A very recent case of the Presidium of the Russian Supreme Arbitration Court (SAC) on OJSC Coal Company “Severny Kuzbass” (the Company) dated 15 November 2011 has had explosive repercussions for the Russian legal community. In this case, the court completely dismantled thin capitalisation protection under the non-discrimination double tax treaty clauses. According to the opinions of tax specialists, this case may pose a threat to major Russian businesses financing their Russian structures via overseas parent companies or companies within the group, resulting in additional taxes and penalties.
Thin capitalisation rules in Russia are governed by article 269 of the Russian Tax Code. The article sets certain limits for Russian companies as to the deductibility of the interest expense under the loan arrangements. The limits vary depending on the creditor – a Russian company, a bank or a foreign company, and the currency of the loan. Russia also has a large number of Double Tax Treaties (DTTs) having anti-discriminatory provisions applicable to situations when one of the parties to the loan is located in the treaty country, and which prevail over Russian national law.
The above case covers special Russian tax rules applicable to loans between Russian and foreign companies having control therein, so-called “controlled debt” rules, set by article 269.2 of the Code. Under those provisions, a Russian company is considered to have a “controlled debt” before a foreign company if following conditions are met:
- a Russian company has an outstanding debt before a foreign company holding directly or indirectly more than 20% of share capital of the Russian company; or
- a Russian company has an outstanding debt before a Russian company being an affiliate of the foreign company under the Russian law and having more than 20% of shares of the Russian borrowing company; or
- a Russian company has an outstanding debt for which such Russian affiliate or foreign company act as a guarantor, assurer, or they otherwise ensure the performance by the Russian company of its debt obligations
In any of the above cases if the debt to equity ratio of the Russian borrower exceeds 3:1 as of the last day of the taxable (reporting) period, the excessive amount of the interest shall not be deductible for the borrower and will be treated as dividends for corporate income tax purposes, ie taxable at 15% WHT or a lower rate under an applicable tax treaty, for the borrower.
However, in those cases where the borrower is registered in a country having a DTT, the negative tax implications of article 269 could be reversed. Such treaties essentially force a country to avoid taxing a company at a higher rate just because it is registered in the other country. The treaties also let companies keep a higher percentage of various income sources, such as dividends and tax deductions and they also stimulate foreign investment.
Before the SAC ruling on the “Severny Kuzbass” case, Russian courts, in most cases, rejected claims of Russian tax authorities trying to apply the provisions of article 269.2 of the Code in those cases when the party to the loan agreement was a company resident in a state having a double tax treaty with Russia, claiming that the provisions of this article are discriminatory for Russian companies having foreign capital, as compared to Russian companies having Russian shareholders; and that the rules of double tax treaties shall prevail.
In the “Severny Kuzbass” case, the SAC has challenged domestic thin capitalisation rules on the basis of non-discrimination provisions. The SAC ruled in favour of the Federal Tax Service and against “Severny Kuzbass,” in particular, because it regarded loans as not at arm’s length.
The fable of the case is as follows. In the period of 2007 and 2008 the Open Joint Stock Coal company “Severny Kuzbass” being a Russian tax resident, had outstanding debts to foreign affiliated companies – Mittal Steel Holding AG (Switzerland) (holding more than 20% of the Company’s shares), Arcelor Mittal Finance (Luxembourg), as well as two Russian companies, being an affiliates of a Cyprus company Front Deal Ltd., holding indirectly more than 20% of the Company’s shares. Interest under the loans with Swiss and Luxembourg was accrued, but no actual payments were made. Interest expenses on the loans were credited against Russian corporate income tax. The loan amount indebted by the Company exceeded the company’s equity by more than three times.
During the Company’s tax audit, Russian tax authorities have reviewed the above loan arrangements and ruled that the above loans shall be treated as “controlled debt” and, therefore, the interest on those loans shall be deductible according to the provisions of article 269.2 of the Code in the respective part only, and claimed additional taxes and penalties for the Company.
