We would like to present the overview of the most important legislation changes in tax for 2016.
Practice of applying the beneficial owner concept develops rapidly.
2016 was marked by a breakthrough in the practice of applying the concept of the person beneficially entitled to income (the beneficial owner concept) as a legal mechanism for the Russian tax authorities to challenge the right of foreign recipients of income from sources in the Russian Federation (mainly dividends, interest and royalties) to apply preferential tax rates contemplated by double tax agreements, treaties and conventions.
What was previously perceived as a purely theoretical risk has become a reality. The cases of MDM Bank1, Bank Intesa2, Credit Europe Bank3, Severstal4 and Krasnobrodsky Yuzhny LLC5 clearly demonstrate that the negative trend of the Russian tax authorities challenging the validity of applying double tax treaties to multitier holding and financial structures that started in 2015 developed last year.
Analysis of the above-mentioned court cases shows that the tax authorities and the courts pay attention to the following factors when evaluating whether it is permissible to apply reduced rates and exemptions from tax at the source under double tax treaties, agreements and conventions:
- Whether the foreign recipient of income from a source in Russia transfers most of the income to an affiliate that is a resident of a different foreign jurisdiction (the payments are of a transit nature), and whether that affiliate would have received tax benefits similar in scope if it had received that income directly from the Russian company paying the income
- Whether such “transit” transfers are made after a brief interval of time from when the income is received on the bank accounts of the foreign recipient of the income
- Whether the formal recipient of the income has clearly expressed powers of an agent, commission agent, or representative of one or several entities with respect to the Russian income received
- Whether the foreign recipient of the income is bound by an obligation (whether contractual or corporate, including under an agreement between shareholders or applicable law) to transfer the income received to third parties
- Whether the formal recipient of the income uses that income (or a part thereof) for its own needs and whether its activity is financially dependent on financing from affiliated companies
- Whether the foreign recipient of the income has sufficient presence (offices, competent personnel, etc.) in the state of its tax residency corresponding to its declared functions
- Whether the recipient of the income performs one or more independent economic functions and whether it takes commercial risks that are usual for entities performing similar functions6
- Whether the governing bodies of the foreign recipient of the income (for example, board of directors, individual directors, etc.) are independent in deciding to distribute after-tax profits to participants/shareholders
- Whether the foreign recipient of the income accounts for the income received from sources in the Russian Federation in its own tax base and what is the effective tax rate of that income in the recipient’s country
- Whether the foreign recipient of the income is owned directly or indirectly by entities that are not tax residents of the country receiving the income
- Whether the recipient of the income has other sources of income and other income-generating assets in the Russian Federation
The tax authority and the court can use all of these circumstances—the recipient of the income not having a sufficient degree of presence at its location, the transit nature of the disposal of income received, the foreign entity that is the formal recipient of the income being controlled by third parties— as the basis for a decision to refuse to apply preferential tax treatment to income from sources in the Russian Federation that is established by an applicable tax treaty. That said, the Russian tax authorities feel no restraint in retroactively applying this approach within the three-year tax audit period established by Russian tax law.
The above-mentioned circumstances evidence that it is necessary to review existing asset holding structures and financial structures to see whether they meet the above-listed criteria. The price for ignoring this new trend could turn out to be too high.
Practical steps in implementing certain provisions of the Russian Finance Ministry’s Main Tax Policy Objectives for 2017 and the 2018 and 2019 Planning Period
It took the RF Finance Ministry less than a month to implement certain measures for improving tax administration and ensuring a balanced budget and revenues to the budgetary system envisioned by the draft Main Tax Policy Objectives for 2017 and the 2018 and 2019 Planning Period. The following measures that have found support among lawmakers and affect most groups of taxpayers particularly stand out:
Change in the penalty amount for late performance of tax payment obligations (Federal Law No. 401-FZ of 30 November 2016)
As of 1 October 2017 a differentiated procedure for calculating late payment interest for late performance of the obligation to pay taxes and levies (Article 75(4) of the RF Tax Code) will be introduced for corporate taxpayers, where, starting with the 31st day of delay, the late payment interest increases from 1/300 to 1/150 of the RF Central Bank key rate. The previous late payment interest rate applies to delays of 30 days or less.
