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International Tax Services, EY, Moscow
Victor Kalgin is a Director at International Tax Services, EY, Moscow
A spate of case law in recent months has helped to crystallize interpretation of the concept of beneficial ownership by the Russian tax authorities. The following article examines the decisions taken in these cases and considers the implications for taxpayers.
From May to August this year a number of important rulings were issued on disputes over withholding tax in which the tax authorities appealed to the concept of a “beneficial owner” (or “person having an actual right to income”).
Arbitration case law in this area goes back quite a long way,1 but we have of late seen increased focus by the tax authorities on the beneficial owner concept. The explanation for this may lie in the “deoffshorization” law, which came into force on January 1, 2015,2 as well as in a number of Ministry of Finance clarifications on this topic which were published last year.3
The “beneficial owner” rules mean that a foreign company which receives income from Russia (first and foremost in the form of dividends, interest and royalties) may not have the right to claim lower rates of withholding tax under double taxation treaties. Lower rates do not apply to companies which cannot be deemed “beneficial owners” of income (or, to use alternative expressions, do not have an “actual right to income”, are not “the actual recipients of income”, are deemed to be “conduit companies”, and so on).
The “deoffshorization” law, which introduced this concept into the domestic legislation, defines the term “beneficial owner” of income,4 introduces a “look through” principle for instances where the beneficial owner is not the immediate recipient of income5 and provides for the possibility to support the status of foreign company as the beneficial owner of dividends.6
The “deoffshorization” law, as well as the Commentaries on the OECD Model Convention, sets out the beneficial ownership rules in a fairly generalized way and with emphasis on the priority of economic content over legal form, which is why, in Russia as in most other countries, the application of the concept develops through law enforcement practice. It is the evolution of this practice in Russia that we are witnessing now.
This case involved a dispute over withholding tax on dividends paid to a Swedish shareholder in 2012. In the opinion of the tax inspectorate, the Russian company which paid the dividends did not have the right to apply the 5% rate of withholding tax under the Russo-Swedish treaty owing to the fact that not all the required conditions were met. In particular, the inspectorate took the view that the Swedish company which received the dividends, Tele2 Russia Holding AB, was not the beneficial owner of the dividends. The inspectorate's reasoning for this conclusion was that the Swedish company which received the dividends:
• did not determine their subsequent “economic fate”, since the entire amount of the dividends was passed on upwards in the ownership chain;
• received shares in the Russian company as a shareholder contribution, i.e. free of charge, indicating that it had no business risk consisting in the potential loss of its own investment;
• in the opinion of the Ministry of Finance, which the tax inspectorate sought in the course of the dispute,7 it could not be considered as the beneficial owner of the dividends since their entire amount was redistributed.
Following an audit the tax inspectorate ordered the tax agent (ZAO Votek Mobile) to pay withholding tax on dividends at the rate of 15%.
The first instance court concurred with the tax authority's position.8 In the appellate court,9 however, the company succeeded in refuting the tax authority's conclusions by presenting the following arguments:
• it follows from a letter received from a competent Swedish lawyer that shares received as a capital contribution become the property of the receiving party (in this case the Swedish company which received the dividends), thus indicating that the inspectorate is mistaken in its view that the shareholder bears no business risk;
• according to clarifications provided by the Swedish shareholder, not all the dividends were passed on.
The court also pointed to the tax inspectorate's failure to prove that the final Swedish shareholder which received the dividends was the beneficial owner of the dividends.
The tax inspectorate has filed a cassation appeal against the ruling, which should be considered by the cassation court in September.
OAO Sankt-Peterburg Telecom is another subsidiary of the same Swedish shareholder (Tele2 Russia Holding AB) which was the recipient of the dividend distribution scrutinized in the ZAO Votek Mobile case. The dispute concerned the withholding tax rate for dividends paid in 2010-2011. The tax authority took the view that the shareholder was not the beneficial owner, presenting a similar line of argument to that which was used in the above-described ZAO Votek Mobile case.
The taxpayer's position in this case is based on the following arguments:
• the Swedish shareholder did not transfer all or almost all of the dividends to its shareholder: of the 7 billion krona in dividends received in 2011-2012, the shareholder distributed only 2.3 billion;
• the dividends received were used by the shareholder, inter alia, in financial and investment activities (loans, purchase of other companies, financing of subsidiaries);
• the conclusion drawn by the Ministry of Finance that Tele2 Russia Holding AB could not be regarded as the beneficial owner of the dividends was based on insufficient information (in particular, financial statements and later clarifications from the company were not considered);
• the company carried on activities and had sufficient capital, and its management bodies made independent decisions on the payment of dividends to shareholders;
• the company incurred various expenses (interest, audit and consulting fees) and received income (interest, dividends, liquidation payments) in connection with its activities;
• the Swedish company which received a portion of the dividends passed on along the chain of ownership is a resident of a state which has a tax treaty with Russia and could have claimed the lower rate of withholding tax if it had received the dividends directly.
