A TAX PLANNING INTERNATIONAL - Baker McKenzie · 2017. 11. 24. · legal planning and tax avoidance. For example, the Russian tax authorities challenged the withholding tax exemption

TAX PLANNINGINTERNATIONALEUROPEAN TAX SERVICEInternational Information for International Business

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Reproduced with permission from BNAI European TaxService Monthly Digest, Bloomberg BNA, 12/31/2017.Copyright � 2017 by The Bureau of National Affairs, Inc.(800-372-1033) http://www.bna.com

DECEMBER 2017

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The Chimera of theBeneficialOwnership Rule inRussia

Kirill VikulovBaker McKenzie, Russia

To apply tax treaty benefits, foreign companies must now providebeneficial ownership confirmations to Russian payers of income.Confirming beneficial ownership under Russian rules may gobeyond the OECD test on proving legal ownership and having noconnected obligation to pass on payments. What makes Russia’sbeneficial ownership approach different based on recent vibrantcourt practice?

At the beginning of 2017, Russia introduced the addi-tional requirement for foreign recipients of passiveRussian source income to confirm that they are ben-eficial owners of income to be entitled to tax treatybenefits. This concept, indicated in most tax treaties,had caught the attention of Russian authorities andwas developed into a standalone, anti-treaty shoppingrule.

Since 2015 Russia has applied its domestic defini-tion of the term, and does not recognize foreign com-panies as beneficial owners if they exercise

intermediary functions and have limited powers todispose of the income, do not exercise any other func-tions, take no risks, and pass on income to anotherparty having no access to the same benefits. The ruleapplies both to intragroup operations and transac-tions between unrelated parties.

Importantly, the Russian tax authorities take the po-sition that since the beneficial ownership wording wasincluded in most of the tax treaties long ago, and theOECD commentary describes beneficial owners aspersons getting the income not through an agency or

Kirill Vikulov is aSenior Associateat Baker McKen-zie, Russia

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nominee relationship and not simply acting as a con-duit for another person who in fact receives the ben-efit, the rule needs to be considered in accordancewith the object and purpose of the tax treaty and couldbe equally applied to past periods. This seems to be aconsiderable change in practice, putting at risk opera-tions with Russia for the past three years opened fortax inspections.

According to the position circulated by the RussianFederal Tax Service to local tax inspectorates, the ben-eficial ownership requirement does not only apply toincome received by a resident of a contracting state inthe form of dividends, interest and royalties subject toa tax exemption or reduced withholding tax rates pro-vided that the recipient meets the express require-ment of being the beneficial owner of the incomeunder the relevant tax treaty.

The beneficial ownership requirement will be effec-tively applied to all Russian source income, includingcapital gains from the sale of shares in property-richcompanies, income from real property, internationalshipping, penalties and late payment interest, andother similar income (which tends to be interpretedbroadly).

Recent court cases show that the Russian tax au-thorities frequently request information on foreigncompanies receiving Russian source income. There isno list of information or detailed guidance on whatspecific documents would be sufficient to prove thatthe recipient is entitled to tax treaty benefits.

The Russian Ministry of Finance has stated that tax-payers must prove their beneficial ownership rights insubstance, and that the authorities do not want to re-strict the confirmation process. Although this may bedriven by good intentions, companies effectively haveto disprove that they are not passing income to otherpersons; the information gets quite detailed and caninclude endless descriptions of functions, risks, com-mercial assets, owned or leased office space, andnumber of employees.

Tax agents are also encouraged to examine the fi-nancial statements of recipients and to check whetherthe income was accounted for, taxed, and not passedon to another party. Russian payers of income effec-tively have to bear a higher burden of proof comparedto the OECD position outlined in the 2014 update ofthe Commentary to the Model Convention, where it issufficient to confirm that the receipt of income is notdependent on the contractual or legal obligation totransfer the payment. The OECD has stated that thebeneficial ownership rules are not intended to substi-tute limitation of benefits provisions in tax treaties orto deny benefits to ‘‘stepping-stone’’ conduits (SeeOECD Model Tax Convention on Income and on Capi-tal: Commentary on Articles 10, 11, 12. Models IBFD.2014).

Russia seem to extend the beneficial ownershiplimitation to a wider range of situations. For example,Russian tax authorities have denied application of thereduced 5 percent withholding tax on dividends for2011 to four historically used Cypriot holding compa-nies of a major steel manufacturer.

