The following article is an excerpt from Awara Russian Tax Guide, the first comprehensive book offering a full overview of all Russian taxation laws and rules. Awara Russian Tax Guide provides insight into the general framework of the Russian tax laws, the Tax Code and its principles. It describes the general rules of the Tax Code Part I and each type of tax and tax regime of Tax Code Part II, among them: Profit Tax, VAT, Personal Income Tax, Property Tax, Employer’s Social Contributions. The book also covers the now so important case law and taxation principles set by court precedents.
The Russian laws on taxation of corporate profits are set out in Chapter 25 of the Tax Code. Russian legal entities, as well as foreign legal entities acting through permanent establishments, are subject to profit tax on their taxable income, which is generally determined as gross income less allowable expenses. To be deducted, all expenses have to be economically justifiable and substantiated by corresponding documents. The law stresses a connection between the expense and earned income: expense has to be incurred in connection with generating income. If the deductibility is contested, the burden of proof rests with the tax authority.
Some issues relating to profit tax have been dealt with in other parts of this Awara Guide to Russian Taxes. Reference is especially made to chapters: Accounting and Audit in Russia; Double Taxation Treaties; Permanent Establishment; Tax Registration and Taxation Status; ; Tax Concessions and Taxation Stimulus; and Transfer Pricing.
All Russian legal entities which are engaged in commercial activities are taxpayers of profit tax for their worldwide income. Foreign legal entities that act in Russia through a permanent establishment are also subject to profit tax (see chapter Permanent Establishment. Foreign legal entities that act in Russia without creating a permanent establishment and receive income from sources in Russia are subject to withholding tax (source tax) for the income from Russian sources (see below about Russian source income).
The following kinds of businesses are exempt from profit taxation:
The Tax Code provides for a number of tax concessions and preferential taxation regimes. These are presented in the chapters General About Russia Tax Law and Tax Concessions and Taxation Stimulus. The chapter General About Russia Tax Law provides a list of all the special taxation regimes intended to stimulate entrepreneurs, small business, certain fields of the economy (such as IT), or certain regions of the country. These tax regimes may be applied for taxation of profit providing the relevant conditions are met.
Individual entrepreneurs are taxed with the personal income tax for their business profits and not the profit tax presented in this chapter. The deductibility of expenses for individual entrepreneurs is however determined in accordance with the rules for corporate profit tax (art. 221). In addition to the default method of taxation by the personal income tax, individual entrepreneurs may also chose a special tax regime such as: simplified system of taxation; unified tax on imputed income; unified agricultural tax; and special tax regimes available for residents of special economic zones.
The profit tax rates for various situations are as follows:
|1. General rate for corporate profit tax||20%|
|2. Withholding tax (source tax) for non-residents||20%|
|3. Dividends from Russian entities received by non-residents||15%|
|4. Income in relation to international transport (freight) income (operating, maintaining, rent, leasing of vessels, airplanes, other
means of transport and containers)
|5. Dividends from Russian and foreign legal entities received by Russian legal entities (unless participation exemption 0% is applied)||9%|
|6. Participation exemption: dividends received by Russian tax residents, provided that they have been participating in the company paying dividends:
• for not less than 365 consecutive calendar days;
• for not less than 50% of the share capital;
• total value of participation is not less than RUB 500 million;
• amount of participation gives the right to receive not less than
• 50% of all dividends
|7. Yields from state and municipal securities and mortgage bonds (art. 284(4))||15%, 9% or 0%
(the actual rate depends on the date of issue)
In reference to what was said above, we remind that taxpayers are eligible for tax concessions and that there are a number of special tax regimes providing for preferential tax treatment and rates subject to meeting the special conditions.
The total tax rate of 20% is divided between various levels of budget in Russia as follows (art. 284): 2% is due to the federal government; and 18% is due to a regional government. The regional governments are left with the right to reduce the part of the profit tax payable to them by maximum 4.5%. This allows for a maximum reduction of the tax rate down to a total of 13.5% (see chapter Tax Concessions and Stimuli).
The taxpayer’s income falls into two major groups: sales income and non-sales income. Sales income is receipts from sales of goods, works, services or property rights (art. 249). Other receipts are deemed to be non-sale income. An open list of receipts subsumed under the latter category can be found in article 250 of the Tax Code. The distinction between sales and non-sales income turns on the different dates of their recognition (art. 271).
At the same time, the law provides a closed list of non-taxable income with the aim to expressly exclude financing items and other receipts from taxable income (art. 251).
The list of excluded (non-taxable) items contains 40 positions, the most important of which are the following:
Inter-company transfers are transfers that occur between a controlling parent company and a subsidiary. A controlling parent-subsidiary relation is in place when the parent holds an ownership share of not less than 50%. The transfer can be made in both directions: from the parent to the subsidiary and from the subsidiary to the parent. A condition for using this provision is that such assets are not further transferred to third parties within 1 year (this rule does not concern money received). The transferring party (but not receiving party) can also be an individual.
Special-purpose financing may consist of, for example:
Assets under special-purpose financing have to be used according to the designated purpose, as instructed by the donor entity. These assets have to be separately accounted for and failure to do so would lead to taxation of the assets as income from the date of their receipt. The taxpayer receiving special-purpose financing must after the end of the tax year present to the relevant tax office a report on the utilization of this financing (in the form mandated by the Ministry of Finance). It has been determined in court that the special-purpose financing must be utilized in the calendar year when the financing (assets)were received. According to a court such special-purpose financing would have to be utilized by the end of the calendar year even when received at the end of the year (Decree of Federal Commercial Court of Moscow district of 09.07.2007, 16.07.2007 No.КА-А40/6343-07-1,2 and ruling of Supreme Commercial Court of 23.10.2007 N 13535/07). In another case the Supreme Commercial Court has ruled that a temporary deposition of money in bank would not qualify as proper utilization of special-purpose financing (ruling of Supreme Commercial Court of 02.04.2008 N 4246/08). Assets that have been acquired or created by means of special-purpose financing do not qualify for expense deductions or depreciation (art. 256).
Another form of special-purpose financing is what is referred to as special-purpose receipts (“zelevie postupleniya”).These include receipts allocated from the budget to recipients of budgetary funds, and receipts for the maintenance and carrying out of the chartered activities of non-commercial entities. The rule concerning separate accounting also applies.
