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About Alinga | |
 17.05.12
SMEs Investing in Russia: Things You Should Know
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It is very well accepted that Small and Medium Enterprises (SMEs) play major roles in most developed economies both in terms of the economy itself and also social infrastructure. They help bring flexibility and resilience to the economy, especially, in times of crisis. They can be an engine of growth as very often it is they, and not the large companies, that find and commercialize the “next big thing.” We can see that one of the responses to the current Global Crisis is to try to encourage the expansion of domestic markets, which can then generate internal growth – a dynamic and thriving SME sector is an obvious driver for such growth. However, the significance of this sector is still not fully recognized in Russia and this is reflected in their level of support in Russia. But attitudes in Russia are changing and we see this in terms of increasing pronouncements of support from top politicians and government officials. In 2011, the AEB established the SME committee to help promote and protect the interests of SMEs doing business in Russia.
The major value of SMEs, and where Russia could really benefit, is the SME’s ability to empower people to make a difference in other people’s lives. Allow a person to start his own business, and he can provide for not only himself and his own family, but also create more opportunities for others to provide for themselves and their families. Also, in the last 20 years, we can see many good examples of SMEs investing in Russia and creating very successful businesses. One common characteristic of these successful businesses is that they have correctly identified their niche in the market and having identified this niche they have focused on doing what they do well. Clearly, there is strong competition, and therefore, it is important to be dominant in your niche and to maintain this by, for example, investing in your brand. The best way to achieve this, apart from advertisement and PR (more importantly, at the beginning), is to invest in the right people and as a consequence, in the quality of services or goods.
What is important to realize is the need for patience and resilience in creating a successful business in Russia and that the ‘quick fix” may not be the best option in the long term. Of course this brings us quickly to the topics of bribery and corruption, which are regularly quoted as being the most difficult challenges faced by international investors when coming to Russia. It will not surprise you that we, along with the majority of successful business owners, will strongly advise managers to adopt best practice and corporate governance. This is becoming even more important with increasing international legislation, for example, the UK Bribery Act 2010, which came into force on 1 July 2011. It was quoted to us recently that “Russia is a school of patience” and we whole heartedly agree with this.
It is also important to keep in mind that in many ways Russia is still a young country. It is very easy to see this when one steps outside of Moscow into the regions. Here, we then quickly find that the infrastructure is still very underdeveloped and indeed around 20% of the population is living on incomes below the poverty line. But we see that Russia has made significant steps forward from the almost anarchy and chaos of the early 1990s to a more established order and a developing and growing middle class, which in itself is an attractive market. We can observe that in recent years, more and more SMEs are looking beyond Moscow to the regions, as attractive investment opportunities. Indeed, we see that a growing number of regions are now very proactive in attracting foreign companies such as Kaluga, Yaroslav, Voronezh etc. Therefore, just from the sheer size of the country, it may be very helpful to adopt a humble mindset and realize that everyday we may learn something new.
As way of introduction to what we feel are some of the most important issues for SMEs investing in Russia to consider, we would point out that the general lack of attention and support for SMEs in Russia means that owners or managers of smaller operations are often shocked by the cost of entry into the market – both in time and money. Start-up, or just general compliance, while still at a very low level of activity, is disproportionately burdensome to a small business, prompting outlays of time and money that would be better directed toward business development. Although, official support for SMEs may be limited, many owners of businesses in Russia have benefited from support from other networks, where they can discuss issues they are facing, for example, the AEB itself; local chambers of commerce or other groupings of expats. When coming to Russia, what is very helpful is becoming quickly aware of such groups and seeing if these may be of assistance to your business. What is clearly important in Russia is to have friends, but also, understand who can be your friend!
Below, we highlight some of the issues that we consider important. We have each been doing business in Russia for more than 15 years, and over this period we have seen that there are regular issues to be addressed during start-up, and with regard to matters of ongoing compliance and financial strategy, and other challenges of doing business in Russia.
