Ongoing Search for a Beneficial Owner of Income: Overview of Recent Court Decisions for 2019

The past year of 2019 was quite rich in tax disputes concerning the issues of determining and qualifying a beneficial owner of income. In this article, we offer a review of key court decisions made in 2019. At the same time, we will only pay attention to the arguments made by regulatory authorities and courts. If required, one may closely review each case by using the details of court rulings specified in the article.

Case of Krasnobrodsky Yuzhny LLC

Ruling No. 304-КГ18-22775 of the Supreme Court of the Russian Federation dated 18.01.2019 in case No. A27-331/2017 of Krasnobrodsky Yuzhny LLC to Interdistrict Inspectorate No. 3 of the Federal Tax Service of the Russian Federation for the Kemerovo Region.

Factual allegations

The Russian LLC paid dividends in favour of its shareholder (Cyprus company) at the reduced rate (5%) under the agreement.

Content of the decision

In the case in point, the courts have concluded that none of the Cyprus companies operates in Cyprus, and therefore, the Cyprus company (LLC member) is not a beneficial owner of income, but a conduit company.

Therefore, the preferential rate under the agreement (5%) shall not be applied.

The courts (tax authorities) paid attention to the following facts:

The Cyprus company does not dispose of the funds received as dividends in full (less current administrative expenses);
The Cyprus company further reallocated dividends received from Russian companies to other founders (Cyprus, BVI);
One of the further founders also registered in the territory of the Republic of Cyprus did not carry out financial and economic activities and reallocated dividends received in full (less current administrative expenses) further to its founders, which shows that none of the entities under the jurisdiction of the Republic of Cyprus carried out actual business activities;
There were no transactions defining business activities of the Cyprus company;
Independent auditor’s reports, according to which the Cyprus company depends on the constant financial assistance of its shareholders, without which there would be a debt, which would not allow the companies to continue as a going concern and fulfill their obligations on the current activities.

Case of Melnik JSC

Ruling No. 304-КГ18-25280 of the Supreme Court of the Russian Federation dated 18.02.2019 in case No. A03-21974/2017 of Melnik JSC to the Interdistrict Inspectorate of the Federal Tax Service of Russia for the largest taxpayers of the Altai territory.

Factual allegations

The Russian LLC paid dividends to its sole shareholder, which is a foreign company, disguised as the transaction to redeem its own shares under the securities sale and purchase agreement.

Content of the decision

The court has concluded that, as a result of the above actions, a part of the profit has been withdrawn in favour of a foreign legal entity, while the scope of rights of the foreign company in relation to the company has not changed. And since the payment of passive income (dividends) has taken place in this case, the Company should have withheld tax at source.

The courts (tax authorities) paid attention to the following facts:

The company has had significant retained earnings and has paid no dividends to its shareholders for several years;
The foreign company had become the shareholder of the company shortly prior to disputable transactions were made (with the share of 99.86%, subsequently 100%);
Immediately after the conclusion of the share sale and purchase agreement, the foreign company opened a bank account with the resident bank of the Republic of Latvia, to which the funds were transferred with the comment “redistribution of funds within the holding”;
The court of appeal annulled the decision of the first instance court on invalidation of the decision of the tax authority, and concluded that, as a result of the above actions, a part of the profit has been withdrawn in favour of a foreign legal entity, while the scope of rights of the foreign company in relation to the company has not changed;
The foreign company, which is the sole shareholder of the taxpayer during the audited period, had limited powers with respect to the disposal of the income received;
There were no transactions defining business activities,
The foreign company obtained no benefit from the income and had no saying in defining its future economic fate;
Coordination of actions between the taxpayer and its sole shareholder.

Case of Ruscam Steklotara Holding LLC

Ruling No. 301-ЭС19-2319 of the Supreme Court of the Russian Federation dated 25.04.2019 in case No. A11-9880/2016 of Ruscam Steklotara Holding LLC to the Interdistrict Inspectorate of the Federal Tax Service for the largest taxpayers in the Vladimir region.

Factual allegations

The Russian LLC paid dividends in favour of its shareholder (Dutch company) at the reduced rate (5%) under the agreement.

Content of the decision

The courts have determined that the company, which is a resident of the Netherlands, is not a beneficial owner of the dividends paid by the company; it is only an intermediate (technical) link and is not the ultimate beneficiary of the income received on its account, which is transferred in transit to the address of two entities registered in Turkey. The Turkish company (ultimate shareholder) has been recognized as the ultimate beneficiary.

The courts (tax authorities) paid attention to the following facts:

Dutch tax authorities have provided information that the Dutch company acts as an intermediate holding and investment company;
Average staff number of the Dutch company is 0 persons;
The company, which is a resident of the Netherlands is a member only of the company;
The director of both the company, which is a resident of Turkey, and the company, which is a resident of the Netherlands, is the same individual;
Activities of the Dutch company and other companies as part of the funds transfer have been controlled by the Turkish holding company;
According to the financial statements of the Dutch company for 2012 – 2013 (submitted by the Dutch tax authorities), the only income of the company is dividends from the company, and the fixed assets are the shareholders’ funds, which serve as a source for the company’s share capital;
In 2011-2012, the company incorporated in the Netherlands paid no taxes due to the carry forward of losses of previous years; in 2013, it recorded minimum taxes payable; in 2014, it recorded no taxes payable, as well as the dividend income for 2014;
According to the settlement account statement of the company, which is a resident of the Netherlands, all dividends received from the company were transferred within a few days to the accounts of foreign companies which have no direct participation interest in the company.

