits and selected loans (35%). Benefits in kind are treated as taxable income valued at market prices (provision of a car for private purposes, etc.). The benefit of receiving a loan at an interest rate lower than the Central Bank of Russia refinancing rate for rouble-denominated loans, or 9% for foreign currency loans, is included in taxable income. There are a number of allowances, deductions and exemptions deducted or excluded in arriving at taxable income. Payroll Taxes Russian payroll taxes were substantially reduced from 1 January 2001. Currently, companies pay the following taxes/contributions/tariffs on an employee's compensation: Unified Social T (generally levied on total ax income payable to employees and contractors at regressive rates from 26% (for low-income employees to 2%); Obligatory Pension Insurance Contributions (also accrued on total income payable to employees and contractors at regressive rates, depending on the cumulative remuneration; the amounts of these contributions reduce the federal portion of the Unified Social T ax); Insurance tariffs for mandatory social insurance against work-related accidents (the current rates of such tariffs vary from 0.2% to 8.5%, depending on the employer's activity). Special procedures with respect to foreign nationals were abolished effective 1 January 2003; i.e., all components of the Unified Social T must now be ax paid on expatriates' remuneration. Remuneration of foreign nationals temporarily residing in Russia is exempt from Obligatory Pension Insurance Contributions.

Taxation of Individuals
Territoriality and Residence For both Russians and foreigners, tax residence in Russia is determined by the number of days


Doing business in the Russian Federation 2006

Chapter 4. Taxation Income payable to contractors working under civil contracts is exempt from the portion of Unified Social Tax attributable to the Social Fund and insurance tariffs provided that accident insurance is not stipulated in relevant contracts.

Tax Treaties
Russia currently honours those tax treaties that were signed by the former Soviet Union until they are superseded by new treaties. Tax treaties that are presently concluded with Russia are based on the OECD Model Treaty, although the UN Model Convention for developing countries has had an influence as well. Local Russian tax authorities generally do not have extensive experience with the interpretation and application of double taxation treaties. Withholding Taxes and Permanent Establishment Withholding taxes on interest, dividends and royalties are typically decreased by tax treaties. Starting 1 January 2002, treaty benefits can be claimed by any entity or person, provided that the tax residence certificate of the foreign company is available (no advance clearance is required to apply treaty rates). A distinct similarity in the definitions of permanent establishment under existing treaties and under domestic law tends to mean that few, if any, treaty benefits are available for taxation of profits. It should be noted, however, that the domestic definition does not require a place of business to be "fixed", unlike most treaties. Some tax treaties provide more favorable rules with respect to certain types of tax deductions when determining the amount of business profits taxable by the Russian Federation (e.g., the German treaty allows for unlimited deduction of advertising expenses). Personal Services Most income from freelance activities is not taxable in Russia if an individual from a treaty country does not derive income through a fixed base in Russia. Employment income is generally taxable, unless the individual spends 183 days or less in Russia during the tax year (or twelve-month period for some tax treaties) and remuneration from a non-resident employer is not borne by a permanent establishment of that employer in Russia. Elimination of Double Taxation Russian provisions for the elimination of double taxation generally take the form of credit for taxes paid in other countries. For personal income tax and for corporate tax on dividends, credit is granted only if a relevant double taxation treaty, which contains such a provision, is in force.

Taxation of Foreign Operations

Resident Russian companies are taxed on their worldwide income, including the profits and losses of foreign branches, interest, royalties and capital gains. Credit relief is available for foreign tax paid, up to the amount of the Russian tax liability, which would have been due on the same amount under Russian rules. Dividends received from foreign subsidiaries are taxed in Russia at 15%. Tax withheld on dividends received from abroad may be creditable if there is a special provision n the relevant double tax treaty. Gains (excess over nominal value of shares) from the liquidation of foreign subsidiaries are aggregated into taxable income. Foreign exchange profits and losses are included in the taxable income/deductible expense.

