A ruling on the high-profile case Oriflame vs. tax authorities was rendered by the Moscow District Arbitration Court (cassation instance) on June 11, 2015. The conclusions drawn by the court in this case affect all foreign companies operating in Russia through subsidiaries. Below we outline the main risks arising from this ruling for Russian companies owned by foreign investors.
In this case, tax authorities and courts questioned the right of the Russian company OOO Oriflame Cosmetics to deduct from its profit tax base the royalties paid to the foreign affiliate Oriflame Kosmetiek B.V. (Netherlands) for the right to use trademark, brand and know-how. Tax authorities also denied the deduction of VAT that OOO Oriflame Cosmetics withheld as tax agent upon payment of royalties to Oriflame Kosmetiek B.V. Although the case formally concerned royalties, the conclusions drawn by court could apply to other types of agreements between foreign companies and their subsidiaries in Russia.
Oriflame Cosmetics SA (Luxembourg), owner of Oriflame trademark, brand and know-how, transferred the rights to their use to its affiliated company Oriflame Kosmetiek B.V. (Netherlands) under a franchise agreement.
The next day, Oriflame Kosmetiek B.V. (Netherlands) transferred these rights to its affiliated company in Russia, OOO Oriflame Cosmetics, under a sub-franchise agreement. For the received rights OOO Oriflame Cosmetics paid royalties to Oriflame Kosmetiek B.V. (Netherlands) which in turn transferred 98.4 % of this amount as royalties to Oriflame Cosmetics SA.
Tax authorities and courts consider that such royalties are unlawful tax optimization, which allowed the Russian company to significantly decrease its tax burden by deducting paid royalties from its profit tax base and deducting withheld VAT, while Oriflame Cosmetics SA and Oriflame Kosmetiek B.V. avoided paying taxes in their respective jurisdictions. Tax authorities and courts argue that such tax optimization is unlawful because OOO Oriflame Cosmetics is registered as legal entity only formally, while it actually operates as Oriflame Cosmetics SA’s representative office.
The court put forward the following arguments to support its position that OOO Oriflame Cosmetics is actually Oriflame Cosmetics SA’s representative office:
A permanent establishment is a tax status which is awarded to a foreign company on the basis of its activities in Russia. If the activities performed by the foreign company in Russia meet certain criteria, then the foreign company is deemed to have a permanent establishment in Russia, regardless of the foreign company’s intention to set up such establishment.
So, for example, a foreign company may be deemed to have a permanent establishment in Russia, if it operates in Russia through a so-called dependent agent. A Russian entity, including a company, may be considered a foreign company’s dependent agent if it:
An agent is deemed dependent if all the above three conditions are met simultaneously.
The court and tax authorities have not established what contracts were negotiated by OOO Oriflame Cosmetics in Russia on behalf of Oriflame Cosmetics SA so that one of the key criteria for dependent agent has not been established in this case. Consequently, the activities performed by OOO Oriflame Cosmetics cannot be deemed to have given rise to a permanent establishment.
To make up for the fact that the above key criterion is not met, the court used the following arguments intended to support that OOO Oriflame Cosmetics is dependent on Oriflame Cosmetics SA:
(1) Since the same employees manage OOO Oriflame Cosmetics and Oriflame Kosmetiek B.V., the court concluded that OOO Oriflame Cosmetics is not independent when adopting management decisions;
(2) The activities performed by OOO Oriflame Cosmetics are subject to detailed instructions from Oriflame Cosmetics SA in the form of a business plan known internally as Success Plan;
(3) Customers strongly believe that OOO Oriflame Cosmetics is an office representing the foreign company Oriflame in Russia;
(4) Since almost the entire amount of royalties transferred by OOO Oriflame Cosmetics to Oriflame Kosmetiek B.V. is transferred by Oriflame Kosmetiek B.V. to Oriflame Cosmetics SA, the court concluded that Oriflame Kosmetiek B.V. is a transit company.
In focusing on proving interdependence, the court failed to consider that, with no other signs of dependent agent, the interdependence of an agent and a foreign company does not give rise to a permanent establishment for the foreign company. It is therefore of no relevance whether OOO Oriflame Cosmetics and Oriflame Cosmetics SA are interdependent, if the above key criteria for permanent establishment are not met.
Tax authorities and courts claimed that, since OOO Oriflame Cosmetics is a dependent agent, this gives rise to a permanent establishment for Oriflame Cosmetics SA in Russia, OOO Oriflame Cosmetics should in fact be considered as a division (representative office) of Oriflame Cosmetics SA. And, since OOO Oriflame Cosmetics is a representative office, it should not have paid royalties, and consequently it should not have deducted royalties from its profit tax base.
In our opinion, the court argumentation is based on an erroneous identification of (а) a foreign company’s permanent establishment (in Russian: postoyannoe predstavitelstvo) arisen from the activities performed by a dependent agent and (b) a representative office (in Russian: predstavitelstvo) as an organizational form of a foreign company’s division in Russia. This error might have stemmed from the use of similar words in Russian for permanent establishment and representative office (predstavitelstvo for both). Although they sound similar in Russian, they refer to different concepts: a permanent establishment is a tax status and a representative office is one of the types of divisions a foreign company can open in Russia (similar to a branch). Foreign companies may at their own discretion open in Russia divisions in the form of branches and/or representative offices. And if a foreign company has a permanent establishment in Russia, this does not automatically result in the opening by the foreign company of a branch or a representative office in Russia, as the company’s intention and decision are required to open such divisions.
The argument that a dependent agent whose activities give rise to a permanent establishment for a foreign company in Russia is not entitled to deduct from its profit tax base the payments made to the foreign is also not based on the law. Dependent agents do not lose their status of independent legal entities, and the law does not restrict their right to deduct payments made to foreign companies.
Courts also noted that since all commercial information passed on to OOO Oriflame Cosmetics as trade secret (know-how) is published on Oriflame site, it is no longer a trade secret and it can no longer be considered as know-how. Courts thus considered that OOO Oriflame Cosmetics should not have paid for know-how as none was passed on.
As additional evidence of unlawful tax optimization, courts refer to the fact that OOO Oriflame Cosmetics paid considerable royalty amounts despite being a loss-making company. Courts did not, however, investigate whether royalty amounts were in line with or exceeded market level, citing the absence of such market in Russia. This conclusion could also call into question the possibility to use CUP method for benchmarking payments for intellectual property rights under transfer pricing rules.
Despite the contestable position held by courts in the Oriflame case, we recommend foreign companies operating in Russia through subsidiaries to take the following actions to minimize the risk of claims from tax authorities:
Should you have any questions or require any assistance, please do not hesitate to contact us.
 Moscow District Arbitration Court Ruling dated June 11, 2015 Case No. А40-138879/14
 Article 306(9) Russian Tax Code
 Please refer to Article 5(5(32) OECD Model Convention for the need to establish the actual use by a Russian entity of the right to enter into agreements in the interests of a foreign principal: “It would not have been in the interest of international economic relations to provide that the maintenance of any dependent person would lead to a permanent establishment for the enterprise. <…> Therefore, paragraph 5 proceeds on the basis that only persons having the authority to conclude contracts can lead to a permanent establishment for the enterprise maintaining them.”
 Article 306(10) Tax Code
 Article 55 Russian Civil Code
The content of this Legal Alert is provided for general information only and should not be treated as a substitute for legal advice for which it is always necessary to consider the actual and specific circumstances of the situation at hand.