Development of court practice regarding application of the beneficial owner concept

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On 2 August 2017 the Commercial Court of Kaliningrad Region delivered its decision (the “Decision”) on NPO Digital Television Systems (the “Company”) (case No. А21-2521/2017). The Decision is currently about the only positive example of the most recent court practice of the Russian courts dealing with application of the concept of the “person beneficially entitled to income” (the beneficial owner concept).

As one could derive from the Decision, the Company raised debt financing from a company incorporated in Hong Kong under several loan agreements at 4% per annum. In 2012 the Hong Kong company used a claim assignment agreement to assign the debt claims to a Cyprus company. The loan interest rate was increased at the same time. The Company treated the accrued interest as its income tax expense.

In the tax authority’s opinion, the Company erred in including the interest in expenses, as the debt was “controlled”. It was also in the tax authority’s opinion, a company incorporated in Jersey and the parent to the Cyprus company was the actual recipient of the interest on the controlled debt. The tax authority held that the Jersey company, being the ultimate holding company of an international group of companies, coordinated the actions of the group companies, took decisions, bore risks and liabilities, including the liability to secure performance of the Russian entities’ obligations. So, from the economic perspective, the transferred funds were directly attributable to the Jersey company (also taking into account that the Company’s financials were included in the group’s consolidated financial statements).

Consequently, in the tax authority’s opinion, the Company should have withheld tax at the source at the tax rates of 20 percent for interest and 15 percent for that part of the interest that was recharacterized as dividends in accordance with the Russian thin capitalization rules.

The Company did not dispute that the debt qualified as controlled under the thin capitalization rules; however, it believed that the interest was attributable to the Cyprus company. For this reason, in the Company’s opinion, the Russia-Cyprus tax treaty, which makes it possible to avoid withholding Russian tax on income of foreign companies when paying interest, and enables application of the 5 percent or 10 percent tax rate on interest recharacterized as dividends must have applied.

In supporting the Company’s position the court relied in particular on the following circumstances:

  • According to the document furnished by the audit company, the Cyprus company spent the interest received on the loans in its day-to-day operations, and no dividends were paid to the ultimate holding Company (in Jersey).
  • The Cyprus company paid taxes on the accrued interest in accordance with Cyprus tax law.
  • It follows from the documents submitted to the case file that in 2011 the Cyprus company began to develop a separate line of business by providing financial and investment funds to different companies around the world.
  • The Cyprus company had an office and a sufficient staff of employees.
  • The tax authority did not succeed in proving that the Cyprus company could not independently use and dispose of the interest received.
  • The loan agreements in question did not contain any restrictive covenants and did not evidence that the Cyprus company was acting under an agency contract, a contract of delegation or commission, or fiduciary management.
  • The tax authority did not prove that the Jersey company accepted and bore the risks and liabilities, including the liability to secure performance of the Company’s obligations.
  • Taking into account the examples of conduit transactions mentioned in the Ministry of Finance of Russia Letter No. 03-00-R3/16236 dated 9 April 2014, the tax authority failed to prove that the Cyprus company transferred all or almost all of the interest and dividends received to the parent company incorporated in Jersey.
  • The tax authority was unable to prove that the Cyprus company received the loan funds from the Jersey company.
  • The consolidated financial statements of the Jersey company did not state that the Cyprus company was controlled and related.
  • The mere fact that the companies are affiliated or are included in the same group of companies is not a ground to consider the debt in question controlled by the group’s ultimate parent company.

Thus, the Company was able to convince the court that the Cyprus company was a real business dealing with provision of debt financing. In contrast, the tax authority failed to prove that interest on the loan funds was transferred to the Jersey company. This case is a rather exceptional example of a favorable court ruling in the context of the overall negative practice of the Russian courts on issues related to applying the beneficial owner concept.

The lawyers of Dentons’ Tax practice have considerable experience supporting tax audits on application of the beneficial owner concept and would be happy to assist in developing a defense strategy and appealing the tax authorities’ claims, and provide legal assistance in connection with restructuring international groups to minimize the risk of tax authority claims.