On 27 February 2012 The Federal Moscow District Arbitration Court upheld the ground-breaking decisions of lower courts to treat a Russian company’s interest payments to its foreign sister company as taxable dividends (rather than as tax-deductible expenses).
The case involved a Russian company NaryanmarNefteGaz (70% owned by Lukoil, 30% by ConocoPhillips) which owed $1.4 billion plus interest to its Delaware-based sister company. NaryanmarNefteGaz treated interest payments on the loan as tax-deductible expenses. However, Russian tax authorities disagreed stating that such debt financing structure breached the “thin capitalisation” rule (Article 269 of the Russian Tax Code) and as such NaryanmarNefteGaz was required to classify such interest payable as dividends.
Under the thin capitalisation rule of the Russian Tax Code, an amount of a loan from a foreign affiliated company (a “controlled debt”) to a Russian company shall not exceed three times the amount of such company’s net assets (i.e. the borrower must have at least a 3:1 net assets to debt ratio). In the event where such ratio is not adhered to, any debt interest repayments in excess of the statutory limit shall be classified as dividends which are non-deductible from the borrower’s taxable profits and subject to a minimum 5% withholding tax (pursuant to Russia’s various double tax treaties). If withholding tax is not paid, a company shall be accessed a fine of 20% of the non-withheld tax plus late payment interest.
The court ruling is even more interesting given that Article 269 of the Russian Tax Code, which establishes such thin capitalisation rule, does not apply to financing from a sister company but rather to financing from a “foreign affiliated company” defined as a foreign company which owns, directly or indirectly, more than 20% of a Russian company’s share capital. In the present case NaryanmarNefteGaz received a loan specifically from its sister company and arguably outside the scope of thin capitalisation rules. Nevertheless, the courts determined that such sister company was a mere conduit for the parent company, used mainly for the purpose of side-stepping Russian tax rules.
NaryanmarNefteGaz was ordered to pay 150 million roubles in corporate profits tax, penalties and interest for the period 2006-2007. The court agreed with the demand of the tax authorities to reduce the expenses of the company by the amount of the loan interest paid in 2006-2007 (3.65 billion roubles), and to re-classify those payments as taxable dividends.
The ruling in this case comes as an even greater surprise, considering that until recently Russian companies have generally been successful in defending any challenges from the tax authorities regarding the legality of their highly-leveraged financing schemes. However, 2011 brought a string of high-profile judgments in favour of the Federal Tax Service in thin capitalisation-related disputes. In October 2011 in the case against coal company “OAO Severniy Kuzbass” (a subsidiary of ArcelorMittal) the court ruled that the non-discrimination provisions in Russia’s double-tax treaties do not preclude the application of Russian thin capitalisation rules. In November 2011 the tax authorities won a similar dispute against Rosneft’s sub-subsidiary, “PromLeasing”, for the amount of 1.7 billion roubles. PromLeasing took out a $3.56 billion loan from its Cypriot parent and wrote off 5.66 billion roubles of interest payment as expenses, however due to its negative net assets it did not comply with the thin capitalisation rule and could not use the double-tax treaty’s non-discrimination provisions as a defence.
These cases illustrate two main developments in the application of the Russian thin capitalisation rule:
- Tax authorities and courts are increasingly looking at financing structures applying the “substance over form” principle. The authorities take into account the group’s corporate ownership structure, financial statements, operations and the overall tax effect of the foreign debt scheme in order to decide whether the main purpose of the scheme is a legitimate business goal or tax evasion.
- Historical defences against thin capitalisation (such as reliance on non-discrimination provisions in double-tax treaties or use of conduit structures, i.e., inserting a “sister” SPV in-between the foreign parent lender and the Russian borrower) may no longer be effective for tax mitigation.
In light of these developments, it would be prudent for Russian companies to re-evaluate their existing intra-group financing structures involving dominant foreign companies and to act with considerable circumspection if planning to establish such schemes in the future.
Legal Department
Oracle Capital Group
