Thin Capitalization and Controlled Debt:
Taxation and Legal Issues in Russia
By Olga Sorokina, Auditor, Alinga Consulting Group
Raising capital presents companies everywhere with challenges. Generally speaking, companies seek financing either through equity (privately-held stakes or public share placements) or through loan facilities. The latter offers significant tax advantages, as interest payments are tax-deductible expenses in most countries – including in Russia. However, in the event a company in Russia seeks debt financing from its owners, thin capitalization rules can prove highly problematic from the standpoint of Russian tax legislation.
In the case that debt financing comes from a company's owners, the interest payments can be seen as essentially veiled dividend payments. Russia has introduced special rules to limit this practice, and as such has adopted two international concepts within its tax legislation with some Russian peculiarities. The first is “controlled debt,” which refers to debt between organizations that is secured by a third party. Usually in such situations, a loan is extended to one organization, and then the promissory note is sold to a third organization friendly to the loan recipient. In the cases we will consider below, the loan is made directly or indirectly between companies within the same corporate structure. This process is often considered legal or at least "safe," as such debt selling happens daily in modern finance and is thus not likely to arouse suspicion.
“Thin capitalization,” meanwhile, is a practice that can require any interest payments to be recorded as dividend payments when calculating profit tax. This is because the interest-bearing loans financing the company are deemed to be "excessive" – and a way of avoiding taxes that should otherwise be paid when making equity injections of share capital.
In the case of loans between related organizations, several steps are needed to determine exactly how the interest on those loans must be treated to comply with Russian tax law.
1. Determining the Existence of Thin Capitalization
Generally speaking, if a company owns more than a 20% equity stake in the company it is making a loan to, the controlled debt in question is considered to be thin capitalization – with some exceptions.
Russian law differentiates between thin capitalization as it arises in the cases of foreign investment and domestic. In the case of foreign investment, thin capitalization can be understood as it arises (or does not arise) in the several cases diagramed and explained below.
If a loan is made by a foreign organization to a Russian organization in which the foreign organization directly controls an equity stake of more than 20%, no complicating issues are created by the loan obligations or interest payments. Direct ownership assumes direct participation by the foreign company in the Russian organization’s registered capital. The relationship can be thought of as shown in the following diagram:
If a loan is made by a foreign organization to a Russian organization in which the foreign organization indirectly holds a 20% equity stake, then the matter is more complicated. The Russian Tax Code defines this indirect relationship as created by a sequence of ownership structures. This can be thought of like Russian nesting dolls. For example:
In this case, B is a wholly-owned subsidiary of the foreign organization and is a majority holder (70%) in C. C owns half of the Russian organization that received the loan. Logically, the foreign organization can be said to control, through the ownership structure, a maximum of 35% of the capital in the Russian organization. In this case, a loan from the foreign organization to the Russian organization would be problematic and interest paid would be included in profit tax calculations.
The calculations depend on the company structure and the relationship between the lending company and the borrowing company.
For example, let's assume that a foreign organization grants a loan to a Russian organization that is part of a corporation headed by the same foreign parent company. Referring to the parent company as "M," the relationship can be mapped in the following manner:
In this case, the foreign organization, by the standards specified in the Tax Code, has neither a direct nor indirect ownership stake in the Russian organization and there is no thin capitalization.
Debt owed to Russian organizations that are legally recognized as affiliates of the foreign organization must also be considered in determining thin capitalization. "Affiliation" is determined in Russia based not only by equity ownership, but also by other factors that could allow for the coordination of decision making processes or for one company's management body to influence the decisions of the other company's management body. This includes agreements to the same or the presence of joint personnel within or the existence of familial relations between members of management bodies within the two companies.
In the following example, Russian organization #1 grants a loan to Russian organization #2. Both organizations are part of a corporation headed by foreign parent company M. Parent company M owns more than 20% of Russian organization #2.
In this case, Russian organization #1 is regarded as an affiliate of the parent company M, because M holds an equity stake of more than 20% in Russian organization #2 and both lender and receiver are Russian companies. Accordingly, the debt owned by Russian organization #2 to Russian organization #1 can be regarded as creating a case of thin capitalization.
In the example above, Russian organization #1 and Russian organization #2 are Russian subsidiaries of the same a foreign company. The lender (#1) is an affiliate of the foreign company as defined by Russian legislation. Therefore, this loan can also be considered a case of thin capitalization.
Debts guaranteed or backed by an affiliate or a foreign company with direct ownership are also considered under Russian legislation. For example:
In both situations, the controlled debt is considered "thin capitalization" and the related accounting rules apply.
Assuming that an organization has established that its debt obligations fall under the thin capitalization rules, how should it proceed?