1. The Basics - Setting up a legal presence: Limited Liability Company (LLC); Joint Stock Company (JSC); Rep Office; Branch
When entering the Russian market one of the first decisions for an SME will be whether to do this alone or to find a local partner and establish some form of joint venture. If you talk to owners of successful businesses in Russia you will learn that one of the most important factors in determining success is to be clear about your objectives and this is especially important in considering the legal form of presence in Russia. Another, very important factor is to start with the right people and this is especially difficult when a company is coming to Russia for the first time. Considering these points the general advice would be that whilst it is possible to establish a successful joint venture, it seems that in practice this does not often work and that the better choice is to establish an own presence. In a recent conference organized by the AEB SME committee and a number of owners of successful foreign SMEs expressed this opinion. However, the value of having a local partner that “knows the ropes” is also important.
We mentioned at the beginning that being very clear about objectives is very important in having a successful business. This is also crucial in determining the structure and form of legal presence in Russia. For example, if as an owner you plan eventually to sell the business then one should consider the requirements of a future buyer or investor. For example, we know that it is generally much easier to sell a business with a clear and transparent corporate structure. In addition, there may be tax considerations relating to an investment holding structure, which may be important in any future sale. Coming to the business itself it is worth considering as well the medium term plan, for example, in the first year you may be planning on establishing a representation but then moving quickly to a “buy sell’ business model – this may impact your decision on the form of presence.
It has certainly become easier to establish a business in Russia. The timeline has shrunk considerably since the late 90s/early 2000s. Registration of a business (for the simplest LLC) used to take about three to five months; now three weeks is usually enough. The time needed to obtain a work permit has also become much shorter (shrinking from six months to two and a half). If a foreigner earns more than 2 million rubles per year, he can qualify under the Highly Qualified Specialist work permit scheme and get his permit in 3 weeks. At the same time, the rules are constantly changing, at times causing delays.
Limited Liability Company (LLC)
As mentioned, the easiest way to go is to set up an LLC, or OOO as it is known in Russian. Russian law allows for a single shareholder and a single executive – the General Director. Both corporate and individual shareholders are allowed. With the individual shareholder, all that is required is a notarized translation of his/her passport and a visit to the notary and the tax office. In order to complete the registration process, it is necessary to have a General Director and this brings us to often one of the first challenges, as the company may not have identified someone to fill the role. Given the wide powers and responsibilities that the General Director has in Russia (it is very difficult if not impossible to limit such powers), this is a very important decision. As an interim solution, until a suitable candidate is found, it may be desirable to outsource this function to a reputable third party. Also, at the incorporation stage it will be necessary to specify a registered address, and again, as an interim measure an out-sourcing specialist can provide a solution until premises have been found.
For a corporate shareholder the process is more complicated – the Chief Executive Officer (CEO) of the corporation must sign the application for incorporation. This can be done in the home country and sent to Russia for translation and filing. However, this is not recommended as one small error could result in having to start over, causing significant delays. If possible, the CEO should come to Russia to complete the process. If this is not possible, then a nominee shareholder (this would be the local manager, if he is trusted or one provided by the legal firm handling the registration) is appointed and he will sign all the application documents.
It is also worth noting that the documents must be submitted in person by the Shareholder (or a Director, specified with appropriate powers in the Company Register) to the Russian authorities or by post, however, the latter is not recommendable as it usually takes 1-2 months and is unreliable.
In addition to the above, the corporate documents (charter/by-laws, certificate of incorporation) must be legalized (apostille attached) in the home country and then translated into Russian. Another common delay in the registration process is simply due to unfamiliarity of legal counsel of the parent company with this process of legalization.
Joint Stock Company (JSC)
There are some differences in the incorporation process of a JSC, known as ZAO by its Russian acronym, (see table of comparison below), for example it has the additional requirement of having its shares registered by the securities commission at incorporation. This legal form is best suited if the company is getting into a joint venture with non-affiliated partners.
