Dechert OnPoint: Georgian Law Developments – Talking Taxes
Dechert Georgia, through the contribution of partners Archil Giorgadze and Nicola Mariani joined by senior associates, Ruslan Akhalaia and Irakli Sokolovski, is partnering with Georgia Today on a regular section of the paper which will provide updated information regarding significant legal changes and developments in Georgia. In particular, we will highlight significant issues which may impact businesses operating in Georgia.
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General Principles of Taxation of Cross-border Transactions in Georgia
In the last decade, not withstanding certain slowdowns, Georgia has experienced a steady increase of foreign investment and economic growth. The increase of foreign investment and economic growth was accompanied by the increase of cross-border activities of Georgian companies and the inflow of non-Georgian nationals into Georgia for entrepreneurial or work purposes. Such economic trends heightened the interest in Georgian tax implications of cross-border activities. This interest was recognized by Georgian legislators too, who have introduced a number of new tax regulations to facilitate and better organize such inflows of foreign direct investments.
Tax regulations of Georgia, introduced in recent years, have pursued two major goals. The first is boosting investor interest in Georgia by simplifying the Georgian tax system and introducing tax concessions. Some of these legislative incentives have been successful, while some have yet to yield the desired results.
The second goal of the Georgian tax policy was the prevention of abusive tax practices and collection of more revenues from increased economic activities. This lead to the introduction of special anti-tax avoidance rules, such as thin capitalization rules and transfer pricing rules. However, inevitably and as is the case in a number of countries, the first goal of simplifying the tax system and making it more attractive to foreign investors created tension with the second goal of preventing abusive tax practices and collecting of more revenues.
Pursuit of the noted two goals resulted in a relatively simple tax system, which, however, requires careful consideration and advance planning by foreign investors when choosing a business model before entering the Georgian market in light of the tax regulations. This article provides a brief overview of the key tax issues which foreign investors or individuals in Georgia for business or work purposes usually have to consider.
Taxation of Expatriates
In the past decade, the number of skilled professionals and entrepreneurs moving into Georgia for work or business purposes has increased dramatically. Such inflow of individuals into Georgia is usually related to certain tax issues.
Individuals moving to Georgia for work for a period exceeding 183 days in any uninterrupted 12 month period automatically gain Georgian tax residency status (“Expatriates”). Prior to the 2008 legislative review, individuals having Georgian tax residency status were taxed by Georgia on their world-wide income. However, after the 2008 changes, income received by Expatriates is taxed only on Georgian source income.
Thus, if Expatriates receive non-Georgian source income, this income will likely be taxed only once in the country of origin of the income; and the income Expatriates receive from a Georgian source shall likely be taxed in Georgia alone. This system effectively mitigates the risk of Expatriates being taxed in two or more countries at the same time.
That said, the vast double tax treaty network of Georgia may help Expatriates to legally reduce their tax burden on their non-Georgian source income to zero. This is especially true with respect to certain consultancy work performed by Expatriates outside Georgia. Furthermore, certain double tax treaties of Georgia exempt dividend and interest payments from the withholding tax of the source country. Respectively, Expatriates may get certain non-Georgian sourced dividends and interest payments free from any tax burden because: (a) a double tax treaty exempts these dividend and interest payments from taxation in the source country (i.e. the country from which the dividend and interest payments are derived from); and (b) Georgia does not tax the foreign source income of Expatriates.
Notably, foreigners may acquire Georgian tax residency status even if they do not reside in Georgia for a long period of time. Under the tax code of Georgia (the “Tax Code”), a person having “significant wealth” may acquire Georgian tax residency status. In order to show “significant wealth,” the individual must prove that his/her assets exceed three million Georgian Lari or his/her annual income exceeds two hundred thousand Georgian Lari for the last three years.
Choosing Business Vehicles: Branch vs. Limited Liability Company
One of the preferred ways of doing business in Georgia for foreign corporations is either incorporating a Limited Liability Company (“LLC”) or a branch (“Branch”) of the foreign corporation in Georgia.