Transfer Pricing
Under the Russian transfer pricing rules, introduced on 1 January 1999, the tax authorities have the right to adjust the prices of transactions between related parties, barter transactions, foreign trade transactions and in relation to sales where the prices fluctuated by more than 20% within a short period. If a transaction meets any of the above criteria (a controlled transaction), the price used can be adjusted for tax purposes if the tax authorities prove that it differs from the market price by more than 20%. At the moment, the transfer pricing rules apply to transactions with goods, work and services. Property rights are excluded from the list of controlled transactions. Russian transfer pricing rules stand out by applying not only to transactions between related parties, but also to transactions between unrelated parties assuming they meet the above criteria. Since the introduction of transfer pricing rules there have been plans to make significant changes to them. These include the extension of the list of related parties (affiliated and sister companies will be included); inclusion of transactions with information or property rights and set-off of mutual liabilities n the list of controlled transactions; and abolishment of the 20% safe-harbour rule and introduction of requirements for taxpayers to maintain transfer pricing documentation. At present, it is not clear if and when these amendments will be enacted.

Competent Authority/Mutual Agreement

A taxpayer who believes that the actions of one or both of the contracting states result, or will result, in double taxation may, regardless of the remedies provided by the domestic law of those states, present the case to the competent authority of the contracting state where it is domiciled.


The competent authorities of the contracting states may communicate directly to reach an agreement. The competent authority for all of Russia's double taxation treaties is the Russian Ministry of Finance. We are aware of an increasing number of cases where such communication took place, although in absolute terms the number remains quite low and the procedure is usually followed only in exceptional cases.

exchange rate. Starting 1 January 2005, the basic tax rate is RR 419 per ton. The above coefficient C is applied on a monthly basis and starting 1 January 2005 is calculated as follows: C=(P-9)*R/261, where: P is average for the tax period price for Urals-grade oil per barrel; and R is the average RR-US$ exchange rate as determined by the Central Bank of Russia over the relevant tax period (a month). For example, the rate of MRET for June 2006 was established as RR 2,376 per ton. Significant amendments were introduced to the procedure for calculating MRET for green-fields and depleted fields. Starting 1 January 2007, a zero rate (so-called royalty holidays) will be applicable to green-fields located in the Republic of Sakha, Irkutsk Oblast and the Krasnoyarsk region until the achievement of an accumulated extraction volume of 25 million tons, if the period of development of the field does not exceed ten years, or equal to ten years for licences on development and extraction, or fifteen years for licences on research, development and extraction. Such amendments were aimed at stimulating the development of new oil fields in Russia. Moreover, the rate of MRET will decline with respect to old fields after the achievement of a depletion ratio of 80% (extraction on such fields is practically 'frozen' now for economic reasons). Oil-related Export Duties In early 1999, the government reintroduced export customs duties on crude oil and oil products. Following increases in world oil prices, the export customs duties have been increasing steadily. In September 2001, the Law on Customs Tariffs was amended to establish the procedure for determining the maximum rates of export customs duties for crude oil. Under this procedure the Russian government reviews export customs duties for crude oil every two months based on the average price of Urals blend. The average Urals crude oil blend price is calculated as the price for Urals blend on world markets (Mediterranean and Rotterdam) for the two months immediately preceding the current two-month period. Starting 1 June 2006, the actual rate of export duty is US$199.80 per ton. As the above information demonstrates, there is a correlation between MRET and Oil-related Export Duties burden and oil prices. Payments for the Use of Subsoil Payments depend on the size of the licence area provided to the exclusive user of the subsoil and apply to the size of the licence area not including mining allotments. The current annual minimum and maximum rates of regular payments are set as follows:

