Arbitration cases on the Russian Beneficial Ownership Concept
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1 Arbitration cases on the Russian Beneficial Ownership Concept 16
2 Who is a Beneficial Owner? An entity or an individual that has a right to use and (or) dispose the income; When determining a beneficial owner, functions performed and risks borne should be taken into account. 17
3 Who is not a Beneficial Owner? Limited authority over the disposal of income; Intermediary functions in relation to received income; Does not perform any other functions and does not bear any risks; Directly or indirectly transfers income to an entity, that could not have a right to apply DTT benefits in case of receiving income. 18
4 Key arguments used by the Russian Tax Authorities to challenge the status of foreign companies as beneficial owners Back-to-back arrangements; No taxes are paid in foreign country with regard to the income received from Russia; No actual authority over the disposal of received income sourced from Russia in accordance with internal documents (e.g. charter); No sufficient substance: - usage of nominal directors; - absence of office space; - absence or insufficient amount of qualified employees; Limited functions performed by the recipient of income: - the company does not bear risks, does not have sufficient assets (apart from those, connected with Russia); - activities of the company are not diversified; The purpose of the company and choice of jurisdiction (e.g. purely tax driven purposes). 19
5 Arbitration cases relating to the Russian Beneficial Ownership Concept Company Date Type of Income OOO TD Petelino 4/8/2015 Royalties PAO Severstal 31/10/2016 Dividends OOO EnergoServis 17/1/2017 Capital Gains 20
6 OOO TD Petelino Case 21
7 Petelino Case-Distribution of Royalties License Sublicense Bermuda Company (IP Owner) Cyprus Company (Licensee) Russia Company (Sub-licensee) License of Trade Mark to Cyprus Company Receipt of royalties from Cyprus Company Royalties Sublicense of Trade Mark to Russian Company Transmission of royalties to Bermuda Company Royalties Payment of royalties to Cyprus Company 22
8 Petelino Case - Commentary (1) This case involved a dispute over withholding tax on royalties paid by a Russian company under a sublicense agreement to a Cypriot company for the use of a trademark. In the opinion of the inspectorate, the Russian company did not have the right to claim a withholding tax exemption under the Russia-Cyprus DTT since the Cypriot company receiving the royalties was deemed not to be the beneficial owner of the royalties. 23
9 Petelino Case Commentary (2) The Tax authority gave the following reasoning for its decision: The rights holder of the trademark was an affiliated company registered in an offshore jurisdiction (Bermuda); The Russian company could have concluded an agreement directly with the licensor (the owner of the trademark); The license agreement between the Bermuda company and the Cypriot company and the sublicense agreement between the Cypriot company the Russian company were concluded a short time apart; The price of the sublicence agreement exceeded the price of the license agreement; There is a tax treaty between Russia and Cyprus but not between Russia and Bermuda; Practically all royalties received by the Cypriot company were transferred to Bermuda; The Russian company received an unjustified tax benefit in the form of a withholding tax exemption under the Cyprus treaty without having a real business objective of concluding a sublicense agreement. 24
10 Petelino Case Commentary (3) The Russian company contested the inspectorate s conclusion using the following arguments: The Russian company could not have used the trademark without concluding a sublicense agreement; Its business operations were genuine; It is normal business practice for the price of a sublicence agreement to exceed the price of a licence agreement, as the sublicensor aims to cover its costs and make a profit; The Cypriot company was a genuinely functioning organization which disclosed royalties received in its statements and paid taxes; Whether or not an agreement could have been concluded directly with the rights holder is not a matter for the Tax authority to judge, as it does not have the right to evaluate the economic expediency of expenses. 25
11 Petelino Case Commentary (4) The Court s position ruled for the tax inspectorate s side; The Court agreed with the Tax Authorities, that the company could sign an agreement with the owner of the trademark directly, and that there was no business purpose in signing the sublicensing agreement. Note: The term beneficial owner ( actual right to income) is not used in Article 12(1) ( Royalties ) of the Russia-Cyprus DTT which could have provided a formal basis for not applying that concept in this case. 26
12 PAO Severstal Case 27
13 Severstal Case: Distribution of Dividends Severstal Payment of dividends in 2011 Recipients Cyprus companies Dividends received are transferred to the companies - residents of the BVI in the form of dividends and repayment of loan principal BVI Beneficiaries of dividends 28
14 Severstal - Commentary (1) The PAO Severstal case The Russian Tax authorities pointed out the following important circumstances in this dispute: Dividends received by Cyprus-based foreign companies were, one way or another (including as principal repayment), transferred to companies registered in the BVI; The articles of association of the Cypriot companies are nearly identical; The Cypriot companies were effectively limited in their rights to dispose of their sole financial asset, shares in PAO Severstal stock, and in fact could not sell shares to an external party outside of their corporate group; They did not possess any property other than PAO Severstal shares, or any business assets; and They did not conduct any business activity other than transfer of dividends. 29
15 Severstal - Commentary (2) Having considered the facts and circumstances, the court ruled that the Cypriot companies were not beneficial owners of dividends received, but had acted as technical agents for transferring funds to the BVI companies affiliated with the taxpayer. In this situation the dividends must be taxed based on the fact that the beneficial owners are located in BVI (no treaty country). Thus, 15% tax rate should apply. To identify the beneficial owner of dividends, the court thoroughly considered the applicability of the Commentaries to the OECD Model Convention, particularly stating that a company that just keeps and transfers income to a third party cannot be viewed as a beneficial owner. In other words, if the income recipient acts as an agent on behalf of a interested party, the reduced withholding tax rates under DTT do not apply. 30