Third parties can perform the obligation to pay tax (levy) (Federal Law No. 401-FZ of 30 November 2016)
Starting on 30 November 2016, the law has provided the opportunity for third parties to pay taxes and levies on behalf of taxpayers (Article 45(1) of the RF Tax Code). A similar provision for performing the obligation to pay social insurance contributions entered into force on 1 January 2017. The law does not clarify whether the taxpayer should or may agree on such payment with the third party in the form of a contract or in any other form, from which it can be concluded that such agreements of a mixed nature (civil-law and tax) between companies and even between companies and individuals are allowed.
Change in allocation of profit tax revenues between the federal budget and the budget of Russian Federation constituent entities (Federal Law No. 401-FZ of 30 November 2016)
In order to balance the budgets of Russian Federation constituent entities, for the period from 2017 through 2020 a different allocation of profit tax revenues between the federal and regional budgets is being introduced (Article 284(1) of the RF Tax Code). During that period the amount of tax to be credited to the federal budget will be calculated based on the 3% tax rate (previously it was 2%), and 17% to the regional budgets (previously 18%). The regional authorities have been granted the right to reduce the rate for tax received by the regional budget to 12.5% (currently to 13.5%), and the rate will become the maximum possible rate for residents of special economic zones (again, for the “regional” tax). This change obviously first and foremost affects taxpayers using reduced tax rates on money going to the regional budgets under the preferential tax regimes established by the laws of such Russian Federation constituent entities.
Limits on the amount of tax losses to be carried forward when calculating profit tax (Federal Law No. 401-FZ of 30 November 2016)
Amendments to Article 283 of the RF Tax Code limit in 2017-2020 the amount of tax losses generated in prior periods that can be used to reduce the tax base of the current reporting (tax) period to 50% of the tax base of that tax (reporting) period determined by the taxpayer without taking that loss into account (Clause 2.1 of Article 283 of the RF Tax Code). An exception to this rule is made only for certain groups of taxpayers receiving preferential terms and paying profit tax at reduced rates in accordance with Article 284 of the RF Tax Code. The law eliminates the time limit on carrying tax losses forward that was previously equal to 10 years.
Starting 1 January 2017 the amount of provisions against bad debts (Article 266 of the RF Tax Code) at the end of each reporting period should not exceed the greater of the following values: (i) 10% of the previous tax period’s revenue, or (ii) 10% of revenue for the current reporting period (previously not more than 10% of the revenue in the current reporting (tax) period). The amount of the cross obligation to the same contracting party is not included when creating the bad debts provisions for tax purposes.
New conditions for applying the property tax incentive to fixed assets that are movable property (Federal Law No. 401-FZ of 30 November 2016)
Starting in 2018 tax exemption with regard to the objects of movable property on the grounds contemplated by Article 381(25) of the RF Tax Code will apply only if the Russian Federation constituent entity enacts a law to this effect (Article 381.1 of the RF Tax Code).
The Kazanorgsintez case, or 50 shades of the appraiser’s report
Since progressive and modern transfer pricing rules have been introduced to the legislation, replacing Article 40 of the RF Tax Code, many tax disputes over a price have come down to ascertaining whether the transaction price corresponds to the market value determined by an appraiser.
It is precisely appraisers’ reports that became the key evidence that a price is at a arm’s length level in the court practice of the first five years of Section V.1 of the RF Tax Code being in effect, even though:
- Lawmakers clearly strove to decrease the appraiser's role in determining the price for tax purposes and put them last in the hierarchy of methods of determining a market price for tax purposes, limited the sphere of application to only one-off transactions and only in cases where transfer pricing methods cannot be used (Clause 9 of Article 105.7 of the RF Tax Code).
- Appraisal techniques rely not only on facts, but also on assumptions and are to a large degree subjective, so the market appraisal result is a priori relative and approximate, which is recognized by the higher courts.
The Moscow Commercial Court’s decision of 20 December 2016 in the Kazanorgsintez case is the crown in the “battle of appraisers” in court practice and an example of strong attention to detail in analyzing an appraiser’s report to determine the market price for tax purposes. The decision thoroughly states the methodological, mathematical and factual defects of the report by an appraiser hired by the opponent that were used in the report prepared by order of the adverse party.