Industry Specifics
Energy, Utilities & Mining
Profits Tax specifics: deduction of expenses related to mineral resources development: Expenses incurred in exploring and appraising mineral resource deposits shall be deducted evenly over a twelve-month period following the completion of the work. Expenses incurred in relation to the development of mineral resource deposits that prove to be unsuccessful shall be recognised for tax purposes within the twelve-month period following notification of the relevant federal agency of the State Subsoil Fund. Expenses related to a "dry well" shall be recognised for tax purposes evenly over a twelve-month period following abandonment of the given well. Expenses incurred in preparing the relevant area for mining activities and in compensating damages to natural resources shall be deducted evenly over a five-year period. Abandonment cost is deducted in the period when incurred. Expenses incurred in obtaining a license for the development of mineral resources, deposits, payments for geological information, levies for participation in a tender, etc. shall constitute the value of the license, which shall be treated as an intangible asset and depreciated within the period of the license. Mineral Resources Extraction Tax (MRET) MRET, introduced on 1 January 2002 replaced mineral resource restoration payments, royalties and excise tax on the production of oil and gas condensate. Specific rates apply for each type of mineral resources, for example: 4% for black coal; 6% for gold; 8% for diamonds and other precious and semiprecious stones; 17.5% for gas condensate; and RR 147 for 1000 cubic meters of natural gas. MRET with respect to crude oil shall be calculated as the amount of oil produced multiplied by a basic tax rate set in RR per ton subject to an adjustment based on a special coefficient (C) reflecting the dynamics of world oil prices and the RR-US$


Doing business in the Russian Federation 2006

Chapter 4. Taxation Starting 1 August 2004, the maximum export customs duties rates for crude oil were set as follows: Average Price for Urals Crude Oil Blend Up to US$109.50 per ton (US$15.00 per barrel) US$109.50 to US$146.00 per ton (US$15.00 to US$20 per barrel) US$146.00 to US$182.50 per ton (US$20 to US$25.00 per barrel) Greater than USUS$182.50 per ton (US$25.00 per barrel) The rate for the right to prospect and evaluate oil fields ranges from 120 roubles/ km2 (50 roubles/km2 for offshore areas) to 360 roubles/km2 (150 roubles/km2 for offshore areas); The rate for the right to explore oil fields ranges from 5,000 roubles/km2 (4,000 roubles/km2 for offshore areas) to 20,000 roubles/km2 (16,000 roubles/m2 for offshore areas). Exact rates for specific areas are to be set by regional authorities for onshore areas and the Ministry of Natural Resources for offshore areas. Excise Tax on Oil Products Currently excise tax is charged on the following transactions involving gasoline, diesel fuel and motor oils: Purchase and receipt of oil products, including receipt of oil products manufactured by a taxpayer from its own raw materials, except in certain cases; Import of oil products; T ransfer of oil products by the producer to the owner of oil products made under tolling arrangements, except in certain cases. Starting 1 January 2005, the following excise tax rates for oil products apply: Oil Product Gasoline under 80 octane Gasoline over 80 octane Diesel fuel Motor oil Rate per tonne 2,657 roubles 3,629 roubles 1,080 roubles 2,951 roubles Export customs duties 0% 35% of the difference between the average price (per ton) and US$109.50 US$12.78 plus 45% of the difference between the average price (per ton) and US$146.00 US$29.20 plus 65% of the difference between the average price (per ton) and US$182.50 Tax regime for investors under Production Sharing Agreements (PSAs) The PSA chapter of the Tax Code, introduced in June 2003, has established a special tax regime for PSAs. The new tax regime for PSAs may be applied only if the following requirements are met: no investor accepted the right to use a given subsoil plot on the terms of development under the general tax regime during a tender; the share of the Russian Federation in the total volume of extracted mineral resources is no less than 32% under direct product sharing agreements; and the given PSA provides for an increase in the share of the Russian Federation in profit production if improvements are made to the project's investment performance indicators. The following specific features of the tax regime apply to investors under PSAs: Import of goods designated for the execution of a PSA is exempt from import customs duties, export of mineral resources produced under a PSA is exempt from export customs duties; Profits tax is levied on the value of profit oil received by the investors and non-operational income reduced by the amount of tax deductible expenses which are not included in the recoverable cost. Cost oil received by investors in compensation of recoverable costs is not taxable; The profits tax rate shall be determined in accordance with the provisions of the Tax Code as of the date when the given PSA takes effect, and shall apply for the entire term the PSA is valid; The mineral resources extraction tax is 50% lower for natural resources produced under a PSA; PSA investors are exempt from property tax on property used to conduct activities under the PSA. The PSA Law, alternatively, provides for the possibility of concluding direct product sharing agreements under which the quantity of mineral resources produced is directly divided between an investor and the state, and the investor is not subject to profits tax or mineral resources extraction tax.


