Development of court practice on thin capitalization cases

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On 24 January 2017 the Commercial Court of Arkhangelsk Oblast delivered a judgement in case No. А05-9115/2016 (the “Judgement”) under the claim of Severnoye Siyaniye (Northern Lights) Oil Company Limited Liability Company (the “Company”).

The case is noteworthy because the tax authorities applied thin capitalization rules to a controlled transaction (a loan agreement) between a lender (a Cypriot company) and a borrower (a Russian company). This was even though the Cypriot company did not participate directly or indirectly in the Russian company and the parties to the loan relationship did not have a common holding company in order to be considered sister companies.

As follows from the Judgement, the court considered that in the periods of 2012-2014 being audited the Company should have withheld tax when paying loan interest to the Cypriot company at the 10% tax rate (the general tax rate on dividends under the Russia-Cyprus double tax treaty). The Company paid the disputed loan interest by assigning receivables under loan agreements to a third party (a Russian company) to the Cypriot lender, and by the Company issuing promissory notes to the Cypriot lender. As the value of the Company’s equity capital was negative throughout the period being audited, the tax authority treated the entire amount of the disputed interest as dividends under Article 269(2) of the RF Tax Code.

The court presented the following arguments in support of its position:

  • The application of thin capitalization rules contemplated by Article 269 of the RF Tax Code is intended to combat tax abuses in concealed distribution of dividends under the guise of paying interest between related parties.
  • The Russian taxpayer’s indirect dependence on the foreign company lender may be expressed in the very fact that both of the entities were controlled by a single center/parent company or a single individual, even if there was no direct relationship of subordination and control between the lender and the borrower (the holding of shares or participatory interests in charter capital).
  • The debt is controlled because throughout the period being audited the Cypriot company indirectly held more than 20% of the Company’s charter capital through family ties. A participant of the Company’s founder was the husband of the sole participant and attorney of the Cypriot lender.

The court’s position in this case could be disputed because completion of the challenged transaction does not fall under the grounds for applying Article 269(2) of the RF Tax Code (in the version in effect during the period being audited). Controlled transactions (loan agreements) between related parties are a ground to apply Article 269(1) of the RF Tax Code, but not Article 269(2) of the RF Tax Code. The existing practice of applying thin capitalization rules to loans between sister companies also does not apply, as the parties to the loan agreement did not have a common parent at any level of ownership. Such an approach by the inspectorate creates tax risks due to broad interpretation of the grounds for applying thin capitalization rules.

Dentons’ Tax practice team, based on considerable experience of applying thin capitalization rules obtained through advising, in structuring transactions and handling court disputes, are ready to assist you in correct application of the rules for accounting interest on debt obligations.