Explanations of the Russian Federal Tax Service on issues of applying the concept of a ‘beneficial owner’
Pepeliaev Group advises that the Russian Federal Tax Service has issued its explanations on issues concerning tax agents applying reduced taxation rates when withholding tax from the income of foreign companies
On the other hand, if income is paid to a non-related party, the tax agent may not have an opportunity to obtain the information which the tax authorities may subsequently obtain within the framework of a tax audit. At the same time, legislators have not resolved the issue of whether a tax agent is liable if it wrongly assesses the information available to it about the recipient of income, as well as whether the tax agent is obliged to collect and analyse this information. At present the Tax Code does not provide for such an obligation (and nor, we note, for the rights of the tax authorities to collect taxes and default interest from the tax agent which failed to withhold).
However, we can suggest that local tax authorities will take the Letter as an instruction to act and will consider the criteria listed in the Letter are obligatory for establishing an actual right to income. And the issue of whether the tax agent is guilty for failing to withhold tax when paying income, will remain unexamined.
In addition, the criteria listed by the Russian Federal Tax Service are ambiguous or, in any case, may be misinterpreted by the lower tax authorities. In particular such criterion as an ‘economic presence’ in the country of residence may be interpreted by local inspectorates as the need to conduct active business activity, which requires assets, a significant number of employees, a big office, and general business expenses.
But such a way of conducting business does not characterise every company. Therefore, for example, a holding company whose activity is to own the shares of subsidiaries, does not need personnel, an office and other items to be recognised as a beneficial owner. The fact that such companies may have the status of a beneficial owner is confirmed by the practice of OECD member states**. In clause 14 b) of the OECD Report 1986 on conduit companies (to which the Commentaries refer) it is directly stated that the main function of a company is to own assets and rights, which in itself does not prove it to be conduit (i.e. does not deprive the company of the status of a beneficial owner). Russian courts have also in a number of cases confirmed the actual right of holding companies to income***.
Some criteria do not at all comply with the requirements of the provisions of the Commentaries to the Model Convention; an example is the criterion regarding the presence of legal and actual obligations to subsequently transfer the income. The Commentaries to the Model Convention (clause 12.4 to article 10) provide that an entity does not hold the status of a beneficial owner if its right to use and dispose of income is limited by contractual or statutory obligation to transfer to other entity. What is more, the Commentaries explain that for the purposes of defining an entity as a beneficial owner, the only limiting obligations that will matter are those which arose directly because of the receipt of the contentious payment. The relationship between an agent and a principal is an example: the agent’s obligation to transfer the income received to the principal arises only after the agent has received this income, which directly depends on the receipt of the payment.
As the Commentaries emphasise, an obligation is not recognised as restricting the right of the recipient of income to use and dispose of it, if, in legal terms, this obligation exists independently of receipt of the income in question, even if the recipient performs this obligation using the income paid to it. For example, if a lessee receives a payment from its sublessee and directly transfers such payment to the owner lessor, this does not mean that the lessee has no actual right to the income.
Our lawyers have broad experience in resolving different tax issues and are ready to assist in preparing the required documents and information, and in drawing up a well-grounded position to defend taxpayers before the tax authorities, as well as subsequently in court.
The Federal Tax Service has sent to tax authorities Letter No. SА-4-7/9270@ dated 17 May 2017 regarding issues of applying the concept of a ‘beneficial owner’ provided for by double taxation treaties. This Letter is aimed at increasing the efficiency of checks performed by the tax authorities over whether the application by tax agents of reduced taxation rates of profit tax is justified with reference to income paid to foreign companies.
The main provisions of the Letter are as follows.
The main provisions of the Letter are as follows.
- When resolving the issue of a beneficial owner, the tax authorities will consider the Model Convention and Commentaries to it as an additional source of interpretation of double taxation treaties (the “Treaty” or “Treaties”). When applying the term ‘beneficial owner’, the tax authorities will proceed from the goals and objectives of the Treaties.
- To prove the presence or absence of a beneficial owner, the tax authorities should use information received not only from foreign jurisdictions, but also from commercial databases, public registers of foreign companies, and other public sources.
- To refuse to apply a reduced tax rate, provided that the tax authority has established that the direct recipient of income is not the beneficial owner (the tax authority is not obliged to establish who actually hold this status) the tax rate established by the Russian Tax Code will be applied automatically. At the same time, the Russian Federal Tax Service explains that the taxpayer (tax agent) may avoid such a situation if, before the resolution under a tax audit is issued, it provides the tax authority with documented confirmation stating who is the direct recipient of income.