Based on these arguments, and taking into consideration the favorable decision on the ZAO Votek Mobile case, the first instance court ruled in the company's favor.
The court additionally emphasized that the official representations, documents, information and financial statements provided by the company constituted the very documentary evidence of the status of the Swedish company as the beneficial owner of the dividends which is envisaged by the Ministry of Finance10 and by the “deoffshorization” legislation which entered into force from 1 January 2015.11
The tax inspectorate has filed an appellate appeal against this decision, which should be considered by the appellate court in September.
The situation in this case was that the tax inspectorate had charged additional withholding tax on interest payments made by a Russian bank to the Dutch company Moscow Stars B.V. That company was involved in the securitization of mortgage loans to individuals, and in 2009-2010 it received interest from the bank in respect of purchased loans. In the tax inspectorate's view, the company could not claim exemption from withholding tax under the Russia-Netherlands treaty since it was not the beneficial owner of the interest. The inspectorate's arguments came down to the following:
• the Dutch company was a conduit entity which transferred the interest received to holders of that company's bonds;
• in accordance with the tax ruling profits tax paid by the Dutch company did not depend on its actual income and expenses;
• the company's risk hedging expenses are negligible;
• the company did not have permanent staff;
• the bank's own statements classified obligations in respect of bonds issued by Moscow Stars B.V. as the bank's own obligations.
The first instance and appellate instance courts12 disagreed with the inspectorate's arguments and took the side of the bank, which demonstrated that:
• interest received by Moscow Stars B.V. on mortgage loans in the period concerned significantly exceeded amounts of interest paid to bondholders;
• expenses incurred by the company for the hedging of interest rate risks were greater than the interest payments themselves;
• the company created reserves for overdue loans;
• failure by borrowers to make loan payments on time did not cause Moscow Stars B.V. to violate its obligations to bondholders;
• interest income of Moscow Stars B.V. differed from its bond expenses both quantitatively and qualitatively: mortgage loans to individuals had fixed rates ranging from 9.8% to 13.5%, while bonds had floating and fixed rates (Libor + 1.75%, Libor + 5.25% and 7% depending on the class of bonds);
• the company's activities involved various risks (credit risk, interest rate risk, risk of changes in market prices of pledged assets);
• the company incurred significant management expenses (administrative costs);
• the company calculated profits tax on the basis of its actual financial result and paid dividends, i.e. the tax inspectorate incorrectly interpreted the tax ruling received by the company;
• the securitization transaction had a business objective and was not aimed at obtaining an unjustified tax benefit.
The court agreed, therefore, that there was no foundation for the tax inspectorate's allegation of interest payments being channeled through Moscow Stars B.V. on a transit basis, and that the company had lawfully received exemption from Russian withholding tax.
The tax authority did not challenge the court's decision at the cassation stage insofar as the beneficial ownership part was concerned.13
This case involved a dispute over withholding tax on royalties paid by a Russian company under a sublicence agreement to a Cypriot company for the use of a trademark. In the opinion of the inspectorate, the Russian company did not have the right to claim a withholding tax exemption under the Russia-Cyprus double taxation treaty since the Cypriot company receiving the royalties was not the beneficial owner of the royalties. The tax authority gave the following reasoning for its conclusion:
• the rights holder of the trademark was an affiliated company registered in an offshore jurisdiction (Bermuda);
• the Russian company could have concluded an agreement directly with the licensor (the owner of the trademark);
• the licence agreement between the offshore rights holder and the Cypriot company and the sublicence agreement between the Cypriot company the Russian company were concluded a short time apart;
• the price of the sublicence agreement exceeded the price of the licence agreement;
• there is a tax treaty between Russia and Cyprus but not between Russia and Bermuda;
• practically all royalties received by the Cypriot company were transferred to the Bermudan rights holder;
• the Russian company received an unjustified tax benefit in the form of a withholding tax exemption under the Cyprus treaty without having a business objective of concluding a sublicence agreement.