Special-purpose receipts include, among other things:
1. Admission fees and membership fees paid to charities and other non-commercial organizations
2. Contributions to mutual funds
3. Donations that are recognized as such in accordance with the Russian Civil Code
4. Funds received for charitable activity
The Tax Code divides expenses into two major groups: sales expenses (connected with production and sale) and non-sales expenses (art. 252). Sales expenses are further divided into direct and indirect expenses (art. 318(1)).
These classifications are merely accounting conventions and do not by themselves result into any restrictions as to the deductibility, but they may affect the timing of the deductibility of expenses. Thus, direct sales expenses are deductible in the reporting (or tax) period in which the income to which the expenses relate is recognized. Indirect sales expenses and non-sales expenses are deductible in the reporting (or tax) period in which they are incurred (art. 318).
In order for expenses to be deductible they have to meet certain conditions, namely, the expenses have to be:
• Be economically justifiable
• Serve the function of generating income
• Be substantiated by relevant supporting documents
Article 252 of the Tax Code establishes that the supporting documents have to be produced in the form as prescribed by the Russian law or by normal business practice of foreign states on which territory the expenses incurred. With recent changes in the law there will be more flexibility for companies to adopt their own templates for the supporting documents. For more details on the requirements to substantiate tax deductions with source documents, please, refer to chapter Accounting and Audit in Russia.
It should be noted that Russian tax law does not require the proof of direct linkage between income and expenses for the latter to be deducted from the former. In other words, the difference of sources of income and expenses does not preclude the deduction.
The law recognizes not only expenses intentionally committed by the company as deductible, but also various kinds of losses brought about by unfortunate circumstances.
Such losses are, for example (art. 254(7); art. 265(2))
1. Losses in prior tax periods revealed in the current period
2. Bad debt
3. Losses due to downtime (or stoppages) caused by intrafirm reasons
4. Losses due to externally caused stoppages for which no compensation has been received
5. Expenses in the form of shortages of stock (if there is no guilty person)
6. Losses due to natural disasters, fires, accidents and other emergencies
7. Foreign exchange losses
8. Technological losses
9. Losses within the established norms of natural decrease at transportation or storage
10. Losses resulting from assignments of claim
Recognition of income and expenses is made in the period in which they arose with the accrual method irrespective of cash settlement The cash method can be used by small-scale business (art. 273). Companies may use this exemption for small-scale business if on an average during the four prior quarters sales revenue did not exceed the amount of one million rubles (net of Value Added Tax).
The date of receipt of sales income under the accrual method is considered to be the day when goods are dispatched, or services and works are transferred (art. 271(3)).
The Tax Code gives quite precise rules for the recognition of various types of income and expenses (arts. 271-273). According to these rules, the date of recognition may depend on various actions or factors, such as:
1. Date of signing an act of acceptance of delivery of goods, works or services
2. Date of receipt of money in bank or cash account
3. Date of settlement or issuance of settlement documents
4. Terms of financial agreements (e.g. date of interest payment)
5. Last date of tax period
6. Date when income was revealed (for income of prior years)
A taxpayer may choose one of the following methods of stock valuation (art. 254(8)):
• The cost of production of a unit of stock
• The average cost
• FIFO (the cost of first acquisitions)
• LIFO (the cost of last acquisitions)
The law recognizes as depreciable assets those fixed assets and intangibles that have a minimum useful life exceeding 12 months and initial value not less than RUB 40,000 (art. 256). The tax accounting and financial accounting rules provide for similar, but not identical recognition rules.
Depreciable property includes fixed assets and intangible assets. Fixed assets are defined as property used in the management and production and sale of goods and services (art. 257(1)). Intangible assets are defined as assets which are the results of intellectual activity and other intellectual property rights (or the exclusive rights thereto) and which are used in the processes of management, production and sale of goods and services for no less than 12 months (art. 257(3)).
To be recognized as a depreciable asset, the fixed asset will have to be used for management, production or sales activities of the company. However, in reference to intangible assets there is in the Tax Code no reference to use in sales activities, although the provision of services as a purpose of their use is included (art. 257(1 and 3)).
The following types of intellectual property qualify as intangible assets:
1. Exclusive rights of a patent-holder to an invention, industrial sample or working model
2. Exclusive rights of an author or other possessor of rights to use computer programs and databases
3. Exclusive rights to a trademark, service mark
4. Possession of know-how, a secret formula or process, information on industrial, commercial or scientific experience
It should be noted that the law stresses the words exclusive rights as a criterion for recognizing intangible assets, meaning that the relevant intellectual property right belongs to a named person and he has the right to freely dispose of it.
It is improbable that a taxpayer would achieve the conditions for being able to deduct goodwill from the corporate profit tax base. In principle the Tax Code allows (art. 132) that goodwill is capitalized in the tax accounts and amortized as an expense over a 5 year period, but this provision is made conditional to the assets having been officially registered as an ‘entity of assets’ (“imuschestvenny complex”). Such a registration is a cumbersome process of unknown duration, and is rarely done, which means that the provision of deducting goodwill as an expense is a dead letter of the law.
The law especially excludes from the scope of intangible assets certain types of expenditures, namely:
1. Research and Development (R&D), which have not yielded a positive result
2. Individual qualities of employees (intellectual and business qualities, qualifications and capacity for work)
Recognition of intangible assets presupposes that there is proper documentation in place. The documentation will have to confirm the existence of the intangible asset and the exclusive rights to the results of intellectual activity in accordance with Russian law or laws of a foreign country, as applicable. Such documentation may include patents, certificates, trademarks, other protective documents and relevant agreements.
Certain types of assets are not subject to depreciation:
• Land, water and other natural resources
• Inventory (stock) and goods (i.e. property which is sold or designated for sale)
• Securities and derivatives
• Assets of budgetary and non-commercial organizations used for entrepreneurial purposes
• Assets acquired with special purpose financing
• Assets received for use without consideration
• Assets temporarily taken out of production process (for more than 3 months)
• Assets undergoing reconstruction or modernization for more that 12 months
Assets are recorded at their historical cost, which is defined as the expenditure for acquiring, erecting, supply and manufacturing of the assets as well as rendering them fit for use, in general excluding VAT and excises (art. 257(1)).