We note here in particular two leading categories of transactions:
- In terms of the number of price disputes resolved on the basis of an appraiser’s report, real estate sale purchase and lease agreements The emphasis in this category of disputes is more on procedural aspects, such as the party submitting the appraiser’s report at all (other evidence may be deemed inadmissible); whether the appraiser is hired before or after transactions; when the taxpayer being audited or its counterparty hires the appraiser and the essential question is whether the comparables are appropriate.
- In terms of depth of analysis reflected in the judicial act, the share purchase agreement
What draws our attention to this category of cases is the scale of the discrepancies between the tax authority’s and taxpayer’s appraisal (by up to 6.5 billion times), and the varied approaches to appraising a business.
The increased attention to detail in such disputes sometimes results in attempts to declare as a company’s related parties a group of minority shareholders holding in aggregate 0.0014% of its shares; a person who played in a mini-soccer tournament organized by the company’s trade union, etc.
Also, appraisers’ reports are often used in practice to value intangible assets, but such cases are more rarely found in court practice. It is likely that as the approaches to valuing intangible assets, including assets that are difficult to value, improve at the OECD level, the number of such disputes will grow and the quality of determining consistency of the price of an intangible asset to a royalty amount will improve.
Right now it makes sense to work out in detail the substantiation of the position put forward in the appraiser’s reports in order to be ready to explain each methodological or mathematical action (adjustment) that was taken or not taken, relying on the facts, and not limit oneself to arguments such as “he’s an artist and that’s how he sees it.”
Range of people whose property can be foreclosed on for tax debts expands
The provisions of Article 45 of the RF Tax Code (the Tax Code) did allow in the past for the possibility of collecting tax debts through a court not from the delinquent taxpayer itself, but from third parties. At issue here are cases where a taxpayer organization owes tax following a tax audit and does not pay the tax for more than three months.
The possibility of foreclosing on third-party property is limited by a number of conditions that can be divided into two groups:
- The debtor organization and the third party from whom the debtor’s tax arrears can be collected must be related, and
- The taking of certain actions evidencing that money or assets are being dissipated (i.e. sold or otherwise transferred from the debtor organization’s assets and are therefore no longer available for foreclosure)
Previously execution could be levied only on the property of those organizations that were subsidiaries or dependent, or main companies with respect to the debtor. Dependence was defined according to criteria set by the civil legislation (more than 20% equity participation).
In 2013 the scope of application was expanded and it became possible to foreclose on the property of other organizations that could be deemed related based on other criteria widely used in tax law.
The federal law of 30 November 2016 set forth a new version of this rule. What at first glance is a minor amendment replaces the word “organization” with “person,” but at the same time opens up new prospects for collecting tax arrears. Apparently, now organizations’ participants or other individuals able to exercise actual control will be among those who could pay the organizations’ tax debts. This approach completely erases the boundaries of financial liability in relationships between business entities and their participants for tax purposes.
At the same time, editorial changes were made to the Tax Code making it possible for a third party to perform a tax payment obligation for the taxpayer. One cannot help but note that this change appeared amid the numerous criminal cases opened in 2015-2016 over tax evasion against individual participants of business entities and terminated according to the procedure of Article 28.1 of the RF Criminal Procedure Code. The thing is that in order to terminate the criminal prosecution, being an individual, the defendant must compensate the treasury for damage by paying taxes for the taxpayer organization. It was difficult to do this until the amendment was made, because it was thought that the duty to pay tax is personal and may be performed only by the taxpayer itself.
Evidently at the first signs of inability to collect arrears from organizations, the tax authorities will shift the burden of paying the tax to their participants (or beneficiaries), forcing them to “voluntarily” perform that duty under threat of criminal prosecution.
The erosion of the principle of dividing tax payment liability goes hand-in-hand with the stricter court practice of applying Article 45 of the Tax Code. Worthy of special note here is case No. А40-77894/15 considered in September 2016 by the Judicial Panel on Economic Disputes of the RF Supreme Court.
