Recently the tax authorities have been challenging the tax qualification of income received by foreign companies (including independent ones) from Russian companies in cross-border transactions. The courts have mostly supported the authorities’ challenges.
Until recently, most of these cases have related to who / which entity actually received passive income (dividends, interest rates, royalties, income from the sale of shares (interest)), but now the tax authorities are also analysing other income streams paid to foreign companies from within the RF (Russian Federation).
As a rule, under the Tax Code of the Russian Federation, this income of the foreign company is tax-exempt in the RF if there is no permanent establishment. However, the tax authorities challenge this qualification of tax-exempt and instead recognise payments as “hidden” distribution of income (or “hidden” alienation of property) favouring foreign companies. Thus they then charge additional withholding income tax.
The tax authorities particularly emphasise evidence that can be used to argue a transaction was “artificial” in nature, conducted to achieve tax savings in the RF via a cross-border transaction. To do this, the whole range of available legislative tools is employed, including the unjustified tax benefit concept and the actual recipient of income concept. Furthermore, the tax authorities are now actively exchanging information with their foreign counterparts and obtaining all information needed from public sources.
Recent court decisions on this matter are provided below for your consideration.
JSC Pokrovskiy Zavod Biopreparatov (Pokrovskiy Biological Products Factory) case (No. А11-11199/2017) – requalification of payments by the Russian company under an agency agreement (in favour of the tax authorities)1
The Russian company entered into an agency agreement with a formally non-interdependent British company (hereinafter – the Agent). According to the agreement, the Agent undertook to find a buyer for a veterinary vaccine. The Agent received remuneration for the services equal to 35.4% of the value of the transaction between the Russian company and the buyer of its products. The Russian company deducted this for income tax purposes.
The tax authority managed to prove in court that the Russian company had obtained an unjustified tax benefit in the form of an expenses deduction under a formally concluded agency agreement (in the absence of actual economic relations between the counterparties). When passing the ruling, the court noted that all the activities related to producing the vaccine that was sold for the benefit of the purchaser of the product had been agreed and performed prior to concluding the agency agreement directly with the buyer. In addition, no UK taxes were paid by the Agent.
Thus the court concluded that alienation of property (cash) took place without any reciprocal provision by the British Agent. In this respect, the provisions of paragraph 5, article 13 of the Double Taxation Treaty between Russia and the UK were applied (the taxation of income received from the alienation of property), according to which payments to a foreign company are subject to withholding tax (i.e. in the RF at 20%).
LLL GaloPolymer Kirovo-Chepetsk Case (А50-16961/2017) – requalification of payments by the Russian company under a service provision agreement (in favour of the tax authorities)2
The Russian company entered into an agreement with a formally non-interdependent Canadian company to provide services and perform project development work relating to hydrocarbon assets. The tax authority discovered that payments under this agreement to the foreign company were illegitimately recognised by the Russian company as expenses for profits tax purposes and that these payments were subject to withholding tax in the RF (by the Russian organisation as a tax agent).
It was proven that there were no entrepreneurial relations between the parties to the agreement, with the services stipulated by the agreement having already been provided by other companies. The Canadian counterparty failed to perform its obligations under the agreement and existed in fact only on paper.
The court concluded that payments to the Canadian company were in effect passive payments – they were part of the property (capital) of the Russian company (with a source of origin connected with the RF) allocated to the foreign company from the level of the Russian organisation on a non-repayable and non-recoverable basis.
Thus, according to the Double Taxation Treaty between the RF and Canada, this passive income of a foreign company was subject to withholding tax in the RF at 20%.
The court specifically emphasised that the tax authorities was able to re-qualify payments to a foreign organisation when the income from active transactions (e.g. from selling goods, work and services) represented a hidden form of passive income payment.
LLL Rusdzham Case (No. А11-9880/2016) – requalification of payments by the Russian company under an agreement for the provision of advisory services (in favour of the taxpayer)3
A Russian organisation and a Turkish company (that both indirectly, via a Dutch company, own the Russian organisation) entered into an agreement for the provision of advisory services. The tax authority concluded that the cash paid by the Russian company for the provided services were in nature actually dividends, and thus subject to withholding tax in the RF at a reduced rate of 10% in accordance with the Double Taxation Treaty between Russia and Turkey.
The court did not support the tax authority’s position and ruled in favour of the taxpayer based on the following:
— there was no evidence that the services were not actually provided;
— there was a discrepancy between the cash paid and the amount of income the Russian company distributed;
— cash was paid for the services provided and not from the net profit;
— the dividends to the direct shareholder of the Russian organisation – the Dutch company – had already been paid;
— corporate income tax was paid in Turkey.
