On 29 June 2016 the Commercial Court of Moscow rendered a decision in the case No. А40-178650/15-75-1487 under the application of Gazprombank JSC (the “Bank”). The decision contains a number of findings that in future may be used both by the tax authorities when conducting tax audits, and by taxpayers to assess their risks when acquiring debt securities from foreign counterparties, and also to determine and confirm the status of beneficial owner of income for the purposes of applying international treaties for the avoidance of double taxation (“DTT”).
In this case tax claims were brought against a Russian Bank as a tax agent which, in the tax authority’s opinion, failed to withhold tax on income at source at the rate of 20% upon payment of the cost of debt securities (Eurobonds) acquired on the secondary market from foreign entities without a permanent establishment in Russia. In the tax authority’s opinion, when the Eurobonds were acquired, in addition to proceeds from the sale of securities the Bank also paid to the foreign sellers accrued interest (coupon) income (“accrued coupon yield”) taxable in Russia.
The Commercial Court of Moscow agreed with this position of the tax authority, acknowledging that the Bank had incorrectly applied Article 309(2) of the RF Tax Code and treated the income of the foreign entities from the sale of Eurobonds as income from the sale of securities nontaxable in Russia.
The court arrived at this finding after supporting the following arguments of the tax authority:
- According to the sale and purchase agreements for the Eurobonds, amounts paid by the Bank to the foreign sellers were comprised of two parts: the sale price of the securities agreed by the parties (“active” income) and the accrued coupon yield (“passive” income). The amount of accrued coupon yield received by the foreign seller represents interest income taxable at source of payment and payable by the tax agent (the Bank).
- One may not uphold the Bank's argument that only a Russian entity actually owing a debt to a foreign lender (the issuer of the bonds) has the obligations of a tax agent, as it is irrelevant whether the entity paying the income is an actual debtor under the obligation or not; the Russian entity is required to perform tax agent's obligations when it pays income from a Russian source to a foreign entity. At the same time the court noted that accrued coupon yield is considered income in the form of interest and has a different legal nature in contrast to the “body” of the debt obligation (according to clauses 2 and 4 of Article 280 of the RF Tax Code in the version that was in effect in 2011-2012). The court found that Russian tax is payable both (i) on interest (coupon yield) payable by an issuer when a security is redeemed, and (ii) on accrued coupon yield which a foreign entity receives when it sells, or otherwise disposes of, a security.
- The Eurobonds acquired by the Bank certify the fact that a loan is provided precisely to Russian borrowers and not to issuers of record, as the latter exist solely to exercise a transit function when issuing Eurobonds to beneficial investors in the interest of Russian borrowers. That said there are no grounds to apply the exemption on tax on income at source according to Article 310(2)(8) of the RF Tax Code, as that rule applies solely to interest payments made from a Russian entity (the actual borrower under the Eurobonds) on the relevant dates to the issuer of record for the purposes of further distribution of such amounts among Eurobond bondholders.
- The Bank is not eligible to the tax benefits under the DTT since it failed to provide the tax authorities within the tax audit with tax residence confirmation with respect to the foreign sellers of the Eurobonds and documents confirming the beneficial owner status of the foreign Eurobond sellers with respect to such income. The fact that the Bank submitted tax residency certificates in the course of the court proceedings without providing documents confirming the foreign entities' beneficial owner status does not justify that the Bank was entitled to preferential taxation under the applicable DTTs.
At the same time, the court did not support the Bank's arguments that:
- The payment of coupon yield was actually represented a payment of a part of the price for the Bank to acquire the securities under the sale and purchase agreement and should be treated as payment of income from the sale of assets (Article 128 of the RF Civil Code and Article 309(2) of the RF Tax Code).
- The Bank cannot be considered the payer of interest income on Eurobonds as it was neither the lender nor the debtor (Eurobonds' issuer) under the debt obligations.
- Given the fact that the Eurobonds were issued by foreign entities (SPVs) , coupon yield payments under the Eurobonds cannot be considered as income from debt obligations of Russian entities and, consequently, from Russian sources (Article 309(1)(3) of the RF Tax Code),
hence from the tax perspective payment of such income should be considered rather as non-taxable income from sale of assets (securities) than payment of interest on debt obligations.
As can be seen from this case, the key issue considered by the Commercial Court of Moscow was the treatment of income paid when acquiring debt securities, both in the context of the provisions of the RF Tax Code, and in the context of interpreting the comments to Article 11 of the OECD Model Convention and the provisions of particular applicable DTTs.
In addition, this court case develops the practice of interpreting the concept of the beneficial owner of income (person beneficially entitled to income) both in analyzing structures for issuing Eurobonds, and in the context of entitlement to a tax benefit under a DTT when disposing of securities.