Concept of the “Beneficial Owner of Income” in the Russian Reality
In the context of the present-day reality, the regulatory agencies start paying closer attention to all the financial transaction and money payments performed by the residents of the Russian Federation in favor of the foreign counterparties. If earlier taxpayers could count on protection from our law enforcement agencies (represented by the judicial bodies), now they may no longer rely on judicial protection when such cases are considered.
The key aspect of consideration of such disputes is represented by the ability to apply provisions of the international tax treaty executed by the country of residence of the relevant income recipient, in other words – application of the concept of the “beneficial owner (actual recipient) of income”.
Gist of Concept
The concept of the “beneficial owner (actual recipient) of income” is as follows. In accordance with the new tax legislation of the Russian Federation, in cases when an international treaty containing provisions on taxation and levies establishes rules and standards, which differ from those provided for by the Tax Code, the international treaty rules and standards shall be applied1.
However if an international tax treaty of the Russian Federation provides for application of the reduced tax rates or tax exemption as regards income gained from the Russian Federation sources by the foreign persons being beneficiaries of such income, then for the purposes of applying such international treaty a foreign person shall not be recognized a beneficiary of such income, if it has limited authority to dispose of such income, exercises functions of intermediary with respect to such income for the benefit of other person without performing any other functions or assuming any risks, if it directly or indirectly distributes such income (in full or in part) to such other person that would not itself have the right to apply the provisions of the international tax treaty of the Russian Federation if such income had been distributed directly to such person2.
Therefore the company applying preferential fiscal terms provided for by the international treaty shall be ready to confirm and prove its status of “beneficial owner (actual recipient) of income”:
- I.e. that it is a company with real substance, and
- carries out real business activity (which means that its transactions have real economic / business goal).
The table below represents the detailed gist and content of these two aspects:
Legal Rationale. Background
The concept of the “beneficial owner (actual recipient) of income” is not a new concept in the international tax planning practice. It was initially reflected in the Model Tax Convention of the Organization for Economic Co-operation and Development (OECD). The Model Convention is used as a basis for the majority of the executed agreements including treaties executed by the Russian Federation with other countries, which provide that only the beneficiaries of such income as, for instance, interest, dividends, royalty may apply benefits of the double tax treaties (including reduced rates).
Moreover nearly all the double tax treaties contain provisions stipulating that the resident of the contracting state shall not be provided any benefits, concessions or exemption from taxes, if such resident’s goal (or one of the main goals) (or a goal of a person related to such resident) was to obtain benefits and advantages of such treaty.
Explanation of the Regulatory Agencies
The regulatory agencies formed a stand on such issue before the modifications to the Russian Federation Tax Code were adopted and initially the Ministry of Finance expressed its opinion in the Letter of the Russian Ministry of Finance of April 09, 2014 No. 03-00-Р3/16236, executed by the Deputy Minister. In the Letter dd April 09, 2014 the Ministry of Finance, acting as an agency competent in the sphere of applying existing tax treaties in connection with the tax concession application, informed that when applying principles of the international tax treaties as regards application of concessions (exemption) in the process of imposing taxes on specific types of income gained from the sources situated in the Russian Federation, it is necessary to determine whether a person applying for concessions (reduces rates and exemptions) provided for by the treaty is an actual recipient (beneficial owner) of the relevant income.
It should be noted that the Ministry of Finance turned to this issue earlier but not on the official level. After this Letter was published the new definitions and requirements emerged in the sphere of the tax legislative practice. In particular there arose a necessity to assess the status of a foreign recipient of income. And the relevant duty is vested with a tax agent – a source of the Russian Federation income which is now obliged to accurately determine whether a foreign recipient is an actual recipient (beneficial owner) of the relevant income.
The specified position was further on consolidated in the following letters3.
