RS From problem to solution Foreign loans are economically-sound, but not always

Foreign loans are economically-sound, but not always

September 2012

Russian and foreign companies, in particular those apart of holding structures, use loan operations fairly often: Russian organisations use borrowed money at an interest rate from “friendly” foreign partners.

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Economically speaking raising funds is profitable for both the Russian organisations receiving money at an interest rate lower than the bank rate and the foreign organisations which receive guaranteed income from the use of such funds. Another advantage is the fact that this interest income, when there are relevant conditions in Double Taxation Avoidance Agreements between countries whose residents are the loan-giver and the borrower, can be income tax exempt in the Russian Federation.

Until recently, paying out loan interest to a foreign parent company was more profitable for a Russian organisation than paying out dividends. Now the Russian borrower has the opportunity to account these interest payments as an expense when paying profit taxes, unlike in the case when dividends are paid out to a foreign company

However, it is worth noting that the Tax Code of the Russian Federation contains numerous limitations for the amount and conditions in regards to accounting loan interest loans between affiliated entities as expenses. Nevertheless, taxpayers, using the statues from Double Taxation Avoidance Agreements found full-proof loopholes for these limitations and fully accounted these expenses for tax purposes. Additionally, upon paying interest to a foreign organisation this income was not subject to taxation.

Taxpayers are especially noted for their use of the 1998 Agreement concluded between the Government of the Russian Federation and the Government of the Republic of Cyprus entitled “On Double Taxation Avoidance in Relation to Income and Capital Taxes”. According to this agreement a Russian organisation when paying out interest income to a foreign organisation is not obligated to withhold taxes from income made. A Russian borrower was entitled to a reduction in its taxable profit for the whole interest amount actually paid to a Cyprus resident if it paid loan interest based on market conditions. That was the very position which was supported by arbitration courts.

But financial and tax authorities of the Russian Federation were convinced that in this case legal tax regulations of the Russian Federation took priority, which was confirmed by letters from the Ministry of Finance of the Russian Federation.

In November 2011 the Supreme Arbitration Court of the Russian Federation adopted Presidium Decree No.8654/11 in which it sides with the tax authorities in an attempt to resolve the situation. The court specified that International Agreement regulations do not rule out the possibility of establishing special national legislative taxation rules (for the countries concluding such agreements) as a way of fighting against tax minimisation aimed at eliminating taxation discrimination.

Despite the fact that the court Decree did not consider the issue of possibly reclassifying the interest paid based on loan agreements as dividends, a few courts (after adoption of the aforementioned Decree) have already started to acknowledge that such a reclassification is justified.

Therefore, current loan relations with affiliated foreign companies have become slightly less attractive in terms of tax minimisation. Nevertheless, this situation does not rule out the possibility of raising borrowed funds in a mutually-beneficial manner, from foreign companies which are not mutually-dependent on Russian organisations, since in this case there is no risk that the interest payments will be reclassified as dividends, while the expenses on paying out interest may be accounted by the Russian borrower for tax-purposes on general terms.

Tatyana Vinokurova
Head of Tax and legal consulting department, ICLC
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