Executive summary

On 7 September 2018, Russia’s Supreme Court issued a ruling on the case involving GaloPolimer Kirovo-Chepetsk OOO in which it supported the conclusions of the tax authorities and the trial court that payments to a foreign company under a service contract should be reclassified as passive income and thereby subject to withholding tax in Russia.

Detailed discussion

Background

In 2012, GaloPolimer Kirovo-Chepetsk OOO (Russian company) transferred payments to the Canadian company Clean Development Investment S.A (Canadian company) on the basis of service and work contracts. The Russian company refrained from withholding tax when making the transfers, as in its view the payments in question constituted income from “active operations” in accordance with clause 2 of Article 309 of the Tax Code.

The tax authorities and the trial court found that the payments were not connected with genuine business activities carried on by the foreign company, and the documentation underlying the transactions concerned was artificial in nature. As a result, the Russian company was charged an additional Russian withholding tax of approximately RUB26 million (approx. US$390,000) and corresponding penalties.

The appellate and cassation courts issued rulings in favor of the taxpayer, but the Supreme Court upheld the conclusions of the trial court and ruled in favor of the tax authorities.

This Alert summarizes the key positions of the parties involved and the ruling of the Supreme Court and the trial court on this matter.

The tax inspectorate’s position

The tax inspectorate took the view that the payments to the Canadian company were effectively made on a non-reciprocal basis, were not connected with any actual business operations (were devoid of economic substance) and constituted passive income that was taxable at source in Russia. Its reasoning was:

• The work and services provided for in the contracts with the Canadian company were actually performed by other persons, including employees of the Russian company itself. This fact is confirmed, in particular, by the conclusions reached by arbitration courts in another case involving the Russian company in question in relation to the same payments. Furthermore, the company also submitted revised Value Added Tax returns for 2011 - 2013 to the tax authority in this connection.
• The fact that the Russian company filed a suit with the Superior Court of Quebec for the recovery of the amounts paid to the foreign company does not alter the fact that the foreign company received income that is taxable in Russia. Indeed, the attempt to recover the money through the courts was itself a contrived exercise.
• According to information from the Canadian competent authorities, the foreign company did not, in the period under review, report income received from the Russian company in its tax returns and did not pay taxes in Canada. Furthermore, the Canadian company did not have assets or other income and did not carry on actual business activity, its director was a nominal figure who denied any connection with the company, and its location was a “mass registration” address. Checks regarding the company’s British shareholder failed to produce any evidence that the latter actually existed.

The Russian company’s position

Objecting to the tax inspectorate’s conclusions, the Russian company asserted that:

• The relationship with the Canadian company cannot be described as non-reciprocal, since it is clear from the content of the contracts in question that the foreign company has obligations to provide services to the Russian company. This is further proven by the fact that the Russian company filed an action with the Canadian courts for the recovery of amounts paid and obtained a favorable decision.
• The tax inspectorate’s arguments that the Canadian company was registered and operated in name only and that the Russian company’s attempts to recover amounts paid were contrived are not supported by proper evidence.
• Income received by the Canadian company from the Russian company may have been reported in the jurisdiction in which funds were credited to its bank account, i.e., in Switzerland.
• The withholding tax in question should be recovered from the foreign company, and not the tax agent (the Russian company).

The court’s ruling

After considering the arguments put forward by the parties, the Supreme Court upheld the tax inspectorate’s position, asserting that:

• Where a dispute arises over whether a Russian entity that pays income to a foreign entity has responsibilities as a tax agent, the tax authorities must prove that the following conditions are met: the payments made may be classified as passive income, and the income is connected with Russia.
• Where income of foreign entities from “active” operations actually proves to be passive income in a disguised form, the tax authorities may reclassify the payments concerned in accordance with the unjustified tax benefit concept.
• The tax authorities proved that there was no genuine business relationship between the Russian company and the Canadian company and that the Russian company had artificially created documentation relating to the performance of contracts that had no reasonable business purpose with a view to obtaining an unjustified tax benefit.
• Since the payments to the Canadian company were not connected with any actual business activity carried on by that company, what effectively took place was the distribution of a part of the Russian company’s assets (capital) to the foreign company on a non-reciprocal basis. The income in question must be classified as passive income, and specifically as “other income” under Article 21 of the Russia-Canada tax treaty, meaning that it is subject to withholding tax in Russia.

Implications

This case is the latest in a series of disputes over the reclassification of payments by Russian entities to foreign contract partners as concealed distributions of passive income through the application of the unjustified tax benefit concept. Now that Article 54.1 of the Tax Code has come into force, and with Russia about to ratify the Multilateral Convention to Implement Tax Treaty Related Measures to prevent BEPS (MLI), the interest of the Russian tax authorities and courts in situations of this kind is only set to increase. Moreover, the case demonstrates the thorough approach taken by the tax authorities with respect to the evidence-gathering process in such disputes.

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

Ernst & Young (CIS) B.V., Financial Services, Moscow

• Vladimir Zheltonogov | vladimir.zheltonogov@ru.ey.com
• Irina Fedonina | irina.fedonina@ru.ey.com
• Natalia Averina | nataliya.averina@ru.ey.com

Ernst & Young LLP, Russian Tax Desk, New York

• Kirill Lukyanets | kirill.v.lukyanets1@ey.com 

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