Reclaimation of VAT
As was reported in "Case Law Update", on April 8 2004 the Constitutional Court held in Ruling 169-O that a company is allowed to reclaim value added tax (VAT) from the government only if the purchased goods or services were paid for with the company's own funds, as opposed to borrowings. If the payment was made from borrowed funds, a VAT return/set-off will be available only once the loan has been fully repaid.
This position contradicts Articles 171 and 172 of the Tax Code, and Article 807 of the Civil Code. Nevertheless, in practice Ruling 169-O was swiftly implemented throughout Russia by the tax offices and the courts, which refused to offset or repay VAT if the VAT payment was made from borrowed funds.
On November 4 2004 the Constitutional Court issued Ruling 324-O as an official clarification of Ruling 169-O. The Constitutional Court took the view that a taxpayer should not be denied an immediate VAT deduction merely because it has outstanding loans and has used borrowed funds in purchasing goods, works or services which are subject to VAT. This conclusion is good news for Russian taxpayers.
However, the Constitutional Court established two important conditions for VAT return. First, a VAT set-off/return will not be allowed if a loan is clearly not going to be repaid in the future. Second, the decision suggests that a taxpayer which itself has committed no violation may be penalized through refusal of a return/offset for input VAT if the supplier fails to account to the tax authorities for VAT on sales to the taxpayer.
The new Constitutional Court ruling has changed the practical application of Article 172 of the Tax Code in favour of taxpayers. This was confirmed by a December 14 2004 decision of the Supreme Arbitration Court (4149/04). The decision states that there are grounds to refuse the set-off or return of input VAT only where there is no intent to repay the debt. This decision is important not only because it supports the new approach to the set-off of input VAT, but also because it demonstrates that taxpayers which lost cases between July and December 2004 stand a good chance of winning on appeal.
In its Rulings 169-O and 324-O the Constitutional Court not only interpreted the provisions of the Tax Code very broadly, but also introduced new conditions for the application of VAT set-off and return. To minimize any tax risk, contractors should be chosen very carefully and no VAT-related purchases should be made if there are reasons to doubt the contractor's good faith as a taxpayer. In addition, loan agreements should clearly state the loan repayment date, the purpose of the loan and that the borrowed funds will not be used for VAT-related purchases.
On September 30 2004 the Ministry of Finance was asked to draw a distinction between lawful and unlawful tax optimization. The new rules on tax avoidance, which will likely be modelled on the German Tax Code (Paragraphs 41 and 42), are expected to be drafted this year and will come into force in early 2006.
In the meantime, the Russian Tax Office has attacked the use of various loopholes by 'bad-faith' taxpayers. As there are no clear criteria defining what constitutes lawful and unlawful tax avoidance under Russian law, a blurred case law distinction between 'diligent' and 'undiligent' taxpayers has been applied - for example in the Yukos Case and Prom Line v Tax Office (for further details please see "Case Law Update").
On July 8 2004 the Constitutional Court passed Rulings 225-O, 226-O and 227-O to remind the Tax Office of another powerful tool to penalize bad-faith taxpayers.
The rulings state that a transaction can be ruled void if it is concluded in order to avoid paying tax. This conclusion was reached on the basis of Article 169 of the Civil Code. Article 169 provides that a transaction is void if its purpose is knowingly contrary to public order or morality. 'Public order' is defined very broadly as the most important principles of society, breach of which can endanger the unity of Russia, its political and economic sovereignty, and social stability. It is left to the courts to determine what specific behaviour breaches public order. Article 169 applies only if a taxpayer intends to reduce its tax liability by structuring its affairs in a particular way.
The Constitutional Court rulings effectively provide that if a deal is purposefully entered into in order to reduce tax liability, it is contrary to public order and can be ruled void. In practice, this means that any tax-planning scheme can be ruled contrary to public order.
The consequences of breaching Article 169 are severe. If intent on the side of both parties is present, everything acquired by the parties as a result of the deal should be confiscated by the Russian state. Article 181 of the Civil Code states that a suit for application of the consequences of invalidity of a void transaction may be brought within 10 years of the day on which performance of the transaction began.
This application of Article 169 of the Civil Code is not new. There were prior cases in which Article 169 was applied to tax avoidance, including a September 21 1999 decision of the Supreme Arbitration Court (73/79), and Constitutional Court Ruling 108-O of May 14 2002. An official letter of the Moscow Tax Office dated March 19 2004 (18-35/140) also states that the application of Article 169 is a very effective mechanism to deal with undiligent taxpayers.
However, the fact that Ruling 225-O has appeared now, when tax avoidance is one of the most politically sensitive issues, and the fact that the case was decided by Russia's most important judicial forum, suggests that as yet is too early to be optimistic about the Russian tax regime.