Russia: Court accepts a tax challenge based on the conduit company doctrine
The Federal Arbitration Court for the Moscow Region has ruled against Naryanmarneftegaz (a ConocoPhilips/Lukoil JV) in a thin capitalisation dispute.
This is a further development in the recent wave of attacks on what the tax authorities believe to be improper defences against the Russian thin capitalisation rules (including the infamous Severny Kuzbass case in late 2011 which denied non-discrimination defence against Russian thin capitalisation rules).
This is effectively the first precedent where the tax authorities succeeded in challenging the "sister company" defence against Russian thin capitalisation rules at the federal court level.
In this particular case the court decided that since the ultimate joint venture partners (ConocoPhilips and Lukoil) provided in their shareholder agreement for subsequent provision of what they called "shareholder loan" (either by them or their group companies), the actual loan provided by a US sister company affiliated with ConocoPhilips should be viewed as a single transaction together with the shareholder agreement. This logic provided the basis to apply Russian thin capitalisation rules as if the loan had been granted directly by the foreign shareholder.
This case is also the first precedent where the tax authorities succeeded in reclassification of interest into dividends for withholding tax purposes under a double tax treaty. Until recently such claims have been typically dismissed based on the literal interpretation of articles 10 and 11 (for example, Wintershall succeeded in recovering "excessive" withholding tax from the Russian treasury as late as December 2011).
This court case is also important in that it effectively introduces the "conduit company" concept into the Russian court practice, which until recently has never been defined in the law. The tests applied to determine whether the lender was a conduit company are however very dubious.
The decision was made at the cassation (final) level of the court and unless the Supreme Arbitration Court (SAC) decides to intervene, this decision is final. The taxpayer technically has three months (ie until the end of May) to apply to SAC, which will have another month to decide if it would want to reconsider the case.
This latest development confirms our previous recommendation: where applicable you should check and reinforce substance/business purpose of the foreign finance companies used to provide debt financing to your Russian operations.
Evgeny Timofeev (firstname.lastname@example.org)