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JSC (ZAO) |
LLC (OOO) |
| The charter capital is divided up into shares (aktsii). This makes it easier to transfer or assign shares as there is a perception of separation of investor from management of the company. | The charter capital is divided up into percentages of membership interest (dol’) – i.e., there is an assumption of the member’s active involvement in the company’s activities. |
| If a shareholder decides to exit a ZAO then he can do so via the sale of his shares either to the other shareholders or to a third party. The value (selling price) of the shares is determined by the parties and is not linked by law to the net asset value of the company. | If a member decides to exit an OOO he can either sell his membership interest to another member or third party, or he can choose to sell to the company and demand that the company pay him his share of the current net asset value of the company. Such a provision must be set out in the charter of the company. |
| Share issues must be registered with the Federal Securities Commission (FSC). | Additional start-up cost and time. No need to register with the FSC. |
| Dividends are paid proportionally to the number of shares owned. | The charter may provide for dividends to be distributed disproportionately from the percentage (%) of membership (ownership). |
| 50% of charter capital must be paid within 3 months of registration and 50% within 1 year. Minimum capital required – 10,000 rub. | 50% of charter capital must be paid before registration and 50% within 1 year. Minimum capital required – 10,000 rub. |
| If the contribution to the charter capital is “in-kind” (property) and not cash, then an independent appraisal is required regardless of the value of such in-kind contributions. Additional cost. | Independent appraisal is not required if the “in-kind” contribution to the charter capital is less than 20,000 rub. |
| The General Director may be appointed by the Board of Directors. | The General Director may be appointed by the Board of Directors. |
Representative Office and Branch Office
Representative and Branch Offices are not independent legal entities, but rather “sub-divisions” of the parent company. A Rep Office can not engage in commercial activity, but a Branch may. In the past, many Rep Offices carried out commercial activities, without any negative consequences as long as they paid the relevant taxes, but it is now less common to establish a commercial Rep Office.
The “accreditation” process as it is called in Russia can take much longer for a Rep/Branch office than an LLC or JSC. This is so because the “accreditation” process (registration with the state) is separate from the tax registration process, and as such, the whole process can take 6 to 8 weeks; however, there is the possibility to opt for a “fast track” process.
There are some advantages of doing business via a Rep/Branch office, such as the ease of moving currency out of Russia and obtaining work visas for staff. However, some activities may be limited or more troublesome, such as the import of goods or certain licensed activities.
A comparison of Legal, Financing, and Tax Aspects: Russian Legal Entity (RLE) vs. Branch or Rep Office
| Russian Legal Entity (RLE) | Branch/Rep Office (B/R O) |
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Legal A separate legal entity that bears its own liabilities. |
Liability is borne by the Head Office |
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Financing and Repatriation of Profits The start-up activities and working capital requirements of the RLE can be financed by the following methods: Charter capital, Loans, Parent (shareholder) financing. Dividends and return of loans can be viewed as forms of repatriation. Service contacts, royalty payments and other similar transactions can also be forms of repatriation. In this arrangement, VAT and income tax withholding, as well as increased foreign currency controls when moving funds out of Russia, are a concern. |
There is no tax due on repatriation of profits after tax [1]. Funds are sent to B/RO from the Head Office to finance operations --> income from sales in RUR received into ruble account of B/RO --> RUR converted into foreign currency and repatriated. The B/RO is responsible for filing and paying taxes. There is better control of the flow of funds when needed as there are fewer applicable foreign currency regulations. |
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Accounting Compliance and Tax Filing In general the accounting requirements are bit more burdensome for RLE as quarterly financial statements must be prepared as well as full tax accounting, including VAT. |
B/ROs are allowed to file and pay quarterly profit taxes. This is an opportunity for tax planning. No value added tax (VAT) accounting is necessary if there is no commercial activity and VAT is recognized as a cost. It should be noted that if a BO or RO engages in commercial activity then full tax accounting and reporting is mandatory. The accounting requirements are not as burdensome – there are no quarterly financial statements, but an annual report on activities (includes quasi financial statements). Rep Offices which do not carry out commercial activities are exempt from VAT on their rent payments. |
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Foreign employees The RLE would need to apply for permits (for the Company and for the employee) and, in addition, register with the Migration Services to issue work visa support. It should be noted that foreign employees earning more than 2 mil rubles (approx $66,000) per annum can qualify for a simplified work permit procedure that is valid for 3 years. |
Current regulations require B/RO to obtain work permits for foreign employees. However in practice this is ignored without serious consequences. If the B/RO deals with government agencies e.g., customs, then the permit should be obtained. The procedure for obtaining work visa support is simpler – i.e., the foreign employee can be in Russia on the proper work visa even if he/she does not have a work permit. The 3-year simplified work permit only applies to Branch offices and not Rep offices. |
[1] Applicable taxes: Profit tax (20%); Social tax (34% from 2011); Property tax (2% per year); VAT 18%.
