2016 was marked by a breakthrough in the practice of applying the concept of the person beneficially entitled to income (the beneficial owner concept) as a legal mechanism for the Russian tax authorities to challenge the right of foreign recipients of income from sources in the Russian Federation (mainly dividends, interest and royalties) to apply preferential tax rates contemplated by double tax agreements, treaties and conventions.

What was previously perceived as a purely theoretical risk has become a reality. The cases of MDM Bank 1, Bank Intesa 2, Credit Europe Bank 3, Severstal 4 and Krasnobrodsky Yuzhny LLC5 clearly demonstrate that the negative trend of the Russian tax authorities challenging the validity of applying double tax treaties to multitier holding and financial structures that started in 2015 developed last year.

Analysis of the above-mentioned court cases shows that the tax authorities and the courts pay attention to the following factors when evaluating whether it is permissible to apply reduced rates and exemptions from tax at the source under double tax treaties, agreements and conventions:

  • Whether the foreign recipient of income from a source in Russia transfers most of the income to an affiliate that is a resident of a different foreign jurisdiction (the payments are of a transit nature), and whether that affiliate would have received tax benefits similar in scope if it had received that income directly from the Russian company paying the income
  • Whether such "transit" transfers are made after a brief interval of time from when the income is received on the bank accounts of the foreign recipient of the income
  • Whether the formal recipient of the income has clearly expressed powers of an agent, commission agent, or representative of one or several entities with respect to the Russian income received
  • Whether the foreign recipient of the income is bound by an obligation (whether contractual or corporate, including under an agreement between shareholders or applicable law) to transfer the income received to third parties
  • Whether the formal recipient of the income uses that income (or a part thereof) for its own needs and whether its activity is financially dependent on financing from affiliated companies
  • Whether the foreign recipient of the income has sufficient presence (offices, competent personnel, etc.) in the state of its tax residency corresponding to its declared functions
  • Whether the recipient of the income performs one or more independent economic functions and whether it takes commercial risks that are usual for entities performing similar functions6
  • Whether the governing bodies of the foreign recipient of the income (for example, board of directors, individual directors, etc.) are independent in deciding to distribute after-tax profits to participants/shareholders
  • Whether the foreign recipient of the income accounts for the income received from sources in the Russian Federation in its own tax base and what is the effective tax rate of that income in the recipient's country
  • Whether the foreign recipient of the income is owned directly or indirectly by entities that are not tax residents of the country receiving the income
  • Whether the recipient of the income has other sources of income and other  income-generating assets in the Russian Federation

The tax authority and the court can use all of these circumstances—the recipient of the income not having a sufficient degree of presence at its location, the transit nature of the disposal of income received, the foreign entity that is the formal recipient of the income being controlled by third parties— as the basis for a decision to refuse to apply preferential tax treatment to income from sources in the Russian Federation that is established by an applicable tax treaty. That said, the Russian tax authorities feel no restraint in retroactively applying this approach within the three-year tax audit period established by Russian tax law.

The above-mentioned circumstances evidence that it is necessary to review existing asset holding structures and financial structures to see whether they meet the above-listed criteria. The price for ignoring this new trend could turn out to be too high.

Footnotes

1. Case No. А40-116746/15

2. Case No. А40-241361/15-115-1953

3. Case No. А40-442/15-39-2

4. Case No. А40-113217/16

5. Case No. А27-20527/2015

6. In other words, can the taxpayer justify the use of the foreign company in its structure with rational business reasons.

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