In the past year, the Russian economy continued its sustained steady growth. Russia now ranks as one of the top ten economies in the world. As in previous years, higher world prices for oil and natural gas continue to be the engine behind much of the growth. The Russian economy still remains dependent on oil & gas and other extractive sectors, such as timber, precious metals, non-ferrous metals and steel, despite the government’s renewed efforts to build more of a manufacturing base, especially in the automotive, aviation, and ICT sectors. Extractive industries taken together still account for the majority of Russia’s overall exports and provide a significant part of federal budgetary revenues.

The Russian federal budget also shows a healthy surplus. Expenditures in 2007 reached USD 270 billion with a surplus of USD 72 billion or 5.9% of Russia’s GDP.

Due to high energy prices, Russia’s financial situation continues to strengthen, with a decline in the country’s total external debt and an increase in its sovereign credit ratings to investment grade. During the past year the rouble has appreciated against the dollar.

Russia’s overall balance of trade continues to register healthy surpluses. According to Russian statistics, the U.S. became the 6th largest exporter to Russia, behind Germany, China, Ukraine, and Japan, respectively. Both Russian and U.S. data demonstrate a strong surge in U.S. exports to Russia, providing some excellent market opportunities for American companies.

Adding to overall economic development, this year continued a steady multi-year trend of strong consumer spending and a construction boom. This dramatic growth has spread well beyond Moscow and St. Petersburg to the regions and to cities of one million inhabitants or more. Per capita GDP is estimated to have reached USD 9 050 in 2007 as compared to USD 7 170 in 2006, leaving Russian consumers with disposable income for foreign products.

Leading European companies, especially those from Germany, France, Scandinavia, and Turkey, are well-established in both consumer and industrial markets in Moscow and St. Petersburg and are branching out to the smaller regional cities. Many well-known U.S. consumer brands are successful, and many Asian companies from Japan, South Korea, and China are also doing well.

In 2007, the American Chamber of Commerce surveyed U.S. companies currently operating in Russia and came up with these major findings: 50% report sales increases of 200% from 2001 to 2005; profitability during 2001 – 2005 was on or above target; 67% expect sales growth of more than 50% through 2008.

The Russian government continued to deepen and broaden state control, both direct and indirect, over the economy, going beyond the strategic sectors, such as energy, aluminum, steel, automotive, machine tools, and aerospace, to a broad range of sectors, including agriculture, transportation, and construction.

Most major corporations have concluded that the country’s potential demands a presence in Russia, with its vast natural resources, impressive human capital, and 140 million consumers. A significant number are finding that presence very profitable, and the majority express optimism for continuing profitable business opportunities now and in the future.

Market challenges

Barriers

Major barriers to the Russian market remain its different business practices and its uneven transition from a socialist, centrally-planned economy to a market-oriented one.

European and Asian companies remain tough competitors for U.S. firms, due to their proximity to Russian markets and their long-standing relations with Russian organizations and companies. Government bureaucracy, poorly established rule of law and corruption affect such areas as establishing a business, tax collection, dispute settlement, property rights, product certification and standards, as well as Russian customs clearance.

Finding qualified local partners and Russian employees has become more difficult and salaries for local employees have risen significantly, especially in Moscow and St. Petersburg. The pool of managers who understand Western accounting and business practices remains limited, as do those qualified, experienced Russians proficient in English. As a result, this group circulates among major companies, bidding up salaries. Recently, Russian authorities have taken steps to encourage international companies to rely more on local talent by tightening visa regulations for foreign workers.

Adequate financial resources for Russian small and medium-size companies still remain a problem, but it is not as acute as it was in years past. More foreign banks are operating in Russia and more cash is circulating within the economy due to the Russian oil and gas boom.

The Russian government continues to use its oil and gas resources to increase state ownership in strategic industries and companies. Foreign companies can find it unclear as to which sectors are open to investment without Russian majority partners. Legislation defining strategic sectors remains under discussion in the Duma, the Russian parliament.

Market opportunities

There are strong growth possibilities in a range of consumer goods and services, fueled by increases in disposable income in Moscow, St. Petersburg, and the growing regional centers:

• telecommunications equipment and services, especially wireless

• autos and parts

• computer hardware and software

• safety and security equipment

• cosmetics and toiletries

• building products

• franchising.