For the purpose of determining the depreciation rates the Tax Code (art. 258) divides all types of fixed assets into 10 depreciation groups, according to their useful lives. By virtue of the Tax Code the Russian Government has issue a depreciated assets classification list(Decree of 1 January 2002 No. 1).
|Depreciation Groups||Useful Life||
(The items indicated are examples only. The law contains much more asset types for each depreciation group.)
|Group 1||1 to 2 years||Hand instruments and tools for construction industry|
|Group 2||2 to 3 years||Pumps for mining industry, medicine instruments|
|Group 3||3 to 5 years||Elevators, loading and unloading machines, office equipment (copiers, computers, phones), cars|
|Group 4||5 to 7 years||Mobile constructions (kiosks), separators, equipment for medicine industry, trucks|
|Group 5||7 to 10 years||Tanks, gas pipes, industry ovens and furnaces, combiners, harvesters, optic wires systems, limousines|
|Group 6||10 to 15 years||Steel furnaces, gang saws, forestry industry machines, barges|
|Group 7||15 to 20 years||Open-heat furnaces, railroad bridges, highways|
|Group 8||20 to 25 years||Blast furnaces, wharfs, electric locomotives|
|Group 9||25 to 30 years||Nuclear reactors, passenger ships|
|Group 10||Over 30 years||Buildings, subway cars, forest shelter belts|
The taxpayer is reminded about the need to verify the applicable depreciation group by referring to the relevant decree of the Government. To note, for example, ‘buildings’ can be found in different depreciations groups depending on the type of the building and materials used.
In case of most fixed assets, a taxpayer chooses a useful life for the fixed asset that falls within the useful life range for the depreciation group to which the fixed asset has been classified by the Russian Government. If an item is not classified to any depreciation group, the taxpayer determines the useful life of such an asset based on the asset’s technical characteristics or recommendations from the producer of the asset (art. 258(6)).
For determining the useful life of an intangible asset, relevance will be given to the terms (indication of duration etc.) provided for in patents and certificates as well as to the provisions in Russian law or the law of a foreign state (if applicable) and the relevant agreements between the parties concerning the term of use of the assets in question. If it is not possible to determine the useful life of an intangible asset, then its useful life is deemed to be 10 years.
The applicable depreciation methods are the straight-line method and the reducing balance method. According to the straight-line method the asset value is depreciated in equal yearly increments over a number of years. The straight-line method is mandatory for depreciation of buildings, constructions and transfer mechanisms in depreciation groups 8-10.
The reducing balance method enables accelerated depreciation, because it recognizes a higher depreciation cost earlyon in an asset’s lifetime. Since many assets are most useful when they are new, this method may be a more realistic reflection of an asset’s actual value, as well as the expected benefit from the use of the asset. Generally, this method commends itself for those who wish to recognize more expenses (and, respectively, to keep the tax base lower) during the first years of the asset’s useful life.
The chosen depreciation method can be changed from the beginning of the new tax period, but a taxpayer can move from the reducing balance method to the straight-line method not more than once within the period of 5 years.
For the straight-line method the depreciation rate has to be determined separately for each item. For the reducing balance method the depreciation is determined separately for each depreciation group (sub-group).
Accelerated depreciation rates are applicable to assets used in a so-called aggressive environment or for assets that are subject to exceptionally high replacement frequency. In these cases the rates may be increased twofold. This increasing ratio of depreciation does not apply, if a taxpayer uses the reducing balance method and his fixed assets are assigned to the first, second or third depreciation groups.
Accelerated depreciation is also available for assets under a financial leasing arrangement, where the depreciation rate can be increased threefold. These provisions apply unless the assets in question are assigned to the first, second or third depreciation group and are depreciated under the reducing balance method (art. 259(7)). Also, the threefold ratio of depreciation can be applied with respect to fixed assets used exclusively for scientific and technical activities.
A twofold rate can be used by agricultural organizations and residents of special economic zones.
Reduced rates may be used upon management decision during the entire tax period and starting from its beginning (art. 259(10)).
The expenditures for capital improvement and for reconstruction or modernization of fixed assets amounting to not more than 10% (30% for depreciation groups from 3rd to 7th) of their original cost can be immediately deducted from the tax base (art. 258(9), Tax Code). However, if such fixed assets are sold within 5 years from the moment of their accounting (entry into exploitation), the amounts of expenditures included in the expenses in the relevant accounting (tax) period shall be re-included in the Profit Tax base.
In the case when the obtaining of title to a fixed asset requires state registration, the asset shall be included in a respective depreciation group from the moment of filing for the registration (art. 258(11),).
For an asset acquired on the secondary market ,the historical cost can be set taking into account the useful life reduced by the months of operation of the asset at the previous owner (art. 259(12)). This option is available only for assets depreciated by the straight-line method.
Losses from the sale of fixed assets (including transaction costs) are deductible over the remaining period of the originally determined useful life in the seller’s balance (art. 268(3)), whereas losses from sales of other assets are deductible in the period when they are sold.
Expenses in the connection of repair of fixed assets are fully deductible in the period they were incurred (art. 260). But in order to spread the expenses more evenly over the years, the taxpayer may create a reserve for upcoming repairs in accordance with article 324 of the Tax Code.
The Tax Code allows to make certain reserves for future or doubtful expenses. According to the law the following kinds of reserves are available: reserve for warranty period repairs and warranty service; bad debt reserve; vacation salary reserve; reserve for future expenses on research & development; reserves for future expenses on commercial activities (available for non-commercial organizations).
The terminology in the Tax Code calls the debt for which reserves are made as doubtful debt, and debt, which has finally turned out to be impossible to collect, is named Bad Debt (due to bankruptcy or expiration of statute of limitations).
The reserve for doubtful debt can be made for any indebtedness, including trade credits, that has not been settled within the agreed times, and that is not secured by any collateral, pledge, security or bank guarantee.
Debt in the form of unpaid interest income cannot be included in the reserve, except for in the case of banks.
The deductible reserve increases progressively depending on the maturity of the debt as follows:
• Debt outstanding 90 calendar days or more – full amount of debt may be reserved
• Debt outstanding 45-90 calendar days – 50% of the amount of the debt may be reserved
• Debt outstanding less than 45 calendar days – no reserve allowed
The maximum allowance for the reserve is limited to an amount equal to 10% of the sales revenue in the relevant period.
