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November 2011 Russian Tax Brief In this issue: Thin Capitalization: the Presidium of the SAC Sets a New Precedent on Non-discrimination ...
November 2011

Russian Tax Brief In this issue: Thin Capitalization: the Presidium of the SAC Sets a New Precedent on Non-discrimination ...................................................................... 2 Thin Capitalization Restrictions: Extension to Loans from Foreign Sister Companies – the Courts Reconsider ........................................ 3 Non-discrimination vs. Russian Thin Capitalization Rules: More Negative Court Practice ................................................................... 4 Courts Disallow Costs Invoiced by the Foreign Head Office of a Law Firm ................................................................................................ 5 Tax Consolidation Law Enacted ........................................................ 6 Impact of the New Transfer Pricing Regime on Interest-free Loans .... 7 Can Renting a Storage Facility Trigger a Requirement to Register for Tax? .......................................................................................... 7 Russia’s Accession to the WTO: Impact on Customs Tariffs and Foreign Trade .................................................................................. 8 Intra-group Financing from Luxembourg: Year-end Action Required .. 8 German Treaty Shopping Rules Violate the EC/EEC Treaty and Should be Amended per the EU ........................................................ 9

Russian Tax Brief November 2011

Thin Capitalization: the Presidium of the SAC Sets a New Precedent on Non-discrimination The most significant development in court practice in relation to taxation in 2011 has been a change concerning the interpretation of non-discrimination clauses of double tax treaties in cases relating to the deductibility of interest accrued on so-called “controlled loans”. The thin capitalization provisions in Article 269 of the Tax Code apply to interest payable by Russian organizations on the following categories of indebtedness (controlled loans):

 A debt obligation to a foreign organization which directly or indirectly owns more than 20% of that Russian organization;

 A debt obligation to a Russian affiliate of such a foreign organization; and

 A debt obligation in relation to which such a

foreign organization or its Russian affiliate acts as surety or guarantor or otherwise undertakes to guarantee the fulfilment of the borrower’s debt obligation.

If the borrower’s debt-to-equity ratio exceeds 3:1 (12:1 in the cases of banks and leasing companies) the borrower is required to calculate the amount of interest on the controlled debt which is deductible using a prescribed formula. Any excess interest is not only non-deductible; it is treated as a dividend for withholding tax purposes.

The Relevance of Non-discrimination Provisions In recent years several taxpayers have been able to satisfy the courts that the disallowance of interest deductions based on these provisions violated an applicable double tax treaty. Typically, such cases have been decided based on the courts’ interpretation of provisions such as the following from Article 25 of the Netherlands-Russia treaty: "Enterprises of a Contracting State, the property of which is wholly or partly owned or controlled, directly or indirectly, by one or more residents of the other Contracting State, shall not be subjected in the first-mentioned State to any taxation or any requirement connected therewith which is other or more burdensome than the taxation and connected requirements to which other similar enterprises of the first-mentioned State are or may be subjected." If “other similar enterprises” is taken to include enterprises over 80% owned by shareholders resident in Russia then it is clear that Russia’s thin capitalization rules are less burdensome for some

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“similar enterprises” than for Russian enterprises wholly or partly owned by shareholders resident in the Netherlands. This is the interpretation ultimately applied in determining the outcome of tax litigation until very recently1. The tax authorities have consistently taken another view in clarifications that “other similar enterprises” means other enterprises wholly or partly owned or controlled by non-residents. Since the thin capitalization rules do not discriminate between companies with shareholders in different foreign countries the tax authorities believe that tax treaties do not override these rules. This view seems to have been accepted by a court of the third instance for the first time in Ruling of the FAC of the Central District of 7 October 2011 in Case No. A09-6854/2010 (see article on page 3).