Starting 1 January 2007, excise will be charged on the sale (rather then receipt) of gasoline, diesel fuel and motor oils and payable by a company which produced such products. Moreover, transfer of oil products by the producer to the owner under tolling agreements, use of oil products for own needs, transfer of oil products to charter capital, transfer of oil products by the owner under tolling agreement, and import of oil products will also be taxable transactions.

Technology, InfoComm, Entertainment and Media

Changes in taxation of the InfoComm sector are driven primarily by the ongoing liberalisation

of the market and new legislation governing certain key areas like interconnection, licensing and universal service obligations. New interconnection rules have altered the way local and long distance operators (including Rostelecom and emerging competitors) settle for origination and termination of local and long distance calls, as well as interconnection set up and servicing. The impact of new tariff-setting regulations on revenue recognition and transfer pricing rules still needs to be assessed. Contributions to and distributions from a universal service obligation reserve will change the revenue and cost base of operators. The most recent development is the introduction of the Calling Party Pays principle, which is also driving substantial change in cost and revenue models, primarily in the wireless sector. The Technology sector is likely to benefit from reform plans carried out by the government. First, the law was passed to introduce the concept of special economic zones, which covers technology parks. Second, effective from 1 January 2007 a special tax regime was introduced for the information technology (IT) industry which should relieve the tax burden on labour compensation costs (which are believed to represent up to 70% of the total cost base). Third, a further boost will be provided by the changes in the profits tax rules easing certain restrictions on the tax deductibility of R&D expenditure. The key challenges posed to the Entertainment and Media sector include plans to abolish a reduced VAT rate for mass media products and services (although these are still far from being finalized and are under debate) and the emergence of new sectors like gambling and mobile content services for which taxation rules are still unclear and incomplete and thus require special attention in order to avoid potential disputes. Of the many rapidly growing industry segments, the most noticeable are filmed entertainment, TV and cinema theatres, in which national players successfully compete with major global ones.

funds and insurance companies. Certain expenses may be deductible for financial services companies, such as loan loss and securities diminution provisions and special reserves created by insurance companies. There are also special provisions on taxation of transactions with financial instruments, such as trading with securities and derivatives (including hedging instruments) and REPO transactions. They require that taxpayers calculate financial results from the above operations based on tax accounting rules which may differ from results in financial accounting records. The key principles for the taxation of securities require that the sales price should be comparable to the fair market value, which differs depending on whether securities are traded on an organized market or not. Only companies with a security broker licence can deduct securities tax losses from income from other operations without any limitations. Companies without a broker's licence have to calculate financial results from operations with listed and unlisted securities separately and may not deduct the net loss from each basket from income from other operations. Income and loss from transactions with derivatives are calculated on an accruals basis. The tax law requires that derivatives transactions be carried out at fair market value and there are special rules for calculating derivatives' fair market price. Losses from transactions with derivatives not traded on an organized market are not deductible from income from other types of operations. Special rules exist for calculation of the taxable base for deliverable derivatives transactions with foreign currency for banks, as well as deliverable forward transactions with underlying assets other than currency valuables. The tax law provides special rules for hedging derivatives transactions. If a hedging derivative meets the criteria established in the law, its income and losses will be included in the same tax base as transactions with the underlying asset. REPO transactions that qualify as such under the Tax Code are treated as loans for tax purposes.

Financial Services
In addition to general provisions, Russian tax legislation prescribes specific treatment of particular types of companies in the financial services sector, such as banks, broker-dealer organizations, pension


Doing business in the Russian Federation 2006

Chapter 5.

