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Permanent Establishment: Court's Warning for Representative Offices

20 Apr 2011

On 8 December 2010 the Moscow State Commercial Court issued its decision in a case involving an analysis of whether the collection of information can result in an entity being deemed to constitute a permanent establishment under Russian law and the double tax treaty between Russia and the United States. Taxand Russia and Taxand US investigate the activities of non-resident companies in Russia through a representative office.

The taxpayer, Bloomberg LP, produces information products, including analytical databases. Between 2006 and 2007 it had a representative office in Moscow, where a number of employees gathered information which was incorporated into its databases. Sales of the products were made primarily from the UK office, but payments for these sales were made directly to a US bank account. However, Russian value-added tax (VAT) legislation required that VAT returns on such sales be filed in Russia and that VAT be paid there.

The outcome of the taxpayer's field audit for the fiscal year 2006 to 2007 was that the authorities held the taxpayer's activities in Russia to constitute a permanent establishment. Accordingly, they issued a claim for additional tax. The taxpayer disputed the finding and appealed.

The two principal issues were:

  • whether activities related to information gathering result in an entity being deemed a permanent establishment, given that under the US-Russia tax treaty, collecting information as a preparatory and auxiliary activity is excluded from the general definition of the activities of a permanent establishment
  • if a permanent establishment existed, how much income should be attributable to such activity.

The authorities maintained that a permanent establishment existed and that the activities of employees in Russia were an integral part of the taxpayer's activities. The taxpayer derived revenue from clients for its databases and analytical data. Thus, such activity formed part of the taxpayer's core activities.

The authorities considered that, in general, all payments for products which were sold to Russian customers and on which VAT was paid should be regarded as revenue of the permanent establishment. It agreed to take into account certain expenses incurred by the taxpayer.

The taxpayer argued that as the collection of information is mentioned in the list of exclusions from the general definition of the term 'permanent establishment' under the relevant tax treaty, and as such activity was auxiliary and preparatory in nature.

Moreover, the taxpayer stressed that such information was provided free of charge. The taxpayer referred to the Amadeus database to demonstrate that similar activities in Europe resulted in profits of between 4% and 6%. Hence, the taxable base for corporate profit tax should not include all payments on which Russian VAT was paid, as most of them effectively related to sales from non-Russian offices, while payments were made directly to a US bank account.

Overall, the court upheld the tax authority's reasoning. It concluded that collecting information and selling products based on such information were the taxpayer's principal business activities. Thus, the Russian office's activities could not be regarded as auxiliary or preparatory, and therefore the taxpayer had had a permanent establishment in Russia in between 2006 and 2007. On this point, the court referred to the Organisation for Economic Cooperation and Development (OECD) Commentary to the Model Tax Treaty, despite the fact that Russia is not an OECD member. Moreover, the court made numerous references to the Ministry of Finance's guidance on interpreting tax treaties.

The court declined to refer to the Amadeus database. The court agreed with the authorities' argument that a tax base is determined on the basis of the deduction of permitted expenses from the taxpayer's gross revenue from Russian sources. The court's decision disregards the Russia-US tax treaty and the technical explanation that accompanies the treaty, which applies a separate and independent enterprise approach regarding the allocation of profits to the branch / permanent establishment. Instead, the court used the direct method, taking into account all of Bloomberg's sales in Russia, including those unrelated to the activities of the branch / permanent establishment. Even though US domestic law has its own "force of attraction" provision, this rule does not extend to profit allocations under a treaty and doubtfully would be applied as broadly as done by the Russian court. The Russia-US treaty explicitly provides that only the profits attributable to the permanent establishment may be taxed. The court's decision also limits the attribution of costs to the branch/ permanent establishment while at the same time expanding the revenue base beyond the confines of the activities of the branch/ permanent establishment. The court's indifference to the treaty and its failure to clearly articulate the reasoning underlying the opinion creates uncertainty and a perilous precedent for US and foreign multinationals operating in Russia. The court which decided the matter was a first instance in court, but the decision was not appealed and is now in force.

However, tax practitioners and others have criticised some of the court's conclusions, particularly regarding the attribution of profits. It appears that a significant part of the revenue in question related to sales activities of the taxpayer's offices outside Russia and therefore should not be taxed in Russia, as there is no 'force of attraction' principle under Russian law and applied under the Russia-US tax treaty. Likewise, the limitation of costs attributable to the branch / permanent establishment to only those reflected on the books and records of the branch/ permanent establishment creates a mismatch between the revenue and expenses reported to the Russian tax authorities that favours the tax authority. Finally, also at issue is the question of whether a tax treaty may be reinterpreted in a manner that differs from the literal meaning of the text on the basis of the OECD commentary.

Taxand's Take

The activities of non-resident companies in Russia through a representative office should be re-assessed.

It is important to:

  • mitigate the risk of activities that the taxpayer regards as auxiliary and preparatory giving rise to classification as a permanent establishment
  • ensure that such an entity is properly registered if its activities may meet the standard for being classified as a permanent establishment

As a result of the decision, representative offices that submit VAT returns without paying profits tax, although they make no sales in Russia, are now in a high-risk group. The contributory factors to the decision appear to include:

  • the absence of clear job descriptions indicating the auxiliary nature of the activities
  • the apparent absence of a clear description of the office's representative functions
  • the failure to separate activities
  • an underestimation of the risks of being classified as a permanent establishment.

The court's frequent references to the Ministry of Finance's interpretations of the tax treaty were also significant. Although they are not binding, such clarifications will evidently play an influential part in the consideration of such cases. As the attribution of profits to a permanent establishment is likely to be a contentious issue that the courts and the Russian tax authority may pursue, MNEs will need to bolster their transfer pricing documentation and possibly consider alternative structures (e.g., incorporation of the branch) to mitigate the risk of profit allocation.

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

Juan Carlos Ferrucho
T. +1 305 704 6670

Taxand's Take Author