The Presidium’s Decision re Severny Kuzbass Even more significantly, the Presidium of the Supreme Arbitration Court on 15 November 2011 rescinded decisions of the lower courts in favour of the taxpayer Severny Kuzbass Coal Company in another case concerning thin capitalization. The taxpayer in the case in question (the “Company”) received a loan from another Russian company, Karelsky Okatysh in 2005. Both companies are affiliated with the Cypriot company, Frontdil Limited, which indirectly holds more than 20% of the Company’s capital. In 2007 the Company received a loan from the Russian company Severstal-Resurs. Severstal-Resurs assigned the outstanding amount of the loan and interest incurred but not paid to a Swiss shareholder of the Company, Mittal Steel Holding AG, which held more than 20% of the Company’s capital. Afterwards the Swiss company assigned this loan (including interest payable) to a Luxembourg group company. Following a field tax audit, the tax inspectorate decided that interest expenses incurred under these loans were non-deductible based on the Russian thin capitalization rules. The Company challenged the tax authority’s decision in court. The trial court ruled in favour of the Company, citing the non-discrimination provisions of the

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For example, Decree No. KA-А40/6616-05 of the Federal Arbitration Court (“FAC”) of the Moscow Region of 25 July 2005 (Russia-Germany treaty); and Decision No. А5619578/2006 of the FAC of North-West District of 9 April 2007, (Russia-Netherlands treaty) and Decision No. 09АП-8641/2009АК of the 9th Appellate Arbitration Court of 10 June 2009 (Russia-Cyprus treaty).

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double tax treaties with Cyprus and Switzerland. The appeal and cassation courts also supported the Company’s position.

to avoid the Russian thin capitalization rules. On this basis the audit decision disallowed deductions for interest on the financing in question.

However, the SAC referred the case to the Presidium and we now know that the Presidium found in favour of the tax authorities. The Presidium’s ruling had not yet been published at the time of writing but it is understood that the Presidium rejected the view that non-discrimination provisions of the applicable treaties prevent the application of the thin capitalization rules in this case. This ruling will set a precedent other courts must follow. Therefore, the ruling will require careful study to establish whether it leaves any scope for a treaty override to apply in other cases.

Most of the tax inspectorate’s arguments arose from its analysis of the shareholder agreement between the joint venture partners, the consolidated financial statements and correspondence between the companies, which shows that the inspectors set out to employ the substance-over-form approach which is not typical in Russia.

Thin Capitalization Restrictions: Extension to Loans from Foreign Sister Companies – the Courts Reconsider Recent court practice has again raised the question, which previously has been answered in the negative, whether thin capitalization rules may apply to financing from foreign sister companies. This issue was much discussed last year when the tax authorities attempted to employ this controversial interpretation of the thin capitalization rules in a number of court cases. All those cases were won by the taxpayers2. The current court case3 relates to Naryanmarneftegaz (hereinafter referred to as “the Company”), a joint venture of the oil companies Lukoil and ConocoPhillips. Other issues are addressed in the case but this article will focus on the treatment of interest on loans from foreign affiliates. ConocoPhillips indirectly owned 30% of the Company’s equity through two intermediate foreign holding companies. The tax authorities challenged the financing of a Russian venture which was carried out through a foreign affiliate of ConocoPhillips. The tax inspectorate took the view that the actual lender was the foreign parent company (a loan from which would be subject to the thin capitalization rules) rather than the foreign sister, and that the use of an affiliated finance company was for no commercial reason other than

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See the June and July 2010 editions of the Russian Tax Brief for details. 3

Decision of Moscow Arbitration Court No. A40-1164/11-99-7 of 5 August 2011, Ruling of the Ninth Arbitration Appeal Court No. A40-1164/11-99-7 of 28 October 2011

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The Company litigated against the decision and has lost the case in the first and appeal instances. The courts supported the tax authorities’ arguments that the Company's indebtedness under the loans should be treated as controlled, because the actual lender is the foreign parent company despite the fact that loans were provided by a foreign affiliate which does not own shares in Naryanmarneftegaz. Below we provide some of the courts’ findings in order illustrate the key facts, the courts’ logic and the scope of the judges’ analysis:

 The shareholder agreement envisaged the

provision of loans to the Russian joint venture. Per the provisions under which the loans were to be provided to the Company they are called “shareholder loans”. The shareholders played a significant role in the granting of such loans by the foreign affiliate.

