By Alexey Ryabov, ACCA, ADIT, Head of Tax Compliance, JTI Russia, Moscow
Long-awaited guidance issued by the Russian tax authorities on 11 March sets forth criteria for the application of the general anti-avoidance rule under Article 54.1 of the Tax Code aimed at combating tax abuses and the receipt of unjustified tax benefits.
The guidance – included in letter No. BV-4-7/3060@ of 10 March 2021, “On Practice in the Application of Article 54.1 of the Tax Code of the Russian Federation” – is addressed to local tax offices.
It sets out four criteria (tests) for how tax inspectors should evaluate the validity of a taxpayer’s transactions and a set of rules outlining tax consequences when the transactions fail to meet those tests. The four tests address the reality of a transaction, the appropriate performer, the proper legal characterization of the transaction, and the business rationale.
The guidance explicitly states that Article 54.1 applies only when any financial damage to the state budget has been caused. In most cases, it would cover contracts and transactions that reduce the taxpayer’s taxes payable to some extent (for example, the purchase of goods or the provision of works and services increasing the cost base).
Reality of a transaction
The first step in the analysis is to evaluate whether a deal really took place between the taxpayer and its counterparty or was just drawn up on paper to enjoy tax benefits. In the latter case, it is considered a sham transaction, which may not be reported for tax purposes. This could result, for instance, in the taxpayer’s purchase cost being disallowed as a tax deduction.
A transaction found to be real (genuine) is then subject to other tests: whether the obligation was fulfilled by an appropriate person, what the actual economic substance of the transaction was, and whether there was any business rationale for it.
Appropriate performer test
The second criterion prevents taxpayers from including shell companies (referred to as “technical” companies in the letter) into a transaction.
A technical company is deemed to be a counterparty that does not conduct any actual business, or that obviously does not have adequate capabilities and resources to perform the contract and avoids paying taxes. This means that where transactions are real, yet the obligation was not performed by the party to a contract, the taxpayer may be denied the right to deduct the respective expenses based on the documents provided by that party.
Adverse tax consequences for the taxpayer depend upon the extent of its “guilt” and its involvement in a tax avoidance scheme (e.g., whether the taxpayer acted intentionally or negligently).
The first form of guilt is intent, which is identified when a taxpayer deliberately takes part in a tax avoidance scheme or knows about such participation. In that case, the taxpayer may reclaim VAT and/or deduct expenses based on the parameters of the actual transaction, subject to disclosure of those parameters and the real performer to the tax authorities. This mechanism in Russian tax practice is often referred to as “tax reconstruction”. Otherwise, the tax authorities will not permit the tax reconstruction and, consequently, will not recognize the expenses and the VAT offset.
The fine for an intentional tax offense is double the standard fine (40% of the taxes unpaid or underpaid).
Second, the guilt could be in the form of negligence. This happens when there are no indications of intentional misconduct, but the taxpayer acts carelessly and fails to exercise proper commercial diligence in relation to its counterparty before entering the contract. However, if all checks and controls expected from any prudent purchaser had been exercised, the taxpayer should have been aware of its counterparty being a shell company.
In the case of negligence, if the real transaction’s parameters and performer have been disclosed to the tax authorities, the taxpayer is entitled to tax reconstruction as well. When the real performer cannot be identified, VAT offset will be also denied but tax-deductible expenses should be determined using the computation method based on market prices for the purchased goods, works or services. The fine for a negligent tax offense is 20% of the taxes unpaid or underpaid.
Finally, the last situation could be the absence of any guilt, which would not trigger any adverse tax consequences for the taxpayer. In such a case, the taxpayer may deduct all expenses and claim VAT offset in the amounts declared on the tax returns without additional conditions.
It is questionable, however, whether the above-mentioned rules for tax reconstruction are fully in line with the Russian Tax Code. Some tax practitioners believe that the form of guilt can affect only penalties for tax offenses but cannot influence the amount of taxes due by taxpayers.
In this regard, it would be an illegitimate and odd sanction to deny recognition of expenses and the VAT offset in the case of intent if the taxpayer failed to disclose actual parameters of transactions to the tax authorities. It is especially unfair to taxpayers who knew about a tax dodging scheme but did not engage in it nor benefit from it.
Sometimes buyers could be innocent victims being forced to purchase goods or services from intermediate companies with insufficient substance without any access to information about the actual producer or performer and the parameters of their transactions with the intermediates.
However, in the first litigation case after the issuance of the guidance, the Supreme Court of Russia confirmed the tax authorities’ approach in making the tax reconstruction dependent on the form of taxpayer’s guilt (decision of 19.05.2021 No. 309-EC20-23981 on the Firm Mary case No. A76-46624 / 2019). This trend is likely to continue in future litigation in Russia.
The letter also clarifies rules for determining the tax consequences of a transaction where a supplier fulfilled its obligations but did not pay VAT. One of the reasons for such a situation could be the use of intermediate shell companies controlled by the supplier. The taxpayer may be disallowed a VAT offset if it was aware of the supplier’s misconduct and benefited from it at the expense of damage to the state budget (e.g., through negotiating a lower price for supplies).
Proper legal characterization of a transaction
This test requires transactions to be reported in accordance with the substance-over-form principle. If this criterion is not met, the consequences are determined based on the real economic relationship between the parties.
In practice, this means that the tax authorities must determine true economic substance of the transactions through the assessment of whether the taxpayer was guided by reasonable economic or other factors and the circumstances demonstrating the taxpayer’s intention to obtain an economic effect.
If a transaction covers up another one, the cover-up transaction should be discarded, and the tax implications be determined based on the underlying transaction.
Business rationale test
This test is explicitly articulated in Art. 54.1 (2) and has been re-confirmed by the guidance. It is generally in line with the principal purpose test introduced by the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting. Under this test, the reduction of tax liability must not be the principal purpose of transactions entered into by a taxpayer.
According to the letter, the tax authorities’ main approach in implementing this test will be assessing “whether the taxpayer would be willing to enter into the transaction for business reasons only, i.e., in the absence of any tax benefits”.
The letter also states that the tax authorities intend to apply the business purpose test to standalone transactions even if, taken together, the transactions are designed to reach economically justified goals.
Applicability of the guidance to cross-border transactions
Although Article 54.1 does not specifically address cross-border operations, Russian tax experts generally believe there is nothing to prevent these rules from applying to them. Therefore, Russian legal entities should also exercise commercial diligence in relation to their foreign contractors to avoid a negligent tax offense.
Moreover, the tax authorities could use the local anti-avoidance rules as additional evidence in combating artificial schemes involving profit distributions from Russia to other countries, with subsequent reclassification of business income into passive income for withholding tax purposes (e.g., service fees into dividends).
Article 54.1 is expected to remain unchanged for the foreseeable future, and the tax authorities will follow the approaches set forth in the letter. As a result, the tax authorities should stop making far-fetched claims against bona-fide taxpayers and be more objective about the collection of evidence and the determination of tax liabilities.
However, the superior tax authorities will require their local offices to collect evidence of taxpayers’ misconduct in a more qualitative way, rather than in the formal manner we’ve seen before. This will most likely result in higher scrutiny from tax inspectors and higher administrative costs for taxpayers to ensure tax compliance.
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