Explanations of the Russian Federal Tax Service have increased the risks of secondary liability for controlling parties

Pepeliaev Group draws your attention to the official position of the Russian Federal Tax Service with regard to the application of the new provisions of bankruptcy legislation on the secondary liability of controlling parties

On 16 August 2017 the Federal Tax Service (the "Tax Service") published its letter No. SА-4-18/16148@ ‘On the application by tax authorities of the provisions of chapter III.2 of Federal Law No. 127-FZ dated 26 October 2002’ (the “Letter”) in which it has clarified and even developed new rules regulating secondary liability of the debtor’s controlling parties, which came into effect on 1 July 2017. The Federal Tax Service has also provided recommendations with regard to the application of the provisions in question by local tax offices.

Below we have outlined the key provisions of the Letter containing clarifications

and practical advice to local tax offices which increase the risks that secondary liability will be imposed on controlling parties.

Specific aspects of the entry into effect of the provisions of Law No. 266-FZ

The Tax Service has clarified the transitional provisions of Law No. 266-FZ and pointed out that after 1 July 2017 it is possible to impose secondary liability on the debtor’s controlling parties based on the new substantive law rules introduced by this Law.

The new developments apply to applications that were filed before 1 July 2017 and were yet to be considered by that date. As for imposing secondary liability under article 3 (3.1) of the Federal Law ‘On limited liability companies’ (the Law On Limited Liability Companies)[1] lawsuits may be filed regarding unlawful actions committed by the debtor's controlling parties before 28 July 2017[2] but within the general statute of limitations.

The transitional provisions of Law No. 266-FZ with regard to instructions from the Tax Service to local tax offices on arranging activities with regard to secondary liability when a dormant LLC^[3] is removed from the USRLE gave the tax authorities’ representatives rather considerable room for auditing the removed LLC’s activities as well as the activities of their controlling parties for a three-year period prior to the filing of claims for subsidiary liability.

Interpreting the signs of a debtor’s controlling party

Referring to the simplification of proving the status of a controlling party by introducing additional presumptions, the tax services have provided detailed theoretical rationale for such presumptions to have been introduced into the Bankruptcy Law, providing practical advice on applying them.

Presumption that there is the status of a debtor’s controlling party when such party benefits from illegal actions or actions in bad faith of the debtor’s management bodies

With regard to the above new presumption of proving the status of a debtor’s controlling party the Federal Tax Service has explained that financial benefit, by analogy with losses, means income received by a controlling party from the debtor’s illegal actions, property (an actual ‘surplus’) as well as income which the controlling party would not have received under normal business conditions (retained profit).

The Tax Service has come up with a non-exhaustive list of the ways to obtain a benefit, first of all, by building a business model divided into risk (so called ‘loss centres’) and risk free (so called ‘profit centres’) elements.

The Federal Tax Service instructs the tax authorities during bankruptcy cases to focus on an in-depth examination of the business’s financial, economic, and organisational structure. The proposed approach to determining benefits makes it possible to extensively apply the relevant presumptive evidence and, during bankruptcy cases, to use the court practice that has formed and is negative for taxpayers with regard to the economic viability of the transactions being evaluated by courts.

A court may regard a person as a controlling party based on the grounds not stipulated by the Bankruptcy Law.

The Tax Service has provided a non-exhaustive list of the grounds describing informal personal relationships allowing the court in its discretion to declare an individual a controlling party of a debtor under grounds not stated in the Bankruptcy Law. These include grounds established by investigative activities (living together, civil marriage, joint official activities (including military or civil service), studying together, etc.).

In extending the list of persons who may be classified as a debtor’s controlling parties, the Tax Service names specialists from the accounting department, legal advisers, corporate secretaries, and other persons producing and maintaining documents as persons who may be have liability imposed on the grounds that the debtor’s documents are missing or distorted.

Explanations have been provided of the presumptions introduced by Law 266-FZ with regard to the new ground for imposing secondary liability for a failure to fully satisfy creditors’ claims

The following may be regarded as causing a failure to satisfy creditors’ claims through the fault of a controlling party.

Material damage to creditors’ property rights inflicted through the effecting or approval by a controlling party of one or more of the debtor’s transactions.

The Federal Tax Service recommends that harm be considered material if caused by transactions with assets involving 20% to 25% of the balance sheet value of the debtor’s property by analogy with article 61.2(2) of the Bankruptcy Law, article 78 of Federal Law No. 208-FZ ‘On joint stock companies’ dated 26 December 1995, and article 46 of Federal Law No. 14-FZ ‘On limited liability companies’ dated 8 February 1998. Harm inflicted by transactions with property involving at least 20% of the assets will also be considered material harm if the lack of such property frustrates the debtor's business activities. If after a transaction is assessed as having led to material harm being inflicted as expressly stated in the Bankruptcy Law, such transaction does not need to be held invalid.

Corporate documents being distorted or missing

Explaining its view of this presumption, the Federal Tax Service has pointed out that secondary liability may be imposed in this case because the company hides documents from a court-appointed administrator and creditors documents that allow a controlling party to be established.

Lack or inaccuracy of data to be entered into the USRLE and the Unified Federal Register of Information ('UFRI')

The Tax Service has drawn an analogy with the provisions of article 432.1 of the Russian Civil Code and has given the same status to data that must be entered into the above publicly available registers and public representations which, if false, deprive the debtor’s counterparties of the opportunity to receive information or mislead them.

