Significant changes to the application of Russian thin capitalisation rules

The reasoning of the court decision makes it clear that this Russian SAC position is universally applicable and is not conditional upon any specific circumstances of the case (the borrower's negative net assets, unpaid loans etc). The court refers to Article 9 of the treaties that permit adjustment of the results of non-arm’s length transactions between associated enterprises in the meaning of OECD Commentary to the Model Tax Convention. The Commentary has been applied to the analysis of whether the loan is real or constitutes a de facto contribution to capital. The court specifies that, if there are grounds for such adjustment, then non-discrimination guarantees should not apply. Yet the resolution contains no substantiation of either this conclusion or of application of the OECD Commentary or any references to their provisions that preclude application of thin capitalisation rules without economic analysis in each particular case.
The Presidium of the Russian SAC also states that the Russian rules are not discriminatory in nature because they apply to all companies that meet the criteria provided for in Article 269(2) of the Russian Tax Code, ie to all companies with a substantial foreign participation.

The above Russian SAC resolution makes it virtually impossible for non-discrimination clauses in double tax treaties to provide any protection against the thin capitalisation rules. Furthermore, justification of court rulings by means of references to the treaties’ provisions on associated enterprises makes protection on the basis of the unlimited deduction provisions of protocols to the agreements with Germany, France, Great Britain, New Zealand, Canada unsustainable, since these provisions apply unless special relations between the lender and the borrower have influenced the transaction results. Please note that such a limitation linked to special relations between the parties is technically absent from the protocols to the treaties with the Netherlands, Belgium and the USA; yet, taking into account the Russian SAC’s acknowledgement that provisions on associated enterprises should be applied universally, the courts would most likely treat this limitation as implied for these protocols, too.

If the debt to equity (net assets) ratio exceeds 3:1 (12.5:1 for banks and entities engaged in leasing activities only), the remaining defence is to use financing by the group’s foreign companies having no direct or indirect interest in the borrower; even so, lower courts are currently establishing a negative practice on this issue based on the rationale that such companies have no business objective of their own. We believe claims by the tax authorities to be almost unavoidable whenever the above ratio is exceeded.
If the above applies to your situation, you should consider to do the following:
• Amend the financing structure and attract funds/security from lenders holding neither a direct nor an indirect interest in the company capital, or ensure the debt to net assets ratio does not exceed 3:1;
• If this limit is exceeded, ensure availability of evidence that the lenders have their own business objectives, are obtaining funds also for other purposes and from sources other than from direct or indirect lender participants, and that the lenders hold the actual right to dispose of the interest to be received;
Consider feasibility of recalculating profits tax obligations for 2009-2011 tax years with application of Article 269(2)of the Russian Tax Code in full and of payment of arrears and interest (thus making it possible to avoid any penalties for tax underpayment), and raising any possible future disputes over recovery of amounts thus paid.