Application of thin capitalisation rules despite tax treaty non-discrimination clauses.


Legal Update No. 286.
Goltsblat BLP advises that the Presidium of the Supreme Arbitration Court of the Russian Federation adopted, on 15 November 2011, a resolution on case No. ВАС-8654/11 on an application from a tax authority for supervisory review of judicial acts of lower courts in relation to OAO Coal Company Severniy Kuzbas.

The SAC Presidium decided on the case in favour of the tax authority, allowing the provisions Art. 269-2 of the Tax Code of the Russian Federation (RTC) to be applied even if a double taxation treaty contains anti-discrimination clauses.

In the case in question, a company with negative net assets raised interest-bearing loans from foreign shareholders and affiliated Russian entities, the debt being recognisable as a controlled debt in compliance with the mentioned rule. On this basis, the tax authorities refused to accept deductibility of the interest costs from the profit tax base.

During the case hearings, the question was raised of the contradiction between the above rules and the discrimination provisions secured in the applicable tax treaties. Courts of three instances ruled in favour of the tax-payer and recognised full deduction of interest costs as lawful on the basis of clauses 3 and 4, article 24 of the international treaties on avoidance of double taxation with Cyprus and Switzerland (the Treaties). Yet the SAC RF Presidium quashed the acts of the lower courts and recognised the inspectorate’s decision in relation to application of the rules as lawful and justified.

So far, only the resolutive part of the resolution has been published but it may be assumed that the arguments of the SAC RF presidium are based on the provisions of clause 1, article 9, clause 5 (clause 7) article 11 and clause 3, article 24 of the Treaties, which permit deduction of interest to be restricted if they do not comply with sums agreed between independent enterprises, i.e., the so-called “arm’s length” criterion. We also believe that the SAC RF Presidium might take one of the following positions: 

  • a ratio of controlled debt to equity capital in excess of 3:1 (the maximum acceptable ratio under the law) is, in itself, evidence that the terms of the loans are evidently not at arm’s length and therefore could not have been agreed between independent parties; or
  • exceeding the 3:1 ratio is not, in itself, evidence of the loan terms not being at arm’s length but, if special circumstances are proved that testify to this, such as negative net assets, the thin capitalisation rules may be applied.

We believe the first position is more likely, although other approaches cannot be ruled out.

The resolution of the SAC RF Presidium thus allows the Russian thin capitalisation rules to be applied irrespective of non-discrimination provisions in international tax treaties of the Russian Federation, this sending the previous regional case law (see resolutions of the Federal Arbitration Court (FAC) for the Moscow Circuit of 30 September 2011 on case No. А40-135537/10-129-428, of 22 June 2011 No. КА-А40/5322-11, of 13 July 2010 No. КА-А40/7211-10, resolutions of the FAC for the Western Siberian Circuit of 21 June 2011 on case No. А70-13648/2009, of 12 April 2010 on case No. А26-3052/2009, resolution of the FAC for the Central Circuit of 21 December 2010 on case No. А54-766/2010 and others) into the oblivion. Yet the question still remains open as to application of the SAC RF Presidium’s decision in the case of special provisions in the protocols to tax treaties permitting unrestricted deduction of interest costs (for example, those with Germany, the Netherlands, France, etc.).

The precedent created by the given case might be of extremely adverse significance for foreign-invested taxpayers using intra-group borrowed financing in substantial amounts. Also to be mentioned is the general increase in the number of cases when the tax authorities challenge structures for financing by related shareholders, including “sister” companies (the Gidromashservis and Naryanmarneftegaz cases) on the basis of the priority of essence over form (loans from foreign “sister” companies are generally not subject to the rules).

The SAC RF Presidium’s resolution necessitates further analysis of the tax risks but it is already clear that financial structures will need changing in most cases.

For additional information, please contact:

to Evgeniy Timofeev
Partner, Head of Tax Practice for Russia/CIS,
Goltsblat BLP
T: +7 (495) 287 44 44,

to Andrey Shpak
Partner, Tax Practice,
Goltsblat BLP
T: +7 (495) 287 44 44,

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