2. Funding your operations
Once you have made the decision to set up in Russia, some thought should be given to funding your start up and ongoing expenses. There are a few options for financing your operations to consider: share capital; loans; parent-subsidiary financing; cost + arrangements.
The statutory share capital for a Russian legal entity is rather small (approx. 220 Euros). There is now a draft law that will significantly increase this cost in the near future and some companies choose to put a lot more funds in at the beginning or after incorporation. This type of funding is not very attractive, as your funds are stuck in Russian rubles, with all the related currency risk. Also, having significant cash at the disposal of your local managers provides “opportunity” – one of the prerequisites for fraud.
A loan is a popular option because it allows for better cash flow management – cash can be sent in tranches when needed and can be re-paid if there is excess cash in the subsidiary. As such, the currency risks and risk of fraud are reduced. In addition, if structured properly, interest on the loans can be charged to profits, reducing your taxes payable. It is also important to observe the thin capitalization rules.
Parent-subsidiary financing is a non-taxable contribution to the capital of the subsidiary by a parent owning more than 51% of the equity of the subsidiary. Apart from the benefit of managing cash flows and currency risks as with loans, this form of financing does not require statutory registration of the increased capital and increases the equity side of the balance sheet. This is also a good solution to improve your net asset position, when required by law.
Cost+ arrangements are becoming more popular as a means of financing a local subsidiary, which is not trading locally. For all intents and purposes, such a subsidiary acts like a rep office but does not have the legal risks accruing to the Head Office. In addition, the “+” aspect is treated as taxable income, therefore, the entity is not making any loss and does not come under undue scrutiny from the tax office. Basically, the subsidiary “charges” the Head Office for all costs (rent, salary, marketing) + a markup based on their internal corporate practice and local market practice (5 to 25%). Taxes are paid to the local budget based on this “profit.”
3. Finding a Manager – local or expat?
Many companies enter the market, and based on bad advice, spend a lot of money only to close in 12 to 18 months. Getting good advice and information from your manager on the ground is key. Should you hire a local (Russian) manager, with a clear understanding of the local culture and business ethics? In addition, he/she may be well connected, making it easier to solve problems when they arise. The disadvantage of this option is that the talent pool for managers is still relatively small in Russia and even as a SME, you will be competing with the big firms and be expected to pay top dollars to managers.
Presuming that as an SME there is no budget to import a high-level expat, along with family relocation costs, another option is to find an expat already settled in Russia, ideally, with a Russian family and looking to stay for a while. These candidates usually speak Russian and have a good understanding of the Russian culture and values. They may have good connections and have worked for startups before, so understand the needs of SMEs on a tight budget. The downside of this group of candidates is that they tend to be entrepreneurial and looking to set up their own business and may not be a long-term solution.
