Artificial business splitting or a justified restructuring of the organisation

Business splitting is not a new subject. A great many organisational structures use every opportunity to reduce the tax they pay, sometimes by building schemes that have nothing to do with reality. Some act in a more elaborate way, but still not carefully enough to go unnoticed. As the tax authorities have widened the practice of stopping taxpayers from obtaining an unjustified tax benefit, they have built up invaluable experience in assembling evidence on the true business purpose of particular decisions. The direction of the taxpayer's actions in creating a fragmented corporate structure is the key question in cases of artificial business splitting. If, on the facts of a particular case, the tax authority concludes that the scheme was chosen only in order to reduce the amount owed to the budget, the taxpayer's actions are classified as bad faith.

In 2019, in the view of many, the Federal Tax Service of Russia, having organised its work on detecting VAT gaps, turned its attention to possible breaches in the use of "tax optimisation" through the special tax regimes the law provides. The most widely used were the unified tax on imputed income (UTII) and the simplified tax system, often applied as a result of artificial business splitting. Whether that is so, we will be able to judge objectively no earlier than 2020. For now we can only take stock of the scenarios the Federal Tax Service of Russia detects, and look at the actions of taxpayers that the courts have refused to treat as artificial business splitting aimed at reducing tax.

To make inspectors' work more effective, the tax service collects and organises the approaches, drawn from court practice, for detecting a formal split of a business. For example, the letter of the Federal Tax Service of Russia of 11 August 2017 No. SA-4-7/15895@ sets out 17 key signs that help inspectors find a formal division of a business. That list of criteria is not exhaustive. We will leave those long-familiar examples to one side and turn to newer factors, formed as artificial business splitting has developed in court practice, which may point to a high tax risk where a split is formal. They include the following combination of circumstances identified by the tax authority:

• a single business (a production process) is split among several persons who apply special tax regimes under which the special regime exempts the main participant, who carries on the real activity, from calculating and paying VAT, corporate profits tax and corporate property tax;
• the splitting scheme has affected the conditions and the economic results of every participant in the group, including their tax liabilities, which fell, or barely changed, as the joint business expanded;
• the taxpayer, its participants, its officers, or the persons who actually manage the operation of the scheme, benefit from the use of the business-splitting scheme;
• the participants in the scheme carry on the same type of economic activity;
• the participants in the scheme were established within a short space of time, immediately before production capacity was expanded and/or headcount was increased;
• members of the group bear expenses for one another;
• direct or indirect interdependence (affiliation) of the participants in the splitting scheme (family ties, participation in management bodies, subordination at work, and so on);
• a formal redistribution of staff among the participants in the scheme, with no change in their duties;
• the controlled persons have no fixed assets, working capital or staff of their own;
• the participants in the scheme use the same signs, designations, contact details, website, addresses of their actual location, premises (offices, warehouse and production sites, and so on), banks at which current accounts are opened and serviced, cash registers, terminals, and so on;
• the only supplier or buyer of one participant in the splitting scheme may be another participant, or the suppliers and buyers of all the participants are the same;
• the activity of the participants in the scheme is in fact managed by the same persons;
• the participants in the scheme share the same services for bookkeeping, personnel records, recruitment, finding suppliers and buyers and working with them, legal support, logistics, and so on;
• the same persons represent the participants in dealings with state bodies and with other counterparties (those outside the splitting scheme);
• indicators of activity, such as headcount, the area occupied and the amount of income received, are close to the limits that restrict the right to apply a special tax system;
• the taxpayer's accounting data, taking the newly created organisations into account, may point to a fall in the profitability of production and in profit;
• suppliers and buyers are allocated among the participants in the scheme according to the tax system each of them applies.

The Constitutional Court of the Russian Federation has noted that the Tax Code allows a choice of one or another method of accounting policy (applying tax relief or declining it, applying special regimes, and so on), but accounting policy must not be used to reduce tax receipts to the budget unlawfully by an abuse of the taxpayer's rights (Ruling of the Constitutional Court of the Russian Federation of 4 July 2017 No. 1440-O). That point is meant to underline the importance of the business-purpose principle: if a business decision is not directed at an independent business purpose, and is taken only to reduce the amount of tax, the decision is unlawful.

Before turning to particular court cases on business splitting, one positive development is worth recording. The practice for calculating the amount of VAT has finally settled. Previously, when a tax authority found that VAT had not been paid to the budget, it often calculated the arrears by charging VAT on top of income, and refused to accept that VAT was included in the price of the transaction, which increased the arrears. The Supreme Court of the Russian Federation, in its Ruling of 30 September 2019 No. 307-ES19-8085 in case No. A05-13684/2017, took the following position: "The court's conclusions as to the lawfulness of determining the VAT base by applying the rate of 18% in addition to the entrepreneur's income from sales, instead of extracting the tax from the proceeds received by applying the calculated rate of 18/118, and as to the correctness of the amount of the VAT arrears in the inspectorate's contested decision, cannot be regarded as well founded."

