Are Risks in Russia Uncontrollable

1
Are Risks in Russia Uncontrollable?

• Legal Structures for Creating a Successful
  Business in Russia
• Philipp H. Windemuth
• Partner

2
Russias Perceived Pros and Cons
3
A. Economic Cooperation between Russia and Japan

• Japan, the worlds 2d largest economy, Russias
  8th largest trade partner
• Political tensions may be resolved in 2005/2006
• Russia is ready for Japanese investment and has a
  favorable view of Japan
• Leading Japanese companies are already invested
  in Russia

4
B. Legal Reform under the Putin Administration

• Foreign press unfairly criticizes President Putin
  for slow progress in legal reform
• President Putin has implemented an impressive
  legal transformation, which is continuing

5
1. Tax Reform

• Most important reform
• Under Yeltsin, hundreds of taxes, intrusive
  audits and excessive penalities
• Under Putin, OECD-type system of rules, with
  favorable tax rates
• Taxes established by federal law, must have an
  economic basis, not be arbitrary and not
  interfere with constitutional rights
• All ambiguities resolved in favor of taxpayer
• No retroactive effect
• International treaties prevail
• As of Jan. 1, 2005, closed list of 15 taxes
  throughout Russia
• Tax authorities continue aggressive enforcement
  of tax laws
• Putin promises amendments to curb powers of tax
  authorities

6
2. Currency Reform

• Entered into effect in June 2004
• All transactions are permitted, unless
  specifically restricted
• Forced conversion percentage reduced from 25 to
  10
• Ruble becomes convertible in 2007

7
3. Securities Legislation

• Transparent securities market
• US-style disclosure rules
• International Accounting Standards
• Significant increase in international IPOs and
  foreign debt offerings
• Russian companies to raise US 35 billion by the
  end of 2006
• Foreign offerings lead to improvement in
  corporate governance and accounting practices

8
4. Real Estate

• Reforms have helped create a boom in housing and
  other real estate construction
• The 2001 Land Code provided underpinnings for
  real estate market
• Nation-wide cadastral system
• Laws on mortgage-backed securities, law on change
  of land categories
• reduction of fees and elimination of VAT for
  sales of land and residential real estate
• On Jan. 1, 2005, Civil Code amendments to protect
  good faith purchasers
• State authorities fully liable for false
  information

9
5. Banking

• In 2004, SP concludes that banking reform has
  begun to move in Russia
• Putin enacts law on deposit insurance and
  manadatory reserves
• Increase in capital adequacy requirements
• Central Bank revokes licenses of non-conforming
  banks
• Number of banks reduced from over 2000 in 2003 to
  1,500 in 2005

10
6. Subsoil Law

• New law to enter into effect in 2006, stronger
  basis for investments, investor guarantees,
  allows pledge and transfer of licenses
• Restrictions on foreign participation for
  strategic fields, on a case-by-case basis
• Russia remains interested in promoting foreign
  investment in the oil sector

11
7. Court System

• One of the weakest parts of the Russian legal
  system
• Substantial improvements if compared to the
  Yeltsin years
• New Civil and Arbitration Procedure Codes
  streamline jurisdictional rules to reduce
  corruption
• Corruption and arbitrary enforcement remain
  problematic
• Putin acknowledges the problem in his 2005
  Presidential Address

12
8. Administrative Reform

• Became top priority in 2004
• Reduction in number of ministries, introduction
  of three-tier system of ministries, services and
  agencies
• Significant internal opposition, requires
  extensive further work
• Putin acknowledges blatant racket of
  officials
• Plans do not include handing over the country to
  the inefficient rule of a corrupt bureaucracy

13
9. Other

• Law on Communications
• Customs Code
• Labor Code
• Law on Credit Histories
• Reform of Natural Monopolies
• WTO Legislation
• Law on Toll Roads
• Banking system, accounting standards and further
  administrative reform
• 3-year statute of limitations on privatizations
• Foreign participation largely unrestricted

14
C. Political Trends

• Concerns about political control and state
  involvement in the economy
• Yukos affair, federal appointment of regional
  govenors, increased state participation in the
  oil sector worries that Russia is drifting
  towards autocratic regime
• Putins moves must be seen in political and
  economic context
• Putin did not inherit a democracy, but a
  cleptocracy, on the brink of economic collapse
• Yeltsin allowed corrupt transfer of most valuable
  property to small group of insiders and corrupt
  bureaucrats
• By the end of 2000, Russia had collapsed
  economically and may have been on the verge of
  political disintegration
• Putin reversed this process, turning Russia into
  Europes fastest growing economy, GDP grew by
  7.1 in 2004, slowing to 5.5 in the first half
  of 2005, urgent measures are being taken to
  return to higher growth