One other option that has become more popular is bringing a young expat over from the home country. Usually not married, ambitious, and looking for international experience, they are usually willing to give 2 to 3 years, with relatively low pay to gain this experience. Salary can be relatively low, but given that the personal tax in Russia in only 13%, they have more take-home pay than in Europe. In this case, the employer is expected to provide a flat for the manager, but not the expensive “Pokhovsky Hills” type.
4. HR issues in Russia
As we mentioned earlier starting with the right people is crucial to your success (or failure). As a general point the labor market in Russia has changed significantly since the collapse of the former Soviet Union. We can observe that 20 years ago staffing was not a problem, but what was an issue was a shortage of skills. Now, we almost have the reverse situation, where in today’s market there is generally not a problem with skills, but there is an issue in finding available staff. So one of the key challenges for an owner of an SME entering Russia is to find talent and then to develop and retain this “top talent”.
It is generally well accepted that Russia has a very well educated work force and that many young people are innovative. One successful owner told us recently that in his view “Russia is a laboratory of ideas”. This is a good starting point for an SME as by its nature the business may be an attractive place to work but the challenge is to attract good people. We therefore find that many SMEs succeed in attracting good people by offering a good working environment; consensual decision making; attention to training and development, and maybe some form of ownership participation. With regard to talent retention and motivation, salary is still the biggest factor. However, job satisfaction and career growth are growing in significance. With regard to additional employee benefits, private medical insurance has become the norm even for SMEs. Meal allowances and compensation for use of mobile telephone are also becoming more popular. What we hear from successful SME owners is that if you show trust in people, then they will respond more than adequately.
When establishing your business in Russia it is certainly worth keeping in mind that you are a “visitor”. With this in mind you should be able more easily to create the bridge between the Russian and European cultures. For, example what may seem a small thing for a foreigner may be a very big thing for your local employees. Since the early 2000s, as Russia has become more integrated into the world economy and a younger generation has entered the work force, Russian professionals have become attuned to what “international-standard service” means. Also, we see it is generally easier to find staff with foreign language skills in addition to professional qualifications. However, as mentioned before, it is still quite a challenge to find talent. What we have been told by successful owners of SMEs is not to underestimate the importance of treating people well, being appreciative and having a good working environment. Also, be open with people and let them know what is happening and treat people with the respect that they deserve. It is as true in Russia as in many other countries that the main capital of the business is not the money but the people.
5. Accounting and Taxation
There are several systems of taxation in Russia. The most frequently encountered include the following:
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General system of taxation – may be applied by all types of legal entities. All taxes and appropriate tax rates (in case of existence of a certain tax base) will be applied.
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Simplified system of taxation – was implemented specifically for SMEs and can be applied by legal entities, where the total annual revenue does not exceed 60 million Rubles (this number is not fixed and may vary from year to year). There are several other limitations, including one that says a corporate shareholder cannot own more than 25% of the shares (i.e., a 100% subsidiary of foreign legal entity does not qualify). The tax rate is 6% (if tax basis is revenue) or 15% (if tax basis is profit). Revenue and expenses are to be calculated on a cash basis.
Taxes and tax rates applied under the General system of taxation are:
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Value Added Tax (VAT): The tax base is the amount of VAT-able sales. General tax rate is 18%; for certain groups of goods – 10%; export operations – 0%.
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Corporate Profit Tax: The tax base is the difference between income and expense, calculated in accordance with the rules of tax accounting. Tax rate is 20%.
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Property tax: Tax base is historical cost of Fixed Assets of the company decreased by the amount of accumulated depreciation, calculated in accordance with rules of financial accounting. A fixed asset is an asset that costs more than 20,000 rubles (exclusive of VAT). The tax rate depends on the region of Russia, but cannot exceed 2.2%.
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Personal Income Tax: The tax base is all forms of compensation (with some exemptions) paid by the employer for the benefit of the employee. This is the employee’s personal obligation; the tax rate is a flat 13% for residents and 30% for nonresidents.