Russian Federation Tax Code
As regards consolidation of theses of the concept of the “beneficial owner (actual recipient) of income” in the national laws of the Russian Federation, it should be noted that until recently the Tax Code did not contain any relevant provisions. Article 7 of the Russian Federation Tax Code was relevantly amended by the Federal Law No. 376-FZ dd November 24, 2014; amendments became effective on January 01, 2015.
In accordance with the tax legislation developments now a Russian entity paying income to a foreign (non-resident) company shall each time determine whether its foreign counterparty is a beneficial owner (actual recipient) of income. By virtue of direct reference of the Russian Federation Tax Code the following persons may act as beneficial owners of income:
- A person which is entitled to use and/or dispose of the income due to its direct and/or indirect participation in the entity or control over the entity or otherwise, or
- A person in which interests some other person is empowered to dispose of such income.
When identifying the beneficial owner of income the functions performed by the persons specified in this Clause as well as risks assumed by them shall be taken into account.
If the recipient of the income is represented by a foreign person, the taxes shall be assessed in compliance with the rules of the international treaty of the state of residence of such person4. For this purpose, as well as before, there should be submitted a duly executed confirmation of the fact that the abovementioned recipient domiciles abroad (a Certificate of Residence).
If the recipient of the income is a resident of the Russian Federation, then the taxes shall be imposed in accordance with the requirements of the Russian Federation Tax Code. And in such case no withholding shall be performed if the Russian taxpayer notifies the tax authority at the place of its tax registration thereof5. The specified procedure of notification has not yet been approved. In order to eliminate such gap the Federal Tax Service of Russia issued a Letter No. GD-4-3/6713@ dd April 20, 2015 binding for the territorial tax inspectorates. The Letter contained recommendation to use a temporary template of notice of taxation of income paid to a foreign person who does not hold beneficial right of ownership to such income. The government official emphasized that the template represented a recommended form, i.e. its use is not obligatory and the entities may use their own forms of such notice.
The Way It Used to Be
Before now, neither the Ministry of Finance nor regulatory agencies imposed such requirements as regards assessment in the process of distributing payments in favor of foreign persons. In the past, such assessment duty was vested with a tax authority of the state of residence of the person applying for tax relief. As a result of such assessment a taxpayer was provided a special document confirming its tax residency (a Certificate of Residence). Provision of a relevant Certificate to a tax agent before income payment was considered to be sufficient grounds for applying preferences of the tax treaty.
Earlier in its explanations6 the Ministry of Finance specified that if a foreign person complies with the following two exhaustive terms than it may considered a “beneficial owner (actual recipient) of income”:
- Existence of legal grounds for receiving income, in particular – existence of civil law contract
- A person shall not only have a right to receive income but shall be an immediate beneficiary (a person which determines the subsequent economic fate of the received income).
As regards previous precedents: before now due to the lack of the principled ground of tax officials in relation to this issue the problem of determining a beneficial owner (actual recipient) of income was not regarded by the courts as a cornerstone. When considering a tax related dispute connected with the situation when a Russian company (Licensor) pays royalty to a Cyprus Company (Sub-Licensor), neither the court not the tax authority faced a problem of determining an owner of intangible asset and whether a Sublicensor may be considered a beneficial owner (actual recipient) of the paid royalty (i.e. a beneficiary)7.
In another similar case,8 the claims of the tax authority were focused on the fact of failure to withhold tax when paying income while the tax agent did not at the relevant moment have a confirmation of the income recipient’s tax residency status. In such case the court stood in defense of the taxpayer as at the moment of the field audit the company had the relevant evidences (which mean confirmation of the tax residency status) at its disposal, and was not obliged to submit any other explanations and documents.
New Approaches of the Courts to Considering the Issue
A new milestone in the history of development of the concept of the “beneficial owner (actual recipient) of income” in Russia is connected not only with the change in the approach of the Ministry of Finance to applying such concept and amendments to the Russian Federation Tax Code. It is also related to the new arbitration practice, which now gives priority to determination of the beneficial owner (actual recipient) of income when considering tax disputes.
