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Tax Connect Flash | Russia: Thin capitalization provisions - old rules, new trends

Russian thin capitalization rules have a long history the roots of which can be traced back to the adoption of the “Profit Tax” Chapter of the Tax Code in the early 2000’s. The rules first appeared in their current form in 2006. From then up until the middle of 2011, court treatment was generally favourable towards the taxpayers, notwithstanding regular clarifications to the contrary from the Ministry of Finance. From mid-2011, however, the court’s approach to the thin capitalization rules has changed drastically, and below we address the key recent developments.

What is thin capitalization about?

Russian thin capitalization rules apply to controlled debts, i.e. situations, in which one of the following three criteria is met:

  • a loan provided by a foreign legal entity which directly or indirectly (via a sequence of other companies; determined as the multiplication of direct participations) owns more than 20% of the Russian entity financed; or —
  • a loan provided by a Russian entity which is an affiliated party of a foreign entity which, directly or indirectly, owns more than 20% of the Russian entity financed; or
  • a loan to a Russian entity in respect of which a foreign entity, which directly or indirectly owns more than 20% of the entity financed, or its Russian affiliate, issues a guarantee, acts as surety or otherwise secures the fulfillment of the debt obligation.

If the “controlled debt”/equity ratio of the borrower exceeds 3:1 as at the last date of each quarter (12.5:1 for organizations exclusively involved in banking and leasing activities), the interest accrued in respect of the part of the debt in excess of the 3:1 (or 12.5:1) ratio is not deductible for profits tax purposes. In addition, the “excessive” interest is treated as a dividend for tax purposes, i.e. is subject to 15% Russian withholding income tax which could potentially be reduced by the application of double tax treaty relief (if applicable).

Key recent developments: prevalence of domestic thin capitalization rules over double tax treaties

One of the recent trends in the court’s decisions has been to deny double tax treaty relief based on non-discrimination provisions.

Indeed many Russian double tax treaties contain non-discrimination provisions assuring that Russian companies, the capital of which is owned by foreign residents, are not treated any less favourably in respect of taxation than other similar Russian companies. As Russian legislation provides (under certain conditions) for precedence of double tax treaties concluded by Russia over domestic tax law where the treaties provide for a more favourable tax treatment than the relevant provisions of domestic law, many Russian taxpayers would use the above non-discrimination provisions as the main argument for challenging the tax authorities’ claims with respect to thin capitalization. The courts have traditionally supported this interpretation of the non-discrimination provisions (e.g. Russia’s tax treaties with Cyprus, Germany and the Netherlands) as overriding the domestic thin capitalization limitations, effectively relieving Russian companies with shareholders resident in a foreign jurisdiction (which has entered into a double tax treaty with Russia) from the domestic thin capitalization rules.

Recent court cases, however, have reversed this position. The courts have now controversially suggested the previous interpretation of non-discrimination provisions to be ‘erroneous’ and have required the Russian domestic thin capitalization rules to be applied irrespective of the non-discrimination provisions in the applicable treaty.

The logic of each case is different:

  • in the PO BMZ case(1), the court analyzed the “Non-discrimination” provisions in the Dutch treaty, which provides that Russian companies, the capital of which is owned by Dutch residents, cannot be subject to any less favourable tax treatment than other similar Russian companies. The court interpreted “other similar Russian companies” to mean “… Russian enterprises, the capital of which is wholly or partly owned by residents of other states”. The court therefore decided that the “Russian thin capitalization rules are not discriminatory to companies with Dutch capital since all enterprises with foreign capital are treated in the same way”, and therefore the treaty does not relieve the taxpayers from the Russian domestic thin capitalization rules. This reasoning is questionable: the Dutch treaty does not define “other similar enterprises”, but in absence of a clear definition it could be argued that the comparison should be made to any similar enterprises, thus, Russian companies without any foreign investments.
  • in the Severny Kuzbass case(2) the court analyzed the “Associated enterprises” provisions in the Cypriot and Swiss treaties, and the comments on the equivalent provisions in the OECD Model Convention. This was the first case ever of such analysis in Russian court practice. The court interpreted the Model Convention to introduce a special tax regime for operations between interrelated parties. This is beyond doubt. It would have been reasonable, however, if the court had then considered the market price, i.e. whether the interrelations between the parties influenced the interest rate payable under the loan. Surprisingly and disappointingly the court did not consider this, but the loan was instead deemed to form an equity contribution, presumably on the basis that the interest due under the loan was not paid by the borrower to the lender. This approach is questionable, as it implies that all controlled debts can potentially be treated as not-at-arm’s-length purely based on the fact that they have arisen from a transaction between independent parties.

