Global Tax Alert | 7 February 2014

Russian court issues adverse decision on the applicability of thin capitalization rules to loans from foreign affiliated companies

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On 16 December 2013, the court of first instance issued a new decision in a thin capitalization case involving the company United Bakers Pskov LLC. The court held that the loan provided by a foreign “sister” company of United Bakers Pskov LLC should be treated as “controlled indebtedness” and consequently, deductions for interest on the loan were subject to the thin capitalization rules.1 The company originally won the case in the first two instances but the cassation court referred the case back to the court of first instance for reconsideration and complete examination of all the significant facts and circumstances, having controversially concluded that a basis for treating interest as having arisen on controlled debt arose from the Associated Enterprises article of the Russia-Luxembourg Double Tax Treaty.

Based on the definition of controlled indebtedness in the Tax Code, loans provided by foreign sister companies are beyond the scope of the thin capitalization restrictions. This is one of the reasons why financing structures whereby the funds are provided to a Russian borrower from its foreign sister company are widely used for investment in Russian companies.

The court followed the reasoning of the cassation court, basing its latest decision on the interpretation of the term “associated enterprises” in the Severny Kuzbass court case and Article 9 of the Russia-Luxembourg Double Tax Treaty.

The decision also refers to the Commentary to the OECD Model Convention, which states that the Associated Enterprises article “is relevant not only in determining whether the rate of interest provided for in a loan contract is an arm’s-length rate, but also whether a prima facie loan can be regarded as a loan or should be regarded as some other kind of payment, in particular a contribution to equity capital.”2

The court concluded that the thin capitalization restrictions provided in clause 2 of Article 269 of the Tax Code should apply in the United-Bakers-Pskov case.

The company has filed an appeal so this court decision is not final. Future Alerts will report any further developments.

The case may be symptomatic of an increased risk of the broader application of the thin capitalization rules to loans from foreign affiliates. Some groups are choosing to mitigate this risk by ensuring that the ratio of debt from and/or guaranteed by foreign affiliates to equity never exceeds the threshold above which an adjustment might be required.

Endnotes

1. Decision of the Pskov Arbitration Court on Case No. А52-4072/2012 of 16 December 2013.

2. Paragraph 1.3 b) of the Commentary to Article 9 of OECD Model Tax Convention.

For additional information with respect to this Alert, please contact the following:

Ernst & Young (CIS) B.V. branch in Moscow
  • Maureen O’Donoghue
    +7 495 228 3670
    maureen.odonoghue@ru.ey.com
Ernst & Young LLP, Russian Tax Desk, New York
  • Julia Samoletova
    +1 212 773 8088
    julia.samoletova@ey.com

EYG no. CM4163