Import Tariffs
Import tariffs (customs duties) apply to most goods. The majority of customs duty rates in Russia are ad valorem (i.e., a percentage of the goods' customs value). There are also specific duties for certain types of imported goods, calculated by volume, weight or quantity. Some duties have a combined rate incorporating the above two types of duty and, therefore, the tax basis may vary. The customs valuation procedure is established in line with GATT/WTO principles and is generally equivalent to the DAF/Russian border transaction value of the goods concerned. Classification of goods for customs purposes follows the international Harmonized System of Coding and Description of Commodities. Base customs duty rates vary widely, from 100% on spirits to 0% for some printed matter and some other priority imports. Zero duty applies, for example, to a wide range of equipment and machinery. Despite this wide possible range, average duty rates fall between 5% and 20% of goods' customs value. The base rates specified in the legislation apply to countries that have been granted Most Favoured Nation status. Some goods from "developing" and "least developed" countries may be imported at 75% of the base rates or zero rates, respectively. However, the range of such goods is limited to raw materials and handmade articles. Goods originating in other countries will be subject to duty at double the base rates. Fixed production assets imported as a charter capital contribution of a foreign investor are also free from customs duties. The goods must not be excisable and need to be imported within the timeframe established for the formation of the charter capital. Exemption is subject to approval by customs. Customs authorities can check to ensure the correct use and further disposal of goods exempted from customs duties.

Customs payments on temporary importation of goods

Goods may be imported by enterprises under a temporary import customs regime, normallyfor a period of up to two years, which requires periodic customs payments of 3% per month of the total customs payments payable had the goods been imported for free circulation. Upon re-export of the goods, the periodic customs payments made are not refunded. Customs have the right to require security for customs payments (e.g., deposit, pledge, bank guarantee, etc.). Goods which qualify as fixed assets for production purposes may be admitted and subject to a 3% monthly customs payment for a temporary import period of 34 months if the Russian user does not yet have property rights (e.g., for leasing). Upon expiration of this period, the goods are considered released for home use. The interest on customs duties and taxes by installments is not payable. Temporarily imported goods can only be used by a person who has obtained customs permission for such temporary importation. A number of Special Economic Zones (SEZ) with a free customs zone regime has been established in Russia. Imports into such zones are free of duty and VAT, i.e. foreign goods are delivered to and used within the SEZ free of import customs duties and VAT. When foreign goods or products of their processing are subsequently released into free circulation to the rest of Russia, import customs duties and VAT are payable. If the goods manufactured in a particular SEZ are exported to foreign countries they will be subject to export duties, if any. Foreign goods which were imported in the SEZ but not processed may be reexported without payment of export customs duties.

Customs Duty Exemptions

The following are exempt from customs duty: transit goods; goods imported by individuals for personal use (worth not more than approximately $2,400 and weighing less than 35 kg); cultural valuables; goods with a nominal total customs value (between US$180 and US$375, depending on import conditions); means of transport involved in the international movement of goods and passengers; humanitarian aid and some others. Goods originating from CIS countries are also exempt from customs duties (subject to certain conditions). Russia, Belarus, Kazakhstan, Kyrgyzstan and T ajikistan form the Customs Union, and goods originating from these countries are not subject to customs duties within the Customs Union.


Chapter 6.

Labour Relations and Social Security

Employment Relations
Employer/Employee Relations
Employer/employee relations are heavily regulated by the Russian Federation Employment Code. Considerable safeguards have been established to protect employees against wrongful dismissal, a harmful working environment and excessive work periods. Employment legislation makes it very difficult for the employer to terminate employment at its own initiative.

Probation Period
Probation periods may not exceed three months (six months for special categories of employee) and must be specifically provided for in the employment contract. Probation periods are forbidden for employees under the age of 18 and for some other categories of employee.

Wages and Salaries

The current monthly minimum wage, set in May 2006, is RR 1100.

