Russia’s Eurobond-Tax Split Pits Budget vs Finance Hub Plan

Russia’s government will have to pick between adding revenue and bolstering plans to make Moscow a global financial hub as it debates a tax on Eurobond coupon payments, according to Deputy Finance Minister Sergei Shatalov.

The government must decide whether to make companies withhold tax on Eurobond coupon payments in the next two months before lawmakers break for summer or let tax exemptions adopted last year expire at the start of 2014, Shatalov said by phone.

“It’s Russia’s sovereign right to tax income earned in Russia,” Shatalov said. “The Cabinet must decide if the country should sacrifice this right for market development and the creation of an international financial center.”

Russia’s government remains at odds over the bond-coupon levy more than a year after the Finance Ministry drew the ire of businesses and investors with a move toward starting to collect a tax on Eurobond earnings channeled through offshore vehicles to non-residents.

Critics of the plan, including state-owned pipeline operator OAO Transneft, said the levy may increase corporate borrowing costs and discourage bond sales. The 20 percent withholding rate, if enforced, may cost Russian companies $1.5 billion, Moody’s Investors Service estimated in February last year. The Finance Ministry exempted borrowers from retroactive levies on Eurobond coupons until Jan. 1, 2014.

‘Key Decision’

The question remains the “key decision” left in the government’s approach to taxing financial markets this year, according to a draft policy for the next three years, dated April 30 and published on the Finance Ministry’s website.

Prime Minister Dmitry Medvedev’s cabinet is scheduled to discuss the document May 16, according his administration’s draft agenda.

The yield on Transneft dollar-denominated bonds due August 2018 fell three basis points, or 0.3 percentage point, to 2.95 percent, less than one basis point from the record low on May 2. Yields on dollar bonds sold by OAO Gazprom, the state-run natural gas exporter, and due November 2016 declined eight basis points to an all-time low of 2.43 percent.

“The Cabinet is standing now at a fork in the road,” Shatalov said. “To keep or not to keep the exemptions.”

Russia’s government is seeking to balance the budget after President Vladimir Putin pledged to boost social spending during his campaign for a third term in office. The fiscal deficit will probably be 0.6 percent this year and 0.2 percent next year, according to the Finance Ministry.

Two Options

The current exemption applies only to Eurobonds sold via a special-purpose vehicle, or SPV, while income from holding domestic corporate debt issued through Russia’s central depository is taxable, according to Shatalov. Either all coupon payments to non-residents should be taxed or none should be, he said. The ministry’s draft policy outlines the two options.

Russia granted foreigners direct access to the domestic government debt market in the first quarter and is planning to open up the corporate market, as part of the plan to create an international financial center in Moscow.

“There is no answer yet, but it’s obvious that the rules must be symmetrical for the depository and SPVs,” Shatalov said. “They may be tipped in favor of the depository.”

Bringing taxation of earnings from Eurobonds and local debt in line with each other “is logical in theory,” Alexander Voloshin, a former chief of staff to Putin and current head of the Kremlin’s financial hub task group, said in an e-mailed response to questions. “How to act still needs to be discussed.”

While taxing Eurobond coupons will “obviously make resources more expensive for Russian companies, it’s not at all evident that it will help the market for our bonds,” Voloshin said.

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