Incorporating a LLC or Branch is an easy process and it may be completed within one (1) day of submitting the required documents to the National Agency of Public Registry of the Ministry of Justice of Georgia. However, prior to the incorporation of a LLC or Branch in Georgia, investors usually consider differences in tax treatment between LLCs and Branches in Georgia.
The Tax Code treats LLCs and Branches in the same way in many respects. However, there are notable differences between the two.
Both are taxed with a corporate profit tax on their net income (i.e. profit) at the rate of fifteen percent (15%), but LLCs pay corporate profit tax on their worldwide income minus related expense while Branches are only liable for the corporate profit tax on their Georgian source income and related expenses.
Another difference is that LLCs are required to withhold five percent (5%) of the Georgian withholding tax from the profits distributed (i.e. dividends paid) to their non-Georgian resident shareholders, while the distribution of profits of a Branch is not subject to a five percent (5%) withholding tax on dividends.
The third important difference in the tax treatment of LLCs and Branches relates to shareholder loans between the shareholders and their Georgian subsidiary. Interest payable on such loans, subject to certain conditions, is deductible from the gross income of the LLCs. However, loan contracts between the head office and Branch are not recognized for tax purposes; respectively, interest payments on shareholder loans are not recognized in case of Branches and therefore such payments are not deductible from the gross income of Branches.
Because the choice of the business vehicle for doing business in Georgia may have important tax ramifications, investors sensitive to tax risks should carefully assess Georgian tax rules when deciding how to structure their business.
Georgian Withholding Tax
If a non-resident derives income from a Georgian source without having a registered Georgian permanent establishment, then the non-resident is taxed at the source of the payment of the income in Georgia. The applicable tax rate may vary depending on the type of income.
In particular, dividends and interest payments made by Georgian residents to non-Georgian residents are subject to a five percent (5%) withholding tax. Amounts paid by entrepreneurs or non-profit organizations for international telecommunication services or transportation services are subject to a ten percent (10%) withholding tax. Income received by non-Georgian tax resident companies from oil and gas operations is subject to a four percent (4%) withholding tax.
The rent or salary paid to an individual is subject to a withholding tax of twenty percent (20%), while other payments sourced in Georgia are subject to a ten percent (10%) withholding tax. If these other payments and interest payments are made to persons registered in offshore or tax-haven countries, then the applicable withholding tax rate is fifteen percent (15%).
Non-Georgian Tax Residents Setting Up Company in Georgia
Investors often opt to incorporate their business as a LLC. Such choice inevitably brings up questions regarding the preferred ways of financing the LLC from a tax perspective and the tax ramifications for distributing the profits of the LLC.
There are two major ways of financing an LLC by its Shareholders: 1) contributing to the capital of the LLC; or 2) providing shareholder loans.
Cash contributions to the capital of the LLC do not trigger tax liabilities for the shareholder or for the Georgian LLC. A non-resident’s return on such contributions in the form of dividends are subject to five percent (5%) of withholding tax.
Unlike cash contributions to the capital, shareholder loans may result in certain tax liabilities for the parties. In particular, interest payments on such loans are subject to a five percent (5%) withholding tax. However, the interest payments are deductible (subject to certain limitations) from the gross income of the tax-payer. Dividend payments are not deductible from the gross income of a LLC, thus, shareholder loans usually reduce the tax burden for the LLC. For this reason, investors usually prefer to provide finances to their subsidiaries in the form of shareholder loans.
With respect to shareholder loans, it is also worth noting that the Tax Code limits certain deductions related to interest payments. Furthermore, shareholder loans fall within the scope of transfer pricing rules of Georgia. Therefore, shareholder loans need careful consideration and planning.