There is strong growth in the energy, transportation, machinery and healthcare sectors:

• oil & gas equipment and services

• aircraft parts

• medical equipment

• pharmaceuticals

• agricultural machinery

• construction equipment.

Market entry strategy

• Perform detailed market research to identify specific sector opportunities.

• Establish a local presence or select a local partner for effective marketing and sales distribution in Russia. Due diligence is a must.

• Maintain a long-term timeframe to implement plans and achieve positive results.

• Use the experience of other, successful U.S. companies in the market. The local American Chamber of Commerce has over 850 members and is a valuable resource.

• Be prepared to offer financing to Russian buyers. Both the U.S. Export-Import Bank (Eximbank) and the Overseas Private Insurance Corporation (OPIC) have programs to address these needs.

• Be prepared also to establish a wellthought-out budget plan and include in the entry strategy advertising, market promotion, and regular visits to the major cities in Russia.

Russia continues to be a major, fast-moving and growing economy offering opportunity and challenge in equal measure. While the economy is producing increasingly positive results, the country remains a complex place to do business. The best opportunities for experienced U.S. companies lie in developing exports in the sectors noted above.

A significant number of U.S. companies are finding that presence very profitable, and the majority express optimism for continuing profitable business opportunities now and in the future.

Encompassing 11 time zones, Russia is the largest country in the world by landmass. Many businesses therefore tend to approach the Russian market on a regional basis. Moscow and St. Petersburg, the major population and business centers, are traditional starting points. However, some companies have successfully entered the Russian market by starting distribution in other key regions first and then expanding into these larger markets. Well-organized distribution channels are established in Western Russia, especially in Moscow and St. Petersburg, and are developing rapidly in Southern Russia, the Volga region, Urals, Siberia, and the Russian Far East. To succeed in Russia it is important to choose sales targets and partners carefully. In general, Russian consumers seek bargains and are price-sensitive, but they are willing to pay for quality, especially for recognized U.S. brands.

U.S. companies have four basic options when choosing a distribution channel.

Agents

It is not a common practice in Russia for foreign companies to rely solely upon the services of an agent. Distributors and representative offices, however, often employ agents in the Russian regions in order to promote their products.

Distributors

The most common market entry strategy is to select a good distributor or several distributors (depending on the product). U.S. companies can consider a variety of national, regional, and local distribution alternatives. In some product categories (e.g., apparel, cosmetics, packaged foods, alcoholic beverages, consumer electronics, and household appliances), foreign suppliers can choose from a growing number of established distributors. A good distributor will typically sell and deliver foreign suppliers’ products to end-users and/or the retail market and provide a wide range of logistical support, i.e., customs clearance, warehousing, inventory management, etc. However, handling promotion and advertising campaigns exclusively through independent distributors can often result in disappointing results. Russian distributors normally handle products from multiple suppliers and are not typically dedicated to promoting a specific company’s product unless the supplier provides substantial support for promotion and advertising.

Branches / representative offices

Some foreign manufacturers, in addition to using distributors, have established their own representative offices. The major advantage of opening a representative office is that foreign companies have more direct contact with their end-users and control over the promotion and distribution of their products. However, such offices cannot be directly involved in commercial activity, as they are not allowed to operate commercial accounts under Russian law. Instead, they typically oversee a network of distributors and/or agents that perform commercial functions. This approach affords greater control by the foreign supplier over the distribution process and helps to reduce risks.

Foreign subsidiaries

Some foreign manufacturers, particularly in the cosmetics, pharmaceuticals, consumer appliances, durables, and industrial products sectors, have registered their wholly-owned subsidiaries in Russia. They then sell directly to their own companies registered in Russia who import for their own account. This approach affords full control of the supplier over distribution and helps to reduce further possible risks from false invoicing and other irregularities sometimes committed by independent importers and distributors. For more information on registering a company in Russia, please refer to the “Establishing an office” section below.

