Export Loan Insurance: Is the Tax Code Ready for Such a Development?

In international trade, suppliers often grant a loan to buyers by deferring payment. This practice is extremely common when technologically complex and unique equipment is manufactured, as the equipment is customized for a particular customer that is not always ready to make a 100 percent advance payment. As a result, the exporter incurs costs but is not certain that it will generate anticipated income on the transaction. From a business perspective, it is normal practice to grant a supplier credit to the buyer. The key issue is to mitigate the related business risk. It is only natural to involve an insurance company in the whole process. If the counterparty defaults on the payment, some of the losses (60 to 95 percent of the total) can be covered by the insurance company.

Unfortunately, the provisions of tax and foreign exchange legislation make this option quite arduous and convoluted.

1. Profit tax

The situation with profit tax seems to be the simplest, as the effective rules of Chapter 25 of the Russian Tax Code allow a taxpayer to account for losses and insurance indemnity correctly.

If it transpires that the counterparty was insolvent or failed to pay under a contract on time, the Russian exporter supplying the goods should recognize unearned revenues for tax accounting purposes. However, this income (that does not have any actual economic basis) may be offset against the expense incurred on the provision for doubtful debts (100 percent of the outstanding debt if delayed for over 90 days, although this does not include interest).

In this case, the tax implications of these two operations can be equal to zero, especially if both events happened in the same tax period. The receipt of the insurance indemnity is booked as non-sales income and as a result, there will be no "double counting" and the income from exporting the goods will not be taxed twice. In actual fact, the exporter will only pay tax on the insurance indemnity included in the tax base, as if he had simply sold the goods at a reduced price. The taxpayer's expenses on the manufacturing of these goods will also be recorded in the tax base in accordance with general rules. Legislation provides no grounds for challenging such costs.

The exporter's expenses on paying an insurance premium to an insurer constitute a more complex issue. Legislation is extremely stringent on voluntary insurance. By default, the tax base may not be reduced by such expenses (clause 6, article 270 of the Russian Tax Code). However, it does provide for a list of exceptions. This list does not include expenses on insuring business risks on export supplier credits. The law allows the taxpayer to deduct expenses on the voluntary property insurance of "other types" (sub-clause 10, clause 1, article 263 of the Russian Tax Code), subject to the following proviso: such insurance should be stipulated by Russian legislation for the taxpayer to conduct its activities. As Russian legislation does not stipulate that exporters must insure risks when granting supplier credits, in practice the taxpayer will be unable to prove its right to deduct these insurance costs.

This situation can hardly be called fair, as there is a clear-cut business purpose and an obvious economic justification for the insurance. Clearly, legislation needs to be changed to this effect. Either this type of property insurance should be explicitly stipulated in article 263 of the Russian Tax Code or the proviso that such insurance should be stipulated by Russian legislation for the taxpayer to conduct its activities should be deleted.

Even in this case, however, some problems will remain. It is well known that long-term export loans are insured or guaranteed internationally by government structures. In Russia, this role is assumed by Vneshekonombank, which is strictly speaking neither a bank, nor an insurance company from a legal perspective. It is possible to anticipate disputes filed by tax offices on the grounds that expenses related to payment for Vneshekonombank's services do not constitute expenses incurred on property insurance, unless article 263 of the Russian Tax Code includes an explicit reference that these expenses should be recognized as insurance costs.

On the other hand, the same argument could be used to argue the opposite point of view. If these expenses do not constitute insurance costs in the full sense of the words, they are not subject to the limitation set by the principle that "only expenses expressly stipulated by law may be deducted" and can be deducted justifiably among other costs relating to production and sales. The list of these costs is open (clause 49, article 264 of the Russian Tax Code).

2. Value Added Tax

Effective legislation on this tax results in double counting if the exporter receives an insurance indemnity instead of revenues.

As in the case of profit tax, the revenues are included in the tax base on an accrual basis, in other words, the tax accrues on amounts that have still not been received and may not be received in future. In general cases unrelated to export, the insolvency of a counterparty would mean that the seller of the goods would have to pay VAT from its own funds. If the business risk relating to supplier credits has been insured, the amount of insurance indemnity is included in the tax base (clause 4, article 162 of the Russian Tax Code). There is no rational explication as to why this rule was retained at the time of the transition from a cash basis to an accrual basis for the calculation of the tax base. Owing to this rule, the taxpayer has to pay the tax twice even though there is only one economic reason for the tax:

•First of all the taxpayer will accrue and pay VAT to the authorities from the amounts that were not received from the buyer, in other words, it will not be able to shift the tax burden to the buyer;

•He will subsequently pay VAT again, with respect to the same sale, on the reimbursement of losses received from the insurance company.