The tax authorities claimed that the Cypriot compa-nies only held shares in Russian companies, that therewas no sufficient substance, and that the authority ofthe Cypriot directors to dispose of the income was

limited by charter documents, which in combinationmade them technical transit companies. Because theCypriot companies were subsequently distributingdividends to personal companies of the beneficiariesin the BVI, the Russian tax authorities disregarded theCypriot recipients that provided their tax residencycertificates and applied the 15 percent Russian with-holding tax (though without consistently applying fulltransparency and attributing income to the Russianultimate beneficiary). Although this may have been anexample of outdated, aggressive tax planning, suchstructures are not uncommon for Russia and have notbeen previously subject to such attacks.

However, when the Russian beneficial ownershiptest is applied, it is difficult to draw the line betweenlegal planning and tax avoidance. For example, theRussian tax authorities challenged the withholdingtax exemption on interest payments made by a Rus-sian subsidiary of a Spanish bank to a Luxembourgtreasury company.

In 2005–08, the Luxembourg company received apurpose loan from the Spanish bank; the funds weresubsequently loaned to the Russian company as wasintended by the Spanish shareholder. Subsequentloans provided by the treasury company out of its ownfunds replaced initial financing. The company had anoffice, increased the number of employees from threeto seven in 2010, provided financing, and concludedswap transactions with other group companies.

Yet the Russian authorities successfully claimedthat the Spanish bank used the fact that the Luxem-bourg company was not the beneficial owner ofincome in order to get access to the withholding taxexemption compared to the 10 percent tax on interestpayments to Spain. The Spanish loan was subse-quently contributed to the equity of the treasury com-pany, resulting in no taxation in Luxembourg, whichwas misrepresented as an indication of the doublenon-taxation and tax abuse.

The twists and turns of Russian court practice onbeneficial ownership are represented in the chartbelow, indicating positive (in green) and negative (inred) court cases and respective amounts of tax assess-ments.

The Russian court practice on the beneficial owner-ship rule may be considerably different from cases de-cided in other countries.

For example, in the Velcro case the Canadian courtrecognized the Dutch company as a beneficial owner,as it had the legal right to receive income, bore cur-rency risk and default risks, and mixed royalties re-ceived from Canada with other income of therecipient stored in the company’s accounts and avail-able to creditors (See, Brian J. Arnold Chapter 3: ‘‘TheConcept of Beneficial Ownership under Canadian TaxTreaties’’. Beneficial Ownership: Recent Trends. IBFD.2013). These arguments were sufficient to prevent rec-ognition of the company as a conduit. However, sincethe Russian test is more blurred, the same case can bedecided against the taxpayer.

How far can this go? There are constant flows offunds in the modern era; management of a group’sfunds is often optimized and there are separate com-panies managing cash-pools, aggregating royalties,etc., so it is increasingly difficult to identify a particu-

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lar beneficiary of the income if the tax authorities startlooking beyond ownership rights.

In a recent court case the Russian tax authorities at-tempted to deny withholding tax exemption on inter-est paid to a Cypriot treasury company, saying that theJersey top holding company of the group was the ben-eficiary (NPO CTS case, Decision No. A21-2521/2017,dated August 2, 2017). So far the Russian court hassupported the taxpayer’s position that the Cypriotcompany used the received interest in its commercialoperations and did not distribute dividends, and thatthe mere indirect holding of shares is not sufficient forsuch aggressive reclassification. But there will cer-tainly be less obvious cases, as any ‘‘legal entity’’ is bydefinition fictio juris. Professor E. Reimer has pointedout that the beneficial ownership rule is inherently un-clear and may well reflect a general application to taxlaw of Heisenberg’s uncertainty principle (developedin quantum physics): the more precisely we can mea-sure one characteristic of an object, the less preciselywe can measure another characteristic.

As it can be clearly demonstrated that a nominee oran agent with no assets and no employees is not thebeneficial owner (clearly measuring this characteris-tic), once we move from these narrow facts to measur-ing beneficial ownership of a working companyreceiving and making multiple payments in the group,the rule gets blurred and infinitely more complicatedto apply (see E. Reimer Chapter 18: ‘‘How to Concep-tualize Beneficial Ownership’’, Beneficial Ownership:Recent Trends, IBFD, 2013). While the debate overwhether beneficial ownership is a suitable anti-

avoidance tool is still ongoing, Russian taxpayers al-ready have to adapt.

Application to Independent Parties

The Russian beneficial ownership rule is not formallyrestricted to payments between related parties, al-though existing case law is focused on distributionswithin groups. And it may be more challenging to re-ceive beneficial owner information from an indepen-dent company that may need to disclose functions,risks, and the ways that the Russian source income issubsequently used and taxed.