 The provisions of the joint-venture agreement and the principles of financing agreed by the partners result in thin capitalization as it is understood in Russia and the USA under the OECD Model Convention.

 The funds were ultimately provided by the shareholder, ConocoPhillips, as the cash calls from the Company were sent to ConocoPhillips and not to its finance company.

 ConocoPhillips stated in the notes to the consolidated financial statements that it received income from the joint venture with Lukoil while the borrower (the Company) was loss-making, which was taken as indicating that the interest was treated as income of ConocoPhillips.

 Where a loan is provided by an international corporation, it can use intermediate companies to reduce the tax burden. The court treated the intermediate finance company as a conduit company used to transfer and transform profits for tax optimization purposes.

 The State of Delaware, the finance company’s

place of registration was considered to be a lowtax jurisdiction and “offshore zone” (based on

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the Central Bank’s Regulations establishing rules for maintaining correspondent accounts with banks registered in territories which envisage a beneficial tax regime or do not envisage the disclosure of financial information).

tax return claiming that it had erroneously used those rules which should not have applied in the case at hand due to the possible recourse to the non-discrimination clause of the Russia-Netherlands tax treaty.

 Article 23 “Non-discrimination” of the USA-

The Company successfully defended its position in the trial and appeal instances (the Bryansk Arbitration court and the 20th Appeal Arbitration court) using an approach based on clauses 3, 4 and 5 of Article 25 Non-discrimination of the treaty. These lower courts confirmed that since the Company was indeed indirectly owned by the Dutch parent, the treaty’s non-discrimination provisions should prevent the application of the Russian thin capitalization rules. Furthermore, the courts rejected an argument that the treaty should not apply because the Dutch parent does not directly receive interest from the Company. Based on their interpretation of Articles 1 and 25 of the treaty, the courts confirmed that the Dutch parent may apply the treaty even if it receives profits from the Company indirectly, e.g. in a form of dividends paid through intermediate group companies.

Russia double tax treaty does not apply as the interdependence of the parties can influence the terms of loans.

 The

shareholder agreement envisages ConocoPhillips’s obligation to secure financing provided to the Company. This made the loans provided subject to thin capitalization restrictions.

Noteworthy in this case is the awareness of the topic demonstrated by the tax inspectors and the judges. The texts of the decisions, which are unusually long, also contain discussions about international groups of companies and the ideas behind thin capitalization restrictions. There is no information on the arbitration court’s website yet as to whether the appeal court’s decision will be challenged by any of the parties, but it seems highly likely that the Company will challenge the decisions of the lower courts in the cassation court. In 2010 it was the cassation court that stopped similar attempts by tax authorities to reinterpret the thin capitalization rules in this way. We will report any further developments.

Non-discrimination vs. Russian Thin Capitalization Rules: More Negative Court Practice As far as we are aware, the first court case lost by a Russian company attempting to defend its right to deduct interest expenses with no thin capitalization adjustment based on the “Non-discrimination” provision of the relevant double-tax treaty in a court of the third instance was that addressed in Ruling of the FAC of the Central District of 7 October 2011 in Case No. A09-6854/2010. In this case the ruling has already been published so we can examine the basis for the decision.

However, the tax authorities appealed and the Federal Arbitration Court of the Central Region rejected the position supported by the lower courts. As regards the non-discrimination clause, the court stated that in the context of clause 4 of Article 25 of the Russia-Netherlands treaty, "other similar enterprises" means “… Russian enterprises the property of which is wholly or partly owned by residents of other states". Based on this interpretation the court concluded that the thin capitalization rules in clause 2 of Article 269 of the Tax Code are not discriminatory in respect of companies with Dutch capital since all enterprises with foreign capital are treated in the same way, and therefore the treaty does not override the Russian thin capitalization rules.

