The particulars of applying Article 269.2 of the Tax Code of the Russian Federation in terms of thin capitalization rules when receiving loans from foreign shareholders is covered in specialized tax publications and media outlets to such an extent that it would seem there should be no doubt as to how to determine the amount of interest on controlled debt included for calculating the profit tax base. However, companies which are indebted to Russian and foreign partners should still be cautious since there are still multiple interpretations of the laws on thin capitalization as well as contradictory judicial practice; in particular, the following:
Applying thin capitalization rules to loans received from foreign subsidiaries;
Standardized interest rates on loans based on the Russian Central Bank’s refinancing rate and coefficients established in Article 269.1.1 of the Tax Code if the debt is controlled;
Payment of profit tax when paying interest on controlled debt.
We will examine each of these situations in turn.
Applying thin capitalization rules to loans received from foreign subsidiaries
Article 269.2 of the Tax Code defines controlled debt as a Russian organization’s outstanding debt:
To a foreign organization which directly or indirectly owns more than 20% of the Russian organization’s charter capital;
To a Russian organization which is, according to Russian legislation, an affiliated entity of the foreign organization in question;
In relation to which such an affiliated entity and/or the foreign organization directly acts as an underwriter, guarantor, or in any other manner is obligated to guarantee the repayment of the Russian organization’s debt.
In other words, based on a literal interpretation of the Tax Code, debt from a loan received from a foreign company with which the Russian organization (borrower) has a common shareholder, is not considered controlled.
However, on 21 June 2012, Russia’s Supreme Arbitration Court (SAC) issued Resolution #SAC-7104/12 on the refusal to submit the case to the SAC Presidium for review and adjudication by a court of the third instance on Naryanmarneftigaz LLC’s petition to the Interregional Inspectorate #1 of Russia’s Federal Tax Service on major taxpayers which proclaimed Ruling #52-17-18/584r dated 15.09.2010 invalid.
The courts ruled that the Russian company Naryamarneftigaz LLC’s debt on a loan issued to the foreign subsidiary Phillips Petroleum International Investment Company was controlled debt. Based on analysis of financing and cash flow agreements, the courts ruled that the actual creditor was not the foreign subsidiary, but rather the shareholder of the borrowing company which necessitated application of the thin capitalization rules to the accrued interest on the loan.
The SAC Presidium upheld the courts’ position, saying that “the dependence of the shareholders that were party to the loan (direct and indirect ownership of a part of the charter capital exceeding 20%) caused the courts to conclude that the inspectorate legitimately reduced the company’s losses and assessed additional profit tax after having acknowledged that the debt to the foreign company was controlled.”
It should be noted that the tax authorities and the Ministry of Finance attempted to classify the Russian company’s debt to the foreign subsidiary as controlled on more than one occasion. However, this was the first time that the supervisory authorities investigated the relations between the companies of the group so deeply in order to determine the actual creditor.
Thus, it is evident that there has been a significant change in the practice pertaining to this issue. It remains a possibility that courts may subsequently take a more conservative approach to issues of how to determine controlled debt.
Standardizing loan interest for controlled debt
Article 222.214.171.124 of the Tax Code states that in the absence of liabilities with comparable conditions between Russian organizations in the same quarter, expenses in the form of interest accrued on loans that the company uses to determine the profit tax base at its own discretion are subject to standardization. The maximum limit of interest which can be calculated into expenses for 2011-2012 cannot exceed:
1.8 times the refinancing rate of the Russian Central Bank on ruble-denominated debts;
The product of the Russian Central Bank’s refinancing rate and the coefficient 0.8 on loans denominated in foreign currencies.
At the same time, Point 2 of the same article in the Tax Code calls for the standardization of interest on liabilities that are considered controlled debts. In such a case, the amount of interest that can be calculated as expenses when determining the profit tax base may not exceed the amount calculated according to the following rules: amount of interest accrued in the reporting (tax) period on controlled debt, divided by the capitalization coefficient calculated as of the last day of the corresponding reporting (tax) period.
