Global Tax Alert | 9 December 2013

Russian court rules on application of thin capitalization rules to a sister company loan

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Executive summary

On 18 September 2013, Russia's Federal Arbitration Court (FAC) of the North-West region issued Ruling No. А52-4072/2012 regarding the application of thin capitalization rules to a loan issued by a “sister” company. The case may signal another adverse shift in the application of domestic and international tax legislation by the Russian tax authorities and courts to financing structures for groups.

Russian court practice already includes at least two cases in which the tax authorities successfully disallowed interest on loans from foreign companies under common ownership: the Naryanmarneftegas case1 and the Pirelli Tyre Services case.2 In the Naryanmarneftegaz case, the decision was based on a number of factors the court accepted as indicating that in substance the loan was approved and financed by a direct or indirect shareholder rather than the sister company and therefore could be treated as controlled indebtedness for the purposes of Russia's thin capitalization rules. The Pirelli decision cited the Naryanmarneftegas as a basis for treating a loan from a sister company as controlled debt but the decision did not record the existence of similar facts concerning the approval and financing of the loan in the Pirelli case.

The arguments on which the new decision is based are completely different and could be applied much more broadly to financing arrangements commonly used in Russia. The decision relies on an extremely controversial position as to how the provisions of international tax treaties interact with domestic legislation.

Detailed discussion


The new court decision concerns United-Bakers-Pskov LLC (the Company), part of the Kellogg Group. The Company received a loan from Kellogg Lux II S.a.r.l. (the Lender) a company registered in Luxembourg. In the course of a tax audit the tax authorities noted that the Company and the Lender were under the common control of Kellogg Europe Company Limited registered in Bermuda. Kellogg Europe Company Limited directly owned 100% of the Lender and indirectly, through a chain of intermediate companies registered in Luxembourg, Cyprus and Russia, owned an 88.43% interest in the Company).

The tax authorities took the position that the Lender indirectly participated in the capital of the Company and thus interest payable by the Company under the loan issued by the Lender should be subject to the thin capitalization restrictions. The tax authorities referred to the legal position set out in the SAC's (Supreme Court of Arbitration) ruling in the Severny Kuzbass case.3 This states that the restrictions on interest deductibility which are set forth in clause 2 of Article 269 of the Tax Code are imposed in cases where a Russian company's business is organized so that there is a high level of debt, the borrower is affiliated with the creditor, which may be either a foreign company or a Russian company affiliated with a foreign company, and the debt obligation is not actually settled. This was a case in which it was clear that the debt was “controlled debt” based on the criteria set out in clause 2 of Article 269 and the taxpayer sought to deduct interest on the controlled debt in full based on the non-discrimination provisions of applicable tax treaties.4

The characteristics of borrower and lenders in both the Severny Kuzbass case and the Company's case correspond to the definition of “associated enterprises” which may be subject to special profits tax rules according to international tax treaties. In the Severny Kuzbass case, the SAC concluded that the Article 9 of the treaties relevant to those cases permitted the disallowance of interest under Article 269 of the Tax Code.

Article 9 of the Russia-Luxembourg tax treaty is similar, envisaging the possibility to adjust income where the same persons participate directly or indirectly in the management, control or capital of a company which is a resident of a Contracting State and any company which is a resident of the other Contracting State. There is, however, a fundamental distinction between the present case and the Severny Kuzbass case.

Court decisions

The courts of the first and second instances ruled in favor of the Company. The ground for their position was that the Lender didn't own directly or indirectly more than 20% of the Company's capital so the interest did not arise on controlled indebtedness and the thin capitalization rules should not apply. Unlike in the Naryanmarneftegaz case, the tax authorities do not seem to have argued that there were reasons for treating the loan as in substance a loan from a direct or indirect parent. Consequently the lower courts' conclusions appear to have been correct.

What the tax inspectorate was arguing was that Russia's right to tax was not merely permitted by the applicable treaty but actually arose from it. This is based on a fundamental misunderstanding of the function of the treaty in question which is “the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital.” The present case concerns neither if Russian domestic law has been properly applied by the taxpayer. Article 9 of the treaty permits adjustments to the taxable income of associated enterprises where conditions are made or imposed between two companies in their commercial or financial relations which differ from those which would be made between independent companies. However, the adjustment in question should be prescribed in the domestic legislation of the contracting state in which the adjustment is made otherwise there has been no avoidance of tax. In the Severny Kuzbass case, the tax inspectorate's adjustment to taxable profit was made based on the provisions of Article 269 under which the indebtedness in question was controlled debt. In the Company's case the tax inspectorate disregarded the fact that the criteria for controlled debt were not satisfied arguing that it was allowed to do so based on Article 9 of the treaty. This would mean that borrowing from a resident of a treaty jurisdiction has exposed the borrower to higher taxation in Russia which clearly goes against the whole idea of a tax treaty.

The cassation court noted that the lower courts did not seem to have taken into account the tax authorities' arguments outlined above and had given no reasons for this. The cassation court abolished their decisions and referred the case back to the court of first instance for reconsideration and complete examination of all the significant facts and circumstances.


The provisions of international treaties concluded by Russia undoubtedly override local tax legislation5 in the event of a conflict. If an applicable treaty contains appropriate provisions it could prevent, for example, the characterization of a ship (based on the Civil Code) as immovable property for Russian tax purposes, changing the profits tax treatment of income from chartering a vessel for use in Russia of a resident of the other contracting state. However, determining whether a right to tax exists or how a certain type of income should be characterized for tax purposes (both things which treaties may do) is not the same as imposing a tax. No conflict exists if a treaty grants Russia the right to tax income and Russian law imposes no tax.

The case is not yet finally resolved. The next hearing will be held in December.

Taxes should be imposed under domestic rules not treaties. Unfortunately the Company is not the first taxpayer to hear the opposite view from the tax authorities in relation to the application of the thin capitalization rules.6 Hopefully, further hearings concerning this case will involve a deeper examination of the issues, leading to an outcome better reflecting how treaties and domestic law should interact.

Future Alerts will cover further developments.


1. Ruling No. F05-14903/2011 of the FAC of the Moscow region of 27 February 2012 (Rejected for revision by Determination No.VAS-7104/12 of the SAC of 21 June 2012). Reported in EY's Russian Tax Briefs of November 2011, March 2012 and June 2012.

2. Decision of the Moscow Arbitration Court on Case No. А40-58049/12 107-325 of 19 December 2012. For more detail, see EY Russian Tax Brief of July 2013.

3. Ruling No. 8654/11 of the Presidium of SAC of 15 November 2011.

4. For more detail, see the EY Russian Tax Brief of January 2012.

5. Article 7 of the Tax Code.

6. For example, Letter of Ministry of Finance No. 03-08-05 of 27 November 2009.

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

Ernst & Young (CIS) B.V., Moscow
  • Maureen O'Donoghue
    +7 495 228 3670
Ernst & Young LLP, Russian Tax Desk, New York
  • Julia Samoletova
    +1 212 773 8088

EYG no. CM4029