Dividend payments to foreign organisations: tax structures and their consequences

Case law on the payment of dividends to foreign organisations continues to develop actively. In most decisions the courts support the position of the tax authorities and refuse the taxpayer tax relief. Cases that end in additional tax assessments of enormous sums no longer shock anyone. Over the past four years the Russian courts have handed down more than 70 rulings on this subject. One of the first, and the most prominent, was the case of PAO Severstal, which ended in an additional tax assessment of almost 1 billion roubles in 2016. The record amount of fiscal liabilities was updated at the end of 2019. At TD Perekrestok the additional tax assessments came to almost 1.5 billion roubles. We examine the mistakes in structuring financial flows that caused enormous additional tax assessments when dividends were distributed abroad.

The concept of the beneficial owner of the income

Agreements of the Russian Federation with foreign states for the avoidance of double taxation (double tax treaties, DTTs) in most cases provide for reduced rates of tax on cross-border transactions. This allows the taxpayer to save on tax.

Such a saving was often the reason for creating international legal structures. In practice the taxpayer created only the formal conditions for applying tax relief by using a DTT and in fact obtained an unjustified tax benefit, which is fundamentally unacceptable to the governments of most states. As a result, the international Organisation for Economic Co-operation and Development (OECD) developed rules for the application of DTT preferences: the Model Tax Conventions and the official Commentaries (that is, the rules) to them, directed at establishing fair taxation and at preventing profit from being taken out of the tax net. A special place among them belongs to the concept of taxing the beneficial owner of the income, and not the formal recipient. In disputes on the taxation of cross-border transactions over the past few years, references to these Commentaries have become an integral part of the clarifications of the Ministry of Finance of Russia and of the rulings of the Russian courts.

Where a taxpayer uses preferential DTT rates without justification, the provisions of the Tax Code are breached, which in the end entails additional tax assessments and fines. The task of the tax authorities under the beneficial-owner concept is to determine the correct tax regime for dividends, royalties, interest on loans, and income from the sale of shares and similar amounts paid to a foreign organisation, and to make an additional tax assessment according to the actual substance of the transactions.

Most often, the substance of the disputes that arise in situations of this kind is as follows:

• a foreign company, registered in a jurisdiction with which Russia has concluded a DTT (as a rule, this is Cyprus), owns shares in a Russian organisation;
• there is formal compliance with the requirements for a beneficial owner of the income set out in the DTT, so that a reduced rate of tax on dividends can be applied (5% under the DTT, against 13% (15%) under the Tax Code);
• the Cypriot company has no expenses on the territory of the country, it owns only the shares in the Russian organisation, and it receives its only (or principal) income from dividends from Russia;
• the Cypriot company is owned by another legal entity (or is connected with it), a resident of a country with which the Russian Federation has not concluded a DTT (as a rule, this is the British Virgin Islands (BVI) or another offshore jurisdiction);
• after the Cypriot organisation receives the funds from Russia, it transfers them almost in full to a company registered in another jurisdiction (the BVI), so the movement of funds is conduit in character;
• the tax authorities consider that, in relation to the income, the Cypriot company performs only technical functions, passing it on to another person. In that case the company is not recognised as the beneficial owner of the income (the beneficiary).

In such situations the tax authorities come to the conclusion that a legal structure of this kind only formally meets the conditions of the DTT for the use of tax relief when passive income is paid from the Russian Federation to a Cypriot company. Since there is no DTT between the BVI and Russia, such transactions must be taxed at the rate of 15% under subparagraph 3 of paragraph 3 of Article 284 of the Tax Code.

When analysing cases of this kind, the tax authorities pay particular attention to the circumstances and facts on the basis of which a foreign organisation is regarded as a "conduit" company, and not as the beneficial owner of the income. These facts are the main arguments of the Federal Tax Service for refusing tax relief under a DTT:

• the recipient of the income carries on no active business abroad;
• a lack of economic substance, because of direct dependence on the shareholders;
• no real profit is derived, because the funds move on to other jurisdictions;
• the "conduit" character of the financial transactions; minimal expenses; and so on.

 

Decisions in dividend disputes

In most cases the courts of the Russian Federation support the position of the fiscal authorities that formal conditions alone are not acceptable for a preferential tax regime when dividends are distributed under agreements for the avoidance of double taxation. In that case the main aim becomes a tax benefit (the application of the 5% rate of tax on dividends between the Russian Federation and Cyprus, and others), which entails a justified refusal of the tax relief provided for by the DTT. The tax burden on the taxpayer therefore increases because of an additional tax assessment of 10% (the transaction of distributing dividends is recalculated and taxed at the rate of 15% provided for by subparagraph 3 of paragraph 3 of Article 284 of the Tax Code). A few examples of court decisions follow.

The case of AO Generium

Additional profits tax of 285 837 855 roubles was assessed against the taxpayer, late-payment interest of 106 850 688 roubles, and a fine of 1 875 100 roubles. The Arbitrazh Court of Vladimir Region, on 28.06.2019 in case No. А11-6159/2018, supported the tax authorities.

