Russian Court decision on permanent establishments

On December 8, 2010, the Moscow State Commercial Court issued its decision in a case involving an analysis of whether the collection of information can constitute a permanent establishment (PE) under domestic law and the double tax treaty between Russia and USA dated June 17, 1992.

Facts of the case

The taxpayer Bloomberg LP produces information products (analytical database). It has a representative office in Moscow where a number of employees gather information. This information is incorporated into the products. Sales of products are made primarily from the UK office. Payments for these sales, however, were made directly to a US Bank account. Even so, Russian VAT legislation required VAT returns on such sales to be filed in Russia, as well as VAT to be paid in Russia.

The outcome of the field tax audit of the taxpayer for 2006-2007 was that the tax authority held the activities of the taxpayer in Russia to constitute a PE and, accordingly, issued a claim for additional tax to be paid. The taxpayer disagreed and appealed the tax authority’s decision in court.

Issue

The two principal issues in court were:

• Whether activities related to gathering information constitute a PE, considering that, under the US-Russia tax treaty, collecting information as a preparatory and auxiliary activity is excluded from the general definition of a PE; and

• If the PE does exist, how much income should be attributable to such activity.

The tax authority’s view

The tax authority insisted that the PE exists and that the activities of employees in Russia were an integral part of the taxpayer company’s activities aimed at creating databases and analytical data. The taxpayer company derives revenues from clients for such databases and data. This means that such activity forms part of the taxpayer company’s core activities rather than being activity of an auxiliary or ancillary nature.

On the second matter, the tax authority took the view that, in general, all payments for products which were sold to Russian customers and on which VAT was paid should be regarded as revenues of the PE. It agreed to take into account certain expenses of taxpayer.

View of the taxpayer company

The taxpayer took the view that, since collection of information is explicitly mentioned in the list of exclusions from the general definition of a PE under the Tax Treaty and is activity of ancillary and auxiliary nature, undertaking such collection should not constitute a PE. Besides, the taxpayer stressed that it does not sell such information but rather provides it for free. 

On the second matter, the taxpayer used the Amadeus database to demonstrate that similar activities in Europe result in profitability of approximately 4-6 percent. Hence the taxable base for corporate profits tax should not include all payments on which Russian VAT was paid as most of them most of them effectively relate to sales from UK office and payments were made directly to the US bank account.

Decision of the court

The court in general upheld the tax authority’s reasoning. It concluded that collecting information and selling products based on such information are the taxpayer’s principal business activities. Bearing in mind that the Russian office not only collected information but also analysed and processed it, the Russian office’s endeavours were part of this principal business activity. Hence, the work of the Russian office cannot be regarded auxiliary or ancillary and the taxpayer has a PE in Russia. Interestingly enough, in this part the court made reference to OECD Commentary to the Model Tax Treaty, despite the fact that Russia is not an OECD Member. Moreover, the court made numerous references to the clarification of the Ministry of Finance (Minfin) on interpreting tax treaties.

On the issue ofthe attribution of profits, the court declined to refer to the Amadeus database as it stated that there is no evidence that information in this database is reliable. Moreover, it stated that the activities of similar companies in Europe do not necessarily offer an appropriate comparison allowing the profitability of such activity in Russia to be determined.

Therefore the tax base should be the product’s gross sales in Russia less permitted expenses. Surprisingly, the court disregarded the separate and independent enterprise profit allocation method even though the tax treaty explicitly provides for this. Instead, it used the direct method, taking all sales of Bloomberg in Russia, including those not related to activities of PE. The professional community was deeply critical of this approach.

Conclusions

The court which decided on this matter was a first instance court. However, it is not clear whether the taxpayer filed an appeal. A likely area for adjustment could be in terms of the attribution of profits. It appears that a significant part of revenues relates to sales activities of offices of taxpayer outside of Russia; this, therefore, should not be taxed in Russia as there are no grounds for applying Russian law to such revenues. It should be noted that, previously, Russian courts upheld profits being attributed to a PE on the basis of a separate enterprise approach. The present case appears to have been decided in contravention of the leading cases of the courts of higher levels and so might be revised accordingly. Another issue is whether the Tax Treaty may be re-interpreted in a manner which differs from the literal meaning of the text on the basis of OECD Commentary.

Nevertheless, the immediate conclusion to be drawn from this case is that the activities of non-resident companies in Russia via a representative office should be re-assessed in the light of the ruling. It is important both to mitigate the risk of activities the taxpayer regards as auxiliary and ancillary in nature being classified as constituting a PE and to ensure that such a PE is properly registered if its activities may meet the standard for it to be classified as such.
The court decision has put into the high risk group representative offices which submit VAT returns without paying profits tax,, as well as representative offices which make no sales from Russia.

The absence of clear job descriptions, the absence of any clear description of the representative functions of the office, the absence of activities being separated and the underestimation of the risks of being classified as a PE appeared to contribute to the outcome of this particular case.

Another important element was the court’s frequent reference to interpretations of the tax treaty by Minfin. Although they are not binding, such clarifications are evidently of significant importance.

Pepeliaev Group‘s specialists have all the necessary expertise properly to evaluate risks and to devise practical recommendations to minimise them.

For further information, please contact: 

in Moscow – Denis Schekin, Senior Partner, at: (495) 967-0007 or by d.schekin@pgplaw.ru; Andrey Tereschenko, Partner, at: (495) 967-0007 or by e-mail; Elena Ovcharova, Head of the Administrative Defence Group, at (495) 967-00-07 or by e-mail; Peter Popov, Senior Associate,  at (495) 967-00-07 or by p.popov@pgplaw.ru

in St Petersburg - Sergey Sosnovsky, Head of Tax Practice (St. Petersburg), at (812) 333-07-17 or by e-mail