Author: Ekaterina Markova

At the beginning of June 2021, one court decision was a clear retrospective of the application of the provisions governing the taxation of passive income in Russia. Before the start of “deoffshorization”, a common structure of ownership of Russian assets was the participation of foreign «holdings», when shares or stakes in Russian companies belonged to foreign companies. Most often, such holdings were located in countries with which Russia had an agreement on the avoidance of double taxation, which made it possible to pay dividends from Russia to the country of the parent company with minimal taxes (usually 5 or 10%). One of the most popular jurisdictions for the placement of holding companies has long been Cyprus, an agreement with which allowed only 5% of tax from dividends paid from Russia to be withheld if the Cypriot company “directly invested” at least $ 100,000 in the Russian company’s capital. It was about this rate of 5% and «direct investment» that the dispute arose. At the same time, this dispute was between the subsidiary and the parent company, which is not very typical.

On June 3, 2021, the decision of the Arbitration Court of the Altai Territory in the case А03-10399/2020 became available. The essence of the dispute was as follows. From 2005 to 2017, the Russian company (Subsidiary, the plaintiff) paid dividends in favor of its foreign shareholder registered in Cyprus (the Company, the defendant). Applying the Agreement for the avoidance of double taxation Russia — Cyprus (Double Tax Treaty — DTT), the Subsidiary withheld tax at a source of payment in Russia at a rate of 5%. This reduced rate was applied, among other things, in the case of a direct investment by a Cypriot company in the capital of a Russian company in an amount of at least USD 100,000 (since 2013 — Euro). The definition of this “direct investment” from the point of view of Russian legislation was the essence of this case.

From the moment of the emergence of shareholder relations between the parties to the dispute in 2005 to 2013, the main acts in this regard were the norms of the said Double Tax Treaty — DTT, as well as the position of the Ministry of Finance of the Russian Federation, set out in the letter dated 08.12.2004 No. 03-08-02/Cyprus, which means by «direct investment» a purchase of shares both in the initial or subsequent share issues, and when buying shares on the securities market or directly from their previous owner. During this period, the Company provided Subsidiary with a certificate of its tax residency in Cyprus, as well as an opinion from an auditing firm (apparently a Cypriot one) that the amount of the Company’s direct investment in the capital of Subsidiary exceeded USD 100,000, which was carried out by purchasing shares of the Subsidiary on the secondary market.

In 2013, amendments to the provisions of the DTT entered into force, specifying that a direct investment must be made by a person who has the actual right to income in the amount of at least 100,000 euros. In the same year, the Company, in addition to the tax certificate, again submitted an audit firm’s opinion on the amount of investment in the capital of the Subsidiary exceeding the required threshold value. These documents were sent to the tax authority of the Russian Federation and no comments were received in this regard.

In 2015, the position of the Federal Tax Service of the Russian Federation regarding the definition of «direct investment» was slightly adjusted. The letter of the Federal Tax Service dated 13.11.2015 No. SD-4-3/19823@ for the purpose of confirming the right to apply a 5% rate under the DTT contains the requirement to provide the tax agent with documents confirming the fact of direct investment in the capital of a Russian company, as well as documents containing information about the amount of the actual payment of the share in the capital (bank statements, payment orders, confirmation of the depository and clearing company).

In 2017, a new version of Art. 312 of the Tax Code of the Russian Federation had been enforced, specifying that documents confirming the right to apply a reduced rate must meet the requirements for completeness and reliability. For the previous period, the direct investment was confirmed by the above-mentioned opinions of the auditing firm, as well as a copy of the Agreement for the sale and purchase of shares of the Subsidiary in 2005 (in the opinion of the tax inspectorate, they did not meet the requirements for completeness and reliability).

As part of a desk tax audit in relation to the Subsidiary in 2018, the Federal Tax Service inspectorate requested other documents confirming the right to apply a 5% rate (in particular, payment documents, as well as documents justifying changes to the Subsidiary’s register of shareholders). An extract from the Subsidiary’s register issued by the Registrar (received by the Inspectorate of the Federal Tax Service) indicates that the change in the composition of shareholders of Subsidiary in 2005 was due to the «contribution of securities to the registered capital» on the basis of an instrument of transfer. The instrument of transfer itself contains a reference to the minutes of the extraordinary meeting of shareholders of the Company, according to which the shares of the Subsidiary were invested by its shareholder (individual) as a contribution to the registered capital of the Company.

Also in 2018, the Company provided a copy of the Set-off Agreement, 2005, on the offset of counterclaims between an individual and the Company. Under the terms of this agreement, the Company had a debt to an individual in the amount in accordance with the purchase and sale agreement for shares of the Subsidiary, and the individual was in debt in a larger amount. The representatives of the Subsidiary came to the conclusion that there were contradictions in the documents provided by the Company, which led to a double payment for the shares of the Subsidiary. Since the Company did not provide other documents on payment for the purchased shares, the documents of the Subsidiary’s Registrar were taken as a basis, indicating that the shares were added to the company’s authorized capital (and not their purchase).

As a result of the proceedings, in 2018 the Subsidiary independently made a decision to withhold additional tax on dividends at a source for the period from 2005 to a rate of 10%. Subsidiary withheld the amount of additional accrual from the dividends due to the Company in 2018 and paid to the budget. The remaining amount of dividends (after withholding) was transferred by the Subsidiary to the Company. However, the inspection report of the Federal Tax Service Inspectorate entailed additional accrual of the amount of tax at the source due to the need to recalculate the amount of dividends for all previous periods at the official rate of the Central Bank (currency rate difference). The Subsidiary also paid the additional accrued amount to the budget by sending a claim to the Company for reimbursement of the amount paid. Since there was no compensation, in 2020 the Subsidiary filed a court claim with the arbitration court. However, the Company filed a counterclaim against the Subsidiary for the obligation to pay dividends in full.

During the trial, the court concluded that in the absence of the original Agreement for the sale and purchase of shares of the Subsidiary (as well as bank statements confirming the actual payment for it), there are no grounds for applying a reduced 5% rate in respect of dividends. The court also found that the Subsidiary lawfully withheld an additional tax at a source (to 10% in total) from the income in the form of dividends for the period 2005-2017. Accordingly, the Company illegally acquired (saved) the funds belonging to the Subsidiary. The argument of the defendant (Company) that the plaintiff missed the 3-year limitation period on demand was rejected by the court, since the Subsidiary is considered to have learned about the groundlessness of the 5% rate only in 2018.

This case study retrospectively demonstrated the change in the approach of the Russian legislator and law enforcement practice in connection with a business model including a “foreign element”. If at the beginning of the establishment of relations between the Cypriot holding company and its Russian subsidiary in 2005, a fairly loyal approach was practiced in Russia, then from 2015 (the official launch of “deoffshorization”) everything began to change significantly. Since 2018 (when the proceedings were initiated in respect of transactions justifying «direct investment»), the approach was already quite radical — everything that is not confirmed by the maximum standard of proof is considered unfounded. The outcome of the trial in such circumstances is logical, even though so far there is only a decision of the first instance. And in this case, one can only guess about the possible outcome of the case if there were no discrepancies in the evidences presented by the foreign holding.