04.08.08

Recently, one of Alinga's clients successfully defended itself in court against the Tax Authorities. We believe that the case may be of interest and help to other businesses as well.

Survey of a Tax Dispute:
A Recent Case at the Moscow City Arbitration Court
By Petr Semenov, Auditor, Alinga Consulting Group

Background

The Tax Inspection held a field audit, examining all 2004-2005 taxes for a business. On the basis of their findings, the Inspection accused the business of tax violations. After a failed appeal to the Federal Tax Service (UFNS) in Moscow, the business took the case to arbitration.

Points in Question:

1. During the period of 2004-2005, the business leased an office located in a residential building. Expenses associated with this lease and electricity expenses for the office were used as VAT deductions for the period.
2. The cost of goods sold was also used by the business in calculating VAT deductions and profit tax. The goods were purchased from a firm that had been founded by other firms which in turn had been founded solely by individuals; not one incorporated entity was listed as a founder on these company's registrations.

Position of the Tax Authorities

On the first point: the lease in question stipulates that the office was to be used for "accommodating (размещения) employees." While this particular wording is not unusual as concerns leases in Russia, the inspection reasoned from it and the fact that the office was located in habitable space in a residential building that it was intended as a residence. Thus, the space could not be used as an office and was in violation of Article 252 of the Tax Code, which outlines criteria for the accounting of lease expenses. They argued that only if the building were reclassified (from residential to another classification) could lease expenses stemming from it be claimed as expenses in the calculation of profit tax.

Furthermore, because the premises did not qualify as office space, expenses for electricity used there also did not qualify as expenses for the purposes of calculating profit tax.

Lastly, because of the expenditures were in violation of Article 252, no VAT deductions could be made concerning them.

On the second point: Goods acquired and subsequently sold by the business were purchased from two firms founded by individuals who have founded several other firms.

The inspection, taking into account precedents set forth by the High Court of Arbitration on “Good Faith Tax Payers,” concluded that the business had entered into a contract with a "questionable contractor" without performing sufficient due diligence.

As evidence, the tax authorities obtained information from the Federal Tax Service showing that the contractor was not in full compliance with its registration, accounting, reporting, and tax liabilities. As further evidence, the authorities subpoenaed the general director of the supplying firm. After initially claiming that he was both general director and head accountant of the firm (also considered suspicious by the Russian tax system), he was shown documents indicating that he was not, in fact, the general director and it was not his signature on several documents in question.

Also testifying were individuals listed as founders of the firm of the supplier, who claimed that they had never founded a firm; they had not founded the firms which created the firm which supplied goods to the business.

Taking all this into account, and in particular because the primary accounting documents had been signed by an unknown person, the tax authorities argued that none of the resulting expenses could be claimed for purposes of profit tax calculation and, as such, could not be used for VAT deductions.

Position of the Business

On the first point: in defense of its accounting and deductions, the business presented the lease of the office space and documentation and reports of the electricity used in the office. All documents were in the proper form and substantiated by letters from contractors confirming the use of the premises as an office, agreements for janitorial services for the office, and primary accounting documents related to the lease. The lease itself, as it had been concluded for a period of more than one year, had been previously submitted to and approved by the state registry.

Furthermore, the business cited precedents in similar cases in which the court had supported the position of the business.

On the second point: the business argued that proper due diligence had been performed as concerned the alleged "questionable contractor" and that all primary documents had been drawn up in accordance with Russian law. The purchase was confirmed by invoice and further confirmed by a railroad invoice for the transport of the goods in question. The goods had been produced by a large, well-established factory (showing that they were likely not stolen or pirated) and no legal affiliation existed between the supplier and the business (showing that no illegal business schemes were at play).

Position of the Court

On the first point: The court completely upheld the argument of the business. The court ruled that the residential status of the premises is irrelevant for the purposes of calculating VAT and profit tax. Furthermore, the court ruled that there was no legal basis for the inspection's reasoning that "accommodation" and "residence" were legal equivalents. Furthermore, in accordance with the applicable legislation, the lease had been registered properly.

The court also fully supported the business's arguments as concerned expenditures for electricity, ruling that all the primary accounting documents needed to claim the expense were in order. Furthermore, the court stated that, for the purposes of calculating profit tax, consideration of only those conditions set forth by the Tax Code was sufficient; other criteria stemming from other areas of the law held no connection to the subject of taxation.

On the second point: the court ruled that the expenses claimed for the purchase of goods were lawful. The court stated that, in this case, Chapter 25 of the Tax Code provided no basis for taking into consideration for tax purposes defects in the formulation of documents (such as if they had been signed by persons not authorized to sign them). The court cited precedents for its decision.

The court ruled that all documentation (i.e. invoices and bank statements) were in order as concerned the expenditures incurred by the business for the acquisition of goods.

However, as concerned the VAT deduction, the court also pointed to precedents for denying VAT deductions made based on documents signed by unauthorized persons. The court ruled to deny the VAT deductions claimed by the business in this case as well.

Epilogue

The Tax Authorities, as of the publication of this article, had appealed the decision once to a higher court. That court, however, left the decision without change.

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