On June 11, 2015, Moscow District Arbitration Court handed down its ruling in the controversial Oriflame case. In the case, the tax authorities challenged the lawfulness of a Russian organization deducting VAT and expenses (for profit tax purposes) on royalties paid to an affiliated foreign company for use of a trademark, trade name and know-how. According to the judgments, the rights holder (a Luxembourg tax resident) is a 100% grandparent of the Russian sublicensee, while payments were made via a Dutch sister company (formally, the Russian organization concluded a subfranchise agreement with the Dutch sister company, which in turn had a franchise agreement with the Luxembourg rights holder).

Sadly, the court of cassation instance did not accept the arguments by the Russian taxpayer and refused to set aside the judgments of the first and appeal instances. The court based its decision against the appeal on the following conclusions:

  1. Affiliation of the rights holder and the Russian organization;
  2. Participation of employees of the Luxembourg rights holder in management of the Russian organization, supervision of that organization's activities by the Luxembourg company (including by introducing common corporate standards, policies and business procedures), accountability of employees of the Russian organization to officers of the Luxembourg company. As a result – the Russian organization was not an independent undertaking;
  3. The Russian organization resold goods purchased from the Luxembourg company;
  4. The Russian organization positioned itself commercially (including before customers) as a division of the Luxembourg company;
  5. The Dutch sister company's activities were transitory (the Dutch sister company transferred practically all revenue received from the Russian organization to the Luxembourg rights holder).

In the opinion of the court, these reasons are sufficient to ignore the presence of the Dutch sister company in the operational structure and to treat the Russian organization as conducting business on behalf and in the interests of the Luxembourg company, that is, as a dependent agent of the Luxembourg company. Consequently, the court recognized the Russian organization as a permanent establishment of the Luxembourg company, and the payment of royalties to the Dutch sister company as inconsistent with reasonable business purposes.

Besides changing the treatment of the relations between the Russian organization and its affiliated foreign structures (effectively the grounds for tax reconstruction), the court advanced other arguments for its decision concerning the subfranchise agreement itself:

  1. The information containing commercial experience transferred to the Russian organization was publicly available (and therefore does not qualify as know-how);
  2. Permission to use the trademark was not required, since the rights thereto were exhausted by putting the goods into the commercial cycle in the RF.

Finally, in substantiation of the Russian organization's receipt of an unjustified tax benefit, the court indicated that the royalties received from the Russian organization were practically untaxed in either the Netherlands or Luxembourg.

At present we can only speculate as to how the Oriflame case may affect Russian law enforcement practice, however, it should be noted that any effect is unlikely to be positive. A significant portion of the professional community is critical of the court's approach to applying the doctrine of unjustified tax benefit in this case, as well as to the interpretation and application of Russian tax law and international tax treaties concerning the creation and taxation of permanent establishments of foreign organizations through so-called dependent agents. Specialists are also concerned by the way the courts are essentially diluting the entire notion of permanent establishments of foreign organizations (the established notions of when a foreign organization has a permanent establishment and how the tax base is formed), as well as the increasingly bad habit of courts of selectively applying OECD guidance on the interpretation of international tax treaties. All of this undermines the efficacy and predictability of the Russian tax system.

Time will tell whether these concerns are justified.