From a commercial perspective, the obligation ofan unrelated company to disclose information to aRussian counteragent doesn’t make much sense. Butthe Russian tax authorities claim they don’t have anymeans to check foreign companies that have no pres-ence in Russia or, more importantly, any means to col-lect taxes from foreign taxpayers (the exchange ofinformation under tax treaties and assistance in col-lection of taxes are not considered sufficient). As aresult, tax liability and penalties of foreign taxpayerscan be collected from Russian payers acting as taxagents, who will then have to exercise their right of re-course to foreign recipients. Given this shift of liabil-ity, Russian companies now frequently ask thatcontracts include express obligations to provide allnecessary confirmations and information, or to buildin a gross-up mechanism to increase payments by theadditional tax amount. In this context, beneficial


owner confirmations may be inadvertently turnedinto carefully drafted tax indemnities.

Obligation to Identify All Beneficial Owners

The Russian Federal Tax Service takes the positionthat in order to deny a tax exemption or reduced with-holding tax rate it is sufficient for the tax inspectorateto disprove that the indicated foreign company - re-cipient of income is not the beneficial owner. This wasalready demonstrated in the case of a Russian bankthat had been making interest payments on bonds toits Dutch parent bank. The Russian tax authoritiesclaimed that the Dutch bank had only been a nomineewith respect to a portion of payments that had gone toother recipients in Turkey and Romania—recipientsthat had not been properly disclosed by the bank de-spite having had the opportunity to do so. As a result,the treaty benefits were rejected in full (without con-sidering reduced rates treaty rates with Turkey andRomania) (Credit Europe Bank case, decision no. A40-442/2015, dated July 25, 2017).

In a recent dividend case, the Russian tax authori-ties denied the application of the 5 percent reduceddividend withholding tax to a Russian fur auctioncompany on its dividend distributions to its Cypriotparent company (Souzpushnina case, decision no.A40-73573/17-20-612, dated October 11, 2017). TheRussian tax authorities not only determined that theCypriot participant was owned by an offshore com-pany in Belize, but they also received informationfrom the bank and Cypriot tax authorities on almostmirror payments to Belize. In the course of the policeinvestigation they received all electronic documentsand correspondence of the Russian company employ-ees, confirming that the Cypriot shareholder was atechnical company and identifying the ultimate Rus-sian beneficiary behind the Belize company. Althoughthe tax authorities did not dispute that the Russian in-dividual ultimately owned the business, they refusedto ‘‘look through’’ the offshore company (similarlyhaving a technical role) and to apply the 9 percent in-dividual income tax directly stating that there was noevidence of payments to the individual. It remains tobe seen if the taxpayer can provide confirmation onreceiving income in order to avoid multiple tax events.

The lack of a clear, ‘‘look through’’ approach alsocreates risks where the Russian subsidiary applies5–10 percent reduced withholding tax on dividendspaid to a direct shareholder that made a compulsorydirect investment in the company. If the direct share-holder lacked substance, and the grandparent com-pany was considered the beneficial owner of thedividend stream, the Russian tax authorities wouldpreviously deny application of the qualified tax treatyrates, arguing that the investment thresholds (whichapply under some tax treaties with Russia) were notmet. This seems to be a contradiction since the Rus-sian Tax Code now expressly allows treating the nextentity in the shareholding chain meeting the test as abeneficial owner, and all investments made usingassets of the 100 percent subsidiary should be ulti-mately considered to be the property of the share-holder, if simple logic is followed.

This may also undermine the fundamental ap-proach that in case the Russian tax authorities reclas-

sify a transaction for tax purposes (as denying a taxtreaty benefit to the direct recipient and reattributingthe income to another person amounts to tax reclassi-fication), they must perform a full reclassification anddetermine the ‘‘true’’ taxpayer’s tax obligation (Resolu-tion of Supreme Arbitrazh Court No. 17152/09, datedJuly 6, 2010).

This may not be achieved if the Russian tax authori-ties are not motivated to identify the relevant foreigntaxpayer—beneficial owner, and they merely deny taxtreaty benefits and collect taxes from the Russian taxagent. In case of this short-sighted approach, foreigngroups may inadvertently lose tax treaty benefits evenif companies that are ultimate recipients of incomeand have access to the same or similar benefits as abeneficial owner cannot be clearly ascertained, or ifsuch confirmations are not duly provided. Instead, theburden to disprove that there is tax abuse is shifted totaxpayers, the income is transferred offshore, and nocompany in the chain having access to tax benefitswould meet the tax treaty requirements.