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Social insurance payments: The tax base is all forms of compensation (with some exemptions) paid by the employer for the benefit of the employee. This is the employer’s only obligation; the tax rate is 30% for 2012. There is also an additional 10% for employees that earn over a certain threshold. It should be noted that recent changes to the law applies this tax to foreign employees on a work visa unless they are on the Highly Qualified work permit.
Submitting tax returns and financial statements. Local tax authority
Every company is obliged to prepare financial statements using its accounting data. Financial statements shall include a balance sheet, Profit and Loss statement (P&L), related addenda, as well as notes to statements. Financial statements shall be signed by both the chief executive and the accountant of a company. These documents must be approved by the Meeting of Participants at the annual meeting.
Every company shall provide quarterly bookkeeping reporting within 30 days upon the expiration of the quarter and the annual bookkeeping reporting within 90 days upon the expiration of the year.
A financial year for Russian companies must be the calendar year. Interim quarterly statements shall be made containing the progressive total starting from the beginning of the financial year.
All legal entities should also submit tax returns to the local tax authority. All reporting dates for every tax declaration are strictly defined. Companies may submit all documents manually by visiting the tax office, via internet using special software, or simply sending them by post.
If the company is late in submitting even one report, the local tax authority has the right to block the company’s bank account and to keep it closed until the company submits the report. The bank account may be blocked for many other reasons such as unpaid taxes, fines, penalties, etc. Very often, outstanding tax obligations exist only in the computer records of tax inspectors and not in reality. This is due to poor administration and low levels of qualification of the staff of tax inspectorates and, as result, they block the company’s account without any legal basis. It can take considerable time and energy to settle this problem, so in order to avoid any interruption in the company’s activity, we strongly recommend a reconciliation of all balances concerning tax obligations with the local tax authority, at least once every 6 months.
Financial and tax accounting
There is a pronounced difference between financial and tax accounting in Russia.
Financial accounting includes all information concerning the economic activities of a company and on the basis of this information, a company will prepare financial statements – including profit and loss (P&L), Balance Sheet and Cash Flow Statements.
Tax accounting is being used only for calculating Corporate Profit Tax obligations. It should be noted that most Russian accountants focus on tax accounting since this is what the tax office is most interested in. As such, very often the financial statements prepared do not accurately reflect the company’s financial standing.
Companies must take into account that financial results (profit) in accordance with financial accounting will differ from the profits calculated in accordance with tax accounting requirements because there are differences between methods of recognizing income and expenses for financial and tax accounting purposes. In other words, some expenses may not be allowed as deductible expenses in tax accounting. The same may be true for recognition of income.
6. Closing down your business in Russia
Before making a commitment to set up in Russia, it is important to understand what it takes to liquidate or officially wind down the legal presence. The words from the song “Hotel California” come to mind when it comes to this issue – “you can check out any time you like, but you can never leave.” Before investing in setting up a legal presence, be aware that closing down a legal entity or rep office can take from 6 to 12 months and can be quite expensive. The main problem is reconciling your tax records with the tax office. As mentioned, the tax administration is still quite bureaucratic and records may not be easily accessible due to technical difficulties. This can result in repeated visits to the tax office to clarify the status of taxes filed and paid.
Nearly all aspects of start up and ongoing compliance (legal and tax/financial) require either hiring one or more individuals, or outsourcing. Either way, it is a real cost when it comes to Russia and it doesn’t wait for your sales to come in. For some businesses, working initially via a distributor or other partners, or simply working directly from the home office for a period – until business revenue can be more clearly projected – may be a sensible first step.
For those who are ready and committed to fully entering the Russian market, this overview has hopefully provided some basic guidelines to better prepare you for discussing the process with professional service providers. To become a successful business in Russia your company needs to develop an excellent reputation in terms of the major stakeholders - employees, customers and investors. We wish you every success for your business in Russia
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