Windemuth

Are Risks in Russia Uncontrollable?: 

Are Risks in Russia Uncontrollable? Legal Structures for Creating a Successful Business in Russia Philipp H. Windemuth Partner

Russia’s Perceived Pros and Cons: 

Russia’s Perceived Pros and Cons

A. Economic Cooperation between Russia and Japan: 

A. Economic Cooperation between Russia and Japan Japan, the world’s 2d largest economy, Russia’s 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

B. Legal Reform under the Putin Administration: 

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

1. Tax Reform : 

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

2. Currency Reform: 

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

3. Securities Legislation: 

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

4. Real Estate: 

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

5. Banking: 

5. Banking In 2004, S&P 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

6. Subsoil Law: 

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

7. Court System: 

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

8. Administrative Reform: 

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

9. Other: 

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

C. Political Trends: 

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 Putin’s 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 Europe’s 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

Control over Media: 

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

D. Structuring of Investment: 

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

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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

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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.

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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

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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

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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

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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

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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

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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

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(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

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(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

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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

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g. Due Diligence Prior to commencing discussions, perform a standard due diligence investigation including: the validity of the owner’s 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

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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

E. Taxation: 

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

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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

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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

F. Conclusion: 

F. Conclusion With GDP growth of 7.1% in 2004, Russia today is Europe’s 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

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Much of the current criticism of Russia’s political developments under President Putin is overstated Following the chaotic Yeltsin years, the thrust of Putin’s 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.