Russian Thin Capitalization Rules in Light of Double Taxation Treaties: Trends in Court Practice
- By Oxana Kovaleva
- Feb. 09 2010 00:00
Capital Legal Services
For the purpose of protecting domestic interests, most states limit taxpayers’ ability to recognize interest on loans or credits as expenses reducing corporate profit tax payments, particularly where such interest is paid to a related entity outside the state. In tax practice such limitations are called “thin capitalization rules.”
Russian tax legislation has imposed its own thin capitalization rules, which are applicable when: 1) there is controlled debt; 2) if the amount of controlled debt is three times (or more) greater than the borrowing entity’s own capital as of the last day of the relevant reporting/tax period.
A controlled debt under loan obligations accrues in the following three cases:
1) If a Russian entity is indebted to a foreign entity controlling more than 20 percent of the Russian entity’s registered capital; or
2) If a Russian entity is indebted to a Russian entity recognized as an affiliate of the above foreign entity under Russian law; or
3) If the above affiliate and/or foreign company is/are a surety or guarantor for a debt obligation of a Russian entity or otherwise undertake(s) to ensure performance of its debt obligation.
If all the conditions for applying these rules are met, a Russian entity may recognize interest as expenses only within limits established by the tax legislation. Interest paid in excess of the limits does not reduce the corporate profit tax base and is recognized as equivalent to dividends subject to corporate profit tax.
Until recently, Russian thin capitalization rules were not applied only if such special conditions are provided in a double taxation treaty between Russia and the state in which the lending company is resident (e.g. Russia has treaties with Germany and the Netherlands).
Russian courts have always supported taxpayers and confirmed their right to recognize interest paid to German and Dutch creditors as expenses without any limitations, as application of the thin capitalization rules in this event would have contradicted the international treaties that have priority over the Russian tax legislation.
However, much to the regret of taxpayers, only a limited number of international treaties expressly provide for the possibility to recognize interest for tax purposes without any limitations. In view of the above, precedents established by commercial arbitration courts of the Moscow region and Northwestern circuit (Resolution No.KA-A40/9453-09-2 of the Commercial Arbitration Court of the Moscow Region and Resolution No.A26-6967/2008 of the Commercial Arbitration Court of the Northwestern Circuit) are invaluable for taxpayers. In these cases, when assessing the lawfulness of nonapplication of the Russian thin capitalization rules, courts have for the first time referred to the provisions on nondiscrimination provided in the international treaties with Cyprus and Finland.
The courts have concluded that the Russian thin capitalization rules would not apply pursuant to the Russia-Cyprus Double Tax Treaty and the treaty concluded between Russia and Finland. The courts followed the assumption that interest paid by a Russian taxpayer to a foreign creditor is recognizable for tax purposes on the same terms as interest paid to Russian creditors.
Also, courts noted that Russian companies whose capital is owned or controlled by a foreign entity are not subject to a tax burden different from that of similar Russian companies.
When courts decided that thin capitalization rules not being applied is lawful, they also noted that tax authorities failed to prove that terms of the transactions concluded with related parties were different from the terms of transactions with unrelated parties.
Court practice may not yet be considered fully formed. However, taking into account the fact that the provision on nondiscrimination referred to by the courts in the above court cases is made part of virtually each effective double taxation treaty concluded by Russia, the above court decisions may have a far-reaching effect, particularly in view of a recent resolution of the Constitutional Court of the Russian Federation, where the court supported the formation of a system of precedent-based law in Russia.
Thus, in view of the above, the following questions should be answered:
1) Does the treaty establish the right to recognize interest paid to foreign entities and their affiliates as expenses without limitation?
2) Does the treaty establish the principle of nondiscrimination for Russian companies whose capital is owned or controlled by a foreign entity?
If the answer to the first question is “yes,” you have the right not to apply the Russian thin capitalization rules.
In the event that the answer to the second question is also “yes,” then in view of the presented court practice you may refrain from applying the thin capitalization rules established by the Russian tax legislation. Tax authorities are most likely to disagree, and you would probably have to protect your interests in court. However, your chances of success would be good.