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Application of Russian Thin Capitalisation Rules Improved to Benefit Investors

On 25 September 2011, the Double Taxation Treaty between Russia and Switzerland was signed. A key amendment to the DTT is the implementation of improved thin capitalisation rules. Taxand Russia discusses the impact that the improved thin cap rules are likley to have on multinationals doing business in Russia.

Russian thin capitalisation rules apply if the amount of the debt of a foreign company exceeds the capital of the Russian Company by more than three times. Excess interest is not deductible and is qualified as a dividend for the tax purposes and should be withheld. The application of thin cap rules has often resulted in foreign companies being worse off in comparison to Russian companies.

However, there's a trend appearing in court case decisions to counter this imbalance. Judges are now paying more attention not only to formal rules, but to facts and actual relationships between entities to understand the substance, as well as the form, of the business structure and its operations.

Previously thin cap rules were not applied when a foreign "sister" company lends to a Russian company. This gap in the law has often been used to optimise taxes. In a recent case the taxpayer used its sister company's loan scheme to avoid thin cap rules. The court decided that the loan financing had in fact been made by the mother's company via the sister's company and that thin capitalisation rules applied.

In the case of Naryanmarneftegaz, LLC, which was decided in court on 5 August 2011, LUKOIL and ConocoPhillips had strategic agreement based on an economic partnership. The court carried out an investigation of financial and other documents and concluded that the loan given to Naryanmarneftegaz, LLC was in fact made out by LUKOIL and ConocoPhillips through a "financial company" called Phillips Petroleum International Investment. The judge said that in this situation the interest is characterised as dividend under the law of Russia, so the loan transactions were controlled and therefore thin cap rules should be applied.

Taxand's Take

Improving the application of Russia's thin cap rules both from a legislative as well as judicial perspective will bring benefits to investors. However, close attention should be paid to the substance of your investments to ensure you maximise their performance and mitigate future risks.

Your Taxand contacts for further queries are:
Andrey Tereschenko
T. +7 495 967 00 07

Ivan Zelenin
T. +7 495 967 00 07

Taxand's Take Author