One of the main mistakes taxpayers make when they build a structure through business splitting is the "interdependence of taxpayers". Interdependence of taxpayers is not, by itself, proof that an unjustified tax benefit was obtained. If, however, it is established that the parties to a transaction use that interdependence for coordinated actions that have no reasonable economic or other objective cause, that the activity has the features of a business that is not carried on independently, and that one participant in the "scheme" carries on formal economic activity solely in order to understate income and obtain an unjustified tax benefit, the tax authority will assess the conduct of the group of taxpayers as a single business structure. In that case the likelihood of adverse legal and economic consequences for the taxpayer, including a refusal to apply the reliefs and preferences of the special tax regimes, is extremely high.

In one case, an individual entrepreneur against an interdistrict inspectorate of the Federal Tax Service of Russia (case No. A05-13684/2017), the tax authority found that the taxpayer had understated the tax base by artificially inserting into the chain of business transactions, and by creating a fictitious document flow with, business entities that were formally separate but in fact controlled by the taxpayer. In the inspectorate's view, those actions were directed solely at moving part of the taxpayer's own income (revenue) to third parties, by formally leasing out a petrol station, so as to avoid exceeding the income ceiling set for the simplified tax system.

By combining the income from the activity of a group of affiliated persons (three individual entrepreneurs), the tax authority found that the income ceiling permitted by paragraph 4 of Article 346.13 of the Tax Code had already been exceeded in the third quarter of 2013, so that from 1 July 2013 the entrepreneur lost the right to apply the simplified tax system.

Hearing the dispute, the court found that the activity of the entrepreneur and of his interdependent persons was in fact the activity of a single business entity, whose total income exceeded the maximum permitted for the simplified tax system. An additional assessment was therefore made against the taxpayer of 4,591,762.93 roubles in VAT and 1,031,152 roubles in personal income tax, together with 1,150,596.59 roubles in late-payment interest and a fine of 642,174.40 roubles.

In another example (case No. A53-16343/2018) the taxpayer defended its position and proved in court that the corporate structure of the business model was economically justified. The dispute concerned a decision making an additional assessment of 33 million roubles against a limited liability company. It rested on the inspectors' conclusions that the director of the company (the father) and an individual entrepreneur (the daughter) were affiliated persons who, by allocating the expenses of selling goods, had created a scheme concealing the actual activity of a single person, the company itself. In support of those arguments the inspectorate pointed to signs of a formal split: a single IP address, a shared accounts function, a shared contact telephone number, and common production resources.

The court disagreed with the tax authority. It held that the company and the individual entrepreneur carried on activities of a different character: the company manufactured furniture and supplied it wholesale, and the entrepreneur sold it at retail. The volumes of furniture supplied by the company to the entrepreneur were confirmed by documents, and the audit did not confirm any overstatement of the product price that might have indicated bad faith or an intention to dilute the tax base. The court stressed that the mere fact that those persons had opened current accounts at the same bank, their family ties, and the entrepreneur's use of a special tax regime (UTII) were not sufficient grounds for treating the transactions between the company and the entrepreneur as an attempt to avoid tax.

A review of court practice in 2019 shows, on the whole, that the courts are paying closer attention to the details of the taxpayer's real economic activity and to the way its business processes are built. They assess the circumstances and conditions in which a particular corporate structure took shape at the taxpayer, and also business custom and the trends in the industry.

That careful and detailed approach often separates processes built by bad-faith taxpayers for the sole purpose of evading tax from business structures that objectively need their lines of business to be diversified and kept separate. It has to be said that this approach, which places artificial limits on the taxpayer's choice among the tax regimes the legislator has made available, substantially narrows the taxpayer's freedom of action.

Sergei Pivovarchik, managing partner at Consul Group, notes.

The absence of direct prescriptions and prohibitions in legal acts, on the one hand, gives public authorities unlimited discretion and, on the other, rules out protection outside the courts, because the law lays down no clearly defined, specific prohibitions and restrictions. It is hard to take a positive view of that gap in the legislation, which so far is filled only in practice. In the present conditions, with taxpayers abusing, on a large scale, the rights granted to them, it may be the only way to make the business community observe the rules of the game. A global aim is not always achieved without local casualties. "When trees are felled, the chips fly."

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