Employment Contracts
A written employment contract in Russian setting out the basic terms of the employment relationship must be concluded with each employee working in Russia. Russian employment law provides all employees with minimum guarantees that cannot be made worse by any other agreements between the employer and the employee unless federal law provides otherwise. As a general rule, employment contracts are concluded for an indefinite period. A fixed-term employment contract may also be concluded, but it cannot be concluded for more than five years, and only in those circumstances specifically provided for by the Russian Federation Employment Code. Moreover, recent court practice shows that the employer must prove and substantiate the reasons for a fixed-term employment contract in the event of any dispute. Otherwise, the employment agreement shall be deemed to have been concluded for an indefinite term. Under Russian employment law, job duties and obligations should be defined in the employment contract. This is very important since an employee cannot subsequently be required to perform tasks outside the scope of duties described in the employment contract. In accordance with Russian employment law, employers are required to issue an internal order each time an employee is hired, transferred to a new job, granted a vacation, disciplined or dismissed, among other situations.

Working Hours
Under Russian employment law, employers are required to keep a record of all time worked by each employee, including overtime. The standard working week in Russia is 40 hours over a five- or six-day week. Russian legislation specifically defines the permitted working hours and the proper compensation for overtime and holiday/weekend work. On the eve of public holidays, the law requires that the workday end one hour earlier.

Paid Holidays, Vacations and Days Off

All employees are entitled to a minimum of 28 calendar days of paid leave per year. Normally, vacation entitlement is granted to employees after they have worked at a company for six months continuously. Doing business in the Russian Federation 2006

Russia has eight official annual public holidays, which in aggregate entitle employees to twelve days off (see box at the end of Chapter 1). In accordance with the Russian Federation Employment Code, the length of days off (time off between work weeks) shall be no less than 42 hours.

Termination of Employment
An employer may terminate employment only on the specific grounds provided in the Russian Federation Employment Code. Detailed and varied termination requirements make it advisable to seek legal advice before dismissing an employee. An employee must give two weeks' notice of resignation.

Chapter 6. Labour Relations and Social Security

Other Benefits
Under current legislation, all employees are entitled to paid sick-leave allowances. However, under recent legislation, the benefits for temporary incapacity to work shall not exceed a sum equal to RR 15,000 for one calendar month. There are private health clinics in major Russian cities, and membership could be one way of giving employees an additional, Western-style benefit (although it would be subject to taxation in certain cases). Historically, it has been common practice for employers to provide meals during the day due to the lack of external catering facilities readily available to employees. Daycare, housing and transportation benefits are fairly common in Russian enterprises, especially in the case of large enterprises in isolated locations. employment agreement with the respective employee. A list of instances when employees may have to work on days off and non-working holidays without their prior consent was introduced. Provisions concerning trade unions, strikes and collective disputes were significantly revised and amended. For example, a meeting of employees that adopts the decision to strike shall be deemed eligible provided that not less than half of the aggregate number of the employees of the company (or its branch, representative office or any other subdivision) or the entrepreneur have attended the meeting. Additionally, collective disputes defined in the Employment Code shall be resolved by employment arbitration decision, which shall be binding for all parties to the dispute.

Health and Safety

Health and safety standards are in force and require negotiation and approval by the workforce. New enterprises must pass health and safety inspections, and new machinery must also pass such inspections before being put into use. Legislation mandates health insurance for employees and allows for determination of liability and compensation for injury. In practice, Russian health and safety standards are not yet as stringent as in many countries and are not always applied as rigorously as they could be.

Stock Options and Other Equity Based Compensation Plans

Liberalization of currency control legislation, which now allows Russian citizens to purchase foreign securities, has given multinationals operating in Russian the long-awaited possibility of implementing equity-based compensation plans. Although the legislation on stock option plans and other types of long-term incentive plans is still rather undeveloped, especially in the area of taxation and labour law, Russian and multinational companies have started to introduce equity-based elements into the compensation packages of management personnel. It will take some time for equity-based remuneration to become a standard part of management compensation packages, but there is a clear trend in the Russian market of increased use of equitybased plans as a retention and motivation tool.

