The supreme court has clarified the application of a reduced tax rate under a double taxation treaty to dividends in conditions of thin capitalisation

On 6 March 2018 the Judicial Board for Economic Disputes of the Russian Supreme Court issued its Ruling in the case of SUEK-Kuzbass JSC. In this Ruling the Judicial Board has clarified the rules for applying a reduced tax rate under the Double Taxation Treaty[1] with Cyprus to interest under controlled debt which was reclassified as dividends when the lender is not a shareholder of the borrower.

The facts of the dispute

In 2013 SUEK-Kuzbass JSC (the “JSC”, the “taxpayer”) entered into loan agreements with the Cyprus company SUEK PLC (the “Company”), which indirectly owned 99% of the JSC’s shares. The JSC deducted the interest paid under loans in full as expenses.

The tax authority recognised the debt to the Company as controlled debt, and reclassified the excess amount of interest as dividends and applied the 10% tax rate under the Double Taxation Treaty with Cyprus because the Company had no direct contribution to the JSC’s capital. According to the Memorandum of Understanding to the Double Taxation Treaty with Cyprus a direct contribution to the capital means in particular the acquisition of shares, a direct membership interest in the capital.

The taxpayer insisted on applying a 5% tax rate referring to the provisions of clause 15(d) of the Commentary to article 10 the OECD Model Tax Convention about the reclassification of the loan amount as a contribution to the capital.

The lower courts supporting the position of the tax authority specified that the provisions of the Double Taxation Treaty with Cyprus with respect to applying 5% when taxing dividends presuppose the presence of a direct contribution to the capital of the organisation. This means the Company should directly own shares in the JSC, rather than be an indirect member.

The position of the Russian Supreme Court

The Russian Supreme Court (the “Supreme Court”) dismissed the courts' conclusions that it was impossible to apply the 5% tax rate under the Double Taxation Treaty with Cyprus, based on the argument specified by the tax authority and lower courts. At the same time, having recognised the fact that the Company complied with the condition regarding a contribution to the capital, the Supreme Court referred the case to the first instance court to be reconsidered for the purpose of checking the status of the Company as a ‘true’ beneficial owner.

The Ruling of the Supreme Court contains the following position.

• For the purposes of applying a reduced tax rate on dividends the source of which is Russia, this payment needs to be recognised as dividends - meaning income from membership in the capital (a contribution to the capital) - in accordance with Russian tax legislation.

• According to articles 269(2) and 269(4) of the Russian Tax Code, for taxation purposes the interest paid to a foreign party within the framework of controlled debt is equated to dividends paid to such company. These provisions similarly apply to the income paid to a foreign company which is not a member of a Russian company. Accordingly, interest paid to such foreign company is recognised for taxation purposes as dividends as if it was paid directly to a shareholder.
• The provisions of article 10 ‘Dividends’ of the Double Taxation Treaty with Cyprus apply to such dividends as to income from a membership interest (contribution to the capital), irrespective of the fact that from the standpoint of Russian civil legislation such party cannot be recognised as a member of a Russian company and is not entitled to dividends.
• Based on the genuine economic substance of a transaction from the common interpretation of the concept of ‘capital’ reflected in clause 15(d) of article 10 to the OECD Model Tax Convention, the concept of ‘capital’ includes, among other things, loans granted to a Russian company, the interest under which is reclassified as dividends under articles 269(2) and 269(4) of the Russian Tax Code.
• The application of reduced tax rates by contracting states under double taxation treaties is provided for in order to encourage direct investments (contributions to subsidiary companies). The approach of the tax authority confirmed by the lower courts in fact led to the following: having complied with the necessary conditions, in particular having actually invested in the capital of a Russian company, a foreign company was deprived of the right to apply a reduced tax rate in contravention of the purposes and substance of the Double Taxation Treaty with Cyprus.
• When interpreting a double taxation treaty it is necessary to take into account the provisions of Resolution No. 53 of the Plenum of the Supreme Court dated 12 October 2006^[2]. According to clause 7 of the Resolution the particular tax rate which corresponds to the true economic content of the transaction should be applied.

What to think about and what to do

The Supreme Court has confirmed that the application of tax rates under double taxation treaties should be based on the purpose of the double taxation treaty and should be guided by an analysis of the original economic content of the transactions. The condition concerning investments that have been made is deemed complied with irrespective of how these investments are formalised from the standpoint of corporate procedures and civil legislation if, for taxation purposes, the income paid is treated as dividends.

The approach of the Supreme Court can be applied also to other double taxation treaties, including to those in which other requirements are established for applying a reduced tax rate in comparison with the Double Taxation Treaty with Cyprus (a specific membership interest in the capital, etc.).

Moreover, this approach can be applied to situations not connected with the application of ‘thin capitalisation’ rules, when it is necessary to prove the right to apply a reduced tax rate on dividends. For example the position of the Supreme Court allows the so-called ‘pass-through approach’ to be justified in cases when the tax authorities refuse to apply the provisions of a double taxation treaty referring to the fact that the actual recipient has no actual right to income, and the beneficial owner does not have the required membership interest in the Russian company.

The clarifications of the Supreme Court allow taxpayers and tax agents to significantly widen the range of remedies to defend their positions in disputes associated with the taxation of payments under the conditions of double taxation treaties.

Help from your adviser

Pepeliaev Group's lawyers are ready to assist with the practical application of the new interpretation of the rules for applying reduced tax rates under double taxation treaties. This may include assessing the implications and risks of the actions performed as well as drafting the necessary documents to confirm the status of beneficial owner.

With our partners in the international networks Taxand and Terralex, which bring together consummately professional teams of independent advisers from all around the world, we draw up recommendations concerning how to use foreign jurisdictions. In doing so, we comply with the strictest confidentiality requirements.