May foreign holding companies that serve the interests of one group of persons not be beneficial owners of income?
Law firm Pepeliaev Group advises that the court has used in practice the conclusions of Letter No. SA-4-9/8285 of the Russian Federal Tax Service dated 28 April 2018 regarding the application of international tax treaties by foreign holding companies that serve the interests of a single group of persons.
On 20 December the City of Moscow State Commercial Court considered a dispute between AO ForteInvest (the “Company”) and Inter-District Inspectorate No. 48 of the Federal Tax Service (the “Tax Authority”) regarding the application of the preferential withholding tax rate of 5% under the Agreement between the Government of the Russian Federation and the Government of the Republic of Cyprus for the Avoidance of Double Taxation with respect to Taxes on Income and on Capital (the “DTA”).
It follows from the facts of the case that the Company paid dividends to a holding company located in Cyprus and withheld, as a tax agent, tax at source at a reduced rate of 5%. Afterwards, within a very short period of time, the holding company forwarded in transit almost the entire amount of the funds received to its shareholders, which are registered within the British Virgin Islands and have no right to enjoy the benefits under the DTA.
The Tax Authority disagreed with this approach to the use of the DTA since the holding company had no actual right to the beneficial ownership of income and its existence within the group structure was not economically justified, since the foreign holding company performed no activities other than receiving income from the Russian Company. In the tax authority's opinion, the foreign holding company was only a party which served the interests of its own group and of other parties affiliated with it, and the reasons for its existence were not connected with actual economic activities. Therefore, when the Company was acting as a tax agent, it should have withheld tax of 15% on the amount of the dividends paid.
The Commercial Court has upheld the Tax Authority’s arguments and dismissed the claims of the Company. The decision of the Court is based on a conclusion that the foreign holding company which was the recipient of income in Cyprus had no economic activities, specifically:
- the foreign holding company was founded two months prior to the incorporation of the Russian Company;
- the only assets held by the foreign holding company were the Russian Company’s shares;
- the foreign holding company incurred only insignificant administrative expenses connected strictly with the formal performance of the requirements of Cypriot legislation;
- the foreign holding company incurred no general business costs which demonstrate that actual economic activity was performed within Cyprus, such as payroll costs or lease payments;
- the foreign holding company did not pay any taxes within Cyprus;
- the foreign holding company forwarded in transit almost the entire income received as dividends to its shareholders registered in the BVI within a short period of time after the dividends had been received from the Russian Company;
- the bank accounts of the Russian Company, of the foreign holding company and of its shareholders are opened with the same Russian bank;
- the shareholders of the foreign Holding Company and the foreign Holding Company itself were created almost at the same time by the same group of persons with the sole purpose of gaining access to the reduced withholding tax rate under the DTA.
This is the first confirmation in Russian case law of the Russian Federal Tax Service's conclusions stated in its letter dated 28 April 2018 that foreign holding companies providing services to only one group of persons have no right to enjoy reduced withholding tax rates set out in international tax treaties, unless the existence of such foreign holding companies is due to valid economic reasons, and in this case the reduction of costs on paying the withholding tax may not be treated as a business purpose.
Further to the above, the court concluded that the foreign holding company was of a technical nature and that the requirement concerning the economic presence of the foreign company that was the owner of income within the Republic of Cyprus was met only formally and, therefore, that the foreign holding company had no actual right to the income. The income received as dividends should have been taxed by the Company at the 15% rate, without the DTA being applied.
What to think about and what to do
When a Russian tax agent applies provisions of an international tax treaty, it should not only formally meet the requirements of the Russian Tax Code and of the appropriate international tax treaty regarding confirmation of the beneficial ownership of income, but it would be prudent to take into account the conclusions set out in letter No. SA-4-9/8285 of the Russian Federal Tax Service dated 28 April 2018.
Help from your adviser
Pepeliaev Group offers a wide range of services to provide comprehensive support for business on international taxation issues including those connected with the application of rules regulating the beneficial ownership of income.
Our experts have unique methodological expertise in issues relating to the application of rules regulating the beneficial ownership of income. They are ready to provide assistance in formulating a well-grounded position and defending taxpayers before tax authorities and subsequently in court.