The substance of the case

In 2012-2014 a Russian company distributed dividends to its Cypriot shareholder companies. As tax agent, it withheld tax on this income at the rate of 5%, under subparagraph "a" of paragraph 2 of Article 10 of the Agreement between the Government of the Russian Federation and the Government of the Republic of Cyprus for the avoidance of double taxation with respect to taxes on income and on capital of 05.12.98.

Following a field tax audit, the tax inspectorate refused the application of the preferential rate and assessed additional profits tax on the income in the form of dividends at the rate of 15%. It determined that the Cypriot shareholders perform technical functions in passing the income on to another person and cannot be regarded as the beneficial owner of the income.

The tax service found the taxpayer's arguments unfounded: that the Cypriot shareholder companies carried on business in full compliance with the legislation and with commercial practice in Cyprus, and that the management of the parent companies acted independently and decided the "economic fate" of the dividends received from Russia.

The court's decision

The court supported the tax authorities, stating that the Cypriot organisations:

• hold shares in Russian companies as their only asset, and the dividends received are their only income;
• have only a formal right of ownership of the income;
• distributed the dividends further on to companies in the BVI, with the purpose of payment stated as "under loan agreements" or "payment of dividends", which is a conduit movement of the income.

This proves that the Russian company had no right to apply the reduced rate of profits tax of 5% when transferring dividends to the Cypriot companies, since they are not the beneficial owners of the income.

The conclusion

This court case has the classic set of gaps in a taxpayer's application of a DTT. The court's decision points to the importance of complying with the requirements for the application of the provisions of a DTT, and of the absence of a conduit character in the movement of funds through low-tax jurisdictions.

A similar case was considered in the Ruling of the Supreme Court of the Russian Federation of 03.12.2018 No. 304-КГ18-19526, in the case of OAO Shakhta "Polosukhinskaya" No. А27-27287/2016.

The court held lawful the additional assessment against the taxpayer of profits tax in the amount of 429 506 540 roubles and of late-payment interest in the amount of 168 450 716 roubles.

The case of AO TD Perekrestok (OOO Agroaspekt, X5 Retail Group)

Following the tax audit, 1 426 178 896 roubles of profits tax were assessed in addition. The fine was 82 668 686 roubles. The Arbitrazh Court of the City of Moscow supported the tax authorities (decision of 22.11.2019 in case No. А40-118135/2019).

This case is an example of the most economically advantageous pattern of distributing dividends in favour of a foreign legal entity, a "hidden" one. In such cases a foreign company first advances a loan to a Russian company at a certain rate of interest. The Russian legal entity then pays the interest back to the foreign company, which from the standpoint of the Tax Code is an expense for the purposes of profits tax. As a result the foreign company receives income from sources of activity in the Russian Federation, applying a reduced rate of tax to the transaction (5%), while the Russian legal entity records these payments for the calculation of profits tax, which helps to reduce the tax base and the liabilities to the budget. Where the legal entities are related parties, the transactions are recognised as an offence.

The substance of the case

In 2013-2015 X5 Retail Group carried out a public restructuring of assets through a series of interrelated intra-group transactions, agreed with the competent authorities of the participating countries. In the course of the audit the tax authorities determined that, within these transactions, a mechanism had been created for reallocating the group's profit without payment of tax in the Russian Federation and in foreign states. This was held to be bad-faith conduct aimed at obtaining an unjustified tax benefit, and an abuse of the provisions of the DTT.

As a result of these transactions, one of the Russian legal entities (TD Perekrestok) acquired from a Cypriot affiliated person (Speak Global Limited) an 83.4% participation interest in the charter capital of OOO Agrotorg (the Pyaterochka brand) for 82.5 billion roubles. A set-off of obligations in the amount of 11.5 billion roubles was made against a debt previously extended from Russia to Cyprus. 66.3 billion roubles were converted into a loan, and the remaining part of the funds was paid at once.

The rights of claim of TD Perekrestok to 66.3 billion roubles were, however, structured in such a way that X5 Retail Holding Limited (Cyprus) at the same time incurred a debt obligation of exactly the same amount to the company X5 Capital S.a r.l. (Luxembourg), which in fact created the conditions for a sequential transfer of funds from Russia to the Luxembourg company through the Cypriot participants in the group. The Luxembourg organisation was owned by Perekrestok Holdings Limited (Gibraltar), which was owned by X5 Retail Group N. V. (the Netherlands), the organisation common to all participants in the holding, which in its turn was owned by CTF Holdings Limited (Gibraltar), the principal parent structure.

In the course of the audit the tax inspectorate came to the conclusion that the restructuring chosen was directed at obtaining an unjustified tax saving by:

• an unlawful increase in the non-operating expenses of TD Perekrestok by the amount of interest on the loan (a breach of the provisions of Articles 45, 247 and 252 of the Tax Code, of Resolution of the Plenum of the Supreme Commercial Court of the Russian Federation of 12.10.2006 No. 53 and of Resolution of the Plenum of the Supreme Court of the Russian Federation of 23.06.2015 No. 25);
• a reduction of the profits-tax base;
• a hidden distribution of dividends in favour of the beneficial owner of the income;
• an unlawful application of the preferential provisions of the DTT between the Russian Federation and the Netherlands, because the companies are affiliated.

