On March 3, 2016 the Commercial Court of Moscow rendered a decision on case No. А40-241361/15 (the “Decision”) under the claim of BANK INTEZA joint stock company (the “Russian Company”). The decision contains a number of findings that in future may be used by both tax authorities when conducting tax audits, and by taxpayers to assess their risks when the beneficial owner concept is applied.

Tax claims were brought against a Russian entity as a tax agent that had failed to withhold taxes on interest paid to a “sister” Luxembourg creditor entity (the “Luxembourg Company”) the beneficial owner of which, in the tax authority’s opinion, was the Russian Company’s Italian parent (the “Italian Company”). The Commercial Court of Moscow agreed with the tax authority’s position, declaring that the loan had been channeled through the Luxembourg Company in order to be able to apply the more favorable tax treatment of interest at the source of payment contemplated by the double tax avoidance treaty (“DTT”) between Russia and Luxembourg.

The court arrived at this finding based on the following:

  1. the terms of the Russian Company’s debt obligations to the Luxembourg Company were identical to the Luxembourg Company’s debt obligations to the Italian Company, including the amount, currency and term of the debt (thanks to the obligations of the Luxembourg Company to the Italian Company being regularly prolonged);
  2. the purpose of the loans given by the Italian Company to the Luxembourg Company was to finance the Russian Company, which was confirmed by the Luxembourg Company and actual cash flow;
  3. the Luxembourg Company did not have staff members competent to make independent decisions on issuing loans, for one thing because the most qualified employee was a member of the board of directors of several entities (a “mass” board member);
  4. the interest received from the Russian Company was transferred to the Italian Company “immediately almost in full” or was contributed to the Luxembourg Company’s equity, from which loans were issued to the Russian Company in subsequent years, which was deemed equivalent to the Italian Company receiving the interest, as the Luxembourg Company was totally owned by the Italian Company.

The following aspects of the dispute reflected in the Decision are worth noting in particular:

  1. There was an extensive body of evidence gathered by the tax authority, including by sending requests to the competent authorities of foreign states. In addition to the Luxembourg Company’s submissions and data from its financial statements, the body of evidence included:
    • detailed responses to international requests of the Italian and Luxembourg competent authorities (stating the terms and conditions of specific agreements, including addenda thereto, and tax amounts paid in the country);
    • analysis of the resumes of the Luxembourg Company's employees;
    • analysis of the terms of the debt obligations and actual cash flow;
  2. Simultaneous application and detailed description by the court of a number of key concepts apart from the concept of beneficial owner that are used in international practice to combat tax evasion:
    • the concept of conduit companies, which are entities devoid of separate economic value created with the sole purpose of accessing DTT benefits and redirecting (“channeling”) funds to their beneficial owner;
    • the concept of treaty shopping, which is choosing a jurisdiction to create a company with most favorable international tax treatment without a business rationale for doing so that is not associated with enjoying such treatment;
    • back-to-back financing, which means issuing a loan using another person’s funds;
  3. The concept of “double non-taxation,” meaning no taxation or minimal taxation at the source of the income in Russia and in the country of the intermediate company (in this case, in Luxembourg) thanks to formal compliance with local legislation, which, according to the OECD Commentaries to the Model Tax Convention on Income and on Capital is contrary to the goals and objectives of the DTT. OECD documents were widely quoted, and not only the commentaries to the Model Tax Convention on Income and Capital, but also a 1986 report on conduit companies, and establishing a dependence of the Russian Company’s financing structure on international tax arrangements (the G20 summit).

The court’s position on this case deepens the tendency to apply the concept of the beneficial owner of income payable by Russian companies to their foreign affiliates, and also the concept of unjustified tax benefit outlined after the relevant amendments to the tax legislation were adopted in 2015 and a number of clarifications of the competent authorities and case law, in particular, on the MDM-Bank case (No. А40-116746/15), and the Torgovy Dom Petelino  case (No. А40-12815/15) of which we have already written (please see p.5 here for more infomation (in Russian only)).