U.S. exporters are advised to cultivate personal relationships with their Russian representatives and clients, to proceed gradually, and to ensure they have a contingency plan should problems arise. Since it is often difficult to find information on Russian companies, it is strongly recommended that U.S. firms consider using the International Company Profile Service to validate potential partners. The U.S. Commercial Service strongly advises against the risky practice of having a company representative visit Russia only once or twice, select a representative, grant exclusive representation, and then move quickly to consignment or credit sales without first establishing a payment and performance history. In addition, exporters are cautioned to take primary responsibility for registering their brand names in Russia and not to rely on a partner to do this. Finally, it is important to provide a Russian partner with Russian language product information and marketing materials. These can be prepared in the U.S. or done jointly with a Russian partner.

The U.S. Commercial Service provides assistance to U.S. companies in finding local partners through the International Partner Search, International Company Profile, Flexible Market Research, and the Gold and Platinum Key Services. The Foreign Agricultural Service (part of the U.S. Department of Agriculture) provides similar assistance to U.S. exporters of agricultural and food products.

Establishing an office

The U.S. Commercial Service can provide basic counseling on registration requirements and procedures. However, it is strongly recommend that interested U.S. companies seek legal advice on business registration. U.S. Commercial Service staff can provide contact information for U.S. and Russian consulting firms that offer professional legal advice in this area.

Registration options

The following basic laws and government resolutions regulate business registration in Russia:

• The 1999 federal law “On Foreign Investment in the Russian Federation”

• The 1999 Civil Code

• The August 8, 2001, federal law “On State Registration of Legal Entities”

Russian Government Resolution No. 319 “On Authorized Federal Entity of the Executive Power, Providing State Registration of Legal Entities” of May 17, 2002, and a number of legal acts.

Conducting business without registration is illegal. Although the federal law governing the process is uniform throughout Russia, it is often subject to local interpretation.

Russian law offers several commonly used structures to conduct business:

Representative or branch office of a foreign company

Registration as an individual private entrepreneur

Companies:

Limited Liability Company (OOO)

Privately-held, closed joint-stock company (ZAO)

Publicly-held, open joint-stock company (OAO)

Branch offices and accredited representative offices are both legally distinct from Russian corporations, which may be established by foreign firms either as joint-stock companies with partial Russian ownership, or as wholly-owned subsidiaries of a foreign firm. Foreign ownership can be as high as 100%, with some exceptions. For example, foreign stakes are restricted to 25% in defense-related enterprises.

Branch offices

In Russian terminology, branches are not considered independent legal entities, though they may negotiate, market, or provide other business support on behalf of firms based outside Russia. However, they may not technically generate a profit on their operations in Russia and are not allowed to conduct commercial activities in the country. Setting up a branch may be worthwhile if a foreign company is starting to pursue business in Russia and is exploring opportunities. Many large U.S. firms began their Russian operations as locally-established branches.

U.S. firms should not use the term “branch” with registration authorities if the purpose is to register as a company. Branches of foreign firms must register with the State Registration Chamber, which is part of the Ministry of Justice of the Russian Federation. Registration details are available on the State Registration Chamber’s website at www.palata.ru. As part of the registration, the State Registration Chamber will include the newly registered branch in the State Register of Branches of Foreign Legal Entities Accredited in Russia.

Accredited representative offices

Like branches, accredited representative offices are not independent legal entities; they may not earn a profit in Russia or be involved in commercial activities. After accreditation is obtained, the office should register with the local or regional registration chambers, located in many Russian cities. Advantages of an accredited office include annual (rather than monthly) reporting requirements for some activities (including some tax payments), and the ability to issue invitations for U.S. partners to visit Russia on business visas. Up to five foreign employees may work with an accredited office of a foreign company. Offices are usually accredited for one– to three-year terms. Branches can be accredited for a five-year term.

Accredited representative offices also must register with the State Registration Chamber in order to be included in State Register of Branches of Foreign Legal Entities Accredited in Russia. They are also advised to register with appropriate state organizations, depending on their industry. Such agencies include the Central Bank, the Ministry of Economic Development and Trade, the Ministry of Finance, the Ministry of Transportation, the Ministry of Industry and Energy, and others. According to the law, accreditation of a representative office or branch should take 21 days. Accreditation fees are as follows: representative offices: USD 1 000 for one year, USD 2 000 for two years and USD 3 000 for three years; branches: 60 000 roubles plus USD 500 for the first year with an increase of an additional USD 500/year up to five years. An additional USD 500 may be paid for an expedited accreditation within seven days.