The Company filed a claim and won the case in the courts on three instances. The inferior courts referred to Article 24 on non-discrimination of Russia’s DTTs with Cyprus and Switzerland and ruled that Russian thin capitalisation rules do not apply to the taxpayer’s debt to a Swiss shareholder and Russian affiliated companies (connected with the taxpayer by a common holding in Cyprus) and that the issue of deductibility of interest expenses for Russian corporate income tax purposes shall be governed in line with the provisions of DTTs.
Article 24 of the DTTs is based on the following principle. Enterprises of a Contracting State, the capital of which is owned by residents of the other Contracting State, shall not be subjected in the first-mentioned State to any taxation which is more burdensome than the taxation to which other similar enterprises of the first mentioned State are subjected. The courts position was that since the Company’s capital was directly controlled by a Swiss resident and indirectly by a Cypriot resident, application of the Russian thin capitalisation rules would have resulted in more burdensome taxation, and therefore discrimination against the taxpayer as compared to other Russian taxpayers whose shareholders were not foreign residents.
However, the SAC, being a court of supervision, did not support the above position of the lower courts claiming that DTTs apply only in those cases when the rules of domestic law establish different rules which contradict the DTTs provisions and that interpretation of article 24 by the inferior courts was too broad, thus effectively making it impossible to apply Russian thin capitalisation rules to interest expenses. While, at the opinion of the SAC, the provisions of DTTs are aimed against the discriminatory taxation of persons registered in one contracting state in other contracting state and do not prohibit introduction of special taxation rules on the national level to prevent tax avoidance. Article 269.2 of the Code is thus a local rule limiting the deductibility of interest expenses for Russian taxpayers, but not discriminating against them.
In support of its position, the SAC has posed the following arguments:
According to the SAC, article 269.2 of the Tax Code can be applied when a Russian company’s business has the following features: a high level of loans, an affiliation between borrower and creditor represented by a foreign as well as a Russian company that is affiliated with the former, and defaulted debt. Displaying these features proves that enterprises are affiliated. Article 9 of the DTT provides a special adjustment of taxable profits generated by such enterprises, given the special affiliated nature of their commercial or financial relations.
The Court also referred in its Commentary to the OECD Model Convention, as a framework document, stating that the provisions of those articles can also be applied to determine if a loan interest rate is at arm’s length and if it was a real loan or it is in fact another payment, eg a contribution to the charter capital.
Given this, the SAC concluded that article 9 of a DTT not only allows, but requires the application of national thin capitalisation rules, and clause 3 of article 24 of a DTT, providing for deductibility guarantees, does not apply to those residents of the contracting states who display features of affiliated corporations.
The Court also rejected the Company’s position relating to the application of Article 24.4 of the DTTs stipulating that enterprises of a Contracting State, the capital of which is owned by residents of the other Contracting State, shall not be subjected in the first-mentioned State to any taxation which is more burdensome than the taxation to which other similar enterprises of the first mentioned State are subject. According to the SAC position, this provision means that any and all Russian organisations that fall under article 269.2 of the Tax Code should be subject to the procedure established by these provisions and that the procedure merely introduces an additional condition that Russian taxpayers should meet to qualify for the interest deduction without limitations. According to the SAC, the rules of article 269.2 cannot be considered discriminatory against Russian entities with significant foreign capital if they maintain “controlled debt” to a foreign entity.
According to the opinions of many lawyers and tax experts, the SAC’s interpretation of the DTTs was too broad and may result in a series of tax disputes before the courts. At this stage, it is difficult to predict what further impact the above decision may have on Russian tax practice and if Russian inferior courts will accept and follow the position of the SAC however, it is definitely clear that Russian companies with foreign capital will carefully revise their intra-group loan arrangements and consider the risk of additional tax payments and their impact on current and anticipated finance structures, and, if necessary, make changes to these structures.
Ekaterina Narinyan
Head of Trust and Fiduciary Service (CIS),
Oracle Capital Advisors
Original publication from “Offshore Investment” magazine, April 2012
