The Law To Counteract Tax Schemes
Main provisions
1. Under article 54.1(1) of the Russian Tax Code a taxpayer is not permitted to decrease the tax base and/or the amount of tax payable as a result of distorted information concerning business operations (the total of such operations), and taxable items to be reported in the tax and/or bookkeeping records or the taxpayer’s tax reporting documents.
The question arises of how this regulation correlates to article 54(1) of the Russian Tax Code, according to which: “if any errors (distortions) are identified in the calculation of the tax base relating to previous tax (reporting) periods, the tax base and the amount of tax in the current tax (reporting) period must be recalculated for the period in which the above errors (distortions) were committed”. In other words, it is unclear what should be understood to be a distortion of information concerning business operations and taxable items (an “impermissible distortion”) as set out in article 54.1(1) and a distortion committed while the tax base was calculated as per article 54(1) of the Tax Code: is the content of these terms the same, and if not, where does the difference lie?In connection with article 54.1(2) of the Tax Code, it could be suggested that an impermissible distortion should be primarily understood as the recording of transactions which did not actually occur (illusory transactions). Such actions are treated as tax fraud, i.e. intentional (deliberate) acts. It is questionable, though, whether an impermissible distortion includes transactions that are recorded at variance with their actual content.
It should be mentioned that article 9(1) of Federal Law No. 402-FZ “On accounting” dated 6 December 2011 disallows the inclusion in bookkeeping records of any documents that were used to formalise business events that did not take place, including those underlying bogus and sham transactions. In accordance with article 10(2) of the above law, it is prohibited to record bogus and sham transactions in accounting ledgers.
2. Article 54.1(2) of the Tax Code stipulates that if no circumstances exist provided for by clause 1 of that article, then the taxpayer has the right to decrease the tax base and/or the amount of tax payable in relation to the completed transactions (operations) in accordance with the rules of the relevant chapter of part 2 of the Tax Code, provided that the following conditions are met simultaneously:
1) the main purpose of the transaction (operation) is other than the non-payment (incomplete payment) of tax and/or the obtaining of a tax credit (tax refund);
2) the obligation pertaining to the transaction (operation) has been discharged by a person/entity which acts as a party to the agreement entered into with the taxpayer and/or a person/entity to which the obligation to complete the transaction (operation) has passed by law or under a contract.
This regulation, alongside the requirements of part 2 of the Tax Code (article 252(1) etc.), introduces two separate conditions as follows. Complying with these conditions is necessary to decrease the tax base and/or the amount of tax payable:
1) the transaction (operation) mainly has a business purpose, not a tax purpose;
2) the obligation pertaining to the transaction (operation) has been discharged by a particular person/entity.
2) the obligation pertaining to the transaction (operation) has been discharged by a particular person/entity.
3. Article 54.1(3) of the Tax Code states certain circumstances which cannot, on their own, be treated as an independent ground (i.e. they are insufficient) for invalidating a decrease of a taxpayer’s tax base and/or the amount of tax payable, namely if:
1) the source reporting documents have been signed by an unidentifiable or unauthorised person;
2) the taxpayer’s counterparty has violated legislation concerning taxes and levies;
3) there is an opportunity for the taxpayer to obtain the same business result by completing other transactions (operations) which are not prohibited by law.
These clauses somewhat restrict, but do not exclude, the effect of the rules contemplated by article 54.1(1) and 54.1(2) of the Tax Code, as their aim is to clarify rather specific matters. In addition, they are not new for practice.
4. Article 82 of the Tax Code has been updated with clause 5, under which the tax authority, when carrying out tax control, is responsible for proving the circumstances set out in article 54.1(1) and 54.1(2) of the Tax Code.
PG's comment. Based on this provision, it can be concluded that it is incumbent on the tax authority to prove that there has been an impermissible distortion, and that the taxpayer did not meet the conditions of a business purpose or that a certain person/entity did not discharge its obligations. In practice, during tax audits the tax authorities will collect evidence, including by way of obtaining documents and clarifications from the taxpayer itself, summoning witnesses etc., whereas evidence will actually be proved only when a court dispute arises.
PG's comment. Based on this provision, it can be concluded that it is incumbent on the tax authority to prove that there has been an impermissible distortion, and that the taxpayer did not meet the conditions of a business purpose or that a certain person/entity did not discharge its obligations. In practice, during tax audits the tax authorities will collect evidence, including by way of obtaining documents and clarifications from the taxpayer itself, summoning witnesses etc., whereas evidence will actually be proved only when a court dispute arises.
Duration
The law will come into force one month after its official publication, i.e. on 19 August 2017.The law contains special transitional regulations. According to these, the rule of article 82(5) of the Tax Code that, when carrying out tax control measures, a tax authority proves the circumstances referred to in article 54.1(1) and 54.1(2) of the Tax Code, is applied to:
- desk tax audits of tax returns (calculations) submitted to the tax authority after 19 August 2019; and
- field tax audits and audits of the completeness of the tax calculated and paid in the context of transactions consummated between related parties (if the tax authorities resolved after 19 August 2019 to schedule such audits).
