TAX NEWS - 2010

Russia Tax: Thin cap rules may be applied to foreign sister companies

A recent Russian court ruling indicates that loans issued by foreign sister companies to Russian borrowers could now be treated as being subject to restrictions under the thin capitalization rules, thus creating new tax risks for foreign companies investing into Russia.

The Russian thin capitalization rules (stipulated in article 269, section 2 of the Tax Code) currently apply to the following loans (so-called "controlled debt"):

- Loans provided to a Russian company by a foreign parent company that holds directly or indirectly more than 20% of the share capital of the Russian company;

- Loans provided to a Russian company by another Russian company affiliated with a foreign parent company with a 20% direct/indirect participation in the Russian company; or

- Loans secured in any way by a foreign parent company with a 20% direct/indirect participation in the Russian company or by a Russian company affiliated with such a foreign parent company.

Accordingly, Russian borrowers of controlled debt must ensure that their debt-to-equity ratio does not exceed the established ratio of 3:1 (or 12.5:1 for banks and leasing companies). If the ratio is exceeded, the excess interest may not be deducted and that amount will be recharacterized as a dividend subject to the 15% Russian withholding tax (unless the rate is reduced under an applicable tax treaty).

A literal reading of article 269, section 2, suggests that loans received from foreign sister companies are not covered by the thin capitalization rules and, to date, the Russian tax authorities generally have accepted this interpretation. However, in a recently announced decision, the Russian Arbitration Court of Appeal upheld the decision of a lower court that recognized the debt of a Russian company to a foreign sister company as controlled debt. The case started with the Russian tax authorities challenging the deduction of interest on a loan obtained by a Russian company from its foreign sister company.

The tax authorities took the position that the funds provided to the Russian company actually belonged to the foreign parent company, which raised the funds through an IPO and subsequently distributed them among its subsidiaries. The Arbitration Court of Appeal followed the "substance over form" approach, establishing an affiliation between the parent company, the lender and the borrower and concluding that the funds received by the Russian company de facto originated from the parent company, even though they were technically provided to the Russian company under a loan agreement with the foreign sister company. The Russian company's debt was actually with the parent company and, therefore, should be treated as controlled debt. This conclusion indirectly supports a previous position taken by the Russian Ministry of Finance in private clarifications, in which the Ministry stated that a court may decide to establish an affiliation between parties on grounds beyond those set forth in the Tax Code (i.e. when there is a direct or an indirect participation of less than 20%) and apply these conclusions for purposes of the thin capitalization rules.

The above decision contradicts several other decisions in which the courts followed the literal interpretation of article 269 of the Tax Code and resolved the cases in favor of the Russian taxpayers, thereby refusing to consider the loans as controlled debt.

The Russian authorities are slowly but steadily beginning to scrutinize loans received from foreign sister companies, which, in the past, have been the most common way of arranging intercompany funding into Russian subsidiaries. The fact that article 269 does not specifically include such loans within the purview of the thin capitalization rules may not be a guarantee that the rules will not be invoked. However, with the government's recent efforts to "ease" Russia's rules to attract more foreign investment into the country (e.g. announcing plans to introduce a participation exemption on capital gains, simplifying the work permit and visa processes for foreign employees, etc.), the decision on foreign sister loans seems to diverge from the attempts made so far, and may not be further endorsed, at least in the near future.

In any case, companies financing operations of their businesses in Russia through foreign sister companies should reevaluate the risks involved, taking into account the new possible interpretation of the Russian thin capitalization rules.