Russian guidance reinforces requirements to establish beneficial ownership status
On 1 June 2018, Russia’s Federal Tax Service (FTS) made available a letter dated 28 April that it sent to the regional departments of the FTS and their tax offices and that functions as guidance to the local tax authorities on the application of the concept of beneficial ownership (BO). The letter clarifies the criteria that the tax authorities should consider when determining BO status, provides practical examples of when tax treaty benefits should be denied and summarizes tax controversy practice regarding the application of the concept. Although the guidance in the letter is not binding tax law, the tax authorities generally have to follow guidance issued by the FTS. The guidance likely will make it more burdensome for foreign recipients of Russia-source income (e.g. aviation finance companies leasing aircraft to Russian airlines) to qualify for benefits under an applicable tax treaty and prove BO status.
The BO rules, introduced into the tax code in 2015 and amended in 2017, require foreign companies seeking benefits under a Russian tax treaty to provide the payer of the relevant income with documentation that establishes that the company meets Russia’s BO requirements. The foreign company also must provide a tax residence certificate, an “apostil” (unless the treaty parties agree to waive this requirement) and a notarized Russian translation of all documents that are in a foreign language. The Russian Ministry of Finance has issued several letters that clarify the steps a Russian payer of income must take to confirm that the foreign recipient is the beneficial owner of the income. Failure to comply with the documentation requirements will result in the Russian payer being held liable for withholding tax on the payments at domestic rates (e.g. 15% on dividends and 20% on interest, royalty and other payments) and fines (20% or 40% of understated tax) and late payment penalties.
The key interpretations and conclusions of the FTS in the new letter are as follows:
- The BO concept is a tool used to prevent tax treaty abuse. It should not be applied in a narrow technical sense—when determining BO status, the tax authorities must consider the purpose and meaning of the treaty, as well as the substance-over-form principle and preventing tax treaty abuse. Under the FTS’ interpretation, BO falls within the scope of the “unjustified tax benefit” concept and the general anti-avoidance rule (GAAR) and, therefore, should be applied in conjunction with the GAAR.
- Where a dispute arises regarding the application of treaty benefits, the key responsibilities of the tax authorities are to analyze the business purpose and the nature of the relevant transaction. Treaty benefits should be denied where a series of transactions was carried out with the main purpose of eroding the tax base or where arrangements were set up in such a way to allow the granting of reduced tax rates under a treaty.
- The application of the BO concept in conjunction with the GAAR allows the tax authorities to expand the application of BO beyond cases involving treaty abuse. For example, the authorities can reclassify the arrangements (e.g. debt into equity) and apply tax rules relevant to the reclassified income, and interpret a series of transactions as hybrid structures resulting in the application of the relevant local rules preventing base erosion.
- The BO concept may apply not only to the receipt of passive income, but also other types of income (e.g. intercompany service fees).
- Tax treaty benefits may be granted only to a tax resident of the treaty partner country that is the actual (beneficial) owner of the income.
- Treaty benefits may not be granted where financing activities and income repatriation are not sufficiently connected with the investment of foreign capital into the Russian economy.
- Holding companies generally should not be treated as beneficial owners because their business activities are limited to investing in affiliated entities and financing (treasury) activities, and they receive only passive income (such as dividends, interest and royalties). One-time business transactions of holding companies (e.g. consulting services, foreign currency exchange gains, purchases of preferred shares, participations in other companies, etc.) are irrelevant in the overall BO analysis.
- Taxpayers must be able to substantiate why their transactions are executed in a certain form and the participation of a foreign entity in their business and transaction structure, and provide a reasonable and sustainable justification for such structure and the risks assumed.
- The tax authorities should consider all of the following factors when analyzing whether a foreign recipient of income is the beneficial owner:
- Reasons for including the foreign entity in the structure, and whether the entity operates as an independent business unit;
- Whether the foreign entity has economic substance, such as ownership of sufficient tangible and intangible assets, personnel and offices, and whether it incurs a material amount of expenses to maintain its operations, etc.;
- Evidence that the company receiving income does not pass on the income to another nonresident company;
- Ability of the company’s officers to exercise power and authority with respect to the use and disposal of the income received from Russia; and
- Level of business activities and entrepreneurial risks assumed.
According to the FTS, the foreign company should not be treated as a beneficial owner of income if the company’s activities cannot be viewed as a separate business unit, the company is not engaged in or bears no financial or other risks customary for entrepreneurial activities, the payments received flow through to other affiliated entities, the company earns no benefit from the use and disposal of the income received and the company’s employees do not exercise management and control over the company’s operations. If the tax authorities determine that some or all of these factors are present, they likely will conclude that the company does not meet the BO requirements.
The tax authorities may deny tax treaty benefits if they can show that the income recipient does not meet the BO criteria. It is not necessary for the authorities to ascertain the identity of the real beneficial owner of income, but if the taxpayer discloses the beneficial owner and provides evidence that the actual beneficial owner is entitled to the reduced tax rates under the relevant treaty, the tax authorities should verify whether the actual beneficial owner receives the income from a participation in the company that directly received the income from Russia, examine any evidence presented by the recipient of the income to support the BO status and confirm that the actual beneficial owner reported the indirectly received income and paid tax on the income in its country of residence.
Aviation finance and leasing industry impact
The application of tax treaty benefits and BO status have been areas of focus for the Russian tax authorities in recent years in the aviation finance and leasing industry, and this trend is likely to continue. The FTS letter clarifies the practical approach that the tax authorities will take in determining BO status, and clearly signals that the authorities intend to rely on the BO concept in conjunction with the GAAR to prevent tax base erosion and treaty abuse. This will require taxpayers to prepare comprehensive BO documentation, as well as documentation demonstrating the business purpose of cross-border transactions of leasing aircraft to a Russian airline before receiving any income from a Russian source.
Lessors should understand the contents of the FTS letter, and be aware that they may need to provide additional information to the tax authorities to support BO status and the business purposes of transaction(s) and their ownership structures. They also should review existing and future cross-border transactions and international structures, consider whether any restructuring is needed to mitigate potential tax disputes and ensure that robust documentation evidencing substance, functions, risks, etc. is available.