Several interpretations are possible for how the new regulations will take effect in terms of timing, for example: 1. The transitional provisions apply to article 82(5) of the Tax Code only and do not cover article 54.1 of the Tax Code. Pursuant to article 5 of the Tax Code, article 54.1 of the Tax Code should only apply prospectively, i.e. in relation to subsequent tax periods starting after 19 August 2017. For example, with regard to VAT it should apply starting from Q4 2017, while for profit tax it should apply starting from 1 January 2018. Such interpretation is hardly acceptable: it makes the transitional provisions meaningless as the provisions of article 82(5) and 54.1 of the Tax Code are obviously related.
2. The wording of the transitional provisions follows a pattern that is typical for the application of procedural regulations. Therefore, before the law enters into force, any audits, being procedural actions, will be carried out in accordance with the previous rules; after the law enters into force, the audits will follow the new rules, i.e. taking into account article 54.1 of the Tax Code.
However, such interpretation does not match the content of article 54.1 of the Tax Code since it openly contains substantive rules, i.e. regulations governing monetary relationships, concerning the right to record expenses, deductions, etc.
3. Through article 82(5) of the Tax Code, the transitional provisions apply to article 54.1 of the Tax Code. Accordingly, when carrying out audits scheduled after 19 August 2019, the provisions of article 54.1 of the Tax Code apply.
In this case, the question arises of whether it is lawful to extend the new regulations to previous tax periods. In furtherance of article 57 of the Russian Constitution, clauses 2 to 4 of article 5 of the Tax Code set out special rules that apply to the duration of pieces of tax legislation. These special rules prevent regulations from having retroactive effect if they worsen the position of taxpayers and, conversely, allow regulations which improve the position of taxpayers to have retroactive effect.
Taking into account these regulations, article 54.1 of the Tax Code does have retroactive effect, i.e. it extends to previous tax periods only insofar as it eliminates or mitigates the liability for violations of legislation concerning taxes and levies, sets out additional guarantees for the protection of taxpayers’ rights, eliminates taxpayers’ obligations or otherwise improves their position as compared with previous legal regulation.
It should be assessed for specific situations and taking into account the opinion of the taxpayer itself which of the provisions of article 54.1 of the Tax Code improve the position of taxpayers.
At the same time, it cannot be ruled out that the tax authorities and courts will actually apply the new regulations retroactively without taking into account how they affect a taxpayer’s position owing to the overspill and mutual influence of the old and new rules. Such was the case with the application of section V.1 of the Tax Code while audits were conducted and disputes concerning pricing were considered for periods before 1 January 2012, when article 40 of the Tax Code was in effect.
General assessment
The new regulations are aimed at counteracting tax evasion and the unlawful refunding of tax, which may occur via:1) documenting sham transactions;
2) setting up artificial (purely formal) legal constructions when structuring business and transactions;
3) using sham (bogus) organisations.
Although the law adopted seeks to codify the rules set in Resolution No. 53 of the Plenum of the Russian Supreme Commercial (‘Arbitration’) Court ‘On commercial ('arbitration') courts assessing whether a taxpayer was justified in obtaining a tax benefit’ dated 12 October 2006 (“Resolution No. 53”), it does not feature the term ‘unjustified tax benefit’. In view of this, the question arises of how article 54.1 of the Tax Code relates to the provisions of Resolution No. 53, as well as the approaches and positions of the Russian Federal Tax Service elaborated in court practice and described in letter No. ED-5-9/547@ dated 23 March 2017. This question will be resolved as new practice of courts and administrative bodies is formed.
Although it is aimed at standardising court and administrative practice by applying direct legislative regulation to situations which involve various schemes for evading tax, this law offers more questions than answers.
For example, may taxpayers insist on a complete tax restructuring when they are subject to the provisions of article 54.1 of the Tax Code, i.e. demand that the expenses incurred and taxes paid should be recorded? In particular, are the tax authorities entitled, when they identify a sham organisation among the suppliers, to refuse the entire amount of expenses and VAT deductions to the taxpayer, or only the part which represents the ‘markup’ of the sham organisation (as they have been doing more often of late)?
Although the law adopted seeks to codify the rules set in Resolution No. 53 of the Plenum of the Russian Supreme Commercial (‘Arbitration’) Court ‘On commercial ('arbitration') courts assessing whether a taxpayer was justified in obtaining a tax benefit’ dated 12 October 2006 (“Resolution No. 53”), it does not feature the term ‘unjustified tax benefit’. In view of this, the question arises of how article 54.1 of the Tax Code relates to the provisions of Resolution No. 53, as well as the approaches and positions of the Russian Federal Tax Service elaborated in court practice and described in letter No. ED-5-9/547@ dated 23 March 2017. This question will be resolved as new practice of courts and administrative bodies is formed.
Although it is aimed at standardising court and administrative practice by applying direct legislative regulation to situations which involve various schemes for evading tax, this law offers more questions than answers.
For example, may taxpayers insist on a complete tax restructuring when they are subject to the provisions of article 54.1 of the Tax Code, i.e. demand that the expenses incurred and taxes paid should be recorded? In particular, are the tax authorities entitled, when they identify a sham organisation among the suppliers, to refuse the entire amount of expenses and VAT deductions to the taxpayer, or only the part which represents the ‘markup’ of the sham organisation (as they have been doing more often of late)?
