Despite actively developing cross-border economic, trade and customs law and adjusting to European standards and World Trade Organisation (WTO) principles, Russia has seen the adoption of court rulings that actually hamper foreign capital flow into the country. In January 2012 Russia's Supreme Arbitration Court (SAC) published a ruling that prohibits taxpayers with foreign capital from deducting the interest they pay on loans "with a foreign element". Apart from the prospect of reducing foreign investments, this ruling may already entail the additional assessment of considerable taxes on Russian borrowers when tax audits take place.

The Ministry of Finance has noted on a number of occasions that its priority in the sphere of taxes is to reduce the number of benefits that are granted by international double tax treaties. This trend directly affects foreign entities that invest in their Russian subsidiaries by making loans. Protocols have already been signed to the tax treaties with Cyprus, Switzerland and Luxembourg to allow for the application of national thin capitalisation rules – such rules limit the interest which may be deducted by a Russian borrower and provide for the remaining interest to be reclassified as dividends.(1)

With the protocols not yet in force, the tax authorities are increasingly trying to change the case law involving tax treaties by urging courts to take a different approach to interpreting them. A dangerous trend is that lately the courts have tended to support these attempts, whereas they used to advocate the priority of tax treaties over the limitations imposed by national legislation. Moreover, the tax authorities have won support at the highest judicial level. For instance, on November 15 2011 the SAC prohibited a taxpayer with foreign capital from deducting interest it had paid on loans "with a foreign element".(2)

Foreign investors may choose whether to finance their subsidiaries in Russia by investing in the issued capital or by granting interest-based loans. The second option is better for the investor in tax terms, because interest is deducted from taxable profit.

However, Russian legislation sets out certain limitations. Article 269(2) of the Tax Code limits the deductible interest for loans extended by a foreign participant (holding a share directly or through another company) or its related Russian company, as well as for loans secured by a foreign participant, where the loan exceeds the Russian borrower's net assets by a certain amount. In such cases the Russian borrower faces a number of adverse implications. For example, the interest payable to the creditor under such a loan is classified as a dividend and therefore may not be deducted from taxable profit.

These rules apply automatically – that is, irrespective of:

  • whether the Russian taxpayer has been found to be abusing the legislation;
  • the purpose of the loan; and
  • whether the terms of such loan are comparable to similar loans extended on the market.

The thin capitalisation rules apply only to companies with foreign participants (ie, where more than 20% of the capital directly or indirectly owned by foreign entities).

Russia is a party to more than 80 double tax treaties, most of which aim to rule out discrimination based on the 'origin of capital' and 'receiver of income' criteria (eg, treaties with Cyprus, Switzerland, the Netherlands, Germany and France). The first criterion essentially means that Russian companies whose capital is controlled in full or in part by a resident or residents of a foreign state should not be subject in Russia to any requirement which is more burdensome than the requirements to which other Russian companies with fully Russian capital are or may be subject. The second criterion means that interest paid to the resident of a foreign state should be deducted for tax purposes on the same terms as if it were paid to a Russian resident.

Until now, Russia's commercial courts have taken the approach that the non-discrimination provisions trump the Tax Code, including the thin capitalisation rules, by virtue of Article 15 of the Russian Constitution and Article 7 of the Tax Code.(3) This position was upheld by the SAC, which on a number of occasions pointed to the precedence of international treaties, including double tax treaties, over national legislation.(4)

Although in its Resolution 8654 of November 15 2011 the SAC ruled on a specific case, in light of the specifics and terms of the loan agreements that have been signed, it will affect the general approach of the regional commercial courts. Tax authorities will undoubtedly use this resolution whenever possible to impose additional taxes on Russian borrowers, taking the first opportunity during tax audits that are now in progress (with regard to the previous tax periods). This may result in the collection of considerable tax revenues for the state budget. The resolution does not contain a precedent-forming clause – the SAC's conclusions were reached in connection with a specific case, rather than by denying in principle the non-discrimination provisions of the tax treaties. Nevertheless, related foreign investors and Russian borrowers should consider carefully the terms of loan agreements to be signed and, if necessary, reconsider those that are presently in effect.

For further information on this topic please contact Julia Alexandrova at Pepeliaev Group by telephone (+7 495 967 0007), fax (+7 495 967 0008) or email ([email protected]).


(1) Article 269(2) of the Tax Code.

(2) The text of Resolution 8654/11 was published on the SAC's official website on January 10 2012.

(3) See, for example, Resolutions of the Federal Arbitration Court for the Moscow Circuit KA-А40/9171-11 (August 24 2011), KA-А40/4501-11 (June 23 2011), KA-А40/5322-11 (June 22 2011), KA-А40/14232-10-2 (December 13 2010), KA-А40/7751-10 (July 28 2010); Resolutions of the Federal Arbitration Court for the North West Circuit A26-6967/2008 (September 23 2009) and A56-19578/2006 (April 9 2007); and Resolution of the Federal Arbitration Court for the Central Circuit А54-766/2010 (December 21 2010).

(4) See, for example, Resolution 14163/05 of the Presidium of the SAC (April 18 2006).