Significant changes to the application of Russian thin capitalisation rules

Pepeliaev Group advises that the Russian Supreme Arbitration Court (the “SAC”) has published on its web site Resolution No. 8654/11 dated 15 November 2011 in the case of OAO Coal Mine Severny Kuzbass touching upon the issues connected with the application of the Russian thin capitalisation rules. The resolution changes the existing case law in a significant manner with regard to what should take priority: non-discrimination provisions of international double tax treaties or Russian thin capitalisation rules.

In the above case, the tax dispute concerned the application of articles 269(2) – 269(4) of the Russian Tax Code, pursuant to which the portion of interest on liabilities that exceeds a certain threshold must be reclassified as dividends. The reclassification may affect liabilities to a foreign company that holds a stake of more than 20% in the issued capital of the Russian taxpayer, as well as a number of other liabilities connected with the dominant foreign company. Moreover, such reclassified interest may not be deducted from the profit tax base. However, until recently the courts believed that Russian taxpayers with foreign participation would be discriminated against if the Russian Tax Code were applied over double taxation provisions of the treaties signed by Russia.

The headline result of the case was the conclusion of the Presidium of the SAC stating that the rules of article 269(2) of the Code intended to prevent tax abuse cannot be treated as discriminatory with regard to Russian companies with material foreign participation, if they have controlled debts to foreign companies. The Presidium of the SAC pointed out that the relevant articles of international treaties (in the above case, these were treaties with Cyprus and Switzerland) that are intended to prevent discrimination with regard to taxing the residents of one contracting state in another contracting state do preclude special tax arrangements in the national legislation of these contracting states as a tool to fight tax avoidance.

Pepeliaev Group comments

When referring this case to the Presidium of the SAC, the panel of the SAC’s judges believed that what expenses should be deductible from the profit of Russian companies for tax purposes should be determined based on the national, i.e. Russian, legislation and that international treaties, in principle, do not cover the deductibility of taxpayers’ expenses for profit tax purposes in contracting states. However, pursuant to the Resolution, such restrictive approach was not upheld: the Presidium assumed it was necessary to provide some, although brief, arguments to support its position according to which the Russian thin capitalisation rules do not contradict the non-discrimination provisions of international treaties.

However, the Presidium’s approach to analysing the thin capitalisation issue in terms of fighting tax abuse provides the taxpayers with the option of justifying their failure to apply articles 269(2) – 269(4) of the Tax Code based on the circumstances of each specific tax dispute. Moreover, a reference to the official Commentary to the OECD Model Tax Convention in the arguments of the Presidium of the SAC raises a number of complicated international taxation issues that need to be analysed carefully in case of each individual taxpayer.

New risks

As the Presidium of the SAC has changed the existing case law regarding the Russian thin capitalisation rules being subordinate to the provisions of double tax treaties, companies that receive loans from related parties should reevaluate their tax risks and applicability/non-applicability of the Russian thin capitalisation rules based on approaches laid down in Resolution No. 8654/11 of the SAC’s Presidium dated 15 November 2011 and taking into account the specific circumstances in which the funds were obtained.

Legal advice

Pepeliaev Group lawyers will be happy to assess the opportunities and tax risks arising in connection with the changes in the application of Russian thin capitalisation rules, as well as to assist with elaborating the taxpayer’s position in specific cases. This is especially so since in the above case the court did not take into account double tax treaties with other states (apart from Switzerland and Cyprus), including those that in some situations directly provide for interest expenses incurred by Russian taxpayers to be deducted for the purpose of their business operations.

For further information, please contact:

in Moscow – Andrey Nikonov, Senior Partner, at: (495) 967-0007 or by e-mail; Vladimir Voinov, Senior Associate, at: (495) 967-0007 or by e-mail;

in St Petersburg - Sergey Sosnovsky, Head of Tax Practice (St. Petersburg), at (812) 640-60-10 or by e-mail