Why Russia is unhappy about the Cyprus bailout tax

Russia is threatening to retaliate against the European Union's controversial bail-out plan for the tiny island state of Cyprus, which would impose almost unprecedented taxes on local bank depositors – almost a third of whom are rich Russians.

Though it may seem like the growing political mess in Cyprus ought to be an internal matter for the EU, the island's embattled Finance Minister Michalis Sarris is reportedly heading to non-EU Moscow for urgent talks on Wednesday with the Kremlin. He's expected to discuss concerns about the direction of the tiny EU country that has been the biggest single source of foreign investment in Russia, by far, for many years running. The extent to which big Russian corporations and wealthy tax-evaders have been the hidden hand behind the financial rise of Cyprus is little known. Still, Russia's influential role with the country may yet have a big effect on the outcome of the current crisis.

On Tuesday, Cyprus announced it would scrap plans to tax bank accounts of 20,000 euros ($26,000) or less, thus exempting the small local depositors whose angry street protests have caused major political discomfort in Nicosia. But experts say that could mean taxes will have to be raised for richer depositors, above the 6.75 percent planned for accounts less than 100,000 euros ($129,000) and 9.9 percent for accounts holding more ­– which very likely means Russians will be hit even harder.

The Kremlin immediately slammed the EU for drawing up the bailout plan, including its controversial tax provisions, without consulting Moscow. Russian President Vladimir Putin's spokesman on Monday slammed the tax plan as "unfair, unprofessional and dangerous." Prime Minister Dmitry Medvedev was quoted by news agencies as saying "this simply looks like the confiscation of other people’s money."

Russia is threatening to alter the terms of a 2.5-billion euro loan made to Cyprus in 2011. The Russians may alter the easy terms they offered earlier, and compel the near bankrupt country to pay the loan back sooner.

More seriously, Cyprus faces a potential exodus of Russian companies and bank depositors. In past years these are the same that fueled the growth of its banking sector to dimensions that are several times larger than the size of the country's entire economy. Russians hold almost 16-billion euros (about $20 billion) in Cypriot banks, which is almost a third of the total. And big Russian state-owned banks, Sberbank and Vneshtorgbank – whose stocks are currently plummeting on the Moscow stock exchange – are estimated to have up to 7-billion euros stashed in Cyprus bank branches.

"For quite a long time, Cyprus has been the major offshore zone where Russian corporate earnings are banked, and then re-invested in Russia," says Grigory Birg, co-director of research at the independent Investcafe equity research provider in Moscow.

How this works

It works like this: Russian companies and wealthy oligarchs set up shell companies in Cyprus, which then invest in Russian operations and “repatriate” their profits to Cyprus, where they pay a flat corporate tax of 10 percent compared to more than 20 percent in Russia. Since Cyprus adopted EU banking rules in 2004, experts say, the scrutiny has become a little tougher, but not enough to discourage most rich Russians.

According to Russian central bank figures, little Cyprus invested almost $14-billion in Russia in 2011, compared with barely $2.3-billion invested by Russia's biggest European trading partner, Germany.

"Cyprus is really convenient place for Russians, because it's in the EU, has a low tax rate, and has adapted itself to Russian customers. It offers infrastructure, proximity, and Russian-speaking staff. It's about capital protection … but now, no matter what happens with this tax plan, that's bound to change," says Mr. Birg.

"Cyprus' role as a European financial center is going to be drastically reduced. Many people will find it wise to remove their money, whether the tax goes through or not. Many will look for a new offshore zone to work with, though it may not prove so easy to replace all the advantages that Cyprus has offered," he adds.

Silver lining in Russia?

Some experts suggest the crisis may work to the advantage of greater law-and-order in Russia. They suggest that the Cypriot finance minister might have the option of trading information to Russian authorities about anonymous Russians with big sums parked in Cypriot banks, in exchange for easier loan terms and other Kremlin help.

"Russian authorities have long pursued a campaign of “de-offshorization,” declaring that this practice of cycling money through other countries is bad for Russia," says Alexei Makarkin, deputy director of the independent Center for Political Technologies in Moscow.

"In practice, it has usually meant that money just gets shunted from one offshore destination to another... But this crisis may signal that the 'quiet harbor' is a disappearing certainty as the world becomes more global and more transparent. There will be fewer and fewer such harbors in the world, and a guy with a suitcase full of cash is going to face much more trouble than in the past… This causes quite a lot of disquiet among our business elites," he says.

Yury Korgunyuk, an expert at the independent InDem Center in Moscow, which specializes in corruption studies, says the near panic exhibited by many in Russia's political and business elites speaks volumes about who actually benefits from the practice of offshoring.

Nervous

"Our two top leaders reacted nervously when news of this plan hit, their negative response was almost the first thing we heard. This suggests that all the talk about struggling against corruption is just rhetoric, and our leaders care about the feelings of a very different constituency," he says.

"It's long been clear that a considerable part of the Russian economy is managed from that offshore zone in Cyprus. Even people who are close to the Russian authorities keep their cash there, meaning they do not trust Russia or the Russian authorities to keep their money safe," he adds.

Experts say that the Russian rich will almost certainly seek to diversify to new offshore zones: The English channel islands, Hong Kong, Singapore, Switzerland, and even the former Soviet Baltic republic of Latvia are mentioned as possibilities.

Rustam Vakhitov, head of tax practice at International Tax Associates, a Dutch-based consultancy, says it's a sharp and unexpected lesson for many in Russia's elite.

"Quite a few Russian companies have been caught in this situation, and they're suddenly really nervous about the prospect of having 10 percent of their cash confiscated," he says.

"One of the lessons Russians are learning is that no place is really safe. Whatever the track record of a place, whatever seemed to be reliable just yesterday, there can be these painful surprises in foreign jurisdictions," he adds.