Interest on Credit in the Income Tax Structure: Tax Risks to Be Considered

Alexei A. Yakovlev
Head of Tax Litigation Practice

The economic policy of the Russian authorities is targeted at meeting the consequences of the crisis. The Central Bank has already reduced the refinancing rate several times during 2010 to stimulate Russian economic and financial recovery. These measures are directed at making credit resources accessible and are meant to improve the crediting process. The reduction of real bank rates is progressing at a slow pace, although the credit market is becoming more active.

According to Article 269 of the Tax Code and its regulations, charges can be entered in the accounts to decrease the income tax basis. What are the principle risks that should be taken into consideration by the management of companies that are planning to attract credit, considering the latest trends in tax litigation practice?

At the end of 2009, the panel of the Supreme Arbitration Court tried a case and passed Resolution No. 11200/09 on Nov. 24, 2009. The dispute related to the following: In 2001, a taxpayer took out a loan. Tax inspectors examined the taxpayer for the period of 2005-06 and considered that the interest on credit was included in the income tax charges for the given period illegally, since it was to be paid during the period of 2010-14, while the principal debt had to be repaid by 2010. Such loan conditions, in fact, differ from standard business practice where payment of the principal debt and interest do not have significant time differences. However, without straight or indirect reference to illegal tax optimization, the panel of the Supreme Arbitration Court stated that since under the condition of the loan agreement payment must be arranged for the period from April 1, 2010 to Nov. 1, 2010, the company has no obligations on debt repayment until that period, which means that it has no charges to be included into the tax base when computing income tax.

This legal position of the Supreme Arbitration Court provoked indignation among both taxpayers and banks. Firstly, the structure of Paragraph 25, “Income Tax,” of the Tax Code does not regard payment as the main criterion for recognition of income and expenses for the majority of taxpayers. Secondly, because of the financial crisis, not all debtors could repay their loan interest in the agreed time. This is why interest payments moved away from the repayment period, not as a result of active tax optimization but because of objective conditions. Moreover, in the crisis and post-crisis periods, a practice for the refinancing of debt became widespread in business and banking where the new credit repays the earlier loan and the repayment period for interest payment is postponed. As for the legal position of the panel of the Supreme Arbitration Court in Resolution No. 11200/09, dated Nov. 24, 2009, it could either cause considerable problems with the loans granted earlier or lead to credit reduction in the recovering Russian economy. Application of this legal position to all tax litigation cases involving taxpayer companies, where the question of the tax basis reduction on loan agreements is considered, could be a reality since the legal positions of the panel of the Supreme Arbitration Court were legalized as obligatory precedents by Resolution No. 17, dated Dec. 12, 2007.

However, help for taxpayers came not from the judicial authorities but from the financial bodies. In an official letter, No. 3-2-06/22, dated March 17, 2010, referring to the Finance Ministry position, the Federal Tax Service specified the necessity of accounting for interest under loan agreements during the whole period of the contract regardless of the contract conditions relating to the date of payments under the loan agreement. Such an approach, according to the Federal Tax Service, fits the general format for acknowledgement of income and expenses for taxation under an accrual method, according to which income and expenses are recognized in the accounting period to which they refer, independent of the actual date of payment.

We may only hope that local tax authorities will take into consideration the official letter of the Federal Tax Service No. 3-2-06/22, dated March 17, 2010, and not Resolution No. 11200/09, dated Nov. 24, 2009, from the panel of the Supreme Arbitration Court. However, it is also desirable that a positive signal is received from the Supreme Arbitration Court, so that taxpayers can have peace of mind.

This situation is reminiscent of 2004 when the Constitutional Court took a tough stance on the use of loan budgets in the accounting of VAT deduction — see Constitutional Court Decision No. 169-O, dated April 8, 2004 — but then softened its approach significantly — see Constitutional Court Decision No. 324-O, dated Nov. 4, 2004.