Case of Extra CJSC

Decision of the Arbitration Court of the Ivanovo region dated 19.07.2019 in case No. А17-11142/2018 of Extra CJSC to Interdistrict Inspectorate of the Federal Tax Service for Ivanovo (Regulation of the Second Arbitration Court of Appeal dated 15.11.2019 kept the decision without amendments).

Factual allegations

The Russian LLC paid dividends in favour of its shareholder (Cyprus company) at the reduced rate (5%) under the agreement.

Content of the decision

In the case in point, the courts have concluded that the Cyprus company does not operate in Cyprus, and acts as a transit company used solely for transferring funds to the UK.

Therefore, the preferential rate under the agreement (5%) shall not be applied.

When making a decision on additional taxes, the tax authorities considered the following circumstances:

The authorized capital of the Russian company increased with the help of borrowed funds raised by the Cyprus company;
Absence of interest payment terms in the loan agreements indicates that the Cyprus company had no intention to receive any income;
The Cyprus company was registered in January 2013, and in the same year (in August) acquired shares of the Russian company, which indicates the technical nature of the company;
As part of international cooperation, the tax authority provided a settlement account statement of the Cyprus company issued by an Estonian bank, which indicates that all the funds were subsequently transferred as loans to Estonian companies affiliated with the Cyprus company;
According to the information provided by the Cyprus tax authorities, the Cyprus company had no employees other than its director;
The authorized capital of the Cyprus company (EUR 1000.00) was not paid by the shareholder;
The Cyprus company acquired shares of the Russian company from its founder (Estonian citizen), and the payment under the sale and purchase agreement was not made;
The income of the Cyprus company consists only of dividends (99.9%), the remaining income is interest on loans granted to affiliated companies;
Loans were granted solely for the purpose of creating visibility of transactions;
All activities of the Cyprus company were limited to receiving dividends and granting loans in favor of affiliated companies.

Case of KCA Deutag Drilling LLC

Decision of the Arbitration Court of the Sakhalin region dated 01.08.2019 in case No. А59-8433/2018 of KCA Deutag Drilling LLC to Interdistrict Inspectorate No. 1 of the Federal Tax Service for the Sakhalin region (Regulation of the Fifth Arbitration Court of Appeal dated 25.12.2019 kept the decision without amendments).

Factual allegations

The Russian LLC paid dividends in favour of its shareholder (Dutch company) at the reduced rate (5%) under the agreement.

Content of the decision

In the case in point, the courts have concluded that the Cyprus company operates in Cyprus, and does not act as a transit company used solely for transferring funds to the UK.

Therefore, the preferential rate under the agreement (5%) is legally valid.

When making a decision on additional taxes, the tax authorities considered the following circumstances:

The ultimate shareholder (parent company) was a company registered in the UK;
The current account of the Cyprus company to which the dividends were transferred was opened in the UK.

When making a decision to annul the decision of the tax authority, the court took into account the following circumstances:

The Cyprus company allocated the money received as dividends to a company registered in Germany;
The Cyprus company paid taxes in Cyprus on interest income received in 2014-2017;
According to the calculations submitted, if the Russian company directly granted a loan to the German company (bypassing the stage of paying dividends to Cyprus), the total amount of taxes payable in Russia would be less than the actual amount (accordingly, the payment of dividends is not a transaction generating a tax benefit);
The Cyprus company was incorporated in 2003, conducted real business activities (providing corporate support services to other companies), owned other assets in addition to the Russian subsidiary;
The decision to transfer dividends to the settlement account in the UK (rather than Cyprus) was caused by a large-scale crisis in Cyprus, which was accompanied by freezing of accounts;
During the period under consideration, the Cyprus company adopted no resolutions on the distribution of dividends in favor of the English company;
The case file provides no evidence of the actual receipt of distributed dividends by the English company;
The loan was granted in US Dollars, while the accounts of the Cyprus company are kept in Euros; by granting a loan in another currency, the Cyprus company was exposed to currency risks (exchange rate risk);
The Cyprus company also bears an additional risk of non-repayment of the loan (after receiving dividends, the Cyprus company independently disposed of its asset by allocating it to receive interest income);
The Cyprus company paid all necessary taxes in the Republic of Cyprus;
According to the testimony of the witnesses, all instructions were received not from the management of the Russian company, but from the directors of the Cyprus company;
The Cyprus company bears administrative expenses at its own cost (wages of employees, directors’ remuneration, legal and consulting services, office rental costs);
Dividend income is recognized by the Cyprus company in its financial statements;
In addition to the share in the Russian company, the Cyprus company had other assets (accounts receivable on loans granted).

Summary

The review of the most recent court decisions shows that:

Court practice related to the application of the concept of the beneficial owner of income has not changed. Courts continue to pay due and close attention to this issue and consider all circumstances to verify the beneficial owner of income;
No new circumstances / indicators / evidence, which tax inspectors and courts rely on when investigating the issue of qualification of a foreign entity as the beneficial owner of income (compared to previous court decisions and letters of the Ministry of Finance) have appeared;
Most cases relate to the period of 2010-2015, i.e. the period when due court practice on these issues has not yet been formed, and taxpayers paid no due attention to the issues of documenting the form and content of transactions with foreign companies. This may be the reason for not making decisions in favor of taxpayers in most cases.

The first court decisions made in favor of taxpayers give some hope that in the near future taxpayers will take a more responsible approach to documenting transactions with foreign counterparties, which will help to improve the judicial practice.

Alexey Oskin

Deputy Director

Tax and Legal Practice

Korpus Prava (Russia)