On 13 October 2016 the Commercial Court of Kemerovo Region delivered a judgement in case No. А27-20527/2015 (the “Decision”) under the claim of Krasnobrodsky Yuzhny Limited Liability Company (the “Company”).

The case is an example of the development of Russian court practice related with application of “beneficial owner” concept when dividends are paid to foreign companies.

In its judgement the court held that the persons beneficially entitled to the dividends were companies registered in the British Virgin Islands and not the Cypriot parent company. As a result, the court declared that when paying dividends to the Cypriot parent company the Company had illegitimately applied withholding tax at the tax rate of 5%.

According to the judicial act, the Company’s sole participant (an individual) had acquired shares in the Cypriot company, and, in December 2010, had paid for an additional shares issue of the Cypriot company by contributing a 100% share in the Company. In October 2012 the Cypriot parent company contributed RUB 3.1 million to the Company’s capital; the investment amount exceeded US$100,000 at the official dollar exchange rate.

In 2012 Company paid dividends to the Cypriot parent company:

  • US$3.5 million in November 2012;
  • US$1 million in December 2012.

When paying the dividends the Company withheld tax at the tax of 5% provided for by Article 10 (2a) of the Agreement between the Government of the Republic of Cyprus and the Government of the Russian Federation for the avoidance of double taxation with respect to taxes on income and on capital dated 5 December 1998.

The court held that the Cypriot parent company and its Cypriot shareholder were flow-through, “conduit” companies, not actually entitled to income in the form of dividends. In denying the Company, the court took the following circumstances into consideration:

  • According to the Cypriot parent company’s financial statements, obtained by tax authorities through an international request, in 2012 the Cypriot parent company had investments of only the 100% participatory interest in the Company, and the only income was in the form of the Company’s dividends. Moreover, the Cypriot parent company had made a contribution to the Company’s assets not long before receiving the dividends. The Cypriot parent company’s expenses were negligible and were associated, for example, with remuneration of directors, a secretary, accountants, payment for a registered office, etc.
  • The Company paid the Cypriot parent company dividends of US$3.5 million on 15 November 2012 and US$1 million in December 2012. The Cypriot parent company in turn paid its shareholders US$3.4 million in dividends on 30 November 2012. In addition, the Cypriot shareholder of the parent company paid dividends to its shareholders registered in the British Virgin Islands, and also paid off US$1 million in debt.
  • In 2012 and 2013 the Cypriot parent company received US$6.1 million in dividends and paid its shareholders US$6 million in dividends.
  • The independent auditor’s reports on the financial position of the Cypriot parent company and its Cypriot shareholder show that those companies rely on constant financial assistance from their shareholders and without that assistance there would be debt keeping the company from retaining its status as a going concern and meeting its current liabilities.

The court supported the tax authority’s position that the dividends paid by the Company were not actually received by the companies registered in the Republic of Cyprus. Those dividends were transferred using a transit scheme to companies that were residents of the British Virgin Islands. As a consequence, the court declared that the tax authority proved that there was a tax evasion scheme (unjustified tax benefit) in the fact that the Russian company actually paid dividends to companies that were residents of a country with which the Russian Federation does not have a double tax treaty.

However, the court supported the Company’s arguments that the tax audit materials did not contain evidence that the Company’s actual beneficiaries were citizens of the Russian Federation. Due evidence was also not submitted during the hearing of the case neither by the tax authority, nor by the Company, despite the court’s requests. Moreover, the tax authority failed to establish facts proving that the Company was aware of the transit nature of the dividends paid. As a consequence, the court held that the fine provided for by Article 123 of the Russian Tax Code could not be imposed on the Company for failing to withhold tax on payment of dividends. Herewith the Company was obliged to pay outstanding amount of tax.

The court’s position on the case confirms the trend of application of the beneficial owner concept to income paid by Russian companies to their foreign affiliates, and also the concept of unjustified tax benefit. The trend was outlined after the relevant deoffshorization amendments to Russian tax legislation, as well as in a number of clarifications of the competent authorities and in judicial acts, in particular, on the Credit Europe Bank case (No. А40-442/15-39-2), the Bank Inteza case (No. А40-241361/15), the MDM-Bank case (No. А40-116746/15) and the Torgovy Dom Petelino case (No. А40-12815/15), of which we have already informed.