On 11 July 2016 the Commercial Court of Moscow rendered a decision in case No. А40-442/15-39-2 under the claim of Credit Europe Bank CJSC (the “Bank”). That decision is yet another judgment on the subject of applying the concept of the person beneficially entitled to income to the tax implications of Russian companies paying passive income abroad.
In this instance, tax claims were brought against a Russian entity as a tax agent which, in the tax authority’s opinion, wrongfully withheld tax at the rate of 5% according to Article 11(2) of the Agreement for the Avoidance of Double Taxation (“DTT”) between Russia and Switzerland (in the version before the adoption of the Protocol of 24 September 2011) when paying interest to a “sister” Swiss creditor entity (the “Lender”). The tax authority held that the Bank should have withheld tax at the rate of 20%, because the Lender is not the beneficiary (actual owner) of the interest, as it placed deposits in its own name but on behalf of other legal entities and individuals and acted as an intermediary in transferring funds.
The Commercial Court of Moscow agreed with the tax authority’s position, declaring that the Swiss bank (the Lender) was an agent (fiduciary manager) that, on the instruction and for the account of third parties incurring all of the risks, essentially placed funds in deposits of a Russian bank/taxpayer, which was reflected in the IFRS statements of both banks (the Russian bank documented clients’ deposits as fiduciary deposits of affiliated nonresident banks). In the court’s opinion, other persons (investors) and not the Swiss bank were the actual recipients (beneficial owners) of the interest in question paid by the Russian bank under the loan agreement the principal under which was provided using those deposits.
The court arrived at this finding having upheld the following arguments of the tax authority:
- The bank had the ability to establish the actual owners of the interest income, i.e., the Lender’s clients who provided funds to the Lender in order to place them in deposits.
- The Bank's argument that information about the Lender's clients could not be obtained due to banking secrecy rules merely evidences that the Bank “recognized the intermediary nature of the activity” of the Lender.
- The Lender did not treat the deposits and interest in question, respectively, as its own funds or its own income, as it recorded those amounts off the balance sheet; the Lender recorded only the agent’s fee as income.
- The Bank's argument was untenable that the conditions for using the 5% rate under the DTT do not establish requirements of the status of “beneficial owner” of the income, as they provide for the reservation “notwithstanding the preceding provisions of this paragraph” (second sentence of Article 11(2) of the DTT). The Commentaries to the OECD Model Tax Convention expressly provide for the requirement of the “actual recipient of income” status in order to apply the benefit under the DTT; if the income is paid to an agent or nominee holder, the provision by a State that is the source of the income of a benefit under a DTT will not correspond to the objectives and goals of the DTT.
- It is not enough that there be legal grounds for receipt of income in order to consider a person the actual recipient of income (beneficial owner). The recipient of income should also be the direct beneficiary: it should receive benefit from the income received and determine its further economic fate.
- The tax agent withholding tax at the rate of 20% does not mean that beneficial owners of interest income cannot file requests for refund of tax amounts with the tax authority (if they are entitled to a refund of those amounts) pursuant to clauses 2 and 4 of Article 312 of the RF Tax Code.
In this case the Commercial Court of Moscow once again clarified the application of the concept of beneficial owner, but now in a situation where a Russian borrower receives funds from a foreign company, the fiduciary manager of fiduciary deposits. It is noteworthy that the court found that the tax authority not having information about the lending bank’s clients due to banking secrecy requirements is not a basis to treat a foreign lender as the actual recipient of income. In effect, the court’s position came down to the fact that the provisions of the DTT cannot be applied if income is paid to a foreign bank performing the functions of agent or nominee holder, unless the Russian company proves that the borrowed funds were (i) provided by the lender from the lending bank’s own funds or (ii) are not directly intended for payment to third parties.
The court’s position on this case deepens the tendency to apply the concept of the person beneficially entitled to income (beneficial owner) to 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 judicial acts were made, in particular, on the Inteza Bank case (No. A40-241361/15), the MDM-Bank case (No. А40-116746/15), and the Torgovy Dom Petelino case (No. А40-12815/15) of which we have already written.