Russia's Tax Code includes thin capitalisation rules which limit or disallow the deduction of interest paid by a Russian company which fails to meet the prescribed debt-to-equity ratio. In relevant cases Russian companies have resisted challenges by the tax authorities to the deductibility of interest by invoking the non-discrimination clause of a relevant double tax agreement, and until recently the Russian courts have upheld their contention that the non-discrimination provisions established by double tax agreements prevail over the thin capitalisation restrictions contained in national legislation. However, in a recent case (Number KA-A40/13648-10 of 18 November 2010) on the issue the Arbitration Court of Moscow region found in favour of the tax authorities and ruled that the taxpayer in question, a company which was the wholly-owned subsidiary of a Cyprus parent company, was ineligible for treaty benefits.
Following a tax audit of the Russian subsidiary, the deduction of interest on loans made by the parent company was disallowed on the grounds that the interest was on a controlled loan and in excess of the amount deductible under the Tax Code. The investee company claimed that the interest should be deductible on the basis of the non-discrimination clause of the Cyprus/Russia double tax treaty. The tax authorities rejected this argument. In their view, the Russian investee was not covered by the non-discrimination clause because it should not be treated as a Russian enterprise for the purposes of the treaty. On the basis of clause 1(e) of Article 3 of the treaty, which provides that the term “enterprise of a Contracting State” means an enterprise carried on by a resident of that contracting state, they contended that the Russian investee should be treated as a Cypriot enterprise for treaty purposes, as it was 100% owned and controlled by its Cyprus-resident parent company.
The company litigated against the authorities’ stance and both the court of the first instance and the appeal court rejected the tax authorities’ arguments that it should not be regarded as a Russian enterprise for treaty purposes. However, the tax authorities appealed to the Federal Arbitration Court (cassation instance), which accepted their arguments, annulled the decisions of the lower courts and remitted the case to the first instance court for a new hearing.
The decision of the Federal Arbitration Court appears to have been based on Article 47 of the Joint Stock Company Law, which provides that “The highest management body of a company shall be the general meeting of shareholders.” It therefore determined that management was exercised by the parent company in Cyprus rather than the general director in Russia and that the company was a Cypriot enterprise. The court’s ruling does not provide any information on why it came to this conclusion, and in particular on how the company was managed in practice.
It is too early to say whether this is a one-off aberrant decision or whether the same reasoning will be applied in other cases. It does illustrate the need in all cases to establish that there is no discrepancy between the form and the substance of transactions and arrangements, and that companies are demonstrably managed and controlled from where they claim to be. It further underpins the global trend of tax jurisdictions worldwide requiring companies to have a necessary degree of business substance in the jurisdictions where they are active, rather than existing merely for the purpose of gaining access to double tax treaty benefits.
This is in fact also our position and advice to clients before proceeding with the establishment of Cyprus companies and structures involving investments into Russia. Cyprus also follows the ‘substance over form’ and ‘business purpose test’ doctrines which allow the Cypriot tax authorities to recategorise an artificial or fictitious transaction or structure.
Moreover, the Assessment and Collection of Taxes Law, which was amended to transpose the EU Mutual Assistance Directive 77/799/EEC into domestic legislation, contains general anti-avoidance rules under which the Commissioner of Inland Revenue may disregard artificial or fictitious transactions and assess the person concerned on the proper object of tax. The provisions apply to local or international transactions, and to residents and non-residents.
Finally, Cyprus’s own rapidly developing body of anti-avoidance legislation is aimed at denying companies without any significant business substance or commercial rationale for existing in Cyprus, (i.e. mere letterbox or brass-plate companies) the benefits available under the island's tax laws and double tax treaties. Where an intermediate holding company is superimposed on operating companies merely to obtain savings in withholding taxes, the tax authorities may be able to set aside the structure by applying a general anti-avoidance doctrine. In this respect ‘substance over form’ issues should be considered carefully in order to avoid any possible challenge by the tax authorities using the general anti-abuse legislation. We shall monitor the situation and keep our clients and contacts informed about developments.