Georgian Transfer Pricing Rules
All Double Tax Treaties of Georgia have specific rules related to international transfer pricing. The current Tax Code introduced these rules on 17 September 2010 but the Revenue Service was relatively passive in enforcing the rules because the rules lacked guidelines for the application of transfer pricing methodologies. The deficiency was corrected by Decree #423 (dated 18 December 2013) of the Minister of Finance on the Assessment of International Controlled Transactions by providing guidelines for applying the international transfer pricing rules of Georgia.
Under the transfer pricing rules, the Revenue Service is authorized to adjust the commercial and financial terms (including the price of goods and services) of a transaction between two related parties if those terms differ from what would have been agreed between independent parties (the “Arm’s Length Principle”).
The Arm’s Length Principle essentially authorizes the Revenue Service to increase the price of the transaction and therefore require Georgian companies to declare more income in Georgia. Alternatively, the Revenue Service may require a Georgian company to apply withholding taxes to the larger amount of income paid by the Georgian company to a non-Georgian resident. This authority creates tax risks for tax-payers with respect to related party transactions. Therefore, any transaction between related parties should be carefully considered and analyzed for all tax implications.
Transactions with Offshore Companies
Offshore companies have often been used by investors for tax planning purposes in Georgia. However, Georgian tax policy makers countered such practices by enacting special rules to deal with transactions with offshore companies. Furthermore, the Revenue Service has also increased its diligence in auditing such transactions.
As of the date of this article, the Tax Code states that any transaction carried out by a Georgian company with an offshore company is automatically subject to the Arm’s Length Principle. This means that tax-payers have to declare their tax liabilities with respect to such transactions in reference to the Arm’s Length Principle. Otherwise, the Revenue Service is authorized to make adjustments to the prices or other terms of the transaction.
In addition, Georgian source income of offshore companies is subject to a higher withholding tax. In particular, Georgian sourced payments in favor of offshore entities are mostly subject to a fifteen percent (15%) withholding tax. The same types of payments by residents to other non-residents (i.e. non-offshore residents) are only subject to taxes varying from five to ten percent (5 % to 10%).
For tax purposes, there is a list of offshore countries that are qualified as such by the Government of Georgia,1 including (but not limited to) the following: Hong Kong, Guernsey, British Virgin Islands, Cyprus, Cayman Islands, Lichtenstein, and Monaco.
Double Tax Treaties of Georgia
Georgia has entered into international treaties for the avoidance of double taxation with forty-seven countries.2 These treaties provide important tax benefits for investors and individuals conducting business activities in Georgia. These treaties exempt certain types of income from taxation in Georgia or reduce the applicable tax rate. Furthermore, under some treaties an investor may deduct taxes paid in Georgia from the taxes an investor must pay on the same income in its own country of residence.
Investors usually prefer to enter Georgia from jurisdictions with which Georgia has entered into the treaty on the avoidance of double taxation. However, in light of the level of development of the Georgian legal system, investors should also take into account the relevant international instruments for the protection of foreign investments.
Such protection is usually availed to the investors under bilateral investment treaties (the “BIT”). The BITs provide material protection of foreign investments in Georgia. In particular, BITs offer investors the opportunity to submit any legal dispute with Georgia related to the investment in a LLC to the International Centre for the Settlement of Investment Disputes or similar international dispute resolution organizations.
In recent years, the Georgian tax system has undergone major changes that have simplified some aspects while making the application of Georgian tax law more complex. Though the reduction in the number of taxes has made Georgia more appealing to investors, with the number of anti-tax avoidance rules and practices targeting offshore and related party transactions, investors should consult with an expert in order to fully understand the tax implications on their potential investment prior to investing in a business in Georgia.
Note: this article does not constitute legal advice or tax advice. You are responsible for consulting with your own professional tax advisors concerning specific tax circumstances for your business.
1 Article 134(5), Tax Code; Decree 132 of the Government of Georgia (dated 30 May, 2013) about determination of the list of the tax havens/offshore countries.
2 Official web-page of Ministry of Finance: http://mof.ge/4793 the day of last visit: 30 November 2014.