Tax Messenger. Reclassification of a Loan as an Investment. Tax Edition. What has happened? Background to the Dispute:

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1 3 October 2017 Tax Messenger Tax Edition Reclassification of a Loan as an Investment EY s Russian Tax & Law practice was named a leading Tax firm in Russia in World Tax 2017, an annual guide published by the International Tax Review. What has happened? On 16 August Russia s Supreme Court rejected the application for the cassation appeal in Case No. A /2016 (the NK Russneft-Bryansk OOO case) to be referred for review by the Economic Disputes Panel, supporting the tax authority s view that the taxpayer had been fairly charged additional profits tax owing to the fact that interest accrued under a loan agreement with its parent company had been improperly deducted against profits tax. Background to the Dispute: In 2005 the taxpayer received a loan of 950 million roubles from its parent company with interest payable at 8% per annum and a repayment date of 30 December 2007.

2 Between 2007 and 2014 supplemental agreements were concluded between the parent company and the taxpayer, which increased the amount of the loan and set a later date for repayment. As a result of these supplemental agreements, the amount of the loan rose to 3,435,000,000 roubles and the repayment deadline was extended until 31 December By the end of 2014, the taxpayer s total outstanding debt to the parent company amounted to 4 billion roubles, including the amount of interest acknowledged but not paid to the lender, which the taxpayer deducted against profits tax. The tax authority concluded that the taxpayer had understated the tax base as a result of claiming an unjustified tax benefit by deducting interest accrued under a loan agreement with a related entity. The taxpayer insisted that the interest deductions had been made in full compliance with the requirements of Chapter 25 of the Tax Code: the interest was economically justified, was supported by documents and had been incurred in carrying on activities aimed at receiving income. The fact that the companies were related was not in and of itself a sufficient basis to conclude that the taxpayer had received an unjustified tax benefit. The Position of the Courts: The Supreme Court and lower courts supported the position of the tax authorities, making the following points: 1. The funds received from the parent company in the form of loans had been invested by the taxpayer in the construction of an oil loading terminal. The subsidiary acted as the investor for the construction of the terminal. 2. In the period from 2005 to 2014 the subsidiary operated at a loss and had negligible income from financial and business operations, showing that it had no sources from which to repay the loans or pay interest within the time limits stated in the loan agreement and the supplemental agreements. 3. At the time of concluding the loan agreement and providing the funds, the parent company had sufficient information on the taxpayer s financial situation, and was therefore aware that it had no sources from which to repay the loans and pay interest. 4. The fact that the loan was not repaid as required by the agreement and no interest was paid indicates that the loan was fictitious. Based on these arguments, the courts concluded that the taxpayer s parent company had, in the period from 2005 to 2014, transferred funds in the form of loans which essentially constituted investments in the development of the company. The loan agreement had been drawn up only for the sake of appearance without any intention to create legal consequences for the lender and the borrower, the real purpose being to reduce the subsidiary s profits tax base through the deduction of interest charges which were never intended to be paid. What does it mean for you? The Supreme Court s ruling shows that there is now an increased level of tax risk for a borrower in claiming tax deductions where a loan was issued by a related company which was aware of the borrower s inability to settle the debt within the agreed time limit. We recommend that companies should, from the outset of a project, prepare a financial model which demonstrably allows for the principal and interest to be paid by the due date stated in the agreement, and if the project fares badly (worse than predicted by the financial model) they should prepare an updated financial model and thereby substantiate the need for the loan agreements to be extended. We do not regard the legal position taken by the courts as hindering intragroup project financing as long as there is documentation to support the economic reasoning for decisions made. Authors: Dmitri Babiner Arseny Arakelyan 2

3 For additional information please contact the author of this publication: Dmitri Babiner +7 (812)

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