The income paid to the foreign companies in the course of carrying out the transactions in question is subject to tax in accordance with the requirements of the Tax Code (paragraph 1 of Article 43 of the Tax Code, subparagraph 2 of paragraph 1 of Article 309 of the Tax Code, paragraph 2 of Article 310 of the Tax Code) at the rate of 15% under Article 284 of the Tax Code.

The court's decision

The court fully supported the position of the tax authorities and noted that OOO Agrotorg had been among the participants in the group before the transaction as well, that management decisions on the companies' activities were taken centrally, and that the transaction produced no change of beneficiary.

The payment of interest on the loan for the purchase of the interests, and the amount of the settlement under the sale and purchase agreement for the interests in OOO Agrotorg, were recharacterised as a "hidden" distribution of profit in favour of the shareholders of the Russian company, that is, as dividends, without payment of tax in the Russian Federation.

In arguing for this recharacterisation, the tax inspectorate pointed to the conduit transfer of interest income by X5 Retail Holding Limited (Cyprus) under the mirror obligation in favour of X5 Capital S.a r.l. (Luxembourg). X5 Capital S.a r.l. had concluded a "ruling" with the tax authorities of Luxembourg, under which the interest received was recognised as dividend payments and exempted from tax. Thus, in fact, the taxpayer itself classified the income from interest on the loan as dividends for the beneficial owner of the income.

The tax authorities also, in order to determine the correct rate of tax on the dividends in question, examined in detail whether each participant in the cross-border transactions had a beneficial right to the income. They established that all the key decisions on carrying out the sequential series of transactions inside the holding were taken by one and the same person, Perekrestok Holdings Limited (Gibraltar) and its director Franz Wolf.

The conclusion

In this case particular attention is given to the tax authorities' analysis of a group of related companies, to establishing the beneficial owner of the income, and to going into the local legislation of the countries involved in the transactions. Having noted the taxpayer's offence, neither the tax authority nor the court indicated a method of restructuring the holding that would be correct from the standpoint of the Tax Code. The fiscal authorities pay attention not only to obvious transactions (such as dividends), where the taxpayer, at minimal cost and superficially, complies with the formal requirements, creating companies in order to take profit out of the tax net and to extract capital, but also to real companies that have a publicly intelligible economic strategy, including one agreed with the competent authorities.

Today the tax authorities analyse in detail the actual activity of an international legal structure, going into the specifics of the activity abroad and examining in detail every transaction that has a connection with sources of funds from the Russian Federation.

How to reduce the risks

Over the past ten years the tax services have gone through a far-reaching evolution: today they can obtain almost any tax (financial) information on the movement of funds and on the taxpayer's actions abroad. In present-day conditions it is becoming ever harder to obtain tax relief, given the case law, which is developing rapidly, and the implementation of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI)3, which comes into effect in Russia on 1 January 2021 and, almost at one and the same time, changes the rules for applying most DTTs. Nevertheless, many provisions of the MLI are already applied by the Russian courts. For many of today's participants in international transactions, the preferences of DTTs will become practically inapplicable.

The main thing to take into account when distributing passive income in favour of a foreign parent company is compliance with the criteria set out in the international conventions and the recommendations of the OECD, in the Tax Code (Articles 309, 310 and 312) and in the case law, which is developing rapidly (letters of the Federal Tax Service of Russia of 06.05.2019 No. СА-4-7/8448@, "Review of court disputes on the application of the provisions of international tax treaties and on abuse of the legislation in cross-border transactions"; of 28.04.2018 No. СА-4-9/8285, "On the practice of considering disputes on the application of the concept of the person who has the beneficial right to the income (the beneficial owner)"; and of 17.05.2017 No. СА-4-7/9270@, "On the practice of considering disputes concerning the unlawful application by tax agents of preferential terms of taxation when charging profits tax on the income of foreign organisations").

A taxpayer acting in good faith, and keeping to these conditions, will be able to reduce the risks of being held fiscally liable. The three fundamental principles of good faith are:

• that the movement of funds within cross-border transactions is not conduit in character;
• a transparent and economically justified business purpose for the presence of the beneficial owner of the income in a particular jurisdiction;
• management and control, with the corresponding budgeting and administration, at the parent company.

It is plain that it is harder for a taxpayer to make use of the right to apply tax relief under a DTT, and to defend that right, when carrying out international transactions.

"A structure for holding assets in Russia through foreign jurisdictions, popular among business owners for its 'convenience and confidentiality', can become a serious problem. In order to rule out fiscal or even criminal liability for their actions, most often committed through carelessness, business owners need to understand in good time their personal aims and the company's aims over the long term, and to reorganise the corporate structure in accordance with them," says Vasile Lupu, head of the international tax practice at Consul Group.

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