The capitalization coefficient is determined by dividing the amount of corresponding outstanding controlled debt by the amount of equity capital corresponding to the foreign organization’s share of direct or indirect participation in the Russian organization’s charter (share) capital (fund) and then dividing the result by three (by 12.5 for banks and organizations that are involved exclusively in licensing activities):
CC= CD / (EC * SO) / 3 (12.5), where
CC – capitalization coefficient;
CD – controlled debt;
SO – share ownership of the foreign organization controlling the debt in the taxpayer’s charter capital.
In this case, the amount of equity capital does not factor in tax liabilities, including current liabilities on taxes and dues, delays, installments and investment tax credit.
However, the Tax Code does not specify in what sequence interest is standardized on debts with a rate higher than the maximum rate stipulated in Article 269.1 of the Tax Code if the debt is also controlled according to Article 269.2 of the Tax Code. It is possible to assume two possible options for standardization in this situation:
A maximum amount is calculated for interest which can be included as expenses in the total amount for each point separately. When calculating profit tax, the smallest of the allowable amounts is taken into account.
Calculation of the maximum interest that can be applied as expenses when calculating the profit tax base which is performed sequentially based on a literal interpretation of the requirements of Article 269 of the Tax Code. First, the maximum amount of interest is calculated in accordance with Article 269.1 of the Tax Code. Then the maximum amount of interest is calculated on the controlled debt, where the maximum amount of interest calculated according to the rules of Article 269.2 is applied for the amount of interest accrued in the reporting period. In other words, the total amount of interest accrued is standardized according to the formula:
It is obvious that the first option for standardization is more beneficial for the taxpayer and appears more logical from a common sense perspective. The majority of specialists prefer this method of calculation in their own consultation services; however, this method has not been officially endorsed.
There is also a lack of developed judicial practice on this matter. Correspondingly, if the taxpayer exercises the right to interpret all insurmountable doubt, contradictions and ambiguities of the legislation on taxes and duties in his own favor (Article 7.3 of the Tax Code) and chooses the first option for standardizing interest, then it is possible that he may have to defend his position in court.
Taxation on controlled debt interest payments
Another issue that companies face when paying interest is applying tax rates when fulfilling the function of a tax agent in terms of calculating and withholding profit tax from the foreign entity’s income. The following inconsistencies and discrepancies can arise here:
Will the borrowing company be the tax agent for interest payments on the lending Russian company’s controlled debt? This question is relevant for situations when the controlled debt arises from a loan received from the Russian company for which the foreign shareholder acts as the guarantor.
Is the interest on the controlled debt equivalent to the dividends in an amount exceeding the maximum and being paid to a resident of a country with which there is a double taxation treaty if the possibility of reclassifying the loan interest as dividends is not directly provided in such a treaty?
There are not explicit explanations for each of these questions in the existing legislation and specialists from regulatory bodies, as well as tax consultants, have opposing opinions on these issues.
Interest payments on controlled debt to a Russian lending company
For taxation purposes, the amount of interest exceeding the maximum limit and calculated in accordance with the provisions of Article 269.2 of the Tax Code is equal to the dividends paid to the foreign organization with which there is a controlled debt and is subject to taxation at a rate of 15% (Article 269.4 and Article 284.3 of the Tax Code).
It would seem that Article 269.4 of the Tax Code pertains to situations concerning debt liabilities to foreign companies. In our situation, the loan is provided to the Russian organization, but the Tax Code does not cover taxing the source of income of the interest paid on the liabilities to the Russian organization. Furthermore, the interest according to the loan agreement is calculated by the lending Russian organization as non-operating income when determining the profit tax base. In other words, the presence of double taxation is quite apparent when the tax agent withholds profit tax.
The Ministry of Finance has upheld this point of view on multiple occasions in Letters N 03-03-06/2/92 dated 06.05.2009, N 03-03-06/1/969 dated 25.09.2007, N 03-03-06/1/480 dated 11.07.2007 and N 03-03-06/1/23 dated 23.01.2007.