- The concept of a beneficial owner will not be applied only to passive income paid to foreign companies (in the form of dividends, interest and royalties). Since the concept of a beneficial owner, in essence, is a mechanism for battling abuse of beneficial conditions of Treaties, this concept is applied ‘in relation to various types of income paid to a foreign company’, i.e. also to active income. Therefore, tax authorities will check beneficial owners with respect to any income paid from sources in Russia. In this regard Russian taxpayers need to be ready to have and to timely provide the tax authority with confirmation not only of the residence of the recipient of income, but also confirmation that this person is a beneficial owner*, with respect to each income paid to a foreign company.
- Based on an analysis of court practice, the Russian Federal Tax Service has defined the criteria for beneficial owners which the tax authorities will use when conducting audits. Benefits will be provided only to companies which confirm that the recipient of income: (a) has an economic presence in the country of residence; (b) has wide powers to dispose of the received income; and (c) used, in its business activity, the income paid to it.
In addition, it has been proposed to the tax authorities that they analyse recipients of income during an audit taking into account the following circumstances:
- whether directors of foreign companies make decisions independently;
- whether business functions are performed;
- whether there are signs of activity being conducted (personnel, an office, and general business expenses);
- whether commercial risks are borne;
- whether or not there are legal and actual obligations for the subsequent transfer of income;
- whether or not transit payments are systematic, which transfer income from a resident of the member state under the treaty to a person who has no benefits under the treaty.
Pursuant to the Letter the tax authorities should not limit themselves to analysing only contentious operations relating to the transfer of income from a Russian entity to a foreign company, but should assess the economic activity of the group in general.
The criteria listed in the Letter will have double significance for taxpayers. On the one hand, the signs of a beneficial owner have been specified, which should be used by both the tax authorities and by taxpayers. This allows the tax agent, if it has doubts as to whether the recipient has an actual right to this income, to request a larger volume of information and to analyse primarily the criteria specified by the Russian Federal Tax Service.
On the other hand, if income is paid to a non-related party, the tax agent may not have an opportunity to obtain the information which the tax authorities may subsequently obtain within the framework of a tax audit. At the same time, legislators have not resolved the issue of whether a tax agent is liable if it wrongly assesses the information available to it about the recipient of income, as well as whether the tax agent is obliged to collect and analyse this information. At present the Tax Code does not provide for such an obligation (and nor, we note, for the rights of the tax authorities to collect taxes and default interest from the tax agent which failed to withhold).
However, we can suggest that local tax authorities will take the Letter as an instruction to act and will consider the criteria listed in the Letter are obligatory for establishing an actual right to income. And the issue of whether the tax agent is guilty for failing to withhold tax when paying income, will remain unexamined.
In addition, the criteria listed by the Russian Federal Tax Service are ambiguous or, in any case, may be misinterpreted by the lower tax authorities. In particular such criterion as an ‘economic presence’ in the country of residence may be interpreted by local inspectorates as the need to conduct active business activity, which requires assets, a significant number of employees, a big office, and general business expenses.
But such a way of conducting business does not characterise every company. Therefore, for example, a holding company whose activity is to own the shares of subsidiaries, does not need personnel, an office and other items to be recognised as a beneficial owner. The fact that such companies may have the status of a beneficial owner is confirmed by the practice of OECD member states**. In clause 14 b) of the OECD Report 1986 on conduit companies (to which the Commentaries refer) it is directly stated that the main function of a company is to own assets and rights, which in itself does not prove it to be conduit (i.e. does not deprive the company of the status of a beneficial owner). Russian courts have also in a number of cases confirmed the actual right of holding companies to income***.
Some criteria do not at all comply with the requirements of the provisions of the Commentaries to the Model Convention; an example is the criterion regarding the presence of legal and actual obligations to subsequently transfer the income. The Commentaries to the Model Convention (clause 12.4 to article 10) provide that an entity does not hold the status of a beneficial owner if its right to use and dispose of income is limited by contractual or statutory obligation to transfer to other entity. What is more, the Commentaries explain that for the purposes of defining an entity as a beneficial owner, the only limiting obligations that will matter are those which arose directly because of the receipt of the contentious payment. The relationship between an agent and a principal is an example: the agent’s obligation to transfer the income received to the principal arises only after the agent has received this income, which directly depends on the receipt of the payment.
As the Commentaries emphasise, an obligation is not recognised as restricting the right of the recipient of income to use and dispose of it, if, in legal terms, this obligation exists independently of receipt of the income in question, even if the recipient performs this obligation using the income paid to it. For example, if a lessee receives a payment from its sublessee and directly transfers such payment to the owner lessor, this does not mean that the lessee has no actual right to the income.