The Russian entity PO BMZ (the “Company”) obtained loans from its Russian sister companies and credit facilities from major Russian commercial banks guaranteed by its direct Russian parent. All of the Russian group companies were more than 20% owned indirectly by a Dutch entity.

The above reasoning is questionable. The treaty does not explain what is meant by “other similar enterprises”. One could argue that the restriction of the comparison to those enterprises whose capital is wholly or partly owned or controlled, directly or indirectly, by residents of third countries may be justified only if it is clearly indicated in the treaty – which is not the case for the Russia-Netherlands treaty. Otherwise such comparison should be made to any similar enterprises, including those owned or controlled by residents of the first-mentioned state (Russia in the case at hand).

In 2007 and 2008 the Company incurred interest expenses on the debt financing. Initially interest expenses deducted were limited by the Company in accordance with the Russian thin capitalization rules. Subsequently, the Company filed a corrected

Interestingly, the court did not provide any comments on the interaction of the “Nondiscrimination” clause with Article 9 of the treaty which may be interpreted such that relief under the non-discrimination clause applies only to arm's-

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length interest, leaving the contracting states free to challenge the deduction of non arm’s-length interest without any unduly restrictive reinterpretation of the non-discrimination provisions. In the case in hand neither the tax authorities nor the court explored the question of whether the interest incurred by the Company was set at an arm’s-length level.

 The courts cited the Russian domestic tax

Together with the above-mentioned Severny Kuzbass and Naryanmarneftegaz court cases this constitutes a decidedly negative trend in thin capitalization related jurisprudence in Russia.

and the methodology applied in accounting for income and attributing expenses among its subdivisions supported the view that they could not be viewed as separate subdivisions.

Courts Disallow Costs Invoiced by the Foreign Head Office of a Law Firm The tax authorities challenged the deduction of expenses by the Russian branch of CMS Cameron McKenna LLP (the firm) in the following circumstances. Lawyers employed by the legal entity’s head office and based in the UK were involved in the provision of legal services via the branch to clients in Russia. The branch invoiced its customers in Russia fees for services including the work of the UK-based lawyers (time spent multiplied by hourly rates) and recognised such fees as part of its taxable revenue. In accordance with the firm’s internal policies and procedures the UK head office invoiced the Russian branch fees for the use of the UK-based lawyers and those fees were recognized by the branch as deductible expenses. The taxpayer tried to prove the deductibility of the UK fees through litigation. The court of the first instance ruled in favour of the taxpayer. The appeal court and the cassation court 4 supported the conclusion of the tax authorities that the fees of the UK-based lawyers employed by the head office could not be deducted by the Russian branch. The key argument seems to have been that the concept of a “separate and independent enterprise”, which is found in clause 2 of Article 7 of the Russia-UK double tax treaty and which was relied upon by the taxpayer, could not be applied in this case because, in the opinion of the courts, the head office and the permanent establishment (PE) in this particular case did not act as separate units but rather acted as a single business enterprise. This conclusion is based on the following:

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Ruling of the Ninth Appeal Court No.А40-138835/10118-799 of 9 June 2011 and Ruling of the Moscow Federal Court No.А40138835/10118-799 of 9 September 2011.

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definition of expenses and concluded that the fees of the UK-based lawyers could not be recognized as expenses by the firm’s Russian PE as the amounts related to internal dealings rather than to the purchase of services from other entities.

 The nature of the activity of the foreign entity

 In addition to the allocation of the time charged by the foreign lawyers, the head office also allocated to the PE some management and general administrative costs (which were not challenged by the tax authorities). The courts concluded that if the Moscow and London offices were to operate as two separate enterprises, the head office would have not been able to allocate to the branch the management and general administrative costs, as they should have already been included in the fees for the legal services “purchased” by the Russian branch.