The amount of reserve may be carried forward to the next tax period. Any reduction in the amount (as a result of corrections, etc.) will have to be included in the income for the period, whereas any increase should be included into expenses.
Companies extending repair guarantees (repair warranties) may create a reserve for future expenses connected with warranty repair and warranty servicing (art. 267, Tax Code). In order to create a reserve, the company has to determine the rules for the applicability of the reserve and its maximum amount in the tax accounting policy.
It is a condition of the reserve that the actual sales contracts contain provisions of such warranties (guarantees).
The limit of the amount of the reserve is a product of the share of expenditures for warranty-related repairs in the company’s income from warranted goods (or works) for the previous three years and gains from the sales of goods and works in question during the accounting period (art. 267(3)).
In the case that the company has engaged for less than three years in sales of warrantable goods then the limit is determined based on the sales in the actual period, In this case, the company has to draw a plan of fulfillment of guarantee obligations, and the expected expenses have to correlate with this plan. After the end of each tax year the reserve will be adjusted in accordance with the expenses actually incurred for warranty works and the volume of sales. As the warranty period expires, the amount of the reserve which has not been used will be credited into the non-sale income for the period.
From 2002 on taxpayers were able to make a reserve for vacation salaries (art. 324.1). In practice the possibility to make such a reserve is limited. This because the law mandates that at the end of the year the reserve has to be terminated and any unused balance of the reserve has to be credited into income. From the new tax period the reserve can be built up again with monthly transfers. As vacations are usually taken in the middle of the year the provision of the reserve would be more valuable if the time cycle of the reserve would match the time of actual vacations.
Losses from previous tax periods may be carried forward and deducted from future profits (art. 283). The loss carry-forward is available for 10 years following the year in which the loss occurred. Hereby supporting accounting documents will have to be kept going back to all the periods to which the loss refers to. However, losses from sales of securities and fixed-term financial instruments are accounted separately and are carried forward separately in accordance with the loss carry-forward rules applicable to other tax losses.
Tax losses incurred in separate tax periods are carried forward and used in the order in which they are incurred (art. 283(3)).
The benefit of carry-forward of losses will pass on to any successor company formed in the process of reorganization or mergers according to the more detailed provisions of the law.
From 1 January 2011 those taxpayers whose income is subject to 0% rate cannot carry forward any losses incurred during the period when this rate is applicable (art. 283(1)).
The law recognizes as deductible the interest paid on any debt liabilities, regardless of their form, be it bank loans, trade and commercial credits, securities, other loans or borrowings (art. 269(1)).
The deductible interest is, however, restricted to the comparable average interest rates charged on the market (arm’s-length principle). A deviation of more than 20% from the market rate may lead to an adjustment for the taxation purposes.
When there is no information available on comparable market rates (or at the taxpayer’s choice), then the cap on the interest allowed for deductions is limited by formal criteria. The limit for interest denominated in rubles is the prevailing refinancing rate of the Russian Central Bank multiplied by 1.1. For debt in foreign currency the 15% rate is applied.
However, there have been enacted in the Tax Code several deviations of temporary character so that that the maximum deductions are set differently as per below:
Loans in foreign currency
– For period 1.9.2008-31.12.2009 maximum deductibility 22%
– For period 1.1.2011-31.12.2012 maximum deductibility Russian Central Bank refinancing rate multiplied by 0.80
1. Loans in Russian rubles
– For period 1.9.2008-31.12.2009 maximum deductibility Russian Central Bank refinancing rate multiplied by 1.5
– For period 1.1.2010-31.12.2012 maximum deductibility Russian Central Bank refinancing rate multiplied by 1.8
To note, transfer pricing rules also apply to interest deductibility, as well as the thin-capitalization rules discussed below.
All direct expenses connected with the arrangement of the loan are deductible expenses. Such are for example transaction fees, commitment fees and penalties.
The Tax Code provides for so-called thin capitalization rules that aim to prevent foreign companies from evading payment of profit tax by repatriating profits from Russian subsidiaries in the form of excessive interest on debt instruments instead of taxable dividends (Items 2-4, Article 269). Indeed, since interest is deemed to be a deductible expense for a Russian borrower, it may reduce the tax base for profit tax, whereas dividends may not. Moreover, as a rule, dividends are subject to source tax in Russia, which means that the Russian subsidiary is required to withhold profit tax upon payment of dividends to its shareholders. Interest is therefore a more advantageous form of repatriating profit for taxpayers than dividends.
The thin capitalization rules are applicable under the following conditions:
(a) debt financing is provided by a foreign company that directly or indirectly owns more than 20% of the Russian company;
(b) debt financing is provided by a Russian affiliate of such a foreign company; or
(c) the repayment of the loan is guaranteed or secured in another way by such foreign company or its Russian affiliate notwithstanding who is the creditor.
In cases when the debt corresponds to the above-mentioned criteria, it is called “controlled debt.”
Debt from foreign affiliated company
The debt financing provided by a foreign affiliate (as opposed to a Russian affiliate) of a foreign shareholder is not regarded as controlled debt. Lately, however, the Ministry of Finance has opined that upon taking loans from a foreign affiliate of a foreign shareholder, such loans would also have to be counted as controlled debt (Letter of the Ministry of Finance of 27 November 2009, No. 03-08-05).
The above-mentioned position of the Ministry has found support in as recent court resolution. In a resolution of February 2012 the Federal Commercial Court of Moscow in the case of Naryanmarneftegz LLC v. the Tax Inspectorate, declared that the amount of debt to a foreign affiliate should be counted as controlled debt (FCC MC Resolution № А40-1164/11-99-7 of 27.02.2012). The resolution was motivated by reference to the consideration that the ultimate source of the financing was a company for which the financing would have been considered controlled debt if this company had extended the loan directly to the end borrower. It was thereby claimed that the foreign affiliate was used as a middleman exclusively for the purpose of creating formal conditions to avoid falling under the applicability of the thin-capitalization rules. The scheme was thus considered as an attempt by the creditor to gain an unwarranted tax benefit, based on which the court argued that the transactions would have to be taxed according to their real essence by applying the thin-capitalization rules.