Further Amendments to the Employment Code

Please note that the Russian Federation Employment Code was recently amended. The amendments will come into force in October 2006. Overall, more than 300 articles of the Russian Federation Employment Code were amended and more than 10 new articles were introduced. Most of those amendments are of a technical nature and aim at improving the wording of the Employment Code in order to eliminate existing controversies and inaccuracies and to ensure better application of the Employment Code. In particular, the following major amendments should be noted: Provisions of the Russian Federation Employment Code with respect to rules for calculation of the duration of working time for moonlighters were amended and became more flexible. If an employment agreement with an employee acting as the sole executive body is terminated in the absence of any wrongdoing by the employee, the employer is obligated to pay the dismissed employee a special severance allowance of three months' average salary. This is the minimum amount of severance allowance and may be increased by an

Foreign Personnel
Employment and Work Permits
According to the Federal Law "On the Status of Foreign Nationals and Stateless Persons", employers must obtain a special employment permit if they wish to recruit or hire foreign workers. All foreign employees must receive a work permit from the migration authorities before being allowed to work in the Russian Federation. Both permits are required not only for foreigners working under employment agreements, but also for those providing services under civil law (service) contracts, or engaging in entrepreneurial activity (except in some cases expressly stipulated by the Federal Law "On the Status of Foreign Nationals and Stateless Persons"). Although Russian law does not expressly prohibit personnel provision agreements, neither does it expressly make provisions for them. The Russian


immigration authorities have taken a firm position on not issuing work permits under personnel provision agreements. Foreign employees intending to be seconded to Russia under personnel provision agreements will have to make additional local arrangements in accordance with Russian labour law. The Federal Law "On the Status of Foreign Nationals and Stateless Persons" and related legislation provide severe sanctions for violations of migration rules, including even the deportation of foreign employees. This last scenario could make it difficult or even impossible for such foreign nationals to obtain further entrance visas, while employers would also be likely to face penalties of up to US$10,000 and encounter complications in processing future permits and visa requests.

Working while on a business visa previously a widespread practice due to its convenience is no longer permitted by the migration authorities. Russian representative and branch offices of foreign legal entities are no longer allowed to invite foreign citizens to Russia. Therefore, they have to apply for invitations for their personnel through the relevant accreditation bodies the State Registration Chamber or the Russian Chamber for Commerce and Industry. These authorities only provide visa support to the accredited employees of the representative and branch offices. However, some amendments to Russian immigration rules with regard to representative and branch offices of foreign legal entities may be introduced in the near future, which may grant them a status equal to that of Russian legal entities. Every foreign employee, without exception, must fill in an immigration card at a border checkpoint and keep it until leaving Russia. After obtaining mandatory registration within three days of arrival at the place of her/his residence (registration stamped on the back of the immigration card), a foreign employee may reside freely in the country until his/her visa expires. It is worth mentioning that there are some territories in Russia of "limited access to foreign citizens" (such as frontier zones on Sakhalin, areas around airbases in the Moscow region or submarine bases in the Murmansk region) which require special entrance permission from the state security bodies in addition to a Russian visa.

Visa Requirements and Immigration Card

All foreign personnel must obtain a work visa to enter the Russian Federation (except for the citizens of most of the former Soviet republics and citizens of a few other countries). Visa applications must be supported by an invitation from the employer a Russian individual or a Russian legal entity. Initially, work visas allow only a single entry to Russia and a stay of just 90 days. After arriving in the Russian Federation, the foreign employee must convert her/his visa into a multiple-entry visa good for up to one year. Having received the multipleentry visa, the foreign employee is allowed to leave and re-enter the Russian Federation.


Doing business in the Russian Federation 2006

Chapter 7.