 The courts stated that if the branch and the head office provided advisory services separately from each other, and the branch “purchased” services from the head office, the branch would then have been considered a tax agent with an obligation to calculate, withhold and pay Russian VAT. The branch, on the contrary, did not withhold and pay VAT on the acquired services as these services were claimed to be internal dealings with the head office. International tax practitioners may well question the arguments and conclusions found in the above court rulings as these are in clear contradiction to the authorized OECD approach to the attribution of profits to PEs. This approach (described in detail in the OECD’s Report on the Attribution of Profits to Permanent Establishments and cited in the Commentaries to Article 7 of the OECD Model Tax Convention) is based on the premise that the profits to be attributed to a PE are the profits that the PE would have earned at arm’s length if it were a legally distinct and separate enterprise performing the same or similar functions under the same or similar conditions and dealing wholly independently with the enterprise of which it is a PE. Although the OECD approach is not legally binding in Russia the OECD commentaries to the Model Tax Convention are widely regarded in Russia as a useful source of treaty law interpretation and are sometimes cited by the Russian Ministry of

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Finance in clarification letters and by courts in their rulings.

or indirectly holds at least a 90% share in the others.

Separately, one may question the merits of applying the Russian-UK double tax treaty provisions to a UK partnership, which does not qualify as a “person” in the context of the treaty.

Requirements for Establishing a Group

Many foreign entities with PEs in Russia may wish to reconsider their current tax practices in the light of the above court rulings in order to reduce tax uncertainties. Those that “purchase” services from their head offices should consider switching to recognising head office costs incurred for the purposes of the PE’s activities on a basis more readily acceptable in Russia or purchasing services from legally separate related entities. The taxpayer may appeal to the Supreme Arbitration Court to conduct a supervisory review of the ruling of the cassation court within 3 months from the date it came into force (i.e. 9 September 2011). Currently there is no information regarding such an appeal on the official web-site of the Supreme Arbitration Court.

Tax Consolidation Law Enacted On 21 November 2011 the law concerning consolidated groups of taxpayers was officially published in Rossiiskaya Gazeta5. Taxpayers will be able to apply to establish a consolidated group of taxpayers from 1 January 2012.

The group of companies should satisfy the following main criteria on applying to establish a Group:

 the aggregate amount of federal taxes which must have been paid in the preceding calendar year was at least10 billion roubles;

 the total revenue of the group in the preceding calendar year was at least 100 billion roubles; and

 the aggregate value of assets of the group as at the preceding 31 December was at least 300 billion roubles. These thresholds seem likely to be the main barrier to companies wishing to form a Group. The authorities have already changed them at least twice to expand the range of eligible companies, but they still seem to be rather high. The law includes other criteria, for example, the companies should not be undergoing reorganisation, insolvency proceedings or liquidation and their net assets should exceed charter capital.

Administration

Most provisions of the law have not changed significantly in comparison with the draft reviewed in the August Russian Tax Brief. However, some significant amendments have been introduced which are covered in this article.

Tax accounting, tax calculation and tax payment responsibilities for the entire Group will be imposed on one participant, which is designated the “responsible participant”. Should this company fail to discharge its liabilities, all members of the Group will be liable jointly and severally for any tax underpayment, the corresponding penalties and late payment interest.

What is a Consolidated Group of Taxpayers

Tax audits are to be performed with respect to all companies in a particular Group at the same time.

A consolidated group of taxpayers (hereinafter ‘Group') is to be a voluntary association of profits tax payers for the purposes of calculation and payment of profits tax based on the aggregate financial results of all Group participants. The agreement establishing the Group must be registered and accepted by the tax authorities.

What has Changed?

Only Russian companies can participate in Groups. The minimum period for which a Group may be established is two years. A Group may be established by companies if one company directly

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Federal Law No. 321-FZ of 16 November 2011 Concerning the Introduction of Amendments to Parts One and Two of the Tax Code of the Russian Federation in Connection With the Creation of a Consolidated Group of Taxpayers.