2. Compare the amount of controlled debt with the amount of equity capital
After the status of the loan is determined, the size of debt must be compared against the size of the organization's equity.
As a general rule, equity is total assets minus total liabilities (both current and long-term). Equity calculations do not take into account debt in the form of outstanding taxes. Payments to the mandatory pension insurance program are not considered taxes under Russia's Tax Code and thus are taken into account when determining the amount of equity, a process confirmed by the Russian Ministry of Finance.
Having calculated the amount of equity and using the rule diagramed below, equity is then compared with the amount of debt in question and action taken as follows:
Additionally, if a borrower’s equity is calculated for the rate of capitalization is either negative or zero, tax experts believe that the entire amount of interest due must be treated as dividends and is therefore not taken into consideration with respect to profit taxation (Letter from the Federal Tax Service from July 6, 2005, #20-12/47829).
Another point of interest is whether applicable treaties exist between Russia and the home country of the foreign company. The Federal Arbitration Court heard a case concerning a foreign company, which had loaned money to a company in which it also held a 99.99% equity stake (Ruling #A56-19578/2006 from April 9, 2007). The tax authorities claimed that due to this equity stake, the interest paid was not a legitimate tax deduction. The court noted, however, that there was an applicable treaty in force that stipulated criteria for cases in which unlimited deduction of interest was allowed. As the situation met these criteria, and as treaties legally take precedence over Russian legislation according to the Russian constitution, the company was ruled to have applied the deduction legitimately.
3. Determine what interest should be treated as dividends and what should be treated as deductible expenses
On the last date of every accounting (tax) period, the company must apply a formula to determine what interest can be seen as interest, and what must be considered as dividends. The formula runs as follows:
This is where M is equal to the maximum amount of interest that can be considered deductible. P is the overall sum of the amount of interest paid on the particular controlled debt. C is the "capitalization coefficient" and is calculated as follows:
K = N / C * S / 3 (12.5)
This is where N is equal to the amount of outstanding controlled debt. C is equal to the capitalization of the borrowing organization. S is equal to the share held in the borrowing organization by the lending organization. In most cases, the final calculation is to divide by three unless the organization is a bank, in which case the division must be by 12.5.
This calculation is taken separately for each loan that can be considered a controlled debt. The difference between the amounts paid and the maximum allowed as calculated from this formula must be taxed as dividends at a rate of 15%.
Dividend taxes paid in the previous period are not considered in these calculations as tax is withheld upon each payment. It is the Russian organization's legal responsibility to act as tax agent in these situations and pay taxes for the foreign organization's earnings.
If the foreign organization is based in a country that is party to a tax treaty with Russia, this profit tax should be calculated and paid based on the terms of the tax treaty. However, the foreign organization should provide confirmation of the country in which it is based and that confirmation must be certified by a relevant authority in that country and a certified translation into Russian produced.
What about the lending organization? How is that income handled? Let us consider a few specific situations.
1) Payment made to permanent establishments (PE) of a foreign organization in Russia;
Interest within set limits. The full amount of accrued interest earnings is included in the tax base of the PE as non-operating income and is taxed at the general rate of 24%. Confirmation must be submitted to the tax agent that the interest paid is owed to the PE, and tax on the interest earnings is not withheld by the source of payment. In the absence of such confirmation, tax is withheld by the source of payment at a rate of 20%, although interest earnings should later be taken into account by the representative office when the tax base is being determined.
Interest treated as dividends. When interest is paid, the tax agent withholds tax from the excess interest which must be treated as dividends. The PE is paid an amount equal to the difference between the accrued interest and taxes calculated on the "excess" interest at a rate of 15%.
2) Payment made to a foreign organization without a PE in Russia;
Interest within set limits. Earnings received in the form of interest payments are classified as income subject to taxation at the source of payment at a rate of 20%.
Interest treated as dividends. As above, a positive difference between the accrued interest and the interest allowed is treated as dividends. The difference is taxable at a rate of 15% and the dividends are transferred to the lending organization less the 15% tax that must be withheld.
If a Russian organization receives a loan from a foreign bank and a foreign company serves as the guarantor and owns 100% of the Russian organization, then the Russian organization serves as the tax agent responsible for withholding tax on dividends. It would also be responsible for calculating the tax, withholding it from the lender and making the required tax payments (Letter from Moscow Division of the Federal Tax Service).
In summary, raising capital is challenging anywhere. While borrowing is in many cases the most attractive way to raise money, and certainly more advantageous than direct equity injections, loans given between related firms are more complex than meets the eye in Russia. The manner in which funds are borrowed needs to be thought out in order to avoid issues of thin capitalization that can make borrowing less attractive.
Read More about Accounting Services from Alinga Consulting Group
Questions? Ask Alinga's Accounting Experts!