Thin-capitalization rules in Russia

In general, Russian tax legislation contains limitations on deductibility for corporate profit tax purposes of certain types of expenses, including interest accrued on loans and credit. More specifically, it introduces ‘thin capitalisation’ requirements between related parties: a 3/1 debt-to-equity ratio limit for loans granted (or guaranteed) by a foreign company that owns more than 20% of the borrower’s capital directly or indirectly.

A controlled debt under loan obligations accrues in the following cases:

1) The Russian entity is indebted to a foreign entity controlling more than 20% of the Russian entity’s registered capital; or
2) The Russian entity is indebted to a Russian entity recognized as an affiliate to the above foreign entity under Russian law; or
3) The above affiliate and/or foreign company is/are a surety or guarantor for a debt obligation of a Russian entity or otherwise undertake to ensure the performance of its debt obligations.

If any of the above situations applies, then the excessive amount of the interest shall not be deductible for the borrower and it will be treated as dividends for corporate income tax purposes and thus withholding taxes shall apply.

However, a number of double tax treaties (including that of the Russian Federation with Cyprus) allow Russian companies to benefit from more favourable terms and deduct a number of expenses (including interest on loans) without limitations or condition (please see Article 24 (3) of the Double taxation treaty (‘DTT’) between the Russian Federation and Cyprus as attached in this letter). 

Even though the above right of Russian taxpayers provided by DTT that Russia has entered with certain countries (including the one of Cyprus) was previously confirmed by several court decisions, on a recent case (dated 15/11/2011) the Supreme Arbitrazh Court (SAC) of the Russian Federation denied the right to apply the above mentioned benefit of the Russian taxpayer, on the basis of non-discrimination provisions.

The recent court case of Naryanmarneftegaz dated 27.02.2012 on this issue demonstrates that both the tax authorities and the court tend to consider the economic substance of the transaction rather than following the letter of the law, in an attempt to broaden the scope of thin capitalization rules. The tax authorities, departing significantly from their ‘form over substance’ approach, undertook a thorough analysis of the case.

In the light of the above developments TBC can offer you the following assistance:

-a review of your financing structure in relation to the applicability of the Russian thin capitalization rules
-advice on identifying the most tax-efficient source of financing future activities of your company
-draft and or review your existing financing agreements to achieve tax optimization.