In that case the court declared it permissible to collect the tax debt of one business from another company that, making use of the personnel, client base and business contacts of the debtor taxpayer, began to carry on similar business. The novelty of this case is not that the court declared companies related based on signs that cannot be considered clear cut. Following the logic of the court, any company that distributes the same goods, purchasing them from the same source can be considered related. The precedent is dangerous in that the court entirely ignores those provisions of Article 45 of the Tax Code that limit the ability to collect tax debts from third parties to two cases: (a) when the debtor taxpayer sells goods (or realizes works or services) and the person related to it receives revenue from that sale, and (b) when one person transfers assets to a related person without consideration due to a threat of additional taxes being charged. The key element in both cases is the violation of the principle of equivalency when the debtor taxpayer has the right to consideration in the form of payment of money but does not exercise that right, instead creating conditions for the related person to receive either payment or savings.
The facts found in the case show that none of those situations occurred. The person from whom the tax authority attempted to collect another taxpayer’s debt received revenue from the sale of its own goods which it had purchased itself.
If we consider that the basis for collecting from the third party is not revenue but property transferred to it which, following the logic of the tax authority and the court, should be understood to include personnel, the client base and business contacts, then in this case the court entirely ignored the provisions of paragraphs 9 and 10 of Article 45(2)(2) of the Tax Code. According to those provisions, the amount collected from a third party is limited to the residual value of the transferred property according to the accounting records. Obviously, neither the client base nor business contacts are assets that are reflected in accounting, and they do not have an accounting estimate. As a matter of principle, personnel cannot be considered property, as they are employees who, showing foresight, seek a new job without waiting for the shutdown of operations caused by the tax claims. Thus, in the case considered here, no property that would have any residual value was transferred. Consequently, the tax authority had no grounds to demand the entire amount of the tax arrears from the third party. It turns out that if those types of assets had an objective valuation much lower than the tax claim amount, it would limit the amount of collection. By equating these attributes of business to assets not having a valuation, the court allows for full collection, which worsens the standing of the person against whom such a claim is brought.
It is not difficult to predict where such an expanded interpretation will lead. Undoubtedly it will find expression in uniform court practice. Easily overcoming the lowered evidentiary barrier, the tax authorities will collect debts from third parties without heeding the restrictions set forth in law, which, in turn, will lead to subsequent bankruptcies.
Changes in the IP BOX regime in Cyprus
On 4 November 2016 the House of Representatives of Cyprus approved changes to the existing preferential tax treatment of income from the exploitation and/or sale of intellectual property (IP BOX). The purpose of the adopted amendments is to align Cyprus tax law with the provisions of Action 5 of the BEPS plan and the new EU rules for taxation of comparable IP BOX tax regimes.
The current IP BOX tax regime provides for an 80% tax exemption on income from the use of intangible assets after deducting all direct expenses, such as amortization (more than five years) and interest expense, and also 80% of income from the sale of intellectual property. If there are losses, then only 20% of the losses can be transferred to other companies of the group or carried forward to future periods.
According to the transitional provisions, taxpayers applying the existing IP BOX regime may do so until 30 June 2021 for intangible assets that were acquired:
- before 2 January 2016; or
- directly/indirectly from an affiliate between 2 January and 30 June 2016 (and the affiliate should also have applied the IP BOX tax regime to such assets); or
- from an independent party or developed between 2 January and 30 June 2016.
If items of intellectual property were acquired directly or indirectly from an affiliate during the period between 2 January and 30 June 2016 and they do not fall under the above provisions, then the transitional period for such companies is limited to 31 December 2016.
The updated IP BOX tax regime applies to assets created after 30 June 2016. Such assets should be acquired, developed or used in the Cyprus company’s activity as a result of research and development done by the Cyprus company itself. The intellectual property also needs to be used in the company’s activity and generate annual gross income of not more than EUR 7.5 million, or EUR 50 million if the income is generated by a group of companies. Intangible assets to which the updated IP BOX regime applies are patents, computer programs and other intellectual properties that are not obvious, useful and new. Preferential tax treatment will not be granted to “marketing” intellectual properties, in particular, to trademarks, images, etc.
A company applying the IP BOX regime will have to keep track of income and expenses for intellectual properties for which the tax benefits are granted. Such accounting should make it possible to determine a connection between the income from the intellectual property (to which the IP BOX tax regime applies) and costs related to that property.
The changes will affect the ability to enjoy Cyprus IP BOX tax benefits. However, there are new opportunities for structuring intellectual property ownership through the Cyprus jurisdiction, in particular, by concentrating a staff of employees developing intellectual property in Cyprus, which is already reflected in practice, especially in IT-industry. Changes to IP BOX tax regime seem most interesting for IT investors specializing in the development of software, computer games, in IT consulting and other industries associated with the sale of intellectual property rights.
