Thin Cap -- Still an Issue?

As most countries do, Russia protects its right to tax in a variety of ways. One of them is designed to fight erosion of the tax base of Russian entities by paying excessive amounts of interest to related parties. Apart from establishing threshold rates (currently 11 percent for ruble and 15 percent for other loans) the Tax Code provides for so called thin capitalization rules. The rules establish the maximum acceptable debt to equity ratio of 3 to 1 (12.5 to 1 for banks and leasing companies). Should the amount of debt exceed this ratio, the interest on the "excess" portion of debt is nondeductible. Moreover, it is to be reclassified into dividends and taxed as such by way of withholding.

The rules aim to prevent shifting of the taxable income to other jurisdictions, so they only apply if the loan is granted by a foreign company holding directly or indirectly over 20 percent of the shares or capital of the Russian borrower, or by a Russian affiliate of such a foreign company. Additionally, the rules apply if the financing is provided by an unrelated party but such affiliate or the foreign shareholder itself provides surety or in any other way secures the repayment of the loan to the lender.

The current structure overwhelmingly used to circumvent the rules is providing loans by a foreign affiliate of the foreign parent company. This approach utilizes the loophole in the thin cap rules which do capture the loans provided by Russian group companies but fail to do so if the loan is provided by a foreign "sister" company of the Russian borrower. However, as the loophole is quite obvious, it is only a matter of time before it is closed. In fact, it is only surprising it has not yet been done so.

Suppose however the loophole is closed. Would this mean that international groups are bound to comply with the modest 3 to 1 ratio or face the unfavorable tax consequences of incompliance? The answer is no -- it is where the double tax treaty protection comes into the picture.

Let us look at the nondeductibility issue. Most of the double tax treaties provide for the nondiscrimination clause stating in particular that interest payable by a Russian resident company to a resident of the other state should be deductible under the same conditions that would apply if it was payable to a Russian resident. Suppose the loan is granted by and interest is payable to the Russian parent company. This situation is not subject to the thin capitalization rules, which means that they also should be ignored with regard to interest payments to the parent company from a treaty jurisdiction.

The Finance Ministry tried to overcome this in 2004 with regard to Germany by agreeing with its German counterpart that the Russian restrictions on the interest deductibility concerning related parties (with the participation exceeding 20 percent) are compatible with the treaty provision limiting the deductibility by the arm's length amounts. Although this most probably refers to the thin capitalization rules, it does not seem to be enough as the general compatibility with the arm's length provision does not mean the rules are compatible with the nondiscrimination requirements. If they do not, the treaty provision prevails.

This has so far been supported by the regional case law. The Federal Arbitration Courts of Moscow and Northwestern districts, having heard cases of Ferrotek (in 2005) on interest paid to a German entity and of Swedwood Tikhvin (in 2007) on the same paid to a Dutch entity, they respectively found that the Russian thin capitalization rules with regard to deductibility could not be used under the applicable nondiscrimination provisions.

The courts also found that the reclassification feature of the thin cap rules could not be used either as the double tax treaties provide for certain definitions of dividends and interest, as well as for certain tax treatment applicable to the payments defined as such. Accordingly, application of different (less favorable) tax treatment has been found incompatible with the treaties itself.

So where is the catch? There may still be one. First, suppose the foreign parent provides surety to a foreign bank and it is the bank providing the loan to the Russian borrower. In this case this all may not work as the funds lent by a Russian bank would be captured by the thin cap rules all the same because of the surety. Second, the argument not considered by the courts is that the foreign parent presumably has its own foreign parent with a qualifying indirect participation in the Russian borrower. If in this case the parent company lending the monies was Russian, would the loan be captured by the rules? The answer may be yes as the parent company would be considered a Russian affiliate subject to the thin cap rules.

There is a strong counter argument based on another treaty provision stating that Russian companies with the direct or indirect participation of the residents of the other state should not be taxed less favorably than other Russian companies. However, as convinced in the viability of the argument as we are, we have yet to see in the case law whether this provision precludes application of the Russian thin capitalization rules.