Local offices intend to impose secondary liability on the actual controlling parties and beneficial owners of the debtor

The imposition of secondary liability is mainly aimed at “receiving state revenues” and if only a nominal head of the company (director) has liability imposed, this “means that local tax authorities do not properly use the concept of secondary liability”.

It has been recommended for tax offices in all cases to identify and impose liability on the nominal head of the debtor as a co-defendant together with the debtor’s actual controlling party. When the amounts of liability are being reduced for one of the joint debtors it is advisable to supervise the process in order not to let maximum liability be imposed on a person who owns a minimal amount of assets.

The Tax Service has provided a clarification with regard to incentivising parties that are participating in bankruptcy proceedings to cooperate in imposing secondary liability on the debtor’s controlling parties.

A nominal director’s ‘deal’ with the court

Explaining the new rule regarding the possibility for the court to either partially of fully reduce the amount of secondary liability for a responsible person who exercised a nominal management function if, owing to the information provided by this person, the debtor’s actual controlling party was identified and/or the debtor’s and/or the controlling party’s property hidden by the latter was found, the Tax Services emphasises that it is insufficient if the nominal director just points out the person exercising actual control over the debtor and provides appropriate evidence. The nominal director should also provide the data which actually contributed to the judicial decision with respect to the controlling party being adopted and enforced (on the property of a controlling party, their source of income, the debtor’s asset stripping scheme, etc.).

The above position contributes to piling up greater uncertainty for the prospects of reducing or releasing liability for the nominal director and the tax authority establishes unreasonably high standards for such director to cooperate with the court. Additional requirements for the information to be provided by the nominal director to reduce his/her liability may dissuade the nominal director from cooperating and, as a consequence, may make the institution of secondary liability less effective.

Fighting abuses

The Tax Service focuses the efforts of its local offices on fighting abuses when secondary liability is imposed, specifically, on preventing administrators from knowingly filing claims they know to have no hope of success or claims only relating to nominal directors. In this regard the tax service recommends to its subordinate agencies to independently initiate claims regarding the imposition of secondary liability or to include in the defence to the claim additional legal rationale and facts in order to ensure that a claim filed by other persons is upheld.

Incentivising a court-appointed administrator

Law No. 266-FZ has introduced additional remuneration for a court-appointed administrator in the amount of 30% of the amounts received from enforcing the judicial decision to impose secondary liability.

The Tax Service has explained that the relevant remuneration of the court-appointed administrator should be treated as court costs which may be recovered from the debtor’s controlling parties on whom secondary liability is imposed. In the view of the tax authority, this approach will motivate debtors’ controlling parties to voluntarily reimburse losses including under agreements made with its creditors.

At the same time the tax service has provided detailed comment on the mechanism reducing the extent of the incentive. It has explained that remuneration may not be paid at all if, for example, a positive outcome is reached other than through the active effort of the court-appointed administrator or if the administrator resisted imposing secondary liability on the controlling parties.

Classifying the court-appointed administrator’s additional remuneration as court costs in fact results in amounts collected from the debtor’s controlling persons if secondary liability is imposed being increased by 30% of the amount of claims upheld. This should be taken into consideration when the risks of liability are assessed including in the course of normal business activities.

Procedural rights of a secondary defendant specified

Building on the provisions of the Bankruptcy Law on the procedural rights of a person who faces secondary liability and is a defendant under the corresponding claim, the Tax Services provides a non-exhaustive list of these rights: the right to oppose the actions of the court-appointed administrators, transactions, and judicial decisions concerning inclusion to the register of creditors' claims as well as judicial decisions which served as the basis for being included in that register.

The list of procedural rights of a secondary defendant contained in the letter goes beyond the provisions of article 61.15(1) of the Bankruptcy Law, linking the rights of such person solely to the status of the defendant under the relevant claim. Considering the above, we believe that the rights listed in the letter may only be exercised only if the challenge to actions of the court-appointed administrator, transactions, or a judicial decision impacts on the rights and duties of the controlling party.

Proving the controlling party’s status

Stating that the standards have been reduced for proving the status of a controlling party, the tax service recommends, in order to support the shifting of the burden of proof that there are no grounds for imposing secondary liability, that the defendant employ the legal position specified in paragraphs 4 and 5 of clause 1 of the Resolution No. 62 of the Plenum of the Russian Supreme Commercial Court ‘On certain matters of reimbursing losses to persons who are part of a legal entity’s managing bodies’ dated 30 July 2013.

The Tax Service also recommends applying in commercial court proceedings on bankruptcy cases such harsh measures of procedural action as demanding that a secondary defendant appear before the court and that witnesses to be compelled to attend upon the judge’s ruling.

Conclusions

The main reason for the clarifications offered by the Federal Tax Service is to oblige local tax offices to use all tools available under the Bankruptcy Law in order to actually collect tax arrears for the government from the maximum possible number of controlling parties of a debtor including beneficial owners.

Taking into consideration the increased activity of the tax authorities and the retrospective effect of the new rules on secondary liability the risks occurring for the controlling parties require business and operational decisions of the company (both those already made and those currently being made) to be reviewed and reassessed.

If a company's managers, directors, or beneficial owners are ill-informed about the legal implications of violating the Bankruptcy Law, this significantly raises the risks of negative consequences for both the company and its controlling parties.

Help from your adviser

Pepeliaev Group's experts possess extensive experience of protecting the interests of any category of persons involved in the procedures that bankruptcy cases entail. Our lawyers also provide qualified legal assistance in defending the rights of controlling parties who are held liable.