Russian court practice is not precedential by nature. However, as the Severny Kuzbass case was considered and decided by the Presidium of the Supreme Arbitration Court, we have already seen this decision being used as a guideline for other courts and being cited in other cases. Moreover, the Presidium of the Supreme Arbitration Court has refused to hear at least one non-discrimination case on the basis that no review was needed as the cassation court’s conclusions were consistent with the Presidium’s ruling in the Severny Kuzbass case.

Thus, cases, where the taxpayers rely on non-discrimination provisions of treaties as protection from the Russian domestic thin capitalization rules are currently at risk.

Key recent developments: attempts to broaden thin capitalization to loans from foreign sister companies

As currently enacted, the Russian thin capitalization rules do not apply to loans provided by or guaranteed by foreign sister companies. This is the case provided that the foreign sister company is not a direct or indirect shareholder of the Russian borrower, and any loan provided by any such foreign sister company is not guaranteed by a direct or indirect foreign shareholder of a Russian borrower or by a Russian affiliated company to such foreign shareholder.

However, the recent court case of Naryanmarneftegaz(3) on this issue demonstrates that both the tax authorities and the court tend to consider the economic substance of the transaction rather than following the letter of the law, in an attempt to broaden the scope of the thin capitalization rules. The tax authorities, departing significantly from their “form over substance” approach, undertook a thorough analysis of the case. Based on indirect indicators, the tax authorities interpreted loan provided by the foreign sister company to be a loan provided from the foreign parent company itself. Consequently, the tax authorities argued that the use of an affiliated foreign finance company, not supported by commercial reasons, was aimed purely at avoiding the Russian thin capitalization rules. On this basis, the tax authorities treated the foreign sister company as a mere intermediary used solely for obtaining tax benefits, and challenged the deduction of respective interest.

The case was resolved in favour of the tax authorities in the cassation court, which is significant as it is the first ruling in favour of the tax authorities in cassation courts on such a matter. As already mentioned, Russian court practice is not precedential by nature, but in practice decisions of the Supreme Arbitration Court (SAC) are generally being followed by lower courts. There is, as of yet no decision of the SAC on the applicability of the thin capitalization rules to loans from foreign sister companies, but the situation appears ominous for taxpayers, with representatives of both the Ministry of Finance and the tax authorities declaring several times that they intend to tighten up the existing thin capitalization rules. As such, the widespread use of foreign sister companies as a tax-efficient source of financing Russian business activity may have a limited future existence.

In the light of the above developments CMS, Russia can offer you the following assistance:

  • a review of your financing structure in relation to the applicability of the Russian thin capitalization rules;
  • an analysis of the current and planned activities of the company with a view to identifying the most tax-efficient source of financing these activities;
  • a review of your current equity and advice on choosing the most efficient way to increase it;
  • draft and/or review your existing financing agreements to achieve tax optimization; and/or
  • represent your company in any disputes with the tax authorities and/or contracting parties.

Notes1. Decision of the Federal Arbitrage Court of the Central Region dated 07.10.2011 case № А09-6854/2010 2

2. Resolution of the Presidium of the Supreme Arbitrage Court dated 15.11.2011 № 8654/11 case № А27- 7455/2010

3. Decision of the Federal Arbitrage Court of Moscow Region dated 27.02.2012 case № А40-1164/11-99-7


Dominique Tissot Partner - CMS, Russia

Pavel Vasin Associate - CMS, Russia


Dominique Tissot