Are Russian 'thin capitalisation' rules applicable to relations between Russia and Cyprus
The Federal Arbitration Court of the Moscow Region delivers a remarkable decision on the Russia-Cyprus double tax treaty application
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In general, Russian tax legislation contains limits on deductibility for corporate profit tax purposes of certain types of expenses, including interest accrued on loans and credit. More specifically, it introduces “thin capitalisation” requirements: a 3/1 debt-to-equity ratio limit for loans granted (or guaranteed) by a foreign company that owns more than 20% of the borrower's capital directly or indirectly. If the debt-to-equity ratio exceeds this threshold, the Russian Tax Code restricts the deductibility of interest paid on the excess debt.
However, a number of double tax treaties entered into by Russia (which, in principle, have priority over Russian domestic tax law) allow Russian companies to benefit from more favourable terms and deduct a number of expenses (including interest on loans) without limitations under certain conditions.
Consequently, the double tax treaty concluded between Russia and Cyprus on 5 December 1998 (the “Treaty”) permits Russian companies to deduct interest paid under a loan agreement to a Cypriot contractor without applying Russian thin capitalisation rules. Even though this right of Russian taxpayers was previously confirmed by several court decisions1, on 18 November 2010, the Decree of the Federal Arbitration Court of the Moscow Region No. KA-A40/13648-10 (the “Decree”) denied the right to apply the afore-stated benefit for Russian companies with a sole Cypriot shareholder.
The position expressed by the court in the Decree is worthy of a detailed discussion of the relevant case.
Facts of the matter
According to the facts established in the Decree, a Russian closed joint-stock company (the “Russian company”) that is a 100% subsidiary of a Cypriot company (the “Cypriot company”) concluded a loan agreement (the “Agreement”) in 2006 with its sole shareholder. In 2007-2008, the Russian company accrued interest on the loan, including the full amount of the interest in the amount of expenses deductible for corporate profits tax purposes.
However, during a tax audit, the corresponding tax inspectorate of the Russian company stated that the interest accrued under the Agreement must be subject to Russian thin capitalisation rules and, therefore, could not be fully deducted by the Russian company.
The Russian company did not agree with the conclusions of the tax inspectorate (even though its debt-to-equity ratio exceeded 3/1). The argument of the Russian company was as follows:
— According to art. 269 of the Russian Tax Code, thin capitalisation rules are applicable when a company established in Russia has an outstanding debt to a foreign company.
— However, according to art. 24 of the Treaty, interest, royalties and other payments made by the resident of one contracting state to the resident of another contracting state should be deductible for corporate profits tax purposes in the first state on the same conditions as if the payments were being made to a resident of the first state (i.e. rules for deductibility of interest accrued in domestic relations should be applicable to cross-border relations between Russia and Cyprus);
— Therefore, as Russian thin capitalisation rules are applicable only to relations where the lender is a non-resident and are not pertinent to domestic legal relations, they may not be imposed on payment of interest to a Cypriot company.
Position of the courts
The case discussed has been considered by the courts of the first2, appeal3 and cassation instances. While the positions expressed in the decisions of the first two instances were nearly unanimous, and consistent with the conclusions made in court decisions delivered previously (referred to above), and were rendered in favour of the taxpayer, the Decree rendered by the cassation instance has completely changed the situation and supports the opinion of the tax inspectorate.
The arguments forming the conclusions of the Decree are, in our view, notable. They include the following statements:
— On the one hand, the court did not contest the argument that Russian thin capitalisation rules should not be applicable to interest paid under a loan agreement by a Russian company to its Cypriot shareholder according to the Treaty.
— On the other hand, the court referred to the definition of the notion of a “Russian enterprise” in the Treaty. According to this definition, a “Russian enterprise” means an enterprise carried on (i.e. governed) by a Russian resident.
— At the same time, according to art. 47 (3) of the Russian Federal law on joint-stock companies, all decisions under the authority of a general shareholders’ meeting in a one person joint-stock company shall be taken by the sole shareholder of the company (without convening a general shareholders’ meeting under an established procedure as in companies with two or more participants)4. Thereafter, according to the conclusion of the court, the sole shareholder should be treated as the superior managing body of the relevant joint-stock company5. This means that as in the particular case where the Russian company is governed by a Cypriot company, it may not be considered a “Russian enterprise” for the purposes of the Treaty. Therefore, the Treaty is not applicable to relations of the parties in question.
Potential impact of the Decree on your businesses
In principle, the arguments outlined in the Decree constitute an interesting case. Summing up the above, the Federal Arbitration Court of the Moscow Region has concluded that the Treaty should not be applicable to relations between a Russian subsidiary and its sole Cypriot shareholder (in particular, payments of interest under a loan agreement between such parties should not benefit from the provisions of the Treaty). However, this means that a Russian subsidiary with 99.99% participation of its Cypriot shareholder will benefit fully from all the provisions of the Treaty, which in principle breaches the non-discrimination clause of the Treaty.
Please note that even taking into account that the arguments of the Decree are stated clearly (and the position of the relevant court is, therefore, expressed), the Decree is not final: the relevant case has been sent to the Arbitration Court of the City of Moscow (first instance) for review. The relevant review must take place in the very near future, and we will monitor the situation closely and keep you informed.
However, it is very likely that as part of the upcoming review of the case, the Arbitration Court of the City of Moscow may choose to support the position of the superior judicial authority and will adhere to the position expressed in the Decree. We believe that in case the position expressed in the Decree will form a “quasi-precedent”, many groups operating in Russia through a Cypriot holding company may wish to make adjustments to their group structures accordingly.
1 See, for instance, Decrees of the Federal Arbitration Court of the Moscow Region No. KA-A40/9453-09-2 dated 23 September 2009; No. KA-A40/7211-10 dated 13 July 2010; No. KA-A40/7751-10 dated 28 July 2010; Decree of the Federal Arbitration Court of the Central Region No. A54-766/2010 dated 21 December 2010; etc.
2 Decision of the Arbitration Court of the City of Moscow No. A40-11308/10-20-113 dated 8 June 2010.
3 Decree of the 9th Arbitration Appeal Court No. 09AP-19128/2010-AK dated 2 September 2010.
4 An identical provision is provided for by art. 39 of the Russian Federal law on limited liability companies.
5 It is noteworthy that in the decision of the court of second instance with respect to the relevant case, the court stated that the Russian company is governed by its General Director (a Russian individual) and, therefore, should be treated as a “Russian enterprise”.
CMS, Russia can offer you the following assistance:
— review your group structure in order to identify potential options whereby your group’s current chain of ownership can be optimised;
— audit your current cost structure (existing or planned expenses) with a view to assisting you in defining the most suitable and efficient methods of financing or refinancing of your activities;
— audit your current contractual strategy and advice on choosing the most suitable and efficient contractual instruments;
— complete tax planning, draft and/or review of your existing agreements to achieve tax optimisation; and/or
— represent your company in disputes with tax authorities and/or contracting parties.
If you have any questions on the matters referred to in this RUSSIA TAX OUTLOOK, please do not hesitate to contact Dominique Tissot, Partner, and Anastasia Prozor, Associate, or your regular contact at CMS, Russia.
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