Development of practice in unjustified tax benefit cases
In 2016 the Russian Federation Supreme Court rendered two judicial acts summarizing the approaches formulated in court practice when considering cases of unjustified tax benefit. At the same time, the RF Supreme Court formulated several key conclusions which, as can be expected, should bring greater clarity to considering this category of cases.
These are cases А40-71125/2015 (the Tsentrregionugol LLC case) and А40-87379/2014 (the Energokomplekt LLC case). Although the taxpayer won the first case and the tax authority won the second case, both cases essentially combine a common approach of the RF Supreme Court’s Judicial Panel on Economic Disputes to considering cases of unjustified tax benefit.
Both cases were about supply of goods involving suppliers that did not have the necessary resources (warehouses, transport and employees) to engage in supplies.
In considering these cases the RF Supreme Court’s Judicial Panel on Economic Disputes put the question of the reality of the economic transactions completed by the taxpayer first. In the Tsentrregionugol LLC case (Ruling No. 305-KG16-4155 of the RF Supreme Court’s Judicial Panel on Economic Disputes of 20 July 2016), the RF Supreme Court’s Judicial Panel on Economic Disputes also emphasized that the tax authority should bear the burden of proving the transactions are not real.
In this case the fact that the supplies were real was confirmed both by documents (source documents, confirmations of product quality, evidence of movement of the product from suppliers to customer) and by facts (confirmation of resale of the product to end customers and testimony of contracting parties who confirmed delivery).
At the same time, the court declared that the handwriting examination report submitted by the tax authority confirming that the supplier’s source documents had been signed by an unidentified person was inadmissible evidence. The reason for this was that the examination had been carried out without following the methodology.
On the contrary, in the Energokomplekt LLC case (Ruling No. 305-KG16-10399 of the RF Supreme Court’s Judicial Panel on Economic Disputes of 29 November 2016) the court shared the tax authority’s position that the supplies were not real. The reason for this was the consistent discrepancies in the documents evidencing that the documents were made formally only to obtain a tax benefit, as the movement of product reflected in them was economically unprofitable and, in some cases, even unrealistic.
As the appellate court ruling in this case shows, no warehouse was found at the address indicated in the documents, and the product was transported from Magnitogorsk and Novokuznetsk to Leningrad Oblast, then in the opposite direction to Samara, for which there were no rational economic reasons. It took just one day to ship the product from Leningrad Oblast to Samara, which is impossible for objective reasons. Furthermore, the contracting parties did not incur expenses typical for activity for supplying goods (payment for fuel and lubricants, lease of premises, payment of wages to movers and drivers).
As the RF Supreme Court’s Judicial Panel on Economic Disputes stated in the Tsentrregionugol case, in refuting the argument that the taxpayer did its due diligence, the tax authority should prove that the taxpayer knew of the violations by the contracting parties. The taxpayer in turn can clarify how it checked the contracting party’s ability to perform the contract.
When considering the issue of whether the taxpayer showed due diligence, the question of carrying out standard actions to check the contracting party was essentially put on the back burner. The RF Supreme Court’s Judicial Panel on Economic Disputes gave two other factors greater importance.
First of all, the court considered the issue of whether the terms of the transaction corresponded to usual (market) terms. In the Tsentrregionugol LLC case the RF Supreme Court’s Judicial Panel on Economic Disputes emphasized that the price at which the taxpayer purchased the product corresponded to the market price, while in the Energokomplekt LLC case the court noted the lengthy payment installments which it apparently considered a nonstandard transaction term.
The second factor was the evidence that the taxpayer was complicit in the actions of its contracting parties. The tax authority was unable to prove this in the Tsentrregionugol LLC case. In addition, the RF Supreme Court’s Judicial Panel on Economic Disputes once again emphasized that the taxpayer should not be liable for the actions of contracting parties of the second and third levels which it is unable to influence. So the violations by the contracting parties (including nonpayment of taxes) cannot result in negative consequences for the taxpayer.
In the Energokomplekt LLC case the tax authority proved the taxpayer’s affiliation with its supplier and with the foreign customer. However, this fact was not reflected in the judicial act of the RF Supreme Court’s Judicial Panel on Economic Disputes.