15
Control over Media

• Russian government controls television, but the
  press remains largely free and aggressively
  critical
• Major newspapers controlled by Wallstreet Journal
  and Financial Times, and by ex-oligarch
  Berezovski
• When compared with many US channels, even Russian
  TV appears surprisingly objective

16
D. Structuring of Investment

• 1. Investment Vehicles
• a. representation office
• b. commercial branch
• c limited liability company
• d. joint stock company

17

• a. Representation Office
• non-commercial presence
• not a spearate legal entity
• not subject to Russian profits tax
• b. Commercial Branch
• commercial presence
• not a separate legal entity
• may encounter difficulties with operating
  licenses

18

• c. Limited Liability Company
• most flexible and most widely used type of
  investment vehicle
• legal entity, with up to 50 participants
• if single participant, such participant must have
  at least 2 owners
• governed by meeting of participants and
  executive, board of directors optional
• LLC shares are not securities, not subject to
  securities regulation
• sale of LLC shares to 3d parties are subject to
  right of first refusal by other participants
• LLC participants may exit the company at any
  time, with compensation payable at book value.

19

• d. Joint Stock Company
• closed or open type JSC
• closed JSC can have up to 50 shareholders
• if single participant, such participant must have
  at least 2 owners
• governed by meeting of participants and
  executive, board of directors optional for closed
  JSC
• in closed JSC sale of shares to 3d parties
  subject to right of first refusal by other
  shareholders
• shares in JSC are securities and hence
  subject to RF securities regulations

20

• 2. The Joint Venture
• Used by most foreign investors
• Russian partner can provide access to qualified
  personnel, customer and distribution networks,
  and assist with licenses and permits
• Joint ventures are often problematic, due to
  problems between shareholders
• To minimize problems, obtain control, and
  implement careful legal documentation, including
  allocation of authority and put or call
  options
• Interested party transactions
• Use of non-Russian JV holding company

21

• 3. Purchase of Existing Company
• Used by large industrial companies which do not
  yet have an established customer base or
  distribution network in Russia
• Raises issues similar to Joint Venture
• Requires careful due diligence, including
  privatization, ownership rights and hidden
  liabilities (including tax)
• Develop list of warranties, and secure with
  escrow payment where necessary
• Use ERBD, IFC or Japan Bank as lender/co-investor

22

• 4. Greenfield Projects
• a. Introduction
• Used by investors who already have an established
  customer and distribution network
• Local authorities are eager to attract foreign
  investors for greenfield projects
• Recommended regions are Moscow Oblast (Egorievsk,
  Klin, Solnechnogorski and Stupino), Leningrad
  Oblast, Nizhnegorod Oblast and Tula region
• Few restrictions on foreign investors
• No notarization requirements for agreements, low
  transaction costs

23

• b. Ownership of Land
• Most land remains under state and municipal
  ownership
• Procedure of allocation of ownership among
  federal, regional and municipal ownership just
  begun
• c. Zoning
• Land divided into different use categories
• A greenfield project may be built only on
  industrial land, or settlement land zoned for
  industrial purposes
• Most land still zoned for agricultural purposes
  and must therefore be rezoned
• Rezoning requires regional Government Decree,
  state permits and state expert review

24

• d. Acquisition of State and Municipal Land
• Ownership or lease rights may be acquired through
  auction or tender proceeding
• Lease rights may be acquired by direct
  negotiations

25

• (i) Auction or Tender
• Prior to auction or tender, the plot must be
  prepared by
• Completion of land survey and determination of
  borders of the plot
• Registration of plot in the Russian land register
• Preparation of town-planning documentation
  determining the conditions for construction on
  such plot
• Determination of technical conditions for
  infrastructure connections
• Thereafter, the land plot is sold to the highest
  bidder
• Few plots available for sale via auction or
  tender
• Purchaser in auction or tender faces risks in
  construction process

