The New Approach of Russian Courts towards “Thin Capitalization Rules”: the Possibility of an Additional Tax Assessment and the Likely Restructuring of Holding Company Capital Structures

The Supreme Commercial Court (hereinafter –“SCC”) recently made a precedent setting decision in the case of major Russian coal company “Severniy Kuzbass” (case No. А27-7455/2010). The decision can negatively impact Russian companies with certain foreign capital structures for the following reasons. Firstly, the decision changes the approach of Russian courts towards the “thin capitalization rules”, which regulate the financing of Russian companies via foreign loans from “parent companies”. Secondly, and most importantly, the decision’s precedent paves the way for massive additional tax assessments and thus will surely lead to a change in the typical financing structures of Russian holding companies.

The current approach to financing Russian companies with foreign capital

Today, a foreign owner of a Russian company has two main methods to finance the latter – (1) by the payment of charter capital and (2) by the grant of a loan. The second method became widespread in 2004 and 2005, after the globalization of Russian businesses.  The popularity of financing a company by way of granting a loan rather than paying charter capital was due to the beneficial nature of such an arrangement to both sides of the transaction. In the case of the foreign “parent company” (which is often an offshore structure of Russian origin), it immediately receives profit from its investment in the form of the repaid principal and interest, and it does not have to wait for dividends, which may be issued only when the company receives a profit. On the other hand, in accordance with the Tax Code of the Russian Federation, the subsidiary company, as issuer, is entitled to allocate the accrued interest to expenses and thus decrease its income tax liability. Provided, however, that the company stays within the limits of the “family financing” debt-equity ratio limit provisions of the Tax Code, which dictate that the loan amount (debt) shall not exceed three times the amount of the borrower’s assets (equity).

The “Severniy Kuzbass” case in lower courts

The coal company, “Severniy Kuzbass” (a debtor of its shareholder in Switzerland, Mittal Steel Holding AG, as well as of a Luxemburg company - ArcelorMittal Finance), surpassed this ratio limitation and thus, from the Tax Inspection’s point of view, claimed too many tax deductions. As such, the Tax Inspection assessed additional tax on the coal company, which the latter successfully contested in courts of all instances. The lawyers of “Severniy Kuzbass” managed to convince the judges that the debt-equity ratio limitation should not apply because the double taxation avoidance agreement in effect between Russia and Switzerland prohibits unequal treatment of Swiss companies vis-a-vis Russian companies.  Thus, the lack of any limitation of loans between Russian companies would negate a limitation on Swiss owners under the treaty, which shall prevail over the Tax Code of the Russian Federation.

Rationale of the SCC in the “Severniy Kuzbass” case

Yesterday’s decision of the SCC overturned the decisions of the lower courts. It concluded that the courts erroneously referred to the provisions of tax agreements with Switzerland, construing them too broadly. From the SCC’s point of view, these provisions do not annul national rules in the case of the State’s struggle with tax evasion. The court supported its argument by referring to the Commentaries of the OECD Model Tax Convention. In effect, the SCC agreed with the Tax Inspection, claiming that the loans of “Severniy Kuzbass” could not be classified as market loans since their main purpose was tax evasion.

Consequences of the SCC decision

One of the main consequences of this decision and its resultant, new approach is that major Russian companies, such as LUKOIL, Vimpelcom, Rusal, and EVRAZ, can be negatively impacted. Accordingly, it is now apparent that Russian companies with foreign capital should find new methods of financing in order to mitigate the tax risks with regard to the Russian courts’ new approach to “thin capitalization rules”. In fact, with the exception of the banking sector where “thin capitalization rules” do not apply due to their destabilizing effect on liquidity ratios, every economic sector will be affected by this decision.

However, it still remains unclear whether the new approach shall apply to relations regulated by Protocols to double taxation avoidance agreements (i.e. with Germany, France, The Netherlands etc.), which include special provisions allowing unlimited allocations of accrued interest to expenses. This issue is yet to be solved by future court practice.