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17 November 2016 Legal Highlights: Localization in Russia – new opportunities. Alexey Gorlatov and Vladimir Tchikine for The Moscow Times

The Moscow Times  

It is no a secret at all, crisis and sanctions made a certain impact on the Russian economy, however, that does not necessarily mean an adverse impact. The Russian government learned lessons from the sanctions and the crisis and is now trying to step away from a resourceaddicted economy. It is a nice try, as long as it brings certain profits for Russia and companies working here. Import substitution, which is obviously becoming a state strategy, is part of that stepping away, and localization seems to be a logical continuation of that strategy.

One of the steps in this relation is the Special Investment Contract (the “SIC”), which was introduced to support potential investors in transferring business into Russia, creating new facilities and receiving the status of Russian domestic manufacturer. And, of course, the government introduced incentives like preferred access public procurement, tax preferences and overall support and assistance.

The status of Russian domestic manufacturer gives its holder the right to sell domestically produced goods to the government, and may facilitate the sales of such goods to the biggest state-controlled companies of Russia. In addition, an investor that has concluded a SIC can get tax exemptions. There are two ways a foreign investor can get the status. The investor can conclude an SIC with the Russian Industry and Trade Ministry (the “MIT”) or, having fulfilled the established localization criteria without a SIC, obtain confirmation of status from the MIT.

In simple words, the state of Russia gives the investors the right to participate in government procurement in return for investments. This right does not run afoul of Russian WTO commitments because Russia has negotiated observer status in the WTO Agreement on Government Procurement, therefore Russia may establish trade-related measures that otherwise would be inconsistent with the provisions of Article III or Article XI of GATT 1994 for the purpose of government procurement.

The qualifying localization criteria are set in Government Decree 719 of July 17, 2015 (Decree 719). Any manufacturer meeting the criteria may become a domestic manufacturer, however this status needs to be confirmed by the MIT either through a SIC or through special confirmation. There are important differences between an SIC and special confirmation. An SIC makes it possible to attain localization gradually and, in addition to the right to sell to the government, gives the investor the right to tax exemptions with a grandfathering clause, but an SIC requires that the investor make an investment of at least 700 million roubles, the investor can receive the status of exclusive supplier of the government by investing at least 3 billion roubles. As opposed to that, special confirmation can be granted in case the maximum localization per Decree 719 has been achieved and does not give the right to any tax exemption. However, there is no investment obligation.

Furthermore, the failure of the investor to fulfil the localization schedule and/or to make the required investments may lead to an early termination of an SIC that will imply that the investor is liable to pay the tax arrears resulting from tax exemptions and special tax treatment granted to it and a late-payment penalty.

The special tax treatment is set forth in relation to local taxes (or the local part of the federal taxes). In particular, in certain regions of Russia, the local part of the income tax is set to zero. Also, other taxes are significantly reduced, and such preferences are deemed to be in force for several years.

This seems to be a great support from the federal and local government. Of course, such tax preferences are subject to certain requirements to be met, but nevertheless, the parties (the investor and the government) may to a certain extent agree on a few provisions in the contract that may relate to the taxation.

By itself, the decision to localize in Russia is, in fact, a decision to conduct large-scale investments. Such decisions, especially in a situation where the price of commodities is falling and rouble is getting weaker, can be made without expert opinion or a detailed analysis of the investment options. And anyway, localization requires the transfer of technologies into Russia and development of Russian-based technology.

Of course, nothing prevents private companies, or even state-owned companies, from investing in the development of new technologies and improving or transferring existing ones. In 2014, the MIT and the Energy Ministry considered that, for example, an effective mechanism for technological development of the chemical complex would be the localization of foreign enterprises and joint ventures with foreign companies for the purpose of technology transfer. However, the MIT started thinking some time ago about ‘reverse engineering’ — the Ministry plans to establish a Reverse Engineering Center headed by the Development of Industry Fund. Apparently, it will be used for developing domestic analogs of imported equipment.

Reverse engineering itself, and its industrial use, may cause a lot of legal disputes and problems for the end users of such equipment. For example, if equipment created through reverse engineering violated the rights and interests of the relevant technologies’ owners, the latter would be entitled to apply to the court for protection of their rights, including demanding that use of the equipment stop.

However, it doesn’t seem to be a problem at all in projects where technologies are transferred by investors to their own facilities and localized enterprises.

In light of all that, and given that legislation with regard to the SIC is very new and requires a kind of adaptation period, we believe that the government would do better to closely follow up the processes, starting from requirements (which in certain cases may be differentiated), precontract negotiations, contract execution and the performance of the same.



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