It follows from the above discussion that this court resolution should not as such be interpreted as extending the rules of thin-capitalization to cover financing extended by foreign affiliated companies. Rather it should be seen as an instance of application of the taxation principle of rejection of an unwarranted tax benefit which basically is an anti-avoidance rule, and a manifestation of the principle that taxation of transactions should be made according to their real essence, that is, putting substance over form. The real test, then, should be if there has been a real commercial justifiability of financing being received from the foreign affiliated firm. Commercial justification can be confirmed, for example, by the following types of circumstances:
– that the affiliated firm functions as a real financing center of a group of companies;
– that the affiliated firm takes on real commercial risks in connection with extending the financing and has its own resources (staff and other assets);
– other considerations that point to independent activities on the part of the affiliated firm.
Application of thin-capitalization rules
The application of thin-capitalization rules requires measuring the ratio between the net assets of a Russian entity paying interest, on the one hand, and the debt provided or secured by the foreign owner and its Russian affiliates (controlled debt), on the other hand. A thinly capitalized entity is thus one whose assets are funded by a high level of debt and relatively little equity.
If the controlled debt exceeds the Russian borrower’s net assets threefold or more, then the deductibility of interest paid on the controlled debt is limited. All interest exceeding this limit will not reduce the Russian debtor’s profit tax base and will be subject to profit tax as dividends. An exception is made for banks and leasing companies for which the thin capitalization rule is applied if the controlled debt exceeds the amount of nets assets by more than 12.5 times. The law provides a formula to calculate this limit in two stages, as described below.
The calculation of the capitalization coefficient (CC):
CD is Controlled Debt
EB is Equity of Borrower
S% is percentage of shareholding
For banks and leasing companies the latter part of the formula is slightly different, reflecting the higher coefficient of permissible debt:
The calculation of the admissible limit on the interest paid (AL):
AL = RI/CC, where:
RI is the amount of interest really paid
CC is the capitalization coefficient.
The positive difference between real interest (RI) and the allowed limit (AL) is treated as dividends and is subject to Profit Tax at the source of payment (Art. 269(4), Tax Code). (It should be noted that if the equity are zero or less, then all the interest will be deemed non-deductible and will be taxed as dividend (Ministry of Finance Letter No. 03-03-06/1/319 of 30 May 2011).
Contesting the applicability of thin-capitalization rules based on a relevant double taxation treaty
Many experts have brought up the possibility of contesting the applicability of thin-capitalization rules in reference to the nondiscrimination clauses that double taxation treaties (DTTs) usually contain. According to a non-discrimination clause, a company resident in one of the treaty countries cannot be subjected to any taxation requirement which is more burdensome than the taxation to which nationals are subjected in the same circumstances.
The OECD model DTT contains such a non-discrimination clause. Most of the DTTs concluded by Russia are based on this OECD model DTT and therefore include a similar non-discrimination clause. Such a clause is e.g. in the DTTs that Russia has concluded with Germany, Finland, and France. Based on the non-discrimination clauses, it indeed seems that the thin-capitalization rules should not be applied when the investor is a resident of a country with which Russia has concluded a DTT containing such a clause.
Before 2011, taxpayers quite frequently used a reference to the DTT non-discrimination standards as protection from applying the thin capitalization rules to debt but in 2011, the Supreme Commercial Court handed down a precedent-setting decision which restricted the possibility for taxpayers to evade application of thin-capitalization rules on the basis of a DTT (Resolution No. 8654/11 of the Presidium of the SCC in the case of Severny Kuzbass Coal Company v. the Tax Inspectorate of 15 November 2011). In the Severny Kuzbass case, the provisions of the DTTs with Cyprus and Switzerland were considered, including the provisions contained therein on the non-discrimination clause. The Supreme Commercial Court ruled that the provisions on the non-discrimination clause contained in the mentioned DTT do not rule out the application of national rules aimed at fighting tax evasion. The SCC classified the thin-capitalization provisions also among such national rules.
The court stated that the features of thin capitalization are as follows:
(i) a high share of the debt of the Russian borrower;
(ii) affiliation of the borrower and creditor;
(iii) the debt obligation remaining undischarged.
In the court’s opinion, these features correspond to the concept of “associated enterprises,” for which DTTs introduce a special profit tax procedure in view of the presence between them of special commercial and financial relations (Art. 9 of the DTT with Cyprus and the DTT with Germany). Such a special procedure subsists in the fact that any profit which might have been accrued to one of the enterprises, but which was not accrued due to the special relations, can be counted as profit of that enterprise and, correspondingly, taxed accordingly.
According to the OECD’s commentary on the model convention, the above article on associated enterprises does not prevent the application of national rules on thin capitalization insofar as their effect is to assimilate the profits of the borrower to an amount corresponding to the profits which would have accrued in an arm’s length situation. Moreover, the article is relevant not only in determining whether the rate of interest provided for in a loan contract is an arm’s length rate, but also whether a prima facie loan can be regarded as a loan or should be regarded as some other kind of payment, in particular a contribution to equity capital. Proceeding from this, the court concludes that the standards of the non-discrimination clause do not restrict the application of thin-capitalization rules.
We would like to point out that the standard of the non-discrimination clause contains a provision under which Russian enterprises with foreign capital should not be subjected in Russia to taxation that is different, or more onerous, than the taxation to which other similar enterprises in Russia might be subjected (art. 24.4 of the DTT with Cyprus). The court held that this provision did not restrict the application of thin-capitalization rules, as the latter are applied to all Russian organizations using foreign capital without exception. In other words, the court held that similar enterprises with which an enterprise using foreign capital should be compared, are other enterprises with foreign capital as opposed to companies with Russian capital. In other words, thin-capitalization rules, although they impose more onerous rules on companies with foreign capital than on companies with foreign capital, none the less this does not constitute discrimination, since they do not single out some companies using foreign capital among other companies using foreign capital.
Under the rules for taxation of securities fall all kinds of securities, both those that are publicly traded and those that are not (art. 280). Interest on securities is deductible under the general rules (art. 269). Expenses in connection with the issuance of securities, preparation of an emission prospectus, administration costs for the new issue and registration are all deductible expenses (art. 265).
The transfer pricing of securities and derivatives are subject to special rules. The Loss carry-forward rules are set separately for listed and non-listed securities and derivatives. For persons who are not professional participants of the securities market, losses and gains from listed and non-listed securities cannot be offset against each other.
The law expressly recognizes the possibility of a sale (transfer) of receivables at a discount (factoring). The difference between the nominal value of the receivable and the transaction price is deductible depending on the maturity of the receivables within the limits set by the law (art. 279).
