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Loans from Foreign Sister Companies may be Regarded as Controlled Debt: New Court Practice
On 9 April 2010 the Ninth Arbitration Court of Appeal became available. The Court upheld the decision of the lower court, recognising the amount of debt owed to a foreign sister company is considered part of controlled debt - even though under the literal interpretation of the Russian tax law loans from foreign sister companies are not regarded as controlled debt. Taxand Russia reviews the court case and discusses how this impacts multinationals.
Under Russian thin cap rules interest on controlled debt exceeding 3 times the net assets of the company is not deductible and is re-characterised into dividends. However, the definition of controlled debt under Russian tax law does not include loans from foreign sister companies. At present this circumstance is sometimes used to circumvent restrictions imposed by Russian thin capitalisation rules.
In this particular court case, the deductibility of interest on loan from the foreign sister company was subject to limitations. If higher-instance courts uphold this approach, this could result in new tax risks for multinationals with similar financing structures.
Reasoning of the taxpayer
The taxpayer claimed the full deduction of interest on the loan from Heckbert 22, as a debt to a foreign sister company is not included in the definition of controlled debt stipulated by clause 2, article 269 of the Russian Tax Code. Therefore the corresponding limitations on the deductibility of interest should not be applied in cases where the value of a company's net assets is negative.
Reasoning of the tax authority
The tax authority disallowed the deduction in respect of a significant proportion of the interest accrued on the loan granted by Heckbert 22 on the grounds that this company is a member of the same group as OOO Hydromachservice and MirLand Cyprus. Directing the loan via Heckbert 22 was technical, and since the debt is effectively controlled, the deductibility of the corresponding interest is subject to limitations under clause 2, article 269 of the Tax Code.
After analysed the information published on the group's web-site, the court concluded that all companies are indeed members of the same group, which does investment projects in real estate. The group did an IPO on the London Stock Exchange. MirLand Cyprus bonds are listed on the Tel-Aviv Stock Exchange. The court concluded that effectively only MirLand Development Corporation Plc could be the source of funds extended by Heckbert 22. In the court's opinion, the distribution of funds through Heckbert 22 was "purely technical".
MirLand Cyprus is the parent company of both Heckbert 22 and OOO Hydromachservice. MirLand Cyprus controls more than 20% in both companies. Accordingly, all these companies are related parties and the debt of OOO Hydromachservice towards Heckbert 22 may be qualified as controlled debt.
Consequently, the limitations on the deductibility of interest established by clause 2, article 269 should equally apply to the interest on the loan granted by a foreign sister company.
This judgement is an example of the use of the substance over form concept in respect of loans from foreign sister companies. Please note that the Russian Ministry of Finance has already expressed the opinion, in particular in Letter No. 03-08-05 dated 27 November 2009, that such loans should be classified as controlled debt. Accordingly, the lack of an explicit reference in clause 2, article 269 of the Tax Code to loans from foreign sister companies as controlled debt does not guarantee that no limitations will be applied to the deductibility of interest on such loans.
In the past the tax authorities often voluntarily allowed for the deduction of the interest on loans from foreign sister companies, thereby reducing the amount of tax due, in cases where it was possible to prove that such companies did not directly control Russian taxpayers. However, this practice may now change.
It is advisable that taxpayers using similar financing arrangements, including the financing of real estate, perform an audit and reassess corresponding tax risks.
When examining the reasons why the taxpayer lost the case it's noted that the funds were effectively provided by the head company in Cyprus. The court ruled that the financing of the Russian real estate property through a financing company that is the resident of a country with a preferential tax regime for interest income (which was the case of Hungary in 2008), and not directly, constituted a transaction that was not supported by a convincing business purpose. It also cited other unusual conditions in a transaction.
The court judgment might have been different, if it had been demonstrated that the financing company actually and effectively borrowed funds from external sources and if the terms of the transaction had complied with the usual terms of transactions performed on an arm's length basis.
It is interesting to note here the tax authority's approach to the collection of information. The tax authority based its arguments on information about the composition and structure of the group of companies and on data about the group's financial instruments listed on stock exchanges. The tax authority even checked who officially owned the domain name www.mirland-development.com.
The above facts confirm that the tax authorities often act extremely professionally and that they use numerous sources of information about the taxpayer's operations, which came as a surprise to the taxpayer in a number of occasions. These facts also demonstrate that taxpayers need to monitor sources of publicly available information, including public databases, and related tax risks, and also verify the holding and financing structures that they use.
Multinationals financing their Russian entities through foreign sister companies should re-assess the risks of applying thin capitalisation rules.
They should in particular check whether there is business purpose behind structuring debt finance and what tax adjustments are required if debt from foreign sister companies is taken into account for the purpose of applying thin cap rules. What's more multinationals should seek publically available information about the structure to assist with decision making.
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