Companies

Beginning July 1, 2002, companies are required to be registered with the local Tax Inspectorates. Documents for state registration should be prepared and submitted to the local Tax Inspectorate in accordance with Chapter 12 of the August 8, 2001, federal law “On State Registration of Legal Entities”. An authorized legal entity, the Moscow Department of the Ministry of Finance of the Russian Federation (15 Tulskaya Street, Moscow) is currently providing counseling to business people on registration procedures and registration documents.

Further information on company registration, including the list of documents to be submitted, as well as contact information for local tax authorities can be obtained from the following website: www.mosnalog.ru.

Taxation

Major revisions of Russia’s tax code took place from 1999 to 2002. The resulting tax legislation more closely matches the needs of a growing market economy, and many of the provisions of previous legislation that distorted the business environment and kept many businesses in the shadow economy have been removed.

The most fundamental changes were reflected in the new chapters of the Tax Code Part II and affected Value Added Tax, Excise Taxes, Individual Income Tax, Unified Social Tax, and Profits Tax. Also affected was the federal law “On the Introduction of Amendments and Additions to Part II of the Russian Federation Tax Code and to Separate Russian Federation Legislative Acts.” These changes aimed at improving Part II of the R.F. Tax Code were passed by the Duma and enacted into law by 2003.

Implementing the numerous changes in the Russian tax code inevitably results in varying levels of confusion. A general overview of Russian taxes follows, but companies operating in Russia should consult with a professional tax advisor to confirm details and stay abreast of developments.

Profits tax

The profits tax is levied on gross profits. Effective January 2002, the profit tax rate was reduced from 35% to 24%, a list of deductible expenses was drawn up, and the provisions on depreciation were changed. Thus, the tax rate has been reduced in tandem with the introduction of more realistic interpretations of deductible expenses, the combined effect of which is to reduce significantly the profit tax burden.

The new provisions on profit taxation enable foreign companies operating in Russia to benefit from the exemptions in Russia’s dual taxation treaties (the U.S. and Russia have had a dual taxation treaty in place since 1992), which in certain cases could result in advantages to U.S. companies. For example, representative offices are permitted to deduct expenses incurred on their behalf by a parent company located abroad.

Value added tax (VAT) and import duties

VAT is designed as a tax to be borne ultimately by consumers, but is collected on a basis similar to the European Union model. VAT is calculated on the sales value and is applied at a uniform rate of 18%, except for certain foodstuffs, pharmaceuticals and children’s clothes, which are taxed at 10%, and some products that are entirely exempt from VAT (certain financial services and medical equipment).

Imports are also subject to VAT, calculated based on the customs value of the item plus customs duties and fees. In addition, import duties are assessed at specified rates, ranging from 5% to 30%. They are assessed according to classification and are applied to the customs value of the imported goods, including shipping charges and insurance. Goods imported as in-kind contributions by foreign partners to the charter capital of a new enterprise may be exempt from import duties during a period specified in the charter documents under certain conditions.

In general, goods manufactured or assembled in Russia, whether by a Russian or foreign company, and then exported, are not subject to VAT. If these goods are exported before payment is received, then no VAT should be collected. On the other hand, if payment is received before shipment, the exporter must pay the applicable VAT and then request a refund from tax authorities.

Social welfare taxes

Effective January 1, 2001, one Unified Social Tax (UST) replaced employers’ contributions to three separate social benefit funds (the Pension Fund, the Social Security Fund, and Mandatory Medical Insurance Fund). A business is liable for the entire tax due, and no amount is withheld from employees. The total liability for each employee is calculated on the basis of monthly gross pay.

In accordance with the current Tax Code, the employer is obliged to pay UST for foreign individuals. There is an annual descending scale for this tax – 26% on the first RUR 280 000, 10% on earnings from RUR 280 001 to RUR 600 000, and 2% on all earnings over RUR 600 000.

Reduced UST rates apply to the following business categories: agricultural producers (20%), private entrepreneurs and farms (10%), and attorneys (8%).