The deductibility of the loss on transfer of receivables that are not yet due is restricted to the amount of interest rate that would have been paid, if the creditor had received a corresponding amount of debt financing instead. For transfer of overdue debt, 50% of the loss is deductible upfront and the remaining 50% are deductible over a period of 45 calendar days after the transfer. The transaction price of receivables becomes fully deductible in a subsequent sale for the company that acquired the receivables.
The income at the receiving party (factor’s income) is recognized only at the moment of resale of the receivables or settlement thereof by the debtor. The accrued interest is, however, recognized as income when accrued.
A company may in principle deduct from the profit tax base the costs for management services and cost-sharing agreements. Russian tax authorities are, however, known to be prone to challenge the deductibility of such costs and therefore there is always a special risk involved with such arrangements, as evidenced by court practice.
According to the Tax Code deductibility requires that the costs are: (i) economically justifiable (i.e. necessary to generate income) and (ii) properly documented (Paragraph 1 Article 252, Paragraph 1 Article 264 of the Tax Code).
In practice, the tax authorities very frequently cast doubt upon the deductibility of management costs. The most widespread of their requirements are the existence of a formal report on the results of the rendering of services, as well as a statement on rendering of services, signed by the client and executor (see the section Uniform Source Documents). The absence of a report and a statement on rendering of services is commonly viewed by them as being equivalent to the absence of the rendering of the services themselves. From the standpoint of court practice, as a rule, a report is not required if such a report is not envisaged by an agreement (for example, Ruling of the Federal Arbitration Court of the Northwestern Circuit in case No. А56-2942/2008 dated 15 January 2009 and Ruling of the SAC RF dated 27 April 2009 No. SAC-4853/09.
In addition to this, very often the tax authorities reject the idea that it is advisable for a company to bear costs for management services, including in the event that such services are rendered by a foreign parent company. As often as not, the argument used in practice to reject recognition of costs for services as deductible is an indication that the taxpayer has employees on staff who perform functions similar to the services rendered. Furthermore, the tax authorities have declared themselves against recognizing as deductible expenses on auditing accounting records if the keeping of such is not mandatory for the company. The tax authorities are also known to have challenged the deductibility based on the argument that the expenses are not economically justifiable in case the services rendered duplicate the functions of the company’s management or employees.
Expenses for remuneration under contracts with a so-called management company to which the functions of company general director have been transferred might be accepted as management costs. Concerning remuneration of the members of the boards of directors of Russian companies, the tax authorities believe that such remuneration cannot be considered deductible in the absence of a contract concluded between the company and the director.
More than once, courts have expressed the view that the tax authorities are not entitled to inspect the economic advisability of companies’ bearing some expenses or other (for example, RF Constitutional Court ruling No. 366-O-P of 4 June 2007). Very often, during disputes with the tax authorities, taxpayers have to prove the following regarding acquired services:
In a recent case, the tax authorities attempted to contest the deduction of various inter-company charges covering procurement, management, consulting, IT and software, marketing and other operational costs incurred by a foreign head office for the benefit of the Russian subsidiary of the Royal Bank of Scotland (Ruling of the Arbitration Court of the Northwestern Circuit No. A56-94331/2009 dated 19 April 2011). The amount of charges was determined on the basis of the specific cost allocation methods set forth by the underlying services agreements. The total amount of contested charges was around US$41 million.
The court upheld the taxpayer’s position and allowed the deduction of costs due to a number of reasons, in particular:
The costs were supported by documentation, including acts of reconciliation with the attached list of projects and services provided; invoices for the services provided; acts of acceptance for the services provided; memoranda on the fulfillment of relevant service agreements signed by the parties; a list of accounts under the agreements, and an outline of the products delivered thereunder.
The supporting documentation provided by the taxpayer met the applicable requirements of Russian accounting legislation and allowed reliable determination of the volume and cost of the services provided.
The taxpayer lacks its own analyst group, service infrastructure and other units which would allow it to manage the business and personnel on its own (the taxpayer had a total headcount of 371 in Russia, whereas other Russian banks with a similar ranking had a headcount of about 6,000).
The assets and profits of the taxpayer increased during the period of the provision of the services.
Normal 0 21 false false false RU X-NONE TH in its activities and some of the products did not have Russian analogues.
The taxpayer is a member of an international banking group and has to meet its operating standards as stipulated by the parent bank and provide the services to the clients on a uniform level.
In a different case, the tax authorities challenged the deduction of inter-company consulting (management) fees paid by JSC Shell Oil, a Russian subsidiary of Shell, to a Shell service company located in the UK. The services provided included business support consulting, management consulting, and consulting on R&D and technical assistance. The tax authorities argued that the service fees were not economically justified and lacked proper documentation. The taxpayer won the case in the courts of first and second instance, but the court of third instance overturned the decisions of the lower-ranking courts and returned the case to the first instance for a new examination (Ruling of the Moscow District Arbitration Court No. KA-A40/2152-11 dated 21 April 2011).
In brief, the court of third instance instructed the court of first instance to re-examine the documentation presented by Shell Oil to support the services provided. The court stated that the contents of the documents presented (invoices and acts of acceptance), which were made in accordance with UK rules and business practice, were not sufficient for Russian tax purposes, where they had to conform to the applicable Russian legislation and documentation requirements.
Furthermore, the court stated that the content of documents must allow it to ascertain:
(i) the specific matters upon which the UK service provider advised
(ii) the volume and nature of the services provided, and
(iii) the accuracy of the calculation of actual service fees (presumably, the pricing)
In regard to the taxation of management services, it should be noted that in addition to the question of deductibility of expenses from the profit tax base, other taxation issues may also arise. When the services are rendered by a foreign entity, the risk may arise that the activities could lead to a taxable permanent establishment in Russia for the foreign party. This would mean that the parent company itself would be taxed for the proceeds from the management services. This risk may come about if the services are rendered by staff present in Russia. There is also an issue of VAT in connection with such services (see the chapter Value Added Tax).
The law provides, in principle, for the deductibility of all expenses connected with payment of labor (pay-roll expenses; art. 255).
The deductible expenses can be paid in cash or in-kind. These expenses may include any bonuses and incentive payments if a relevant provision is included in the employment contract (or an applicable collective bargaining agreement). Salaries, bonuses and other pay-roll expenses can also be regulated in a relevant company policy or instruction. Under Russian labor law companies shall have in force special policies or instructions regulating various issues in relation to the employment and human resources management.