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The law states that a Group’s profits tax base should be based on the Group’s participants’ income and expenses whereas early drafts provided for adding together profits and losses of each participant. The consolidated profit may not be reduced by any tax losses accumulated by the participants prior to the establishment of the Group. Intragroup transactions are to be included in the consolidated tax base. Early drafts provided for the elimination of intra-group transactions from the calculation. The final text only provides that transactions amongst participants of the Group are not subject to transfer pricing control (except for taxpayers of mineral extraction tax at ad valorem rates, such as those which extract precious metals, ferrous metals, and various types of salt).

Russian Tax Brief November 2011 The law does not exclude companies which have subdivisions outside Russia from participation in a Group.

Likely Impact of the Law The concept of tax consolidation is without precedent in post-Soviet Russia, so implementation may not be straightforward. Thresholds may have been kept high deliberately so that the initial volunteers can act as a kind of pilot project before a final decision is made on how widely consolidation should be made available in future. The establishment of a Group may be beneficial for some. The main advantages of the proposals are the possibility to strengthen control over the tax accounting function, decrease the amount of transactions subject to mandatory transfer pricing control and the respective administrative burden, and potentially optimize the tax burden of affiliates.

Impact of the New Transfer Pricing Regime on Interest-free Loans At present no adjustments can be made to impute interest at a market rate on loans for tax purposes. This is because Article 40 of the Tax Code applies to the price of goods, work and services only. The regime which is to enter into force in January seeks to cover any transaction with a tax effect for the purposes of profits tax, personal income tax, mineral extraction tax and/or VAT. The basis for the extension of transfer pricing control to transactions involving interest, rights to intellectual property, and other transactions not caught by the current provisions is the following language: “The rules laid down in this Section shall apply to transactions which give rise to the need for at least one of the parties to those transactions to record income, expenses and (or) the value of extracted commercial minerals, resulting in an increase and (or) decrease in the tax base for taxes specified in clause 4 of this Article6.” This begs the question, can a transaction escape transfer pricing control if no income or expense arises owing to an operation between related parties being executed free-of-charge, for example, an interest-free loan or a parent-company providing a guarantee or pledging assets so its subsidiary may receive a bank loan? If control will apply to certain transactions only when the price is not zero, this would be inconsistent with the principle

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Article 105.3, the taxes in question are profits tax, personal income tax, mineral extraction tax and VAT.

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established in clause 1 Article 105.3 of the Tax Code: “Where, in transactions between interdependent persons, commercial or financial conditions are made or imposed which differ from those which would apply in transactions recognised as comparable in accordance with this Section between non-interdependent persons, any income, profit or receipts which might have been received by one of those persons, but by reason of that difference was not received, shall be recognised for taxation purposes for the person concerned.” We understand that the Federal Tax Service is aware of this apparent anomaly, and from 1 January 2012 is likely to take the view that the absence of income in cases including interest-free loans and parent-company guarantees provided without charge does not prevent the exercise of transfer pricing control in relation to such transactions.

Can Renting a Storage Facility Trigger a Requirement to Register for Tax? Letter No. 03-02-07/1-279 of the Ministry of Finance of 5 August 2011 addresses an interesting question posed by a company intending to rent premises for storage purposes at a location separate from the company. The question specifically says that the company does not plan to create any workplaces at the premises. In practice, the premises will be kept closed, and will be opened as and when necessary in order to take materials in or out. The persons authorized to do this will be company employees who generally work elsewhere. The reply quotes the definition of an economically autonomous subdivision in Article 11 of the Tax Code, i.e., “any subdivision which is territorially separate from the organization and at whose location permanent workplaces are equipped”. The author then has to resort to case law to describe what equipping a permanent workplace consists of. Rather airily, he says that “it follows from case law that the equipping of a permanent workplace implies the creation of all conditions necessary for the performance of employment duties and the actual performance of those duties. The manner in which work is organized (rotation system or business trip) and the period of time spent by a particular employee at a permanent workplace created by an organization have no legal significance for the purpose of registering the legal entity at the

Russian Tax Brief November 2011 location of subdivision.”