16 Severstal - Commentary (3) Although the applicability of Commentaries to the Model Tax Convention to Russian cases is still an open issue, the court maintained that Russia had consented to interpreting and applying all key provisions of the Model Convention and official Commentaries there to. The court also stated that the Commentaries determine the practice of applying DTTs and therefore could and should be considered for interpreting particular treaty provisions. The court also dismissed the company's arguments on compliance with the letter of the law (first, in 2011, Russian tax law did not require identification of the beneficial owner of income; second, the requirement that the dividend recipient be beneficially entitled to dispose them, as per Article 10 of the Russian-Cypriot DTT, was met in the situation under review). The court supported the tax authorities claims as being related to the prevention of DTT abuse and pointed out that PAO Severstal, which had paid out dividends, was definitely aware that the Cypriot companies were transit conduits and that the actions of the parties involved were intended to obtain unjustified tax benefits 31
17 Severstal - Commentary (4) In defence of its position, the taxpayer stated that one of the companies transferred the dividends to repay a loan, thus demonstrating independent disposal of the dividends received. The court dismissed this argument, pointing out that in fact the taxpayer used the dividends to repay a previously obtained loan to buy shares, which equal transferring money as dividends to an offshore jurisdiction via a technical company. The court also stated that the form of transferring funds obtained from the taxpayer is of no significance whether as a dividend payout to affiliated companies or repayment of loans previously issued to a company affiliated with the taxpayer in order to buy taxpayer's shares as in both cases the funds obtained as dividends are transferred to companies controlled by these foreign entities in accordance with the charter or in compliance with contractual provisions. 32
18 OOO EnergoServis Court Case 33
19 EnergoServis Case- Taxation Capital Gains Russian Company 1 Cyprus Company Russian Company 2 RUB 100M RUB 900M Sale of EnergoServis (ES) shares to Cyprus Company Sale of ES shares to Russian Company 2 Payment of RUB 900M consideration to Cyprus Company Payment of dividends to the resident company of the BVI out of the sale proceeds 34
20 EnergoServis Case Commentary (1) In May 2011, a Russian Company 1 sold its 100% share in ES to a Cypriot tax resident Company, for RUB 100 million. Three months later, Cypriot Company re-sold the shares in ES to another Russian Company 2 for RUB 900 million. Cypriot Company used the proceeds to pay out dividends to its parent company, registered at BVI. Despite the fact that more than half of assets of ES comprised of Russia-based real property items, the Russian Company 2 did not withhold a tax upon payment of the income, since it applied the Russia-Cyprus DTT as applied at the time. 35
21 EnergoServis Case Commentary (2) During their audit, the tax authorities concluded that Cypriot Company serves for technical purposes only and does not meet the beneficial ownership criteria for the income from the sale of shares in ES, since: Cyprus Company had no income-bearing or debit transactions, assets (including own funds for purchasing the shares in ES and had no staff; Cyprus Company did not pay taxes in Cyprus; Throughout the 4 years of its existence, the Cyprus Company effected only one transaction, which comprised the purchase and sale of the shares of ES; 36
22 EnergoServis Case Commentary (3) The transaction for the purchase of the shares of ES had been approved by the Board of Directors of the Russian Company 2 before the Cypriot Company acquired the ownership of these shares; After the sale of the shares of ES, the Cypriot Company paid dividends to its sole shareholder, BVICO, for an amount comparable to the income received from Russia; The Cyprus Company was liquidated a few years after the sale of shares, without effecting any other transactions. 37
23 EnergoServis Case Commentary (4) In the Russian Tax authorities opinion, the transaction involved double non-taxation of the income received by the Cyprus Company. Pursuant to the provisions of the Russia-Cyprus DTT, the income of the Cyprus Company was not subject to tax in Russia. Furthermore, the Cypriot Tax Laws provided for tax exemption in respect of income from the sale of shares. The Russian tax authorities stated that BVICO should be qualified as the beneficial owner of the income. Therefore, Russian Company 2 should have withheld a tax at 20% on the amount of the income paid to the foreign company (i.e. at the maximum rate because Russia has no DTT with BVI). 38
24 EnergoServis Case Commentary (5) It is worth noting that the Russian Tax authorities actively co-operated with the Cypriot tax administration, who provided bank statements of the accounts of the Cyprus Company and other information. It is also important to note that the Russian tax authorities referred to the OECD Model Tax Convention and other OECD documents, because the concept of beneficial ownership introduced recently into the Russian Tax Code was not yet applicable to the reviewed period. 39
25 The way forward: Defense file Art. 312 of Russian Tax Code Starting from 1 January 2017 foreign company should provide to its tax agent a confirmation of the beneficial right to receive income Documents that confirm / deny presence of contractual or other legal obligations to third parties, limiting the rights of recipient on its income; Documents confirming the predetermination of the subsequent transfer of the income by the recipient to third parties; Documents confirming that the foreign recipient pays taxes with regard to the received income from Russia; Additional documents that may be used: - Articles of Association and Memorandum of Association; - Information about employees, job descriptions, staff schedule; - Copies of the commercial agreements with other companies; - Financial statements; - Tax returns that confirm the payment of tax. Russian Tax Authorities may use international tax information exchange mechanisms during the auditing of the defense file. se international tax information exchange m 40
26 Thank you
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