26

• (ii) Non-Tender Proceeding
• Grant to specific investor under long-term lease
  for a strictly defined facility
• Complex procedure takes up to 12 months
• Following completion of the construction, the
  investor should have the right to purchase the
  land plot
• Steps for non-tender proceeding (costs payable by
  investor)
• Application
• Identification of plots
• Preliminary approvals and publication
• Act of selection of land plot
• Survey and registration
• Rezoning
• Approvals for construction
• Appraisals
• Decision to grand the plot, and signature
  oflong-term lease agreement
• Regional differences in procedure

27

• e. Infrastructure
• The majority of land plots lack proper utilities
  connections
• Investor to pay for infrastructure
• Seek advice from technical consultants
• f. Practical Approach
• Arrange meeting with Governor or Deputy Governor
  of the relevant region, and head of the relevant
  local administration
• Perform on-site inspections of land plots
  proposed by the relevant authorities
• Reach a preliminary understanding with the
  relevant authorities with respect to the land
  plot to be proposed for acquisition

28

• g. Due Diligence
• Prior to commencing discussions, perform a
  standard due diligence investigation
  including
• the validity of the owners rights to the land
  plot
• a review of the land plot designation and type of
  permitted use
• possible third-party interests resulting from
  prior land use, privatization or other
  agreements
• liens and other encumbrances
• review of documents and information on the
  availability of infrastructure and utilities
• obtain technical and ecological study of land
  plot

29

• h. Purchase Price
• Purchase price established by regional
  authorities as a multiple of Russian land tax
• Multiple depends upon the population in the given
  area, set by regional governments within certain
  limits established by federal law
• i. Title Insurance
• Title insurance is permitted and available from
  licensed Russian insurance companies
• Insurance premiums are between 1 and 4.5 per
  year of the market value of the insured property

30
E. Taxation

• 1. Profits Tax
• 24 imposed on the differences between revenues
  and deductible expenses
• May be reduced to 20 under regional laws
  granting tax privileges to defined groups of
  investors
• 2. VAT
• Imposed at 18, with a 10 rate applying to
  certain food items, childrens goods, medical
  products and related services
• Imports are subject to VAT, most exports are
  exempt from VAT
• 3. Property Tax
• Tax rate up to 2.2, applies to all fixed assets,
  may be reduced by regional legislation

31

• 4. Payroll Taxes
• Unified social tax on a regressive scale (from
  26 to 2) of relevant salary expenses
• 26 rate applies to salaires up to 280,000 R
  (approximately EUR 9,000) per year
• 2 rate applies to salaries over R 600,000 (EUR
  20,000) per year
• 5. Workplace Insurance
• Levied at industry-specific rates, based on work
  hazard levels
• Standard rate for retail trade employers is 0.2
  of the relevant wage payments

32

• 6. Dividend Withholding
• 15 under local law, reduced to 5 under most
  double taxation treaties
• Treaty between Russia and Japan includes no such
  reduction
• Best to invest via a European subsidiary with a
  favorable tax treaty with Russia (Cyprus or
  Holland)
• 7. Interest Withholding
• 10 under the Russian/Japanese treaty
• 0 under most Russia-European tax treaties
  (including Cyprus and Holland)
• 8. Customs Duties
• Paid by importers on the customs value of goods
  and range between 5 and 10 for most goods

33
F. Conclusion

• With GDP growth of 7.1 in 2004, Russia today is
  Europes fastest growing economy
• Despite inefficient bureaucracy and wide-spread
  corruption, 80 of foreign investors are
  successful in achieving their business plans in
  Russia
• In 2004, 75 of foreign investors posted profit
  increases in excess of 10
• Japanese companies are welcome in Russia and a
  number of leading companies have already made
  significant investments
• Japanese companies are market leaders in many of
  the products which Russia needs most
• President Putin has implemented and is continuing
  to implement significant legal reforms, in order
  to improve Russian investment climate
• Reforms in the area of tax, currency, securities,
  real estate, banking and other areas are helping
  Russia to integrate into international financial
  and commercial markets

34

• Much of the current criticism of Russias
  political developments under President Putin is
  overstated
• Following the chaotic Yeltsin years, the thrust
  of Putins reforms has been to reestablish order
  in Russia and to put Russia back on the path
  towards economic prosperity, a task in which he
  has been extremely successful
• In the current climate, investors will be
  successful if they have a good understanding of
  the legal situation, know their industrial sector
  and, where necessary, seek strategic alliances
  with Russian partners
• Foreign investment can take the form of joint
  ventures, purchases of existing companies or
  establishment of new production facilities,
  depending upon the particular needs of the
  investor.