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an

economically

autonomous

The definition of “workplace” in Article 209 of the Labour Code is then given, “a place where an employee must be or to which he must come in connection with his work and which is directly or indirectly under the control of an employer”. The above leads the author to conclude that a taxregisterable presence will arise in the case of the proposed storage facility.

Russia’s Accession to the WTO: Impact on Customs Tariffs and Foreign Trade The final protocol on Russia’s accession to the World Trade Organization (WTO) was approved on 10 November. Russia will become a fully-fledged member of the WTO after the internal ratification procedures are completed, which will probably be next summer. The accession documents include Russia’s commitments concerning customs tariffs and other foreign-trade regulation measures. The weighted average rate of import customs duty is to be reduced from the current 10% to 7.8%: the weighted average rate for agricultural products will be reduced from the current 13.2% to 10.8%, and for industrial goods, from 9.5% to 7.3%. Customs duties will be reduced gradually over the period to 2020, for example, the customs duty on motor cars is to be reduced from 30% to 25% at the time of Russia’s accession to the WTO (i.e., in mid2012), and then it is to be gradually reduced to 15% over the following seven years, i.e., by the end of the term of validity of agreements on the industrial assembly of motor vehicles signed by the Russian Government. The import duty rates for certain groups of goods will be reduced as follows:

 Dairy products to 14.9% (the weighted average rate is currently 19.8%)

 Cereals to 10.0% (currently 15.1%)  Chemicals to 5.2% (currently 6.5%)  Electrical equipment to 6.2% (currently 8.4%)  Articles made of wood and paper to 8.0% (currently 13.4%). At the end of the transitional period, zero customs duty rates are to be established for cotton articles and high-tech goods. Export duty rates have been fixed for more than 700 types of goods, including oil, metals, fish products, raw hides, wood, cellulose, paper, etc.

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Import tariff quotas will remain for beef, pork and domestic fowl. The quota regime will be effective for pork until 31 December 2019, while the term of effectiveness for beef and poultry has not been determined yet. The customs duties for those types of products will be established as follows:

 beef 15% (55% outside the quota)  pork 0% (65% outside the quota subject to reduction to 25% by 2020)

 domestic fowl 25% (80% outside the quota). The currently applied system of licensing the import of goods (except for the transition to the automatic licensing of the import of alcohol) and the system of notification concerning goods with a cryptographic component will remain within the WTO framework. A transitional period will be established for investors in special economic zones in the Kaliningrad and Magadan regions. During that period, they will continue to enjoy the benefits provided by Russian legislation, thereby allowing them to fully implement their investment projects on the terms previously agreed.

Intra-group Financing from Luxembourg: Year-end Action Required Luxembourg is a jurisdiction sometimes used for intra-group financing of activities in Russia. Certain changes to its transfer pricing rules introduced in 2011 are relevant to any groups with Luxembourg subsidiaries involved in intra-group financing. The Luxembourg tax authorities have issued two circulars intended to provide guidance on transfer pricing considerations applicable to companies performing intra-group financing activities (the first in January and a further clarifying circular in April). Their purpose is to confirm the application of the OECD transfer pricing guidelines to intra-group financing activities and to formalize the procedure for obtaining an advanced pricing agreement (“APA”) from the Luxembourg tax authorities. The other main points can be summarized as follows:

 A grandfathering period is provided until December 2011 for exiting intra-group financing companies to comply with the new circulars.

 The application of the arm’s-length principle to an intra-group financing transaction should be based on a comparability analysis which should take into account assets used and risks assumed, i.e. intra-group financing companies should have sufficient equity to bear the risks

Russian Tax Brief November 2011 attached to their activity and should effectively bear these risks if they materialize;

 In this context, the term intra-group financing

refers to activity consisting of the granting of loans to affiliated companies financed by funds and financing instruments such as public offerings, cash advances or loans;

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receives a payment subject to German withholding tax is owned by shareholders which would not be entitled to a corresponding benefit under a treaty or the Directive (if received directly), it will be entitled to a reduced or 0% rate only if all three of the following tests are met:

 From 1 January 2012 the tax authorities will no

 a business purpose test;  the foreign company must earn more than 10%

longer be bound by APAs that have not been issued in accordance with the new procedure;

of its gross income from its own economic activity; and

 APAs are valid for five years and can be renewed for an additional five-year period; In order to assess a company’s needs in terms of tax and transfer pricing studies, the following key issues should be considered:

 Does the company grant loan(s) or provide advance(s) to associated companies? If so how are they financed?