JSC Melnik Case (No. А03-21974/2017) – requalification of payments by the Russian company as part of the repurchase of its own shares from a foreign shareholder (in favour of the tax authorities)4
The Russian company repurchased 8.11% of its shares from its only shareholder registered in an offshore jurisdiction (Saint Kitts and Nevis) by paying approximately 290 mln roubles. The tax authority concluded that the Russian company had received an unjustified tax benefit without fulfilling its obligation as a tax agent to withhold income tax when making these payments.
The court agreed with the tax authority’s view, noting that the situation implied that the taxpayer had withdrawn cash to a low-tax jurisdiction without paying taxes. This conclusion was based on the following:
— cash was paid to repurchase shares out of the net profit – there was no distribution of dividends (there was a significant amount of accumulated profit);
— cash was transferred by the foreign company to another company shortly (2-3 days) after receipt;
— the foreign company had the characteristics of being a shell company: the sales and purchase agreement was signed by an unauthorised person; and there were no profits from other entrepreneurial activity;
— a physical person – a Russian tax resident – maintained control over the share repurchase transaction.
Thus the court concluded that it was legitimate for the tax authorities to charge additional withholding tax at 20%, as the payments received by the foreign company were recognised as distribution of other income, not as dividends (sub-paragraph 2, paragraph 1, article 309 of the Russian Federation Tax Code).
LLL Mondelez Rus Case (No. А11-6203/2016) - requalification of payments under loan agreements (in favour of the tax authorities)5
The UK company, whose shareholder is a company registered in the US, sold 100% of the Russian company’s shares to another Russian organisation (a subsidiary of the UK company). On the same day, the Russian buyer and the UK company entered into an agreement on novation of the remuneration obligation (under the sales and purchase agreement) into loan obligations of interest payments made under credit notes. As part of its reorganisation, the purchased company was subsequently consolidated into the Russian organisation – the buyer of all 100% of its shares.
The court agreed with the tax authority that payments under these credit notes did not correspond to their legal nature and qualified them instead as “hidden” dividend payments from the RF to the parent company in the US. This made the payment subject to withholding tax at 5%, pursuant to the provisions of the Double Taxation Treaty between the RF and the US.
In effect, the Mondelez Rus case was the first court case in which payments to a foreign company when selling shares within a group as part of restructuring were qualified as a hidden distribution of dividends. Additional tax was charged not at the maximum possible rate of 15% but at a reduced rate of 5% under the Double Taxation Treaty between the RF and the US; the additional tax was charged on both the principal amount of debt (“body”) and the interest rate.
At present, there is a steady trend where the Russian tax authorities are challenging payments to foreign companies on the basis that, under the guise of tax-exempt payments in the RF, profits are being withdrawn from the RF to go abroad, and that subsequently tax legislation and double taxation treaties are being abused.
The tax authorities are focusing not only on the transfer of cash to shareholders and affiliated companies in a group, but also to formally non-interdependent parties (the JSC Pokrovskiy Zavod Biopreparatov case and the LLL GaloPolymer Kirovo-Chepetsk case).
Therefore, when transferring tax-exempt income to foreign counterparties, Russian companies should be prepared to prove the active nature of that income, the fact that services were consumed, the fact that the counterparty really exists (that the company doesn’t exist purely with a “technical nature”), and the overall economic sense of concluding a deal with a foreign party.
1 Resolution of the Court of Arbitration of the Vladimir Region dated 12 September 2018 in case No. А11-11199/2017; the taxpayer has filed an appeal.
2 Pursuant to the Ruling of the Supreme Court of the Russian Federation No. 309-КГ18-6366 dated 7 September 2018 in case No. А50-16961/2017, the decision of the court of first instance (in favour of the tax authorities) was upheld, and resolutions of the appeals and cassation courts (in favour of the taxpayer) were revoked; the taxpayer has filed a supervisory appeal to the Presidium of the Supreme Court of the Russian Federation.
3 Pursuant to the Resolution of the First Arbitration Court of Appeal dated 11 July 2018 in case No. А11-9880/2016, the decision of the court of first instance with regard to the part under consideration (in favour of the tax authorities) was revoked.
4 Pursuant to the Resolution of the Seventh Arbitration Court of Appeal dated 17 July 2018 in case А03-21974/2017, the decision of the court of first instance (in favour of the taxpayer) was revoked; the taxpayer filed a cassation appeal.
5 Pursuant to the Ruling of the Supreme Court of the Russian Federation No. 301-КГ18-8935 dated 12 July 2018, case А11-6203/2016 was declared inadmissible; the resolution of the court of cassation upheld the resolution of the court of appeal (in favour of the tax authorities)