Why Russian Investors Stay in Cyprus Despite Restructuring Hit

A generous tax treaty and a dense web of corporate relationships still attract Russian business interests to the island nation.


Cyprus’s recent bailout agreement came as a rude shock to Spectrum Partners. The Russian hedge fund firm, which manages a long-short Russian equities fund and an emerging-markets debt fund, has been successfully plying its trade from Limassol, Cyprus’s second-largest city, for more than a decade. As part of the debt deal, however, the Cypriot government imposed a stiff €8.3 billion ($10.7 billion) haircut on uninsured depositors, mainly Russians, and slapped on capital controls. Spectrum Partners immediately began weighing a move of its operations to another friendly offshore jurisdiction in Europe.

Yet after considering a variety of alternative locales, including Switzerland, Ireland and the U.K., the firm’s partners came to a surprising conclusion: They plan to stay put in Cyprus, at least for now. “Looking at the whole picture — taxes, regulation, cost of operations and hiring personnel — Cyprus still suits us, as long as they don’t change the regime further,” says Andrey Lifshits, one of two managing partners at the firm. Relocating Spectrum to Russia, where the firm invests most of its money, is not an option, he explains. Simply, Russia has no law regulating hedge funds, and in any event, Lifshits has no desire to exchange Cypriot bureaucrats and regulators for Russian ones.

Many Russian entrepreneurs have made similar calculations in the two months since Cyprus agreed to a €10 billion bailout from the European Union and the International Monetary Fund. The deal forced a dramatic downsizing of the country’s big banking sector, including effective write-downs of more than 50 percent on uninsured depositors at the two leading banks, Bank of Cyprus and Cyprus Popular Bank, better known as Laiki. A large percentage of the uninsured, those with more than €100,000 in deposits, were Russian individuals and companies; they collectively held nearly a third of the banking system’s €68 billion in deposits before the crisis, by some estimates. In addition, thousands of Russian (and Ukrainian) corporations, including state-owned giants like Gazprom and oil producer Rosneft, route hundreds of billions of dollars annually through Cyprus subsidiaries that range from brass-plaque outposts to fully staffed field offices.

Moscow’s initial reaction, by both government officials and private business executives, was outrage over the bailout terms. Many believed they had been targeted for expropriation by EU governments, especially Germany, whose officials made it clear they didn’t want to be seen as bailing out Russian billionaires. Prime Minister Dmitry Medvedev accused the EU of stealing from Russian depositors. “Cyprus is continuing to rob the victims,” he said at a recent cabinet meeting.

Tempers have cooled since then, though. The Russian Finance Ministry quietly made its contribution to the bailout by restructuring a €2.5 billion sovereign loan to Cyprus. Under the deal, terms of which were revealed in IMF documents last month, Moscow lowered the interest rate on the loan by 2 percentage points, to 2.5 percent, and extended the repayment term by two years, to 2018.

Just as significant is the quick outbreak of détente between Russia’s second-largest bank and Cypriot authorities. Andrey Kostin, president of state-controlled  VTB Bank, whose Russian Commercial Bank (Cyprus) subsidiary is one of the largest banks left standing in Cyprus, said he was committed to maintaining its presence there after meeting in Limassol last month with President Nicos Anastasiades and central bank governor Panicos Demetriades (see “Second Chance,” this page). “A line has been drawn for VTB under the so-called Cypriot crisis, during which the bank and its clients managed to avoid financial losses,” Kostin said.


The crisis will certainly have an effect on the commercial ties between the two countries. Private Russian businesses are likely to give a wide berth to Cypriot banks, at least in the near term. But bank deposits are fungible and ancillary to Russia’s real interest in the island: the dense web of corporate entities that act as an alternative financial system for the world’s tenth-largest economy. That system grew up around legal advantages that will be hard to duplicate anywhere else — at least, anywhere else within close physical proximity to Russia, an important factor for most of the country’s business executives.

If Russian companies and investors continue to do business in Cyprus, that should provide a much-needed lifeline for this tiny country of 1.1 million people, which is undergoing a punishing recession because of its debt woes. If the Russians depart, they would take hundreds of billions of dollars’ worth of annual transactions to competing offshore zones: Luxembourg, Latvia and Malta are in the hunt for that business, along with Lifshits’s candidates — Ireland, Switzerland and the U.K. What all that Russian financial business will not do is relocate to Russia.