Thus, the judicial acts rendered by the RF Supreme Court have shown that a taxpayer can win unjustified tax benefit cases. At the same time, it follows from the judicial acts that the court gave decisive importance to examining the circumstances of the transactions. So it should be expected that not only the courts but also the tax authorities will pay more attention to determining the facts in such cases at the tax audit stage.
Formation of court practice on the use of cash pooling
Last year, for the first time the courts gave a legal evaluation to the deductibility of interest on debt obligations arising due to a company’s participation in a cash pooling system, which is understood to be a system for managing available cash on the bank accounts of companies controlled by major multifunctional holdings that have an extensive network of branches, structural subdivisions or subsidiaries.
In particular, in April 2016 the Arbitration Court of Chelyabinsk Region recognized economically justified a system of revolving loans existing under cash pooling agreements concluded between Gazprom Neft LLC, its subsidiaries and credit organizations (the Gazprom Neft Chelyabinsk LLC case, No. А76-15351/2015).
It follows from that judicial act that the tax authority’s claims to Gazprom Neft Chelyabinsk LLC (the “Company”), which is a wholly-owned subsidiary of Gazprom Neft OJSC (the “Parent Company”), consisted in the fact that, in the tax authority’s opinion, the Company’s actions were not economically justified in issuing the Parent Company short-term loans at a lower interest rate than the rates at which the Company itself paid interest on loans raised from the Parent Company in the same periods.
When considering the case, the court established that the Company’s issuance of short-term loans to the Parent Company was done as part of a cash pooling system providing for the accumulation on the Parent Company’s accounts of cash funds from subsidiaries, including the Company, and redistributing those funds as needed among all subsidiaries using the revolving loan arrangements. The court shared the Company’s position that the cash pooling system makes it possible to reduce substantially expenses associated with raising short-term loans from credit organizations offering higher interest rates, allows to effectively control cash flows within the group of companies, and to minimize the group’s credit risks related to raising bank loans. The court also took into account that the use of the cash pooling mechanism was specifically set forth in the Gazprom Neft group’s treasury policy.
At the same time, the Company demonstrated to the court that it raised debts from the Parent Company on long-term financing principles and this was intended to achieve investment objectives, namely, for the Company to acquire a chain of filling stations and tank farms. Among other things, the Company was able to prove that:
- profit earned by the Company in the ordinary course of business was insufficient to achieve these capital investment objectives;
- raising the long-term loan and spending it on investments resulted in an increase in the Company's key production and financial performance indicators, growth in the number of its employees, increase in the Company’s revenue and, as a consequence, in the amount of taxes paid by the Company;
- the loans granted by the Company as part of the cash pooling system, and the loans granted to the Company in order to solve investment objectives differed considerably in terms of their purposes (targeted financing of a long-term investment program and short-term placement of available cash) and repayment periods, which made it impossible to directly compare the interest rates on those categories of loans.
As a result, despite the difference in interest rates, the court recognized that the Company had lawfully deducted interest expenses on the loans granted by the Parent Company in full, thereby indirectly confirming the possibility of using the cash pooling system in a Russian tax regulation context.
When the tax authority appealed this judicial act in the court of appeal the higher court did not see grounds to reverse the decision of the court of first instance and allow the appeal (Ruling No. 18AP-7177/2016 of the 18th Commercial Court of Appeals of 4 July 2016), and the tax authority decided not to file a cassation appeal.
In noting the importance of this judicial act for the development of the practice of cash pooling in Russia, one should nevertheless bear in mind that in this decision the court relied on a quite extensive body of evidence showing that there was real economic substance and transparency in the transactions. One may suppose that without such evidence the court’s conclusions on whether the deductibility of the disputed interest was legitimate could have been fundamentally different.
The Aquapark case, or who can check prices in transactions and how
The RF Supreme Court’s handing down of the ruling of 1 December 2016 in the Aquapark case marked the end of the first five-year period of applying the transfer pricing rules contemplated by Section V.1 of the RF Tax Code. During this transitional period from Article 40 of the RF Tax Code to Section V.I of the RF Tax Code there were two particularly sensitive questions:
- are the local tax authorities allowed to check the price?
- how can the market price be determined for tax purposes?
