On February 15, 2016 the President of the Russian Federation signed Federal Law No. 25-FZ on Amendments to Article 269 of Part Two of the Russian Federation Tax Code with Respect to Defining the Term Controlled Debt (hereinafter the “Law”).
The Law substantially changes the rules for deducting interest expense under thin capitalization rules that are aimed, as the Law’s authors have stated, at combating tax abuses, in particular, those arising in so-called back-to-back financing, and at eliminating unreasonable tax barriers to raising financing for the Russian economy.
The most awaited change was the reflection in the Law of the approach already used in court practice according to which debt not only to Russian but also to foreign affiliates of the foreign company that is a direct or indirect owner of an equity interest in the borrower is considered controlled debt. That said, the threshold for direct or indirect equity interest in the borrower above which the debt is considered controlled has been raised from 20 to 25% (by citing art. 105.1 of the RF Tax Code, which sets precisely this threshold as a criterion for relatedness).
The Law provides three important exceptions from thin capitalization rules that have been actively discussed in the expert community in recent years.
Exception No. 1. Loans issued by independent banks that are guaranteed by related parties and discharged without applying interim measures
Already as of January 1, 2016 loans from independent banks (whether Russian or foreign) are no longer considered controlled debt if they are guaranteed:
- by a foreign entity that directly or indirectly holds more than 25 percent of the Russian debtor company (the “Foreign Entity”);
- or by its related parties (i) in which the Foreign Entity directly or indirectly holds more than 25 percent, (ii) which directly or indirectly hold more than 25 percent of the Foreign Entity, (iii) in which and in the Foreign Entity the same person holds more than 25 percent (“Related Parties”),
if neither the Foreign Entity nor the Related Parties have actually discharged the secured loan itself or paid the loan interest.
Exception No. 2. Debt obligations issued by Russian tax residents not from the Foreign Entity’s funds
As of January 1, 2017 debt obligations of Russian taxpayers to other Russian tax residents that are related to a Foreign Entity (a “Russian Resident”) are not considered controlled debt if the Russian Resident does not have debt obligations to the Foreign Entity comparable to the taxpayer’s outstanding indebtedness to the Russian Resident.
If the Russian Resident has comparable debt obligations to the Foreign Entity, then only the part of the outstanding indebtedness to the Russian Resident that does not exceed the amount of the comparable obligation to the Foreign Entity can be considered controlled.
For the purposes of applying thin capitalization rules, the comparability of a taxpayer’s debt obligations to a Russian Resident and of a Russian Resident to a Foreign Entity are defined differently than for transfer pricing purposes: on the basis of an exhaustive list of criteria consisting of three items:
- the total amount (in other words, if there is more than one debt obligation they are summed up for the purposes of determining comparability);
- the term: if the term of the taxpayer’s debt obligaion to the Russian Resident is not longer than the term of the debt obligation to the Foreign Entity, then the terms are considered comparable;
- if the currency of the debt differs, then the obligations are converted into a single currency at the RF Central Bank exchange rate on the date the obligation arose.
Exception No. 3. Debt arising in connection with the issuance of Eurobonds
An express rule that outstanding indebtedness under a debt obligation that arose in connection with the placement of Eurobonds to a foreign SPV located in countries with which Russia has double taxation treaties is not considered controlled enters into force as of January 1, 2017.
The most ambiguous novelty of the Law could be the fact that as of January 1, 2017 the court is entitled to deem as controlled debt any outstanding debt obligation of a taxpayer if it is determined that the ultimate purpose of the payments under the debt obligation is to transfer funds to a Foreign Entity or Related Party.
It should also be noted that the Law does not contain a rule eliminating in any event double taxation of “above-limit” interest payable by a Russian taxpayer to another Russian company on debt that is deemed to be controlled (at the source as dividends and for the recipient as interest income), in spite of the need to introduce such a rule as experts have numerous times emphasized.