 Will the existing financing activity continue beyond 1 January 2012?

 What is the level of risk borne by the financing company and is the existing amount of equity sufficient in the light of these risks?

 Has the annual remuneration realised by the financing company been validated in a Transfer Pricing study or an APA and, if so, when?

 Are the level of organizational substance and corporate governance of the Luxembourg entity in line with the requirements of the circulars?

 Specific to orphan financing structures: the Luxembourg financing company should earn an arm’s-length handling fee for the activities it performs. The level of remuneration should be substantiated in an economic analysis (not an OECD transfer pricing report). As existing tax clearances may expire at the end of 2011 it may be of utmost importance to take immediate action.

German Treaty Shopping Rules Violate the EC/EEC Treaty and Should be Amended per the EU Pursuant to an infringement proceeding, the EU has asked Germany to amend its anti-abuse provisions. Under German tax law dividends paid by resident companies are generally subject to withholding tax at a rate of 25% and a 5.5% solidarity surcharge (the combined tax rate is approximately 26.37%). Under an applicable treaty or the EU Parent Subsidiary Directive such withholding tax can be reduced to 0% - 15% but relief is not granted automatically in all cases. If a foreign company that

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 a substance test. The infringement proceeding against Germany focused mostly on the 10% gross receipt test since it has not provided an opportunity for the taxpayer to justify the use of a structure economically and based on the business purpose test; and therefore violates the principle of freedom of establishment, while the other two tests are in line with EU law. Recently the German Federal Ministry of Finance released a draft of potential changes to the antitreaty shopping rules, which are likely to come into force from 1 January 2012. The key change is the abolition of the 10% gross receipt requirement. If a foreign company holding a German subsidiary derives income from its own economic activities, it would then in principle be entitled to treaty or EU Directive benefits, irrespective of whether or not such income represents at least 10% of its total gross receipts. In this case no separate business reason or economic justification would be required. Russian groups structuring their investments in Germany through EU holding companies (e.g. Luxembourg) or other treaty countries should closely analyze and, if necessary, secure through appropriate restructuring, that holding companies not eligible for a withholding tax refund under the present wording of the German anti-treaty/antiDirective shopping rules are able to present sufficient economic substance and a valuable business reason for their interposition in the group. For the sake of completeness it should also be mentioned with respect to Germany that the European Court of Justice (ECJ) in the infringement proceeding, C-284/09 European Commission vs. Germany on 20 October 2011 held that the German withholding tax on dividend payments arising from foreign portfolio investments violates free movement of capital guaranteed by the EC Treaty and EEA Agreement. Consequently a refund of the tax withheld will likely be available and the possibility of claiming a refund should be considered.

Russian Tax Brief November 2011

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Inquiries may be directed to one of the following executives: Moscow Energy Chemical & Utilities Richard Lewis Victor Borodin Alexander Smirnov

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Transaction Tax Vladimir Zheltonogov Richard Lewis Alexei Ryabov

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Legal Services Tobias Luepke Dmitry Tetiouchev Alexey Markov Sergey Stefanishin

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Editor Maureen O’Donoghue

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St. Petersburg Tax and Legal Services Dmitri Babiner Anna Kostyra Michael Makhotin

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Information in this publication is intended to provide only a general outline of the subjects covered. It should neither be regarded as comprehensive nor sufficient for making decisions, nor should it be used in place of professional advice. Ernst & Young accepts no responsibility for any loss arising from any action taken or not taken by anyone using this material.

© Ernst &Young (CIS) B.V. 2011. http://www.ey.com/ http://tax.eycis.info

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