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Loan Repayment Ruling Under DTT
On 29 August 2012, the Moscow State Commercial Court decided an important tax case that involved a permanent establishment (PE) of the Cypriot company Earsten Value Partners Ltd (Earsten). Earsten was a subsidiary of a company incorporated in the British Virgin Islands (the BVI Company) and borrowed money from the BVI Company which it then lent to the Russian PE. Under the Russia-Cyprus Double Taxation Treaty, a permanent establishment that is tax resident in Russia is not obliged to withhold income tax when it pays interest to a Cyprus based company. Taxand Russia investigates the proceedings.
To the tax authorities' surprise, the Company had instructed the PE to repay both principal and interest under the loan not to Earsten but directly to the BVI Company. The tax authority viewed this as a tax avoidance scheme and charged taxes as it considered that the DTT was not applicable and therefore tax on the interest should be withheld.
The taxpayer contested this in Court and the Court found in favour of the taxpayer. The Court based its decision on the Commentary to the OECD Model Convention, stating that the DTT is applicable because the loan was made by a Cypriot resident to a Russian resident, and therefore it was irrelevant to whom repayments were actually made.
This is an important ruling for companies under DTT, as it could offer precedent in future tax cases. It is important to note that increasingly countries are basing legal opinion on commentary made to the OECD Model Convention.