The law provides for a list of expenses that are expressly deductible. There is also a list of expressly non-deductible pay-roll expenses. The division between deductible and non-deductible expenses is, however, not clearly distinguishable in view of the many exceptions to the rules, and in view of the general rule of the Tax Code which allows for the deductibility of all justifiable expenses.
There is quite a wide recognition that all pay-roll expenses are deductible, provided that they are mentioned in the employment agreements (collective agreements) or the relevant policies and instructions.
In below tables we list the expressly deductible and the expressly non-deductible pay-roll expenses, respectively.
Expressly deductible pay-roll expenses (art. 255):
Free use or compensation of housing, utilities, meals, food and other items provided for free are deductible only when this provision is stipulated in other laws.
Goods handed out for free to employees or at subsidized prices, such as working clothes and uniforms for personal use of the employee are deductible only when specifically provided by special law.
Expressly non-deductible pay-roll expenses (art. 270):
It is hard to find any logic behind this listing of expressly deductible and expressly non-deductible pay-roll expenses especially as the list of deductibles ends with the provision: “other types of expenses incurred for the benefit of an employee provided for by an employment contract or a collective agreement”. At the same time there is the general rule of the profit tax in accordance with which all justifiable expenses are deductible if properly supported by documents in the form prescribed by the Russian law. We would conclude that the existence of such lists of deductible and non-deductible pay-roll expenses is just a vestige of the earlier Russian tax legislation and even the Soviet past and traditions. The decisive thing ought to be the economic justifiability of the expenses and proper documentation. It is therefore important to accurately specify all compensations and expenses in the employment agreement, or in relevant company policies or rules on expenses reimbursements, salaries incentives, etc. The employment agreement should in any case make reference to these policies or instructions.
It is also important to review the deductibility of pay-roll expenses from the point of view of profit tax against the provisions of personal income tax and employer’s social contrubutions.
The employer has an obligation to carry all justifiable costs connected with business trips and also extend a daily allowance (per diem) for each day of business trip. When duly documented and economically justifiable, the costs will be fully deductible.
In terms of profit tax there exist no more, following a change of law in 2009, any limits as to the permissible amount of deductions. According to the law in force daily allowances are now fully deductible within the limits foreseen by an employment agreement or a relevant company policy.
Compulsory insurance fees, i.e. the insurance that an employer is obliged to contract according to the Russian law, are fully deductible. The same is valid for all employer’s mandatory social contributions (see chapter Employer’s Social Contributions). Deductions on voluntary insurance are restricted by detailed provisions in the law as will be referred to below.
The first requirement for deductibility is that the insurer possesses a license in accordance with the laws of Russia. Therefore pay-roll related insurance payments paid abroad are non-deductible.
The following forms of voluntary insurance are deductible (art. 255):
1. Long-term life insurance, under following conditions:
2. Pension savings plans, under following conditions:
3. Medical insurance, under following conditions:
All other medical insurance premiums are non-deductible
4. Work-related accident insurance
In case an insurance (items 1 and 2 above) that originally was set up as deductible is later amended so that the conditions for deductibility would no further be met, then the previous expense deductions would have to be reinstated in the income for the period (with the exception of cases of force majeure).
All expenses on compulsory insurance of property are deductible within the types of insurances as foreseen by Russian laws and international conventions, which latter are interpreted by the tax authorities in a very restrictive manner. The wording of the law on voluntary insurance of property seems to favor an interpretation that it provides for a closed list of deductible insurance expenses (art. 263). This interpretation is reinforced by the fact that there is separately an open list of non-deductibles (arts. 270; 291,(20.1)). The main condition for deductibility of voluntary property insurance is that the underlying asset is used in production or sales of goods and services
Deductible expenses on voluntary insurance of property must refer to any of the following (art. 263):
A new law containing tax measures to stimulate investment in commercial research and development increasing the deductibility of corresponding expenditure has come in force from 1.1.2012 (art. 262 and 267.2); some of the provisions of the new law apply from June 8, 2011, or retrospectively).
The major change is that there now is right to deduct R&D costs regardless of the success that the activity has yielded in the period when R&D was undertaken (under the old law such costs were to be deducted in equal installments over the year following completion of the relevant R&D).
Other significant provisions of the laws on taxation of R&D expenditure include:
(i) The right in certain fields of activities to deduct R&D expenses at a multiple of 1.5 (that is, deduct 50% more than the actual expenses); such activities comprise among other things:
– Bio-information technologies
– Bio-catalytic, bio-synthetic and bio-sensor technologies
– Cellular technologies
– Nuclear power, nuclear fuel cycle technologies, etc.
(ii) New rules for how to account in taxation for the costs incurred in acquiring exclusive rights to intellectual property (which are recognized as intangible assets) as a result of R&D
(iii) The right to set up reserves for future R&D costs
The right to use the stimulating coefficient of 1.5 in deduction of R&D expenditure is limited to the areas included in a special government-approved list. To benefit from this provision, the taxpayer will need to submit to the tax authorities a report describing the work performed.
The taxpayer may choose how to book costs incurred in acquiring the R&D derived exclusive rights to intellectual property: the costs may either be depreciated in the usual manner or deduct them as other costs over a period of two years.
The R&D reserve can be created for a specific R&D program for a maximum period of two years(after which the remaining value of the reserve much be reversed if not fully expended). The maximum amount of the reserve is to be calculated as the company’s sales income multiplied by 3 percent less expenses incurred by the taxpayer in connection with the formation of the Russian Technological Development Fund. If a R&D reserve is set up, then the taxpayer books all current R&D costs against the given reserve. If the R&D expenses were deducted with the 1.5 ratio, then they are included in the initial value of the intangible asset with the same 1.5 ratio. In case this intangible asset is sold within 5 years after recognition, then the R&D expenses previously included in its initial value with the 1.5 ratio must be reinstated and included in the tax base (as non-sale income).
Following the amendments to the law there are now more comprehensive tax accounting rules for R&D. Taxpayers must account for R&D expenses, including depreciation, material costs, and payroll costs, for each type of project and agreement separately.