Case of Severny Kuzbass
The decision of the Presidium of the Supreme Arbitration Court of the Russian Federation in the so-called case of Severny Kuzbass was the first shot in the sequence of judicial acts supporting the taxmen when considering disputes regarding possibility of applying international treaties principles, which to some extent predetermined further course of judicial practice development9.
This case concerned possibility of applying preferences of tax treaties, which allow the Russian subsidiary to recognize the interest on loan in the loss bypassing the requirements of Clause 2, Article 269 of the Russian Federation Tax Code (rule of thin capitalization). In this case, the court made an unambiguous decision that if the cases are connected with the thin capitalization avoidance of application of Clause 2, Article 269 of the Russian Federation Tax Code using the benefits of the tax treaties is impossible.
The award in this case was followed by a sequence of arbitration court awards, which strengthened the consistent approach of the courts of all levels to considering such cases (see f.ex. cases of Dalelsprom (No. А73-7402/2010), Terminal Sibir (No. А45-3310/2011), SRV-Papula (No.А56-23858/2011),
As one can see, the subject of the abovementioned cases was not represented purely by the application of concept of the “beneficial owner (actual recipient) of income”. The specified cases were connected with the question whether the taxpayers had lawful grounds for recognizing the accrued interests in the loss bypassing the rules of Clause 2, Article 269 of the Tax Code of the Russian Federation. They did not consider requirements of the tax authorities to classify the accrued interest as dividends because no actual repayment of the accrued interest took place. However, the principle, which served as a basis for the court decision (absence of any possibility to apply benefits of the tax treaties bypassing the provisions of the Russian Federation Tax Code) shares origins with the considered concept.
Case of Naryanmarneftegaz
For the first time the tax authorities’ reclassification of the paid debenture interest into dividends was recognized legitimate within the scope of the case of Naryanmarneftedaz, LLC10. In spite of the taxpayer’s arguments that there were no signs of controlled debt (a foreign lender was not a member of the Russian company and did not hold any shares in its charter capital (neither directly nor indirectly) the courts recognized that in fact the foreign parent company used its foreign subsidiary in order to provide a loan to its Russian subsidiary. Therefore the court recognized the lender (fellow subsidiary (sister company)) to be a conduit company used for the purpose of income transformation and obtaining advantages established by the international treaties.
Case of Oriflame Cosmetics
If the previous cases were indirectly related to the issue in question, this case perfectly reflects the Russian courts’ perception of the concept of the “beneficial owner (actual recipient) of income”.
The company being a Russian entity with 100% foreign participation executed a number of contracts for assignment of exclusive rights with its parent company, which, in its turn, executed a similar agreement with its parent company.
When paying a license fee (royalty) to the foreign company the Russian company:
- Deducted VAT from the relevant amounts acting as a tax agent and later on claimed the paid VAT amounts to recovery
- Included the royalty amounts in the expenditure when forming an income tax base.
The relevant scheme looked as follows:
When making decision to dismiss the claims of the Company11 the court was governed by the following logic (the court’s findings are represented in the sequence, which was applied by the court):
- The Company (Russian Federation) is a dependent entity (96.71%) of a foreign company (Luxembourg).
- The Company is technically registered as a Russian legal entity but in fact it carries out activity for and on behalf of a foreign company.
- The Company is a dependent agent of a foreign company (Luxembourg).
- The Company acts as a Permanent Establishment of a foreign company (Luxembourg) within the Russian Federation.
- The Company pays royalty to the parent company (Netherlands) with a single goal of transferring royalty to a parent company registered at Luxembourg, e. the use of an intermediate link represented by the Dutch company is a technical operation/scheme which allows the Company to pay royalty with a minimum tax burden.
- The Company’s payment of royalty to the recipient – parent company (Luxembourg) – was in fact payment transferred by the Company to itself.
- In view of the foregoing, the Company is not entitled to claim to recovery the VAT amounts deducted by it when acting as a tax agent paying royalty and to reduce the income tax base by the amounts of the license fees.