For the same reason, tax will be collected by the authorities with no economic justification if the taxpayer is an exporter. Even if the exporter manages to prove that it is entitled to apply zero percent VAT (this aspect is considered in more detail below), the insurance indemnity will still have to be included in the general tax base and taxed in the general manner. As a result, the exporter will forfeit at the very least the economic benefits of applying the zero percent tax rate on the export of goods as it will pay tax on the insurance indemnity.

In the worst-case scenario, the exporter will pay tax twice even in cases where legislation implied that it should not have paid this tax at all. This is due to the fact that the exporter will not be able to apply the zero per cent VAT rate unless it can prove that "revenues from the sale" of goods "were actually remitted" to its account opened with a Russian bank. Thus, VAT legislation additionally establishes rules for foreign exchange regulation stipulating the obligation to repatriate export revenues.

It is obvious that the exporter will be unable to prove his right to apply the zero per cent VAT rate if he receives only partial compensation for losses relating to the non-remittance of money from a counterparty. There is only one exception – instances where the non-remittance of export revenue is permitted by foreign exchange legislation (paragraph 2, sub-clause 2, clause 1 of article 165 of the Russian Tax Code).

For the time being, foreign exchange legislation obliges an exporter to remit export revenues to accounts opened with authorized banks in cases where an insurance company made the payment on behalf of the insolvent counterparty. In addition, at present, article 165 indicates situations where foreign exchange legislation allows exporters to keep export revenues abroad (for example, to repay long-term foreign loans). The situation is quite different for the insurance of supplier credits. Here, the requirement on repatriation is valid, but cannot be fulfilled for objective reasons. The negative implications of such failure should be eliminated.

The non-remittance of revenues is attributable to the actions of the taxpayer's counterparty and is compensated by insurance cover. In this situation, we believe that there should be no negative tax implications, such as the forfeiture of a person's right to apply the zero percent rate if this person has taken all reasonable efforts to protect its business interests.

Therefore, in terms of VAT, there is clearly a long-standing need to cancel the outdated rule that an insurance indemnity received instead of revenues should be included in the tax base.

In addition, it is necessary to expand the range of documents that can be used by an exporter to prove its right to apply the zero per cent rate in full in cases where it received a substantial insurance indemnity (60 percent or more) instead of revenues. This amendment will not contravene the purpose of the zero percent rate. This rate is granted to preserve the competitive price level of Russian goods abroad by removing the Russian indirect tax from the price. The actual export of goods is key to its application. As in the past, the exporter will have to prove that the goods were actually exported.

3. Foreign Exchange Legislation

Under general rules, an exporter is obliged to repatriate revenues, in other words, to make sure that the foreign counterparty remits the revenues to the exporter's bank account opened with an authorized bank in the Russian Federation (article 19 of Federal Law No. 173-FZ dated 10 December 2003 "On Foreign Exchange Regulation and Control"). A substantial administrative fine is imposed if this rule is broken: the maximum is equal to the total amount of the revenues that were not remitted to Russia, while the minimum equals 75 per cent of this amount (article 15.25 of the Russian Code of Administrative Offences).

In practice, the fine is not imposed if the exporter manages to prove his innocence. Since the remittance of revenues is primarily dependent on the solvency of the counterparty, the exporter has to demonstrate that he has taken all reasonable measures to ensure that the revenues are remitted to Russia: has stipulated contractual sanctions for a delay in payment, filed a claim, filed a statement of claim with court or, even better, established a payment procedure involving letters of credit.

It is worth bearing in mind that the requirement to repatriate revenues was introduced to protect the public interest of the Russian Federation, consisting of the receipt of foreign currency from abroad, and not the property interests of exporters. Measures undertaken by an exporter to protect his interests (guarantee or insurance) do not constitute measures that protect public interest. Consequently, from the perspective of foreign exchange legislation, an exporter that was not paid by a buyer, but (partially) recovered his losses from an insurance company, has broken the law and will face sanctions. This approach can be contested and there are arguments that can be used. However, there is a material risk that there will be a conflict with the regulatory authorities.

The above wording on tax legislation shows that provisions need to be adapted in some way with respect to export loan insurance in order to align their formal application with the purport and principles of tax legislation. Here the legislator needs to make a difficult choice: to advocate the retention of stringent rules governing the repatriation of revenues or alleviate the operating terms of exporters, by expanding their ability to grant supplier credits backed by insurance coverage and allowing for partial repatriation of foreign currency revenues.

In our opinion, article 19 of the Law on foreign exchange regulation should be amended so that exporters would not have to repatriate revenues if the risk of non-payment has been insured and the insurance indemnity has been received within the timeframes and in the amount agreed upon in the insurance contract.

Without such amendments, the institution of export loan insurance will not become widely used as there will always be a risk that the benefits of taking out insurance to cover losses will be offset by a punitive fine imposed by the regulatory authorities on the exporter for failing to remit foreign currency revenues to Russia. In this case, even state insurance of export loans will not attain its goal and Russian exporters will not be able to leverage an effective remedy that is readily available to their foreign competitors.