2016 yielded answers to both of these questions which were developed further in early 2017 in the Review of Court Practice approved by the RF Supreme Court (the “Review”):
- Generally, they are not entitled to check the price. However, if the transaction price (as the RF Supreme Court put it in 2016 “by many times, materially and markedly” — the Review only expressly mentions the criterion of multiplicity) diverges from some market (normal) price, then that price may be evidence of price manipulations resulting in an unjustified tax benefit.
- The first stage of development of the “new” transfer pricing rules passed under the sign of universal use of the appraiser’s report as key evidence that a transaction price corresponded to the arm’s length value. There was scant practice of directly applying transfer pricing methods. At the level of the economic panel of the RF Supreme Court five cases that were based on an appraiser’s report were considered (Mitrix Limited, DTs Minayevskiy, Office Realty, Vnukovo-9, and the Aquapark case already mentioned here), and two cases were considered in which the market price was determined using transfer pricing methods (Aton, Stavgazoborudovaniye).
If the score at the Russian Supreme Court level is “5:2” in favor of the appraisers, the score is even more devastating in the practice of the lower courts, where it was the exception and not the rule to apply or even justify not applying transfer pricing methods.
- Most cases, including the five listed above, considered by the Russian Supreme Court had to do with real estate, where transactions can be considered one-off transactions (clause 9 of Article 105.7 of the RF Tax Code), and this can be used to justify the validity of using the appraiser’s report.
- All the practice of the first five years was formed either in applying Article 40 of the RF Tax Code or in so-called uncontrolled transactions, in other words transactions in which Russia’s Federal Tax Service doesn’t have the right to check the price, but the local inspectorates make it look like they are controlling not the price as such, but the calculation of the tax based on the substance and not the form of the transactions. In this context a clearly nonmarket price is one of the criteria of the parties to the transaction getting an unjustified tax benefit from engaging in such transactions.
However, the following is illustrative:
- Both the tax authorities’ choice of challenging primarily one-off transactions (transactions involving real estate, shares/participatory interests, and much less frequently involving intangible assets)
- and the fact that the tax authorities and the courts, while they have perceived the very possibility of controlling prices in transactions that the law does not treat as controlled transactions, do not however use the tools provided by law, i.e., the transfer pricing methods themselves, to check pricing in controlled transactions.
As a result, a situation is created in which the law and the practice of applying it to controlled and uncontrolled transactions are diverging, where:
- Transfer pricing methods set forth in the law and based on international approaches are applied to controlled transactions (conventionally transactions of multinational and major Russian companies)
- The transfer pricing rules established by law are essentially not applied to uncontrolled transactions (conventionally transactions of small and medium-sized Russian companies), and the price in those transactions is determined based on appraisers’ reports, cadastral value, and sometimes just common sense.
The Russian Supreme Court attempted to bridge this gap in its Review. We will write about what comes of this in the Top 10 for 2017.
Change in the procedure of VAT taxation of e-Services provided by foreign companies
Federal Law No. 244-FZ of 3 July 2016 substantially amended Article 148 of the RF Tax Code and a number of other provisions of the code aimed at adjustment of the place of supply rules for VAT purposes as applied to the electronic Services provided by foreign companies (“e-Services”), and of other tax aspects of providing e-Services. The major part of the new law’s provisions entered into force on 1 January 2017.
Two key points that have radically changed the procedure of VAT taxation of e-Services can be outlined as follows:
- Setting of a separate list of e-Services (clause 1 of Article 174.2 of the RF Tax Code). Now e-Services are in a separate category of services specifically addressed in Article 148 of the RF Tax Code. If previously VAT was not charged in Russia on some of the services that are now in the list of e-Services, starting 1 January 2017 all such services are subject to VAT if the customer is located in Russia. Almost all possible forms of work, services or provision of rights to IP via the Internet (including selling of computer programs, facilitation in conclusion of deals, processing, storing and sorting of information, provision of domain names, hosting services, etc.) are on in the list. The following services were specifically left out of the list of e-Services:
- Supply of goods, performance of work, provision of services ordered online without using the Internet;
- Selling of computer programs (including games) on tangible media;
- Providing advisory services by email;
- Providing Internet access services.