As we see the legitimacy of the position of the Inspectorate as regards this case supported by the statements of motivation was justified using three concepts:
- Unjustified tax benefit;
- Actual recipient of income;
- “Piercing corporate veil”.
In view of the foregoing, and on the basis of analysis of this case it seems that the specified legal proceedings represented a test case evidencing the ambience and position of the state (including legislature, law enforcement officials and regulatory agencies) in relation to the tax optimization schemes aimed at using legal business structures for applying concessions and preferences of an international tax planning and withdrawal of capital abroad. Taking into account the present-day political and economic environment such position of the state is more likely to be regarded as logical than unexpected.
The subsequent awards in the similar cases evidence the intention of the courts to follow the chosen path12.
Notwithstanding the fact that concept of the “beneficial owner (actual recipient) of income” was introduced into the Tax Code of the Russian Federation only in 2015 the double tax treaties did provide for the ability to apply benefits of the double tax treaties (including reduces rates) before only in relation to the entities:
- Which hold beneficial right to own such income (interest, dividends, royalty);
- Which main object(s) of incorporation or existence did not include obtaining concessions under a treaty.
The concept of the “beneficial owner (actual recipient) of income” has quite a long history and is successfully applied within the territories of the other countries (including Switzerland, Austria, Germany, Netherlands, etc.).
Therefore, we cannot blame the regulating agencies, courts and our legislature that that “created” something new trying to complicate the taxpayers’ life, refusing in some cases to apply concessions and preferences with the only aim of replenishing budget with new taxes. They failed to take note of the method of applying tax treaty preferences in time having allowed their foreign colleagues to tread this thorny path.
In view of the foregoing, all the Russian companies carrying out monetary transactions with the foreign counterparties shall be ready to close attention and inspection of the inspection authorities when making use of the benefits of the tax treaties. The key aspects to which the inspection authorities pay attention in such cases and the grounds on which they base their arguments were reflected in the considered cases (Oriflame case reflects them in the most detailed manner). That is why in order to minimize the studied risks we advise you to review them and avoid making the same mistakes.
Moreover, in order to minimize the reviewed risks it seems advisable to adhere to the characteristics required to qualify as a beneficial owner of income of a foreign company acting as a counterparty of the Russian organization. Certainly the specified recommendations may not be considered exhaustive and eliminating the risk in its entirety. Now it is impossible to accurately predict the development of the judicial practice as regards application of the new principles of the tax legislation. However, compliance with such recommendations is an essential minimum and failure to comply shall definitely expose the specified transactions to a risk.
- Clause 1 Article 7 of the Russian Federation Tax Code.
- Clause 3 Article 7 of the Russian Federation Tax Code.
- Letters of the Ministry of Finance of Russia No. 03-08-05/64201 dd December 12, 2014; No.03-08-05/32054 dd July 02, 2014; No. 03-08-13/23614 dd May 19, 2014.
- Sub-clause 2, Clause 4, Article 7 of the Russian Federation Tax Code.
- Sub-clause 1, Clause 4, Article 7 of the Russian Federation Tax Code.
- See f.ex. Letter No. 03-08-02 dd April 21, 2006.
- Award of the Federal Arbitration Court of the North-Western District in a case No. А21-6798/2007 dd November 14, 2008.
- Award of the Supreme Arbitration Court of the Russian Federation No. 1646/07 dd May 29, 2007.
- Decision of the Presidium of the Supreme Arbitration Court of the Russian Federation No. 8654/11 dd November 15, 2011.
- Award of the Federal Arbitration Court of the Moscow District in the case No. А40-1164/11-99-7 dd February 27, 2012
- Award of the Federal Arbitration Court of the Moscow District in the case No. №А40-138879/14 dd June 11, 2015
- See Award of the Moscow City Arbitration Court in the case No. А40-12815/15 dd May 08, 2015
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