The need for complete tax restructuring arises not only from clause 7 of Resolution No. 53 but also from the very content of the concept of a distortion, as well as from the need to determine the due (actual) amount of a tax obligation. In addition, the principle of the economic justification of tax set out in article 3(3) of the Tax Code disallows double taxation.
Can an intrusion into a business relations be avoided when the conditions of article 54.1(2)(2) of the Tax Code are met concerning the discharge of obligations by a particular person/entity?
We believe that the requirement for the appropriate person/entity to discharge the obligations should be considered exclusively as an instrument used by the state to counteract situations when sham organisations are engaged to decrease the tax burden; therefore, meeting this requirement should not lead to a direct intrusion into the contractual relationships. This regulation should be interpreted in a way that would exclude any restriction on entrepreneurial discretion and freedom of economic activity.
Is a taxpayer entitled to argue that, although it had exercised due circumspection, it did not know and could not have known that the obligation had been actually discharged by a person/entity which was not a party to the contract or which was not responsible for performing its obligations in the transaction by virtue of contract or law?
Since we are speaking of the actual legal liability of a taxpayer in connection with acts or omissions by third parties (unless these parties are controlled by the taxpayer), any fault taking the form of negligence (carelessness) should be proved by the tax authorities. Any other approach would mean objective imputation, i.e. imposing liability without taking fault into account, which is at odds with the Constitution.
The requirement to take into account due circumspection is set out in Clause 10 of Resolution No. 53. In addition, the Judgment of the European Court of Human Rights dated 22 January 2009 in the case of Bulves AD vs. Bulgaria states that liability in connection with a tax abuse on the part of a supplier may arise only if the relevant taxpayer knew or could have known of such abuse. In its Ruling No. 1440-O dated 4 July 2017, the Russian Constitutional Court referred to the above Judgment of the European Court of Human Rights, thus acknowledging that it has effect in Russia.
Can a taxpayer be deprived of its rights to record VAT-related income and expenses if the transaction has been completed by the wrong (another) person but the tax authority has not established any ‘budget losses’ (tax benefits as such) since the other person has paid in full any due tax payments relating to the results of its activities?
Depending on the purpose of these regulations, the taxpayer could face negative consequences only in the case of adverse effects for the budget system. The tax authorities must prove that, as a result of a scheme's creation, its participants were able to save tax or obtained the right to a VAT refund. A different, excessively literal interpretation of article 54.1(2)(1) would be unconstitutional.
How do the provisions of article 54.1 of the Tax Code relate to the provisions of Resolution No. 53?
It can be suggested that these provisions relate to each other as article 40 and section V.1 of the Tax Code do: they refer to the same thing but in different wording and with some adjustments. Therefore, in practice it will take tax authorities and courts a long time to apply both regulations in order to work out a common standard. It is still unclear whether the Russian Supreme Court will repeal Resolution No. 53 and approve a new clarification instead.
Looking at the procedure for preparing the document to be considered (draft law No. 529775-6), we would expect the Russian Federal Tax Service to issue a clarification concerning the new regulations. This would also help taxpayers to understand some aspects of them. We would expect a clearer view of the above and many other issues only after the new court practice has formed over a period of several years. It cannot be ruled out that, in the light of article 54.1 of the Tax Code, a formal approach to considering tax disputes will hold sway in law enforcement practice.
Further, applying article 54.1 of the Tax Code will result in the practice being heavily influenced by the ‘Guidelines for identifying circumstances during tax and procedural audits evidencing deliberate actions on the part of a taxpayer’s officers aimed at the non-payment of tax’ drafted by the Russian Investigative Committee (letter No. ED-4-2/13650@ of the Russian Federal Tax Service dated 13 July 2017).
At the same time, codifying (i.e. introducing in tax legislation general rules for counteracting tax schemes) would allow control to be exercised over whether these regulations comply with the Russian Constitution by challenging them in the Russian Constitutional Court, taking into account the official interpretation and law enforcement practice.
What to think about and what to do
Taking into account that the condition for a certain person/entity to discharge its obligations is laid down in legislation, special care should be exercised to create a corporate security system for interactions with counterparties.For instance, it is necessary to perfect not only the procedures for selecting and checking suppliers but also for overseeing the actual making of supplies (performance of work, provision of services) specifically by the parties stated in the contract.
Apart from exercising due circumspection when selecting suppliers, it is necessary to organise work aimed at identifying among suppliers and buyers any firms that are controlled by the company's employees.
Of significant assistance in this will be the information concerning the staff size, income and expenses, taxes paid and tax offences committed by the taxpayers, which, starting from 25 July 2017, must be published in an open data format on www.nalog.ru, and the development of incentives for the employees of the companies’ commercial departments. Such incentives would encourage the selection of real and reliable counterparties, help to control the actual performing of transactions by such counterparties, and prevent any abuse of office.
In addition, taxpayers should be ready to once again confirm and defend before the tax authorities and courts the advantageous approaches and positions that formed in the previous years.