CYPRUS’S KEY ATTRACTION FOR Russian businesses is a double-taxation-avoidance agreement. Resident companies pay a light tax of 12.5 percent on profits booked in the country, below Russia’s 20 percent corporate tax rate. Even better, Cyprus taxes dividends and royalties at a rate of just 5 percent. The country charges no capital gains tax and imposes no levy on capital transfers from Cyprus entities to havens that are further afield and more securely secretive, like the British Virgin Islands or the Seychelles. Those policies allow oligarchs and less wealthy Russian business executives to keep more of their companies’ wealth for themselves and minimize the tax man’s take. In addition, Cyprus uses English law, considered the international gold standard for resolving business disputes.

Russian investors are wary that this statutory paradise could be spoiled as the Cypriot government searches for revenue going forward and fellow EU members attack a regime many see as a magnet for wealth acquired by unsavory means. German Finance Minister Wolfgang Schäuble has cast a particularly jaundiced eye on the special relationship between Russia and Cyprus. “Suspicion arises, and it’s plain to see,” he said in a German television interview earlier this year. “You may ask why Cyprus is the second-largest foreign investor in Russia, and we need clear answers to that.”

But as long as Cyprus’s benefits last, many Russian businesses will keep taking advantage of them. “We have had a lot of requests from clients to look at alternative jurisdictions,” says Natalia Kuznetsova, a partner with PricewaterhouseCoopers’ tax practice in Moscow. “So far, Cyprus’s domestic regime is the best.”

Throughout the post-Soviet period, mineral-rich Russia has generated much more capital than its owners have been willing to reinvest in the country. Net capital outflows totaled a prodigious $782.5 billion between 1994 and 2011, according to Global Financial Integrity, a Washington-based watchdog group on illegal cross-border capital flows. That sum is equivalent to roughly one third of Russia’s gross domestic product last year.

Most of the outside world has taken a dark view of this capital flight, as have some within Russia itself. Sergei Ignatiev, who is stepping down as chairman of Russia’s central bank this month after 11 largely successful years, recently estimated that $49 billion left his country in 2012 via “dubious schemes” that he contended “could be payment for narcotics, illegal imports, bribes and kickbacks to officials, or schemes to avoid tax.”

Business executives and lawyers reject the allegations of criminality. Instead, they say money goes offshore because Russia is unable to create a healthy environment for legitimate enterprise. Local companies are stifled by sticky-fingered bureaucrats’ exploiting vague laws and are subject at any time to expropriation by competitors who have better political connections.

“Entrepreneurs don’t want to hold their assets in Russia, where raiders can take them away with the help of administrative resources,” says Igor Zhigachev, a partner of Moscow-based law firm Zhigachev and Khristoforov, which has helped clients establish offshore entities in Cyprus. “Cyprus was about the middle class looking for predictable rules of the game.”

Global Financial Integrity estimates that only one quarter of Russia’s capital exports over the years qualifies as illicit and says a large part of this category involved so-called transfer pricing, a tax avoidance strategy whereby a Russian company sells goods to a foreign subsidiary at diminished cost to book more profit outside the country.

Cyprus was one of the first countries to think of post-Soviet wealth as an opportunity rather than a threat. Whereas other countries imposed visa requirements on Russians, Cyprus actively promoted itself as a tourist destination. Russia’s newly mobile middle and upper classes quickly began flocking to Cyprus’s Mediterranean beaches, then stayed to buy villas once they could afford them. Up to 40,000 Russian speakers live in Cyprus today, and their language is almost as commonplace as Greek in the seaside city of Limassol. “Cyprus is more than an offshore,” Zhigachev observes. “It has replaced Crimea as a warm place where you try to find a retirement home for your mother.”

Russia’s use of Cyprus as a platform for foreign trade goes back to Soviet times, when Vnesheconombank, the state-run bank that handled Russia’s hard-currency transactions, established a branch there. Cyprus assiduously nurtured these roots as post-Soviet corporations found their feet. The Cypriot government signed one of the earliest and most comprehensive double-taxation treaties with Russia in 1998.

The dividends have been enormous. Cyprus perennially ranks as the leading foreign investor in Russia (Schäuble erred when he called it No. 2). The nominal total for 2011 was $128.5 billion, while Russia “invested” $121.6 billion back into Cyprus. By comparison, Cyprus’s GDP that year amounted to $25 billion. Interestingly, most years have seen larger flows go from Cyprus to Russia than vice versa, belying the island’s image as a path for flight capital.

Although some Russian officials have expressed a desire to repatriate business from offshore havens, often called de-offshorization, many pillars of the Russian corporate establishment use Cyprus as a second home with the tacit approval of President Vladimir Putin’s Kremlin. Lukoil, the biggest private Russian oil company, conducted a $2.5 billion share buyback via its Cypriot subsidiary last year. Big state-controlled companies have been active on the island as well. Cyprus’s entry into the EU in 2004 and its subsequent admission to the euro zone four years later only increased its attraction for Russian businesses. “Putin talks about ‘de-offshorization,’ but he gains a lot from Rosneft or Gazprom transacting business within the euro zone,” says  Valery Tutykhin, a Geneva-based partner with Swiss-Russian law firm John Tiner & Partners.

Cyprus-based securities settlement has been essential to the Russian capital markets. Foreign investors account for most of the liquidity in Russian equities, and they have always been reluctant to take on Russian bureaucracy and custody risk. Brokerages have obliged with accounts domiciled on Cyprus. “The Russian stock market functions because of Cyprus,”   Tutykhin says. “At least 50 percent of the volume flows through Cyprus entities.”

THE BOUNTY OF RUSSIA AND the rest of the Commonwealth of Independent States proved dangerous for Cyprus. Deposits in Cypriot banks swelled to about four times the country’s GDP before the recent banking crisis, effectively making the banking system both too big to fail and too big for the government to bail out. Bank of Cyprus (whose largest shareholder is Russian billionaire Dmitry Rybolovlev, boss until recently of the Uralkali potash empire) and Laiki bet far too much of this money on Greek bonds and securities. When EU authorities and the IMF imposed stiff haircuts on private sector holdings of Greek debt as part of the country’s second bailout package, in 2012, the Cypriot banks were in no shape to bear their share of the losses.

To the smart money, Cypriot banking was a Titanic waiting to hit its iceberg. “It’s just incredible how many Russians still had their money in Cyprus accounts,” says Bernard Sucher, a board member at Moscow-based investment bank ATON. The Cypriot banks “have been on our watch list for two years.”

When catastrophe struck and Cyprus needed a rescue, the EU and IMF vowed to limit their contribution to a bailout to €10 billion, arguing that a greater sum would leave the country with unsustainably high debt. The Cypriot authorities would have to find the other €8 billion or so needed, and the banking system offered the only target big enough. At first the authorities proposed to tax all bank deposits, including those lower than the deposit insurance ceiling of €100,000. The public responded with outrage, however, and Parliament quickly rejected the proposal. The authorities came back with a revised plan to wind down Laiki and transfer its good assets to Bank of Cyprus, which will be recapitalized. Uninsured deposits at Laiki will be converted into equity in the bad bank, a claim of doubtful value. At Bank of Cyprus between 37.5 and 60 percent of uninsured deposits will be converted into equity, implying a steep haircut.

By focusing the write-downs on uninsured depositors, the new plan shifted much of the burden of the recapitalization onto foreigners who had poured cash into the island for two decades. Cyprus also imposed a virtual freeze on capital transfers outside the country, even from banks that remained solvent. Ivan Tchakarov, chief economist at Renaissance Capital in Moscow, estimates that Russian banks have $40 billion in loans to Cyprus-registered companies; payments on those loans are now on hold because of the freeze. The Cypriot central bank has promised to lift capital controls by early autumn.

Competing offshore zones wasted no time in trying to capitalize on Cyprus’s woes. “The Swiss were here in Moscow the next day,” says ATON’s Sucher.

The easiest chunk of business to pry away from Cyprus will be the banking deposits. The island nation was already losing ground in this category before the bailout. Deposits by nonresidents in Cyprus, which grew by more than 30 percent in 2010 alone, hit a plateau when the Greek debt crisis worsened in late 2011 and authorities began talking about private sector involvement in the country’s bailout, according to Moody’s Investors Service.

One visible winner has been Latvia. Deposits from beyond the country’s borders swelled by one third in the two years to December 2012, to about $11 billion, or some 40 percent of GDP, according to Moody’s. Although most of these funds nominally came from distant climes like Belize, almost all of this money originated in the countries of the CIS, the rating agency asserts.

To moneyed Russians, Latvia offers some of the same attractions as Cyprus, minus the sunshine: proximity, a large Russophone population, a heavy reliance on finance for national prosperity and banks that tend not to ask clients too many questions. “Cyprus banks were more likely than any other banks in the world to accept Russian offshore business, except maybe Latvia,” says John Tiner’s Tutykhin. Riga added an extra sweetener in 2009 by offering to grant permanent residency, and thus unhindered access to the rest of the EU, to any foreigner who invested more than 100,000 lats ($185,000).

Latvia is less appealing as a home to offshore business structures. It lacks Cyprus’s bargain tax rates, and as a tiny nation (population 2.2 million) pushing to enter the euro zone, it could well end up in a similar situation to Cyprus’s one day. Domicile is easily divorced from banking relationships in today’s world, professionals say. Hedge fund manager Lifshits contends he never used Cypriot banks for his business. “The Cyprus banking system is absolutely not an issue” for Cyprus-registered corporations, asserts PwC’s Kuznetsova.

So the search for alternative jurisdictions has focused on the short list of countries that enjoy double-taxation agreements with Russia and reputations as offshore financial centers. According to Global Financial Integrity, that list includes Ireland, Luxembourg and Switzerland within Europe and Lebanon, Malaysia and Singapore beyond it. Malta entered the running in April by signing a long-delayed double-taxation agreement with Moscow.

Considering the somewhat limited competition and the high cost of doing business in Luxembourg and Switzerland, observers say Cyprus may hang on to much of its Russian business if the authorities phase out capital controls, as promised, and maintain the key elements of the country’s pro-business environment. Those are big ifs, however, interested Russians say. Spectrum Partners’ Lifshits, with an operating business on Cyprus, is worried about rising support for measures that would require employers to hire a certain quota of Cypriot nationals as a salve for unemployment. “You cannot tell now what is just populist rhetoric and what is real,” he says. “The situation is still very uncertain.”

Others question whether financial necessity will lead Cyprus to alter its prized tax regime, particularly the modest 5 percent levy on dividends. So far, the only tax reform resulting from the crisis has been an increase in the corporate income tax, to 12.5 percent from 10 percent. The new level matches Ireland’s as the lowest in the EU, so it’s not likely to send foreigners fleeing. Any changes to the dividend tax would be another story, tax planner Kuznetsova says. “If Cypriots change the way they handle dividends, they will be out of business forever,” she contends. “They are promising they won’t, but they also promised that bank deposits were safe.”

One possibility that few in the market take seriously is a relocation of Russian business from Cyprus back to Russia. President Putin sounded a call for “de-offshorization” during his annual speech to Parliament in December. After the Cyprus bailout, Igor Shuvalov, first deputy prime minister in charge of the economy, called on the business community to come home and conduct its affairs “publicly, transparently, here in Russia.” Medvedev suggested a new “internal offshore,” or tax-advantaged special economic zone, in Russia’s Far East — perhaps the remote, oil-rich Sakhalin Peninsula or the Kuril Islands, which Russia and Japan are disputing.

But the premier’s idea was quickly shot down by other economic heavyweights, including German Gref, chairman and CEO of Sberbank, Russia’s biggest bank. “Closing internal offshores was one of our first agenda items in the early 2000s,” Gref, who was Russia’s Economy minister at that time, said in a television interview. “To revive the practice now seems less than optimal.” Other business executives quietly recalled the fate of one of their colleagues who had aggressively used special domestic zones for his own tax planning: former Yukos CEO Mikhail Khodorkovsky, who is serving an 11-year prison sentence for fraud and tax evasion.

Putin himself seems less than firmly committed to combating offshore havens. He made no response to central banker Ignatiev’s cri de coeur about capital flight. And far from striking at Cyprus’s jugular when the country was down, Putin pragmatically helped it get back on its feet with the generous loan restructuring. “The story is very simple,” says Andrei Sinyakov, an analyst at Sberbank’s Center for Macroeconomic Research, in Moscow. “Russia does not want a complete collapse of the Cyprus financial system, which would make the damage to the Russian economy much greater.”

A peek into how the Russian government, or at least its economic brain trust, really feels about offshore business and capital exports came from Deputy Finance Minister Alexei Moiseev in an e-mail response to written questions from Institutional Investor about Ignatiev’s diagnosis. “It is clear that those who earn money in Russia and don’t want to put all of this money into Russia do so because the investment climate in Russia isn’t satisfactory for them,” Moiseev wrote. “Capital flight in the current circumstances is a major mechanism which prevents overheating of the Russian economy.”

Whether in Cyprus, Luxembourg or Singapore, excess Russian petrodollars will be keeping bankers and lawyers busy for some time to come.