- Setting of a special procedure of performing the liabilities to pay VAT on e-Services. First of all it should be noted that the amendments have not affected how e-Services provided to companies and entrepreneurs are taxed. VAT on such services is withheld by the tax agent at the source of payment. As for e-Services provided to individuals who are not entrepreneurs, VAT is charged on such services, if those individuals carry out activity in Russia. A person is considered to carry out activity in Russia if he or she (1) resides in Russia or (2) uses a Russian bank account for purchasing purposes, or (3) purchases services using a Russian IP address or (4) a Russian telephone number. The general rule is that in order to comply with their VAT obligations foreign companies providing e-Services are required to obtain special tax registration. Upon registration a foreign supplier receives a taxpayer identification number and access to the taxpayer’s online account through which it files tax reporting related to provision of e-Services (a special form of VAT return and transaction registers). The Code also provides for a special way of paying VAT if an intermediary collects payments from the customers on behalf of the supplier. In this case the intermediary acts as the tax agent and remits tax to the budget.
The tax rate on e-Service-related transactions is 15.25%. The tax base is calculated as the cost of the service determined based on its actual (i.e., set in the contract) selling price. The tax base is determined on the last day of the quarter in which payment (or partial payment) for the service was received. Currency proceeds are converted into rubles on the same date.
Change of thin capitalization rules
In 2016 the RF Supreme Court issued a precedent-setting decision by clarifying the procedure for applying thin capitalization rules to interest on controlled debt when a lender is a Russian company. The court supported the taxpayer's position and stated that reclassification of interest into dividend and its subsequent taxation at source under Article 269(4) of the RF Tax Code (in the version in effect until 2017) do not apply if there is no evidence of a disguised dividend payment (RF Supreme Court Ruling No. 305-KG15-14263 of March 18, 2016, in the Novaya Tabachnaya Kompaniya LLC case).
The court noted that Chapter 25 of the RF Tax Code does not contain provisions according to which dividends not received could be treated as taxable income, thus, withholding taxation at source would result in double taxation, and the absence of rules eliminating double taxation and existing legal uncertainty should be interpreted in the taxpayer’s favor. As a result, the Supreme Court ruled that for interest accrued under a debt obligation to a Russian lender, the only consequence should be limiting the deduction of interest contemplated by Article 269(3) of the RF Tax Code, and a borrower should not act as a tax agent when paying interest to a Russian lender. This position applies to cases where there was no disguised payment of dividends to a foreign company.
Previously, in most similar disputes, commercial courts supported the position of tax authorities, agreeing with reclassification of interest into dividends and the need of consequent withholding taxation at source.
In addition, the Federal Law No. 25-FZ of February 15, 2016, introduced changes to the definition of controlled debt. As of January 1, 2017, an unpaid indebtedness of a Russian company under the following debt obligations is considered to be controlled:
- under a debt obligation to a foreign related party that directly or indirectly participates in the borrower;
- under a debt obligation to a party considered related to the above mentioned foreign party;
- under a debt obligation in which the above mentioned foreign party and/or its related party acts as a warrantor, guarantor or otherwise secures the borrower’s debt obligation.
Debt that does not formally fall under the new rules may also be considered controlled if a court considers that the ultimate objective of payments under debt obligation is a payment to the above-mentioned companies.
Starting from 2017, the threshold of a foreign participation in a Russian company’s capital to consider a loan to be controlled has been raised from 20% to 25%, since interdependence of parties is now determined in accordance with the provisions of Article 105.1 of the RF Tax Code. Moreover, pursuant to the same provision, loans granted by individuals can also be considered as controlled debt, which previously was out of thin capitalization’s scope.
- debt to Russian entities if a Russian lender does not have comparable unpaid debt to a foreign entity (the comparability criteria are stipulated by the law), and the lender has provided the relevant written confirmation;
- debt to a foreign SPV arising in connection with placement of marketable bonds, provided that SPV is incorporated in a country with which Russia has a double tax treaty;
- as of January 1, 2016 debt to independent banks (whether Russian or foreign), provided that neither the principal nor the interest were repaid by a foreign entity related to the Russian borrower, or a party related to that foreign entity.
Other important changes in the rules:
- the maximum interest for previous periods is not recalculated if a capitalization rate changes as compared to previous reporting periods;
- the amount of controlled debt includes sums of controlled debt that arose under all obligations in aggregate.