The Russian company contested the inspectorate's conclusion using the following arguments:
• the Russian company could not have used the trademark without concluding a sublicence agreement;
• its business operations were genuine;
• it is normal business practice for the price of a sublicence agreement to exceed the price of a licence agreement, as the sublicensor aims to cover its costs and make a profit;
• the Cypriot company was a genuinely functioning organization which disclosed royalties received in its statements and paid taxes;
• whether or not an agreement could have been concluded directly with the rights holder is not a matter for the tax authority to judge, as it does not have the right to evaluate the economic expediency of expenses.
It is noteworthy that the term “beneficial owner” (“actual right” to income) is not used in paragraph 1 of Article 12 (“Royalties”) of the Russia-Cyprus tax treaty, which could have provided a formal basis for not applying that concept in the case concerned. Nevertheless, this did not affect the decision of the courts of the first and appellate instances, which took the tax inspectorate's side.14
The Russian company may file a cassation appeal against the court's decision.
It is clear that the tax authorities are increasingly focusing their attention on the validity of the application of lower rates under Russian tax treaties, basing their approach on the “beneficial owner” concept. Although the relevant rules were introduced into Russian tax law from the beginning of this year, this concept has been present in the great majority of Russian double taxation treaties since they were signed. The examples above show that this has led to tax authorities applying the rules to periods before 2015.
Taxpayers are advised to make a careful assessment of the risk of challenges against the use of lower rates in current and previously used structures and transactions. Particular attention should be paid to “transit” money flows (dividends, interest, royalties), foreign companies without an adequate level of presence in their jurisdiction and structures and companies without sufficient evidence of business purpose and without an adequate level of functions, assets and risks attributable to foreign counterparties of Russian companies.
|Taxpayer||Case number||Type of income||Audit period||Outcome for the taxpayer||Is the decision final?|
|Eastern Value Partners Limited||Ruling of the Ninth Arbitration Appeal Court of 5 December 2012 on Case No. À40-60755/12-20-388.||Interest||2008-2010||Positive||Yes|
|ZAO Toros||Ruling of the Federal Arbitration Court of 7 April 2011 on Case No. A41-598/10.||Interest||2007||Positive||Yes|
|ZAO Votek Mobile||Ruling of the Nineteenth Arbitration Appeal Court of 5 June 2015 on Case No. A14-13723/ 2013.||Dividends||2012||Positive||No|
|OAÔ Moscommertsbank||Ruling of the Ninth Arbitration Appeal Court of 26 January 2015 on Case No. A40-100177/13.||Interest||2009-2010||Positive||Yes (as far as the “beneficial owner” part is concerned)|
|OOO TD Petelino||Ruling of the Ninth Arbitration Appeal Court of 4 August 2015 on Case No. A40-12815/15.||Royalties||2010-2011||Negative||No|
|OAO Sankt-Peterburg Telecom||Decision of the Moscow Arbitration Court of 16 June 2015 on Case No. A40-187121/14.||Dividends||2011-2012||Positive||No|
Victor Kalgin is a Director at International Tax Services, EY, Moscow. He can be contacted at email@example.com.
1 For example, the Eastern Value Partners Limited case (Ruling No. 09AP-33421/2012-AK of the Ninth Arbitration Appeal Court of 5 December 2012), the ZAO Toros case (Ruling No. KA-A41/2465-11 of the Federal Arbitration Court of the Moscow District of 7 April 2011).
2 Law No. 376-FZ of 24 November 2014.
3 Letter No. 03-00-RZ/16236 of 9 April 2014 and Letter No. 03-08-05/36499 of 24 July 2014.
4 Clauses 2 and 3 of Article 7 and Clause 3 of Article 312 of the Tax Code.
5 Clause 4 of Article 312 of the Tax Code and, specifically for dividends, Clauses 1.1 to 1.4 of Article 312 of the Tax Code.
6 New edition of Clause 1 of Article 312 of the Tax Code.
7 Letter No. 03-08-13/23614 of 19 May 2014.
8 Decision of the Arbitration Court of the Voronezh Province of 6 October 2014 on Case No. A14-13723/2013.
9 Ruling of the Nineteenth Arbitration Appeal Court of 5 June 2015 on Case No. A14-13723/2013.
10 Letter No. 03-08-05/36499 of 24 July 2014.
11 In particular, clause 1 of Article 312 of the Tax Code.
12 Decision of the Moscow Arbitration Court of 10 October 2014 and Ruling No. of the Ninth Arbitration Appeal Court of 26 January 2015 on Case No. 09AP-53771/2014.
13 See the Ruling of the Arbitration Court of the Moscow District of 19 May 2015 on Case No. A40-100177/13.
14 Decision of the Moscow Arbitration Court of 8 May 2015 and Ruling of the Ninth Arbitration Appeal Court of 4 August 2015 on Case No. A40-12815/15.
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