Accordingly, contrary to the Letter, the ‘transit of funds’ or the presence of legal obligations the recipient of the income to subsequently transfer the funds does not evidence that the entity has no right to this income. Applying the Commentaries to which the Russian Federal Tax Service refers in the first part of its Letter allows for other conclusions to be made or, in any case, requires a deeper examination of all the actual circumstances of the specific case in which income is paid.
The criteria provide for the analysis of a foreign entity in terms of various issues and from different standpoints; therefore, to minimise the risks of the tax authorities raising claims, tax agents should request and analyse information and documents to check whether these criteria are met.
Since the criteria are ambiguous, and, to some extent, they do not correspond to provisions of the Commentaries to the Model Convention, tax agents need to be thoughtful in their approach to each of the above criteria, and need to take into account the specific features of conducting business.
Tax audits will not be limited to analysing only an operation involving a transfer of income from a Russian entity to a foreign one; the whole economic activity of the group will be assessed. Accordingly, it is advisable for tax agents not to wait for a tax audit to be initiated and themselves to analyse the business structure with regard to what risk there is of the concept of a beneficial owner being applied. If needed, they should make a decision to reconfigure the business structure.
With respect to past periods, tax agents should prepare a well-grounded position to justify the application of any rate under the Treaties taking account of the actual circumstances of the payment of every income and the special features of a structure.
What to think about and what to do
With regard to the application of the concept of a beneficial owner, based on the goals and objectives of the Treaties, the tax authorities will consider the concept of a beneficial owner of income as a mechanism for battling the abuse of beneficial conditions of international double taxation treaties by covering any types of payments to foreign entities, when the source of the payment is Russia. This will lead to tax audits of Russian companies which pay not only passive but also active income. Therefore, there will be more entities which will be checked in terms of whether they correspond to the criteria of a beneficial owner and which may face claims under formal grounds when paying active income, owing to the absence of confirmation of the actual right to income as required under article 312 of the Tax Code.The criteria provide for the analysis of a foreign entity in terms of various issues and from different standpoints; therefore, to minimise the risks of the tax authorities raising claims, tax agents should request and analyse information and documents to check whether these criteria are met.
Since the criteria are ambiguous, and, to some extent, they do not correspond to provisions of the Commentaries to the Model Convention, tax agents need to be thoughtful in their approach to each of the above criteria, and need to take into account the specific features of conducting business.
Tax audits will not be limited to analysing only an operation involving a transfer of income from a Russian entity to a foreign one; the whole economic activity of the group will be assessed. Accordingly, it is advisable for tax agents not to wait for a tax audit to be initiated and themselves to analyse the business structure with regard to what risk there is of the concept of a beneficial owner being applied. If needed, they should make a decision to reconfigure the business structure.
With respect to past periods, tax agents should prepare a well-grounded position to justify the application of any rate under the Treaties taking account of the actual circumstances of the payment of every income and the special features of a structure.
Help from your adviser
Pepeliaev Group offers a wide range of services in the area of comprehensive support for business on international taxation issues. We are ready to provide support in analysing situations in which income is paid to foreign entities from the standpoint of the application of international treaties and in terms of whether a right to use benefits (reduced tax rates and exemptions) has been granted when separate types of income are taxed from sources in Russia.Our lawyers have broad experience in resolving different tax issues and are ready to assist in preparing the required documents and information, and in drawing up a well-grounded position to defend taxpayers before the tax authorities, as well as subsequently in court.
* Starting from 1 January 2017, confirmation from a foreign person about the beneficial owner is an obligatory condition for a tax agent to apply the reduced tax rate under Treaties.
** See, for example, the Resolution of the Supreme Court of Italy dated 28 December 2016 in case No. 27113/2016 with respect to the concept of a beneficial owner when a holding company was receiving dividends under the Treaty between France and Italy.
*** See, for example, the cases of Votek Mobile CJSC (No. А14-13723/2013) and Saint Petersburg Telecom OJSC (No. А40-187121/14).
**** The Commentaries explain that a contractual or a statutory obligation arises from the corresponding legal document as well as from the aggregate of the facts and circumstances (rather than obligations, which the Russian Federal Tax Service writes about), the analysis of which will evidence that the recipient of income is legally restricted in using and disposing of the income.
** See, for example, the Resolution of the Supreme Court of Italy dated 28 December 2016 in case No. 27113/2016 with respect to the concept of a beneficial owner when a holding company was receiving dividends under the Treaty between France and Italy.
*** See, for example, the cases of Votek Mobile CJSC (No. А14-13723/2013) and Saint Petersburg Telecom OJSC (No. А40-187121/14).
**** The Commentaries explain that a contractual or a statutory obligation arises from the corresponding legal document as well as from the aggregate of the facts and circumstances (rather than obligations, which the Russian Federal Tax Service writes about), the analysis of which will evidence that the recipient of income is legally restricted in using and disposing of the income.