Withholding on dividends, interest, and royalties

Foreign legal entities without a business presence in Russia are subject to a withholding tax of 6% on freight services rendered in Russia. Dividends and interest are taxed at a rate of 15%, royalties at a rate of 20%. These rates are often applied according to the relevant double taxation treaty. Lease payments and other income are subject to a 20% withholding rate.

Land, property, and personal income

Local authorities may levy a tax on land according to its type and location. The rate is higher in Moscow and St. Petersburg than in other cities and rural areas.

The personal income tax rate is now a flat 13%, following recent tax reform legislation, which sharply reduced the former graduated rate. When applied to expatriates, however, there may be some withholding requirements.

Franchising

During the past 10 years, the franchising sector has developed in Russia mainly in consumer-oriented segments, such as fast food, retail, education and training, fitness and health care, recreation and entertainment, travel and lodging, and the automotive sector. Franchising in business-oriented services is also increasing. Examples of the business-to-business segments where franchise models are successfully used are cleaning services and maintenance, transportation, logistics, express mail services, management training, and consulting.

By all means, franchising is the most visible in the fast food sector. Many local and international fast food franchise concepts successfully operate on the market, although it is far from saturated. Expansion of casual dining is expected over the next few years, as emerging local and new global players enter the market. Also, there is a growing demand for cafes (coffee shops, tea rooms) as the culture of drinking coffee and tea in cafes is penetrating the Russian lifestyle. That demand is being partially met by the arrival of Starbucks to the Russian market in 2007, the emergence of smaller franchising concepts (Travelers Coffee) and augmenting traditional fast food services with additional services catering to coffee drinkers.

Another large segment where franchise opportunities exist is retail trade. According to recent statistics published by Rosstat, Russian retail trade turnover increased 14.7% year-on-year to RUR 6.57 trillion (approx. USD 268 billion) for the January-August 2007 period. For comparison, in 2006, the retail turnover was near USD 250 billion. Assuming that franchising development in retail segments will have some correlation with the development of the total retail market, it is possible to predict a very bright future for the franchise concepts based on retail trade.

Currently, the share of retail sector in franchising operations in Russia is 46%, and the fast food sector represents 22%.

Direct marketing

Due to the relatively underdeveloped state of distribution channels in Russia, direct marketing has become a very effective and profitable alternative for customers, especially outside of Moscow and St. Petersburg. Telemarketing and fax marketing to business customers is common in Russian cities but not particularly effective. By contrast, person-to-person direct marketing works exceedingly well and is cost-effective for the distributor (e.g., health and beauty products) since it also develops an effective distribution network. For a large number of under-employed workers and pensioners in Russia, the option of supplementing their wages and pensions through working in direct sales is quite attractive. By some estimates, from 1.1 to 1.5 million people may be employed in direct marketing in Russia, although the informal nature of the activity makes precise figures difficult to obtain.

Other direct marketing channels (catalogs, e-commerce, and regular mail) are still in their infancy. Major, well-known U.S. direct marketers such as Amway, Avon, Mary Kay, and Tupperware are active in Russia and doing well. The Direct Marketing Association estimates that direct sales accounted for 22% to 23% of the total cosmetics and toiletries market last year. Russian law, however, forbids using direct sales of several different types of products like biologically-active food additives and vitamins. At present, these products can only be sold through pharmacies, kiosks, and health stores. For more information on the direct marketing industry in Russia, visit the Russian Direct Marketing Association website at: http://www.rdsa.ru.

Joint ventures / licensing

U.S. companies often become strategic partners with Russian firms by taking an equity position in Russian joint-stock companies and thus establishing joint ventures (JV). Establishing a JV in Russia demands meticulous planning and sustained commitment. In most cases, other forms of alliance, in which the U.S. partner retains managerial control, are preferable. JVs in which foreign partners hold minority stakes are dependent on the good intentions of their Russian majority owners. Recent experience shows that foreign minority shareholders face serious difficulty in protecting their interests in Russian courts.

One advantage of a JV is that it helps a U.S. firm gain a measure of Russian identity, which can be useful in a culture where many still view foreigners with suspicion. Political pressure is mounting in Russia for domestic content mandates in key sectors or for large-scale procurements. For example, some foreign investments in the oil industry may be required to source 70% of the goods and services from Russian providers. Firms that creatively help oil producers meet these requirements will have an advantage in this industry.