However, officials have taken an opposing viewpoint in some letters. For example, in Letters 03-03-06/1/36 dated 29.01.2009 and 03-03-06/1/386 dated 04.07.2008, the Ministry of Finance stipulates that, despite the fact that the Russian organization is the lender, the positive difference between the accrued interest and the maximum interest is equal to the dividends and is withheld by the tax agent that is acknowledged as the borrower.
If there is a lack of judicial precedent on the matter, the taxpayer must decide at his own risk. In our opinion, the borrower is not the tax agent in the situation described.
Interest payments on controlled debt to a foreign lending company
As mentioned earlier, Article 269.4 of the Tax Code equates the amount of interest exceeding the maximum limit of interest that may be considered as expenses on profit tax, to dividends. Article 7 of the Tax Code and Article 15.4 of the Constitution of the Russian Federation state that the regulations of Russia’s international agreements take precedence over Russian legislation.
Double taxation treaties contain definitions of dividends and interest. Several of them establish the following:
Dividends are income from shares or other rights that are not active debt but which give the right to participate in profits, as well as in income from other corporate rights which are subject to the same taxation as income from shares in accordance with the legislation of the country to which the company distributing the profit is a resident;
Interest is income from any type of active debt.
In other words, the possibility of reclassifying interest on controlled debt into dividends is not directly prescribed.
Examples of similar agreements:
Agreement between the Russian Federation and Germany dated 29.05.1996 (Articles 10 and 11);
Agreement between the Russian Federation and Finland dated 04.05.1996 (Articles 10 and 11);
Agreement between the Russian Federation and the Netherlands dated 16.12.1996 (Articles 10 and 11);
Agreement between the Russian Federation and Luxembourg dated 28.06.1993 (Articles 10 and 11).
The question then arises as to whether interest on controlled debt can be reclassified as dividends in such situations and at what rates tax should be withheld when making payments to a foreign lender.
The Ministry of Finance’s official position is that reclassifying interest as dividends is legal (Ministry of Finance Letters #03-08-07 dated 21.09.2011, #03-08-05 dated 29.08.2011, #03-08-05 dated 01.09.2011, #03-08-13 dated 20.07.2011 and #03-08-05 dated 05.04.2012).
According to the Ministry of Finance, the provisions in Article 269 of the Tax Code on controlled debt allow for interest on such debt to be regarded as dividends on the basis that double taxation treaties define dividends not only as income from shares but also as income from other corporate rights which are subject to the same taxation in accordance with the laws of the country which the organization distributing the profit is a resident of. The Ministry of Finance concludes that there are no contradictions between the Tax Code and the international agreements.
In such a case, tax is levied at the rates indicated for dividends in the double taxation treaty.
Moreover, courts have supported taxpayers who hold an opposing viewpoint (Federal Arbitration Court of the Moscow Region’s Resolution #KA-А40/14232-10-2 dated 13.12.2010, Federal Arbitration Court of the Western Siberian Region’s Resolution #А81-704/2011 dated 15.12.2011, Federal Arbitration Court of the Northwest Region’s Resolution #А26-3052/2009 dated 12.04.2010, Federal Arbitration Court of the Northwest Region’s Resolution #А26-6967/2008 dated 23.09.2009).
In their decisions, the courts pointed to the fact that the taxpayer has the right to pay tax on interest above the permitted standard in accordance with conditions established by international agreements while not classifying them as dividends. In addition, the courts emphasize the principle fixed in the agreements on non-discrimination of residents of one country in another country which are both parties to the agreement.
Accordingly, the rate of taxation indicated in the double taxation treaty is applied to the interest.
In our opinion, the taxpayer has the right to pay tax on interest above the norm in accordance with the conditions of the international agreements while not reclassifying the interest as dividends. However, taking into account the Ministry of Finance’s position, such an opinion will very likely have to be defended in court.
The issues we have examined do not encompass the entire spectrum of the accounting particulars for controlled debt. However, we do hope that this article will prove useful for companies that encounter difficulties in their business activities arising from varying interpretations of the law.
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