What is new in the application of Russian thin capitalisation rules

Pepeliaev Group law firm advises that the Presidium of the Supreme Arbitration Court (the “SAC”) will for the first time consider how the non-discrimination provisions of international double tax treaties correlate with Russian thin capitalisation rules, which in certain cases provide for interest accrued on a taxpayer’s debt to be reclassified as dividends.

Case No. A27-7455/2010 in the Arbitration Court of Kemerovo Region has been referred to the Presidium of the SAC with regard to an instance where the thin capitalisation rules set out in articles 269(2)-269(4) of the Russian Tax Code were applied (Ruling No. 8654/11 of the SAC dated 12 August 2011). We would like to remind you that, pursuant to articles 269(2)-269(4) of the Tax Code, interest accrued on the debt and exceeding a certain threshold is to be reclassified as dividends. Such reclassification affects debt obligations to a foreign company that holds more than 20% in the issued capital of the Russian taxpayer, as well as some other debt obligations connected with such foreign company holding a majority share in the taxpayer. This in turn results in the “reclassified interest” not being eligible for deduction as the taxpayer’s expenses for profit tax purposes.

After considering the above case, the courts of three instances acknowledged that some amounts owed by the Russian taxpayer indeed matched the criteria of controlled debt set out in article 269(2) of the Tax Code. In this case, following the general rule the taxpayer was not allowed to deduct the disputed interest for profit tax purposes. At the same time, the courts believed that such application of provisions of the Tax Court was unacceptable in view of non-discrimination provisions of the double tax treaties signed by the Russian Federation with the Swiss Confederation and the Republic of Cyprus (in the course of the litigation it was established that the taxpayer’s capital in the disputed periods was controlled by a resident of the Swiss Confederation and a resident of the Republic of Cyprus).

Since international tax treaties take precedence, the courts invalidated the decision of the tax authority that disallowed the taxpayer fr om deducting the disputed interest as expenses for profit tax purposes.

Pepeliaev Group’s comments

It should be noted that, to date, state commercial (arbitration) courts have mainly used an approach according to which provisions of the Tax Code on thin capitalisation rules conflict with the non-discrimination rules set in international double tax treaties. What is specific to this case is that the same approach was applied to the interest accrued by the taxpayer for payment to Russian companies that are affiliates of the foreign company holding a major share in their capital.

The panel of the SAC’s judges, when referring the case to the Presidium of the SAC for supervisory review of the lower courts’ decisions, noted that the types of expenses deductible for the purposes of imposing tax in Russia on the profit of Russian companies should be determined by national, i.e. Russian, legislation. As specified in the Ruling of the SAC, “in the opinion of the panel of judges, the cited provisions of the Treaties are not concerned with the methodology or procedure for calculating the profit tax (including the procedure for deducting expenses for profit tax purposes) of the contracting states. Neither do they rule out the application of article 269(2) of the Code, which establishes a limit on deductible interest paid on debt obligations to companies that hold a major share in the capital of the Russian taxpayer.” In other words, the panel of the SAC’s judges suggests, with regard to the matter in dispute, that the taxpayer’s claim to invalidate the tax authority’s decision should be dismissed.

Conclusions and recommendations

If the SAC’s Presidium uses in its Resolution the approach applied by the panel of judges, this will obviously change the situation with similar cases considered by state commercial (arbitration) courts, which will worsen the taxpayer’s position in the relevant disputes with the tax authorities.

In this situation, Pepeliaev Group’s lawyers recommend that taxpayers who have debts covered by thin capitalisation rules check to what extent the court’s upholding of the tax authority’s position in this case might affect the interest on such debt, taking into account that double tax treaties with other states (apart from Switzerland and Cyprus) will be disregarded when considering this case. This will also include treaties that in certain cases directly allow for the unlim ited deduction of interest paid by Russian taxpayers for their business purposes.

For further information, please contact:

in Moscow – Andrey Nikonov, Senior Partner, at: (495) 967-0007 or by a.nikonov@pgplaw.ru; Vladimir Voinov, Senior Associate, at: (495) 967-0007 or by e-mail; Vladimir Boriskin, Senior Associate, at: (495) 967-0007 or by v.boriskin@pgplaw.ru

in St Petersburg - Sergey Sosnovsky, Head of Tax Practice (St. Petersburg), at (812) 640-60-10 or by s.sosnovsky@pgplaw.ru