A pleasant surprise from the Supreme Court to “thinly capitalized” companies
The Supreme Court has rendered an important ruling in a dispute over the thin capitalization rule involving OAO SUEK-Kuzbass (further the “Company”).[1] In this case, the Supreme Court allowed considering the loan principal as investment in capital in order to apply the preferential tax rates for dividends provided under double taxation treaties (further “Tax Treaties”)[2][3] when paying interest re-qualified as dividends under the thin capitalization rule. The conclusions drawn by the Supreme Court will undoubtedly be of interest to all companies that have or are planning to get intragroup loans.
Gist of the dispute
The gist of the dispute is as follows. The Company paid loan interest to a related company based in Cyprus. The relevant Russian tax office applied the thin capitalization rule and re-qualified this interest as dividends for tax purposes. The general tax rate of 10% provided for dividends[4] under the Tax Treaty with Cyprus was applied to the re-qualified interest. The taxpayer, in turn, pressed for the application of the 5% reduced rate also provided for under the Tax Treaty, arguing that all the conditions of the Treaty were met for application of this preferential rate.
The Tax Treaty with Cyprus provides that when dividends are paid to a Cypriot company, the Russian company paying dividends should withhold 10% in tax. But, if the Cypriot company entitled to dividends has directly invested EUR 100,000 in the capital of the Russian company paying dividends, then such dividends should be taxed at 5%[5].
Tax authorities maintained that since the Cypriot lender is not a shareholder in the borrower’s company and thereby has not invested anything in its capital, then the 5% rate should not even be mentioned. The Supreme Court rejected this argument and pointed out that since interest paid to a foreign company are treated under the thin capitalization rule as dividends (i.e. as equity income), then the loan principal should be considered an investment in capital even if the lender is not a shareholder of the borrower and is therefore not entitled to receive dividends from a corporate standpoint.
To support this conclusion the Supreme Court referred also to Item 15 of the OECD Comments on paragraph 2 of Article 10 of the Model Tax Convention[6] which sets out that if the income received from a loan is, in accordance with the rules of national law, considered as dividends, then such loan should be treated as capital.
Fly in the ointment
Despite this positive conclusion for taxpayers overall, the Supreme Court shed no light on the following very important issues:
- If only part of accrued interest is recognized as dividends, does this mean that only part of the loan principal will be treated as investment in capital? In our opinion, only part of the loan should be recognized as investment in such case[7].
- When should investment in capital be calculated if the loan principal is paid at the same time as the loan interest during the tax period?
- If the loan principal is repaid before the interest, will this affect the right to preferential rate for interest re-qualified as dividends?
In addition, the Supreme Court ruling points out that the “regular” requirements for application of the benefits provided for dividends under the Tax Treaty should also be met, i.e. taxpayers must confirm their beneficial right to received income in order to apply the benefits conferred by the Tax Treaty. Otherwise, the provisions of the Tax Treaty will not apply[8]. We therefore recommend taxpayers to prepare in due time the documents confirming the status of beneficial owner of income (defense file).
What does this ruling mean for taxpayers?
This ruling allows taxpayers to treat loan principals as investment in capital to apply the preferential rates provided by Tax Treaties for interest re-qualified as dividends under the thin capitalization rule. This option is particularly relevant in cases where the initial amount of investments in capital is significantly lower than the amount provided by Tax Treaties for application of preferential rates. In addition, taxpayers who have already paid tax at the general rate (e.g. 10%) will be able to claim for a refund of overpaid tax.
What do we recommend?
We recommend:
- Considering whether it would be possible to apply a preferential tax rate for dividends as provided by Tax Treaties to current interest payments under intragroup loans;
- Assessing whether it would be possible to apply a preferential rate for interest re-qualified as dividends paid over the past three years and applying for a refund of overpaid tax;
- Preparing the documents required to confirm the lender’s beneficial ownership of interest income.
We would be pleased to assist with the preparation of the documents necessary for application of preferential rates upon payment of interest and dividends, as well as for refund of tax which has been overpaid because the benefits conferred by Tax Treaties were not applied.
If you would like to discuss this matter further or have any questions, please write to Anton Kabakov.
Yours truly,
[1] Supreme Court Ruling No. 304-KG17-8961 dated March 06, 2018 Case No. А27-25564/2015
[2] Double Taxation Treaty between the Russian Federation and the Republic of Cyprus dated December 05, 1998
[3] The thin capitalization rule provides that if a Russian company is financed from abroad mainly by loans from related companies rather than investments in capital, and consequently, distributes profits in the form of interest which are more beneficial than dividends from a taxation standpoint, then a part of such interest may be recognized as dividends for tax purposes. This rule is provided in Article 269(2) of the Russian Tax Code.
[4] Tax on dividends refers to the profit tax withheld at the source of payment upon payment of dividends.
[5] Article 10 Double Taxation Treaty with Cyprus
[6] Model Tax Convention on Income and on Capital as of July 15, 2014; https://www.keepeek.com//Digital-Asset-Management/oecd/taxation/model-tax-convention-on-income-and-on-capital-2015-full-version_9789264239081-en#page469
[7] We think that such conclusion reflects the logic of paragraph 15 (d) of the OECD Comments to paragraph 2 Article 10 of the Model Tax Convention.
[8] Supreme Court Ruling N 304-KG17-19528 dated December 25, 2017 Case N А27-16584/2016