Russian Federation: Change Of Thin Capitalization Rules

Last Updated: 16 March 2017
Article by Dzhangar Dzhalchinov

In 2016 the RF Supreme Court issued a precedent-setting decision by clarifying the procedure for applying thin capitalization rules to interest on controlled debt when a lender is a Russian company. The court supported the taxpayer's position and stated that reclassification of interest into dividend and its subsequent taxation at source under Article 269(4) of the RF Tax Code (in the version in effect until 2017) do not apply if there is no evidence of a disguised dividend payment (RF Supreme Court Ruling No. 305-KG15-14263 of March 18, 2016, in the Novaya Tabachnaya Kompaniya LLC case).

The court noted that Chapter 25 of the RF Tax Code does not contain provisions according to which dividends not received could be treated as taxable income, thus, withholding taxation at source would result in double taxation, and the absence of rules eliminating double taxation and existing legal uncertainty should be interpreted in the taxpayer's favor. As a result, the Supreme Court ruled that for interest accrued under a debt obligation to a Russian lender, the only consequence should be limiting the deduction of interest contemplated by Article 269(3) of the RF Tax Code, and a borrower should not act as a tax agent when paying interest to a Russian lender. This position applies to cases where there was no disguised payment of dividends to a foreign company.

Previously, in most similar disputes, commercial courts supported the position of tax authorities, agreeing with reclassification of interest into dividends and the need of consequent withholding taxation at source.

In addition, the Federal Law No. 25-FZ of  February 15, 2016, introduced changes to the definition of controlled debt. As of January 1, 2017, an unpaid indebtedness of a Russian company under the following debt obligations is considered to be controlled:

  • under a debt obligation to a foreign related party that directly or indirectly participates in the borrower;
  • under a debt obligation to a party considered related to the above mentioned foreign party;
  • under a debt obligation in which the above mentioned foreign party and/or its related party acts as a warrantor, guarantor or otherwise secures the borrower's debt obligation.

Debt that does not formally fall under the new rules may also be considered controlled if a court considers that the ultimate objective of payments under debt obligation is a payment to the above-mentioned companies.

Starting from  2017, the threshold of a foreign  participation in a Russian company's capital to consider a loan to be controlled  has been raised from 20% to 25%, since interdependence of parties is now determined in accordance with the provisions of Article 105.1 of the RF Tax Code. Moreover, pursuant to the same provision, loans granted by individuals can also be considered as controlled debt, which previously was out of thin capitalization's scope.

At the same time, the following are excluded from controlled debt:

  • debt to Russian entities if a Russian lender does not have comparable unpaid debt to a foreign entity (the comparability criteria are stipulated by the law), and the lender has provided the relevant written confirmation;
  • debt to a foreign SPV arising in connection with placement of marketable bonds, provided that SPV is incorporated in a country with which Russia has a double tax treaty;  
  • as of January 1, 2016 debt to independent banks (whether Russian or foreign), provided that neither the principal nor the interest were repaid by a foreign entity related to the Russian borrower, or a party related to that foreign entity.

Other important changes in the rules:

  • the maximum interest for previous periods is not recalculated if a capitalization rate changes as compared to previous reporting periods;
  • the amount of controlled debt includes sums of controlled debt that arose under all obligations in aggregate.

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