Deductibility of expenses for representation and entertainment (representation expenses) remains restricted to their amount and to their nature (art. 264(2)). The general deductibility is limited to an amount not exceeding 4% of the total annual pay-roll expenses.
It is a condition of deductibility that the representation expenses were incurred in connection with receiving representatives of other entities in connection with discussing mutual business. Deductible representation expenses include, for example, expenses in connection with reception of guests (luncheon, dinner or other similar functions); catering during meetings; costs for premises; costs for translators and interpreters; transport to take the guests to and from the place of the reception.
Representation Expenses occurred in connection with organizing board and shareholders’ meetings are in principle deductible.
The law especially excludes from the scope of deductible expenses the provision of entertainment, recreation, preventive therapy or treatment of illnesses. Due to the specific exclusion of these expenses and in order to avoid misunderstandings we have chosen to call these expenses representation expenses and not entertainment expenses The deductibility of representation expenses is not restricted to the geographical location where such expenses are incurred.
Tax officials are known for attempts to challenge the deductibility of various types of representation expenses. For example, they have tried to deny deductibility of expenses connected with accommodating in hotels of travelling businessmen from foreign partner firms. In one case the regional commercial court rejected such claims of the tax office and supported the taxpayer’s right to deductibility (Decree of the Federal Commercial Court in West-North district of 01.03.2007 N Ф04-9370/2006(30552-А81-27 on case N А81-1259/2005). Another court ruled similarly (Decree of Federal Commercial Court North-West district of 19.06.2008 on case N А13-7506/2006-28).
Expenses for training of staff members are, in principle, deductible (art. 264(3)). There are no restrictions to the amount of the expense, but certain other restrictions apply as detailed below.
Training expenses are considered as deductible expenses under the following conditions:
According to some experts, the restrictions in the deductibility of training costs (and other pay-roll related costs) could be overcome by specifying the costs in the employment agreement in accordance with the general rule.
Expenses connected with entertainment, recreation, medical treatment or other services rendered to the employee free of charge are explicitly excluded from the scope of training expenses.
In line with the provision that training directly benefits the employer, tuition fees for main education at higher and intermediate special schools (colleges and universities) are not deductible.
Expenses on advertising are largely deductible, but some restrictions apply (art. 264(4)).
Most forms of marketing/advertisement expenses are fully deductible, for example:
• advertisement through mass media (press, radio and television, the Internet)
• outdoor advertising, for example, billboards, illuminated signs (including the manufacturing of stands and billboards)
• participation in exhibitions, fairs and expositions
• sample rooms and showrooms
• design, drafting and production of brochures and other marketing material
• design and other works on display windows
• production and registration of trade marks (etc.)
• Price reductions for displayed goods (that have lost their original qualities when exhibited)
Expenses on other forms of marketing costs, than those listed above, are deductible only within a limit equal 1% of sales revenue. It is expressly stated that this restriction applies to free gifts and prizes distributed in connection with marketing campaigns.
Certain other expenses remain expressly non-deductible (art. 270). Some of them are discussed above in connection with pay-roll expenses.
Such other non-deductible expenses are:
In Russia a tax year always equals a calendar year and no exceptions are possible to match a possibly different tax year applicable at the level of a foreign holding.
Tax filings are made quarterly (art. 289). The tax is calculated independently by the taxpayer and declared in the periodic tax filings (art. 286,). Profit tax is declared quarterly and paid in monthly advances (art. 287).
Special rules apply for a number of taxpayers and situations, including:
1. Banks (arts. 290-291, 331)
2. Insurance companies (arts. 293-294, 330)
3. Securities transactions (arts. 280-282, 329, 333)
4. Professional participants of the securities market (arts. 298-300, 329)
5. Non-governmental pension funds (arts. 295-296)
6. Taxpayers having permanent establishments (art. 288)
7. Deferred execution transactions, i.e. derivatives (arts. 301-305, 326-327)
8. Participants of the contract of trust management of property (arts. 276, 332).
9. Permanent establishments of foreign companies (see “Permanent Establishments” section of this Guide).
10. Withholding Tax (from sources in Russia) for foreign companies not having taxable presence in Russia (arts. 309-312)
Income from Russian sources in favor of a foreigner that does not have a taxable presence in Russia (Russian registered entity or permanent establishment) is subject to withholding tax, or source tax, which in essence is a method for charging the profit tax at a standard rate (arts. 309-312).
The general withholding tax rate is 20%. For certain types of income other rates are set:
The 15% withholding rate on dividends also applies vice versa, that is for dividend income received by a Russian entity from a foreign source. In such a case the amount of tax can be reduced, if an applicable double taxation treaty provides for this (art. 275(1)).
The withholding tax is levied on the following types of income (art. 309):
The above mentioned income from intellectual property rights may include:
– Copyrights for literature, art, scientific work, films
– Trade marks
– Layouts or models
– Secret formulas for production purposes
– Right to use information related to industrial, commercial or scientific experience
The taxpayer may claim deduction of expenses from the income before tax. With respect to a financial lease contract, the tax is paid on the lessor’s gross margin of the leasing contract.
A Russian entity paying income to a foreign party has the obligation to withhold the tax (act as a tax agent) separately for each transaction. The tax has to be remitted to the tax office simultaneously with the payment to the foreign party. It should be noted that the tax agent, along with taxpayers, must regularly submit tax return (article 289).
A relevant double taxation treaty between Russia and a foreign country may stipulate that certain kind of source income is not taxable in Russia (and vice versa). According to domestic Russian law, the relief is, however, not automatic, for the tax agent must prior to payment receive a document issued by the relevant authority of the country of the beneficiary that the beneficiary is resident of the treaty country (art. 312).
When no advance relief has been extended and tax has actually been withheld, the taxpayer may claim reimbursement of the tax in accordance with a relevant treaty (art. 312(2)).
The reimbursement claim must be supported by the following documents:
• An application (in accordance with a set form);
• An acceptable document confirming (tax) residency in the treaty country;
• A copy of the relevant agreement or other documentation between the parties to the transaction
• Copy of the bank transfer documents confirming payment of the tax
The tax authority may ask for a translation of the above listed documents. It is noteworthy, though, that the law explicitly forbids the authorities to demand any notarization (or legalization) of the documents. Also, the law expressly forbids requesting of any other additional documents.
The reimbursement claim has to be submitted within 3 years from the end of the y ear when the tax was paid.