Russia - Case of “Perekryostok”: the Current Status of the Multimillion-Dollar Tax Dispute

On July 31, 2021, the Arbitrazh (Commercial) Court of Moscow passed a ruling on case No. А40-118073/19 on the invalidation of the decision of the Moscow Office of Russia’s Federal Tax Service adopted against Perekryostok Trading Company JSC as part of another on-site tax inspection.

This ruling is of great interest to medium-sized and large enterprises as it relates to debt funding between companies of the same group that are not residents of Russia, and is also based on an analysis of such companies entering between themselves into agreements on sale and purchase of shares in the authorised capital of Russian companies.

Below is a brief description of this situation.

TAX SERVICE STANDPOINT

Further to its another on-site inspection, the Moscow Office of Russia’s Federal Tax Service (the tax authority) adopted a decision under which Perekryostok JSC was requested to pay arrears on corporate income tax and tax on income of a foreign company earned from Russian sources. The arrears total nearly 1.6 billion rubles, with penalties of almost 800 million rubles charged.

The tax authority’s claims came after Perekryostok JSC (the Company) carried out a number of transactions (operations) during the corporate restructuring within the X5 Retail Group companies:

1. Acquisition of a 7.87% share in the authorised capital of Agroaspekt LLC from X5 Retail Group (Netherlands).
2. Acquisition of a 6.69% share in the authorised capital of Agrotorg LLC from X5 Retail Group (Netherlands).
3. Acquisition of an 83.4% share in the authorised capital of Agrotorg LLC from Speak Global Limited (Cyprus) under a sale and purchase agreement.

By doing so, 11,500,000,000 rubles owed to Speak Global Limited were offset, with 66,267,000,000 rubles novated into a loan subject to interest payment at a rate of 4.15% per annum, which was later assigned to X5 Retail Holding Limited, and the debt was repaid.

The Company took account of interest expenses so as to calculate and pay corporate income tax. When paying borrowed interest, the Company did not calculate and did not withhold tax at the source of payment as it was acting upon the Double Taxation Treaty between Russia and Cyprus as regards income and capital tax (clause 1 of article 11 of the Treaty).

The remaining 4,732,082,000 rubles owed to Speak Global Limited were novated into a loan subject to interest payment at a rate of 11% per annum, with the debt having then been offset.

The Company took account of interest expenses so as to calculate and pay corporate income tax.

The tax authority concludes that these transactions were carried out in order to withdraw funds from Russia in the interests of foreign companies without paying tax in Russia. The transactions also resulted in the tax authority resorting to the following measures:

1. the Company’s payment of shares in Agroaspekt LLC and Agrotorg LLC in favour of X5 Retail Group has been requalified into dividends, with X5 Retail Group recognised as a company not having actual right to income, which resulted in the charge of additional tax and penalties on foreign company income at a rate of 15%;
2. the interest paid by the Company under a loan agreement in favour of X5 Retail Group has been requalified into dividends, with X5 Retail Group recognised as a company not having actual right to income, which resulted in the charge of additional tax on foreign company income for 2013 at a rate of 15%.

The Company has contested the decision of the tax authority through legal proceedings.

COURT STANDPOINT

Upon examination of the case, the court took the side of the taxpayer and made the following conclusions:

1. the transaction for the acquisition of shares in Agroaspekt LLC and Agrotorg LLC was real, not imaginary, and it had a business-related purpose, specifically to change the structure of intra-group ownership in order to make the X5 Group of Companies transparent and create a consolidated group of taxpayers on the basis of the Company;
2. the legislation and the existing judicial practice do not impose restrictions on economic entities in the use of civil mechanisms (sale of a share in the authorised capital, etc.) as part of restructuring holding companies (changing the ownership structure);
3. the tax authorities cannot interfere with the method chosen by the taxpayer for exercise of their rights (assess the feasibility, rationality and efficiency of a particular transaction) and;
4. the requalification of legal relations should not lead to the diminution of other rights of the taxpayer, including those related to the application of provisions of international treaties, and cannot be carried out in the context of real legal relations (a real transaction and real performance of a transaction), nor can a requalification be carried out if there are no signs of abuse of rights in the taxpayer’s (group of taxpayers) actions (including creation of formal artificial schemes with the sole purpose of gaining tax benefits).

As a result, the court fully invalidated the decision of the tax authority.

It is worth mentioning that the court’s ruling has not yet taken legal effect and is being appealed by the tax authority. A session in the court of appeal is scheduled for October 25, 2021.

CONCLUSION

The decision of the tax authority has revealed the approach of the domestic fiscal department to “internal transactions” performed by a taxpayer within a group of companies for the redistribution of assets involving a foreign company.

With this approach of the tax authority to such kind of taxpayer transactions (purchase of a share in the authorised capital, provision of debt funding), there is a risk of requalification of payment in favour of a foreign company into “hidden” dividends with a subsequent charge of additional tax. Experience has shown that this and other risks must be considered when structuring transactions involving foreign companies