Russian rules currently lack the idea that beneficialownership can be proven with respect to a group ofcompanies (e.g. a fiscal unity), but the Russian Fed-eral Tax Service has declared that it is open to argu-ments and discussions based on the principle oftransparency. However, the relevant court practice isnot so straightforward. In some past cases on thin-capitalization rules for sister company loans, the Rus-sian tax authorities reclassified excess interest asdividends but also reattributed the income flows toforeign ultimate parent companies, allowing Russianpayers to apply the qualified 5 percent reduced with-holding tax rate. This approach was not specificallyexplained in the court decisions, but suggested someliberal interpretation of tax treaties based on the con-cept of transparency.

The Russian Supreme Court even clarified that forthe purposes of reclassified interest under the thin-capitalization rules, the loan amount can be treated asan investment qualifying for the reduced dividendswithholding tax. In contrast, in some recent casescourts supported a very formal approach by denyingthe 5 percent reduced dividends withholding tax: inone instance, denying it to a Dutch ultimate holdingcompany indirectly owning more than 25 percent in aRussian oil service subsidiary due to lack of direct par-ticipation, and in another case denying it to a Cypriotcompany of a major Russian steel company on similargrounds without extensive review of the taxpayer’s ar-guments. So if the beneficial owner position of an in-termediary company receiving dividends ischallenged, this may well result in a higher tax liabil-ity compared to direct shareholding. This might havebeen a conscious step to motivate groups to simplifyshareholding chains, but it may prove to be inappro-priate and discriminatory.

Foreign corporations may face situations where theinformation requested up front to confirm beneficialownership cannot be provided, e.g. if a company ispart of a consolidated group of companies within onejurisdiction for tax purposes, and such group preparesand discloses only consolidated financial statementsso that there are no available accounts on a per com-pany basis, and no financial and tax statements areprepared for a particular taxpayer.


The income of the receiving company may also beabsorbed by losses of other group companies, result-ing in no effective taxation than can be shown on abill. Moreover, as part of the ordinary course of busi-ness, Russian-source income paid to a foreign com-pany may be utilized in a cash-pooling arrangementor distributed on various legal grounds to other re-lated companies in the same or in a different treaty ju-risdiction (e.g. listed active operating or holdingcompanies, or IP companies not engaged in distribu-tion) that may be entitled to the same tax treaty ben-efits but have not provided a tax agent with beneficialowner confirmation in advance, i.e., before the pay-ment. In practice, if a group takes the position that arecipient aggregating and redistributing money flowsdoes not have much substance and is not the benefi-cial owner, it is forced to show a number of upper-tiercompanies, and each would need to evidence benefi-cial ownership, which would dramatically increasethe amount of documents.

Under these circumstances, some internationalgroups acting in good faith may struggle to identify inadvance, and to confirm with a high degree of cer-tainty, the beneficial rights of one particular foreigncompany-beneficial owner of income, and thus willtechnically risk being denied tax treaty benefits even ifthe income is absorbed by companies in jurisdictionsthat have the same tax treaty rates with Russia. There-fore, planning the beneficial owner disclosure be-comes critically important.

Interaction with Limitations of Benefits

Although the Russian tax authorities initially took thebeneficial owner concept out of the tax treaties, its ap-plication does not seem to be restricted by the relevantlimitation of benefits provisions if we look at the Rus-sian court practice. Otherwise, it would seem that theRussian tax authorities would need to grant tax treatybenefits to intermediaries used for non-tax purposes,or to qualifying companies (under the U.S.-type Limi-tation on Benefits, ‘‘LOB’’), which may be more com-plicated comparing to merely proving a transitpayment.

It is fair to say that in most cases where foreigncompanies were recognized as not being beneficialowners of Russian source income, these companieslacked actual substance (e.g. used nominee directorsserving in this position to dozens of other companies)and were used in aggressive tax structuring. There-fore, the use of the LOB provisions for proving taxtreaty abuse would have yielded the same results andwould be a more appropriate tool for denying unin-tended tax benefits. In some cases the Russian tax au-thorities successfully proved receipt of ‘‘unjustified taxbenefits’’ (in accordance with the Resolution of thePlenum of the Russian Supreme Court No. 53) and taxtreaty abuse under Article 1 of the OECD Model Con-vention without heavily relying on the lack of benefi-cial ownership argument.

The Russian Ministry of Finance has been re-quested by the professional community to considerthe correlation between the limitation on benefits pro-visions and the beneficial ownership test. In the mean-time, it may be presumptuous to automatically

assume that meeting the LOB test would guaranteebeneficial owner qualification.

Mandