Commentary for Forbes from Evgenia Zainchukovskaya, Counsel & Head of Tax Practice, and Andrey Sheptiy, Senior Lawyer

The replacement of Russian Eurobonds with domestic bonds has created major tax problems for some investors. The state tried to adapt the Tax Code, but the normalization covered only those who had bought Eurobonds before 1 March 2022. All other investors will have to get along with tax rules that ignore sanctions, asset blocking, and replacement procedures

The Ministry of Finance will exchange its sovereign Eurobonds for local securities on 5 December 2024. Since September, the Ministry has been collecting applications from bondholders. There are nine issues worth $27 billion and four issues worth €5 billion in circulation. The Ministry divided investors into two categories: those who held securities in Russian depositories and those who held securities abroad. For the first category, the deadline for submitting applications will expire on 14 November, while it has already expired on 15 October for the second category.

In order to start the replacement, the authorities had to amend the Tax Code, which previously simply did not provide for the taxation of the Eurobond replacement procedure. The amendments were adopted on 22 October. This means that investors who held their securities in foreign depositories were forced to submit applications for the replacement without yet knowing what taxation procedure they were to deal with.

A new word

The concept of a ‘replacement bond’ appeared on the Russian market about two years ago. Russia’s ‘special operation’* in Ukraine, which started in February 2024, led to sanctions against the Russian financial system and companies. Because of that, borrowers with foreign currency debt had some troubles in fulfilling their obligations on foreign currency bonds.

 The Ministry of Finance was no exception. A mechanism of replacement bonds was invented at that time, when a bond issued under international law with a currency denomination was transformed into a domestic foreign currency bond issued under Russian law. Payments on such bonds are made in roubles. This scheme was pioneered by Gazprom, followed by other companies, and finally the Ministry of Finance decided to replace sovereign bonds by the end of 2024. But it raised tax issues.

Before 2022, investors in Russian Eurobonds had to pay 13% on income from the purchase and sale of bonds and coupons. But investors who held Eurobonds for more than three years could enjoy a tax deduction of up to 3 mln roubles from already paid income tax. Furthermore, the 13% income tax was abandoned in 2019 due to the difference in purchase and sale rates. This was done in a clever way: to calculate the purchase price, the exchange rate at the time of sale was used, and there was no exchange rate difference.

The Tax Code did not provide for replacement of sovereign Eurobonds. The bondholder transfers its security to the Finance Ministry's account in the central depository, and the Finance Ministry transfers a replacement bond to the holder. What are tax consequences of this procedure for investors? This question was asked by members of the Bondholders Association in their letter to the State Duma deputies and the Federation Council senators. In particular, investors pointed out the taxability due to currency revaluation, as well as the loss of the long-term ownership benefit - a tax deduction enjoyed by investors who have owned a security for more than three years.

Normalization is not for everyone

Technically, investors faced the fact that the Tax Code saw the replacement of Russian Eurobonds for domestic bonds as two separate transactions. Evgeniya Zainchukovskaya, Counsel of Tax Practice at VERBA LEGAL, says that, from a civil law point of view, the replacement of bonds is the sale of one security and the receipt of another in exchange.

This means that when receiving a replacement bond, it would be necessary to pay personal income tax from the income resulting from the currency revaluation, since settlements will be made in roubles, not in foreign currency. In addition, the security purchase date would have to change, that is, the benefit of long-term ownership and the right to a deduction, which could entail a partial or full refund of the tax, disappears. These are the problems that investors who addressed the deputies were worried about.

To normalize the situation, it was necessary to introduce the replacement bonds of the Ministry of Finance into the Tax Code as a direct continuation of Eurobonds. The Tax Code, for example, simply prohibits tax officials to calculate the tax base for the replacement transaction. The amendments say that the tax base for such transaction is not determinable. Meanwhile, the Tax Code recognizes the cost of new bonds for tax purposes as the cost at the time of their purchase. This is how the problem of exchange rate differences is solved.

Finally, the holding period for investors in new local replaced bonds will be calculated from the moment of purchase of the corresponding Eurobonds. Andrey Sheptiy, Senior Lawyer of Tax Practice at VERBA LEGAL, explains: if an investor purchased Eurobonds in 2017 and replaced them in 2024, the holding period will be calculated from 2017.