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Having worked within the industry for many years, Advocate’s cabinet of Mr. Andrey Konkov together with team of LLC DSL-Service, Russia, would like to introduce our first of forthcoming number of articles focusing on tax planning and doing business in Russia.
Tax exposure from using foreign conduit companies in the Russian Federation
The following article is concerned with increasing tax exposure from using foreign conduit (transit) companies at tax planning in the Russian Federation.
As it is defined in OECD Glossary of Tax Terms, conduit company is a company set up in connection with a tax avoidance scheme, whereby income is paid by a company to the conduit and then redistributed by that company to its shareholders as dividends, interest, royalties, etc. (http://oecd.org/ctp/glossaryoftaxterms.htm).
The Russian Ninth Arbitration Appeal Court in its Judgement of 28/10/2011 in case No. А40-1164/11-99-7 defined conduit company as the “company used for transfer and transformation of revenue for purposes of reduction of its tax obligations in the field of international economic transactions”.
Usually conduit companies are set up in low tax jurisdictions (tax heavens) or in jurisdictions, which enjoy relevant double taxation avoidance treaties (DTA), enabling them to transfer revenue from the place of doing business at the reduced rates.
Generally, in order to avoid a foreign company to be considered conduit, it is essential for the company to comply with the following criteria:
- company must have self-sustained economic expediency, own assets, in other words, substance, i.e. it must not be used for tax optimization purposes only (treaty shopping);
- company must have a place of management (real office) and real, preferably not nominal, management bodies, in other words, the management of the company must be carried out from the place of its incorporation and not from the Russian territory;
- company must be an actual recipient of revenue and have a right to dispose such revenue;
- individual, who is an ultimate beneficiary of the company, must pay taxes at the receipt of the income from such company.
By way of illustration, we may peruse the most simple and widespread in the Russian Federation scheme of Russian business entity ownership through the chain of Cyprus-British Virgin Islands (BVI) companies, wherein a Cyprus entity acts as a transmitter for transfer of revenue to BVI entity (actual recipient of revenue).
There is Agreement for the avoidance of double taxation with respect to taxes on income and on capital of 05/12/1998 with Protocol of 07/10/2010 thereto (altogether referred to as the Agreement) between Russia and Cyprus, contemplating significant benefits/low rates/reliefs for revenues paid from the Russian sources.
Russian case law analysis shows that benefits/low rates/reliefs, contemplated by DTA, including the foregoing Agreement, in particular Article 29 “Limitation of Benefits” thereof, are not applied to the revenues paid from the Russian source, if such revenues are paid within transaction or series of transactions, carried out in a manner that a foreign entity (conduit company), claiming benefit, forwards directly or indirectly all or almost all revenue to other entity, which would not be entitled to claim benefitunder the relevant DTA, if such revenue would have been paid directly to such other entity, i.e., in our case, if a Russian entity would pay revenue directly to the BVI company, without a Cyprus transmitter.
In other words, benefits/low rates/reliefs for revenues paid from the Russian sources apply only if a company – resident of foreign state, with whom the Russian Federation had executed relevant DTA, is an actual recipient of the revenue.
Therefore, payment of dividends/interest/royalties by the Russian entity to the Cyprus entity, which transfers payment further to the BVI entity (e.g. as a loan repayments, payment of interest or dividends), jeopardizes the Cyprus entity’s right to claim relevant benefit under the Agreement, risks application of thin capitalization & transfer pricing rules and thus an additional charge of tax on the Russian entity.
The same approach is being implemented under the Russian Federation Government Decree No. 84 of 24.02.2010 “On conclusion of international agreements on avoidance of double taxation and prevention of tax evasion on income and property taxes”. As a vivid example of such approach, we may mention the Agreement on avoidance of double taxation and prevention of fiscal evasion regarding profits taxes executed between Russia and Hong Kong on 18/01/2016.
Other examples of tax consequences arising out of using of conduit companies in tax planning are set out in the Ruling of the Presidium of the Supreme Arbitration Court of the Russian Federation of 15/11/2011 in the case of JSC “UK” Severny Kuzbass” No. А27-7455/2010 (https://kad.arbitr.ru/Card/04154295-3f19-4e9b-9d24-fdd4a274cac7)i and the Judgement of the Arbitration Court of Moscow District of 30/10/2015 in case No. А40-16883/15 (https://kad.arbitr.ru/Card/5b461e02-8295-4e7c-8ada-c5ce2a4dcdcf)ii.
In the foregoing judgements, Russian entities were additionally charged with tax on revenues paid to the companies – residents of Grand Duchy of Luxembourg, Cyprus Republic and Swiss Confederation, despite provisions of relevant double taxation avoidance treaties between the Russian Federation and these countries, when those companies were proven conduit.