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Unlimited deduction of expenses for Corporate Income Tax under double tax treaties
On 23 September two Russian second highest courts issued rulings on applicability of domestic thin cap. rules to Russian taxpayers controlled by non-residents. Under Russian thin cap rules a resident company may be subject to thin cap. limitations if it is controlled by non-resident by at least 20%. The limitation may result in i) non-deductibility of excessive interest, and ii) recharacterisation of excessive interest into dividends. Thin cap rules do not apply to resident companies without foreign control.
Most of the Russian double tax treaties contain non-discrimination clause based on the par. 4 of Article 25 of the OECD Model Convention, under which foreign control should not worsen tax position of a resident taxpayer. As this is exactly the result of the application of domestic thin cap rules, it appears that Russian thin cap rules did not always comply with non-discrimination provision under tax treaties.
Previously taxpayers successfully challenged domestic thin cap rules on the basis of tax treaties, although the relevant tax treaties contained specific clauses on full deductibility of interest for Russian subsidiaries of non-residents.
Tax treaties with Cyprus and Finland, on which court decisions of 23 September were based, do not contain a specific clause on deductibility of interest. Thus courts based their decisions on non-discrimination provisions in the relevant tax treaties.
Differently from full deductibility clause which is present in only few tax treaties, non-discrimination provision is present in most of the Russian tax treaties.
Therefore the conclusions of the courts may support the argument for deductibility of interest expense in excess of limitations imposed by thin cap rules for a large number of Russian companies with foreign investment covered by a non-discrimination clause.
To benefit from the tax treaty provisions on non-discrimination a Russian subsidiary of a resident in a tax treaty country would need to perform a 3 step analysis to identify:
- Whether the relevant tax treaty contains a non-discrimination clause;
- If such a clause exists, whether its application is limited in the tax treaty;
- If the non-discrimination clause apply, the subsidiary needs to check whether it uses all available benefits.
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