Russian and U.S. partners often view JVs differently. U.S. companies, especially smaller ones, often view JVs as a means of securing a local partner with experience in the Russian market. On the other hand, many Russian managers view a foreign partner chiefly as a source of working capital and these managers may place a low priority on local market development. While there are many examples of successful JVs, a U.S. investor invites trouble when ceding oversight of any aspect of a JV to a Russian partner who does not share the same objectives. Before making financial or legal commitments, U.S. firms should thoroughly explore whether a potential partner shares their priorities and expectations.

One JV scenario often leads to commercial failure and, in some cases, bitter legal disputes: a U.S. company forms a JV with a Russian partner after a short history of cooperation. The firm then returns to the U.S. as an “absentee” partner. The company has the expectation that the Russian partner will manage daily operations, implement a business plan, and wire profits on schedule. Any firm that forms a JV in Russia should be ready to invest the constant personal attention of U.S. managerial staff to keep the business on course, both before and after the venture has achieved commercial success.

U.S. technology is sometimes licensed for Russian production outside the context of a joint venture. Major hurdles that must be overcome include quality levels attainable by Russian facilities in the absence of significant retooling, uncertain intellectual property protection (especially in the software industry) and difficulty in receiving regular and prompt payments. In the opposite direction, Russian companies generally are eager to license their technologies to foreign companies in exchange for the cash infusion.

Selling to the government

A law on federal procurement, adopted in May 1999, allows foreign firms to participate in public tenders if the product or service is not available from domestic producers, or if Russian production is not considered economical. Regional or local authorities are potential customers for U.S. suppliers. For example, the Federal Ministry of Health and Social Development and some of the regional administrations often buy supplies for distribution to hospitals and clinics. While local governments receive sharply reduced federal subsidies, they have the flexibility to make purchase decisions based on local factors and contacts. Although Russia’s current fiscal situation has improved recently due to the implementation of numerous centralized, federally funded investment programs, as well as four key national priority projects in such areas as education, health, housing, and agriculture, funding for procurement is always a challenge. It should also be noted that there is pressure on many levels of government to purchase Russian goods and services. Since many federal and regional tenders are only available to local companies, U.S. manufacturers are advised to establish good working relations with local tender operators and seek appropriate local partners or distributors who will represent their products at the tenders.

Sales channels

Well-organized distribution channels have developed significantly over the last few years, particularly in the major population centers, such as Moscow and St. Petersburg, and are beginning to expand to the regions. In the consumer sector, some large-scale retail stores have recently emerged in Moscow that are able to buy in bulk and negotiate relatively stable long-term prices. Large shopping malls have opened up on the ring road circling the capital and are giving the Moscow retail environment more of the characteristics of other European cities.

By utilizing these increasingly professional domestic distributor organizations, the task of bringing goods to market in Russia has been greatly eased. However, their geographic coverage can be limited, and accessing markets in some of the regions can still be problematic. In these regions, U.S. firms may encounter erratic distribution, unpredictable (but tough) competition, and word-of-mouth marketing. Although Russia boasts increasing numbers of Western-style stores in major cities, much distribution and retailing still takes place through such informal channels as kiosks and open markets. Utilizing these channels is often a key to success for a U.S. company operating in the Russian market. Those who succeed do so through a combination of improvisation and innovation, combined with a substantial investment of time and a tolerance for early mistakes. U.S. companies with a long-term market development strategy may find regional markets well worth exploring.

St. Petersburg remains the main port of entry for a variety of consumer and industrial products for European Russia (Russia west of the Urals). Vladivostok is the main port of entry for the Russian Far East. In general, the transportation infrastructure in this vast country is still underdeveloped and in need of major upgrades. The majority of cargo moves by rail, and the road network needs to be expanded. Major Western freight forwarders and express couriers are active in Russia.

U.S. exporters seeking general export information/assistance or country-specific commercial information should consult with their nearest Export Assistance Center or the U.S. Department of Commerce’s Trade Information Center at (800) USA-TRADE, or go to the following website: http://www.export.gov.