Corporate T ransparency
Russia has seen improvement in corporate governance practices. Shareholders have asserted their rights with an increased number of minority shareholders and independent directors on Boards of Directors, dividends have increased, clear-cut schemes for their payment have been developed and there have even been several cases of successful legal action by investor advocacy groups. In the area of information disclosure, international and US accounting standards have been adopted in a number of large Russian companies and patterns of constant communication with shareholders and analysts have been developed and maintained. However, there is still plenty of room for improvement in Russian corporate governance practices, and in corporate transparency in particular. T ransparency, though only one of the many aspects of corporate governance, plays a key role in gaining the confidence of investors and often signals the level of overall governance standards. Russian legislation focuses on disclosure of information as a key element of corporate governance based on equal access to information about a company. The current financial and non-financial disclosure requirements by Russian public companies are consistent with EU and IOSCO (International Organization of Securities Commissions) requirements. The average level of corporate transparency has been steadily improving for the last several years. Overall, Standard & Poor's Governance Services index of transparency among the largest by market capitalization Russian companies (according to "Russian T ransparency and Disclosure Survey 2005") has increased to 50% from 46% in 2004, 40% in 2003, and 34% in 2002. The Index has increased roughly 5 percentage points each year from the initial index in 2002. However, there have been no dramatic improvements in these disclosure policies in Russia recently. The disclosure level of Russian banks remains low, especially in comparison with that of their international counterparts, and is lower than the transparency level of the largest Russian non-financial companies. T ransparency of private ownership has slightly decreased. The share of disclosed large private stakes in the aggregate market capitalization of the largest companies has decreased to 11%, as compared to 14% in 2004, while concentration is not decreasing. Furthermore, some of the companies that have completed international IPOs over the past year follow a policy of minimal information disclosure. A greater scope of information available in English and broader disclosure on corporate websites are among the improvements that have been made. There has been no significant progress among first-tier companies, the 54 largest by market capitalization, where the room for improvement is still quite substantial. Those companies that had been public for a while and scored low on transparency in the past tend gradually to adopt higher standards of transparency and catch up with the rest. There has been a sharp increase in information disclosure on shareholder rights and investor relations procedures by these companies. This appeared as a result of companies' efforts to follow the recommendations of the Russian Code of Corporate Conduct, which is particularly focused on disclosures of companies' governance procedures and shareholder rights. The disclosure of ownership and share capital structures has not changed substantially lasting recent years. This disclosure reached 49% in 2005, up slightly from 48% in 2004 and 47% in 2003. T ransparency of the ultimate beneficial ownership of large share blocks is still a problem in Russia. Russian companies are commonly affiliated with each other via their shareholders, while the shareholders do not disclose such information for fear of antimonopoly regulations, investigations, and corporate raiders. Only 38 out of 54 companies disclose the identities of all their major shareholders,


regardless of type. While the proportion may seem high, the aggregate share of such companies in the total market capitalization of the studied firms has fallen from 65% to 56%. Financial information remains a relatively weak area of disclosure for Russian companies. Not all companies (43 out of 54) report their annual financials under IFRS or US GAAP. Among those companies that report under IFRS/US GAAP, the weakest disclosure issues are related-party transactions (indication of whether they are conducted on an arm's-length basis and the disclosure of exact terms), ownership structure of affiliates, and disclosure of the scope of and the fees for the services provided by the auditor. It is worth noting that index growth was mainly caused by progress among companies with formerly poor absolute levels of disclosure. Some of them still have not reached the average disclosure level for last year. Timeliness of disclosure by Russian companies of financial statements according to IFRS or US GAAP has improved. In particular, 36 of the largest 54 companies had published audited financial statements for 2004 conforming to either IFRS or US GAAP as of 12 August, 2005. This is

an improvement on the 26 companies that presented such reports in 2004 for the full-year 2003 and the 20 firms presenting such reports in 2003 for 2002. The ownership structures of Russia's 54 largest public companies remain highly concentrated. All companies have at least one block holder whose stake in the company exceeds 25%. In addition, 46 firms are (beneficially) majority-owned by a single shareholder or controlled by a group of shareholders that are parties to a formal shareholders agreement. As a result, 61% of the aggregate market capitalization of the 54 firms is represented by blocking or controlling stakes. This is a marginal increase on 57% in 2004. Russia is one of the world's most lucrative emerging markets, but still needs improved corporate governance practices to attract foreign investors. T ransparency is an important intangible asset, allowing the most transparent companies to enhance their market value. Despite improvement in the transparency of governance practices, much still needs to be done. Joint effort by the government, companies and investors is needed for the improvement to be notable.


Doing business in the Russian Federation 2006

PricewaterhouseCoopers in the Russian Federation

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