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Deductibility of Interest on Foreign Currency Loans Restricted in 2011 & 2012
Problems Identified and Possible Restructuring Solutions Proposed
For many years, debt financing has remained one of the most common forms of funding Russian companies by foreign companies. The interest deductibility rate on loans in foreign currency, such as USD or EUR has remained relatively high - 15% per annum and in some cases, 22% (during 1 September 2008 to 31 December 2009). Many Russian companies took advantage of this opportunity and chose the interest rate of 15% for loans in foreign currency granted by affiliated non-resident financing companies.
On 27 July 2010, a new law was enacted to substantially reduce the interest deductibility rate for loans in foreign currency. The reduction will be phased in during 2011 and 2012, and will reduce the interest deductibility rate to 80% of the Central Bank refinancing rate. Taxand Russia, with the help of Taxand Luxembourg and Taxand Netherlands, reviews the problems that will arise in light of the new law and the possible solutions for restructuring businesses to mitigate risk and reduce the tax burden.
As enacted, the interest deductibility rate for the purposes of deductibility will be reduced as follows:
Based on the current Central Bank rate of 7.75%, the permitted deduction rate on foreign currency loans would be reduced to 6.2% by the end of 2012, which is almost 2.5 times less than the currently permissible rate of 15%.
For loans with fixed interest rate where the rate has not changed during existence of loan, the basis for calculating 80% Central Bank rate limitation would be the Central Bank rate at the time of the issuance of the loan. Hence, when calculating the allowable level of interest deduction for fixed interest rate loan agreements, the Central Bank rate will need to be reviewed for the period when the loan was issued.
There will be many cases where debt financing arrangements will need to be restructured and rulings for many non-Russian financing companies, such as those domiciled in the Netherlands or Luxembourg, will need to be revised. This issue is also relevant for special purpose vehicles established in securitisations, syndicated loans and other similar structures.
What are the possible options for restructuring?
1) A reduction of the interest rate on foreign currency loans
In principle, the problem of "non-deductible" interest may be resolved simply by amending the interest rate in current loan agreements. The advantage of this solution lies in its simplicity. The obvious drawback is the risk of possible claims from the tax authorities related to earlier fiscal periods. If the borrower and the lender suddenly reduced the interest rate by a factor of 2.5 without amending the other provisions of the loan agreement, would a 15% interest rate for prior fiscal periods be justifiable in economic terms? It is entirely possible that the tax authority may question such a reduction.
It appears that a more considered solution would be to cancel existing loans and to issue new loans on terms that make the reduction of the interest rate justifiable in economic terms - for example, by providing for more reliable means of securing repayments. It would also be possible to establish a "floating" rate based on the LIBOR or EURIBOR and other similar rates. The amendment of existing loan agreements with the same considerations as described above is another alternative.
In this context, it would be prudent to conduct a general tax audit of the structure to identify any benefits that are currently granted to Russian companies free of charge, such as provision of intellectual property and managerial services, to consider sufficient compensation of foreign service providers.
2) Issuing loans in Russian currency
In 2011 and 2012, it will remain possible to deduct interest on loans in Roubles at a level of 1.8 times the Russian Central Bank refinancing rate. In comparison, Rouble loans will allow a higher degree of deduction of interest. However, using Roubles as the currency of the loan will not always be advantageous to a foreign lender. To protect itself against the risk of a fall in the Rouble exchange rate, a foreign lender will most likely require such losses to be reimbursed and/or the repayment amount to be linked to the exchange rate of one foreign currency or another.
The balance needs to be sought between the protecting the interest of the foreign lender to foreign exchange exposure and keeping the loan as a Russian currency loan. Although there are a number of favourable interpretations issued where loans payable in Roubles effectively linked to foreign currency are regarded as loans issued in Roubles, such a loan does not necessarily benefit from interest deduction allowed for loans in Roubles.
It should also be remembered that the term concerning the currency of a loan is one of the terms of the agreement between a borrower and a lender, and in the borrower and lender's particular situation, it may be a preferable solution to select Roubles as the currency.
3) Use of double taxation treaties
Treaties on the avoidance of double taxation concluded by Russia with several countries, in particular with Canada, France, Germany, Great Britain, the Netherlands and the USA, provide for the full deduction of interest by Russian companies controlled by residents of these countries.
Tax treaties with some countries, such as the Netherlands, even provide for this if the Russian company is owned by the other tax treaty State's residents indirectly. Of course, this does allow interested to be deducted with no restrictions whatsoever. For a financing structure to function successfully, the interest rate must be at arm's length. Nevertheless, in many cases the arm's length interest level will exceed 80% of the Central Bank rate and the use of double taxation treaties may be effective in economic terms.
It is prudent to analyse the group structure of the companies involved to establish the deductibility of interest, and in particular whether there is a holding company in the structure which will allow provision for a higher level of interest deductibility.
These are only some of the possible solutions. It is obvious that Russian companies with significant quantities of loans in foreign currency will have to evaluate the deductibility of interest on foreign currency loans in 2011 and 2012. Preparing for such an evaluation and restructuring of debt financing will ensure that interest deductibility is maximised while the risks with tax authorities minimised.
Financing companies which obtained tax rulings on loans to Russian companies, in particular in the Netherlands and Luxembourg, will need to analyse the applicability of these rulings for the years 2011 and 2012 and consider making necessary amendments.
Your Taxand contacts for further queries are:
T. +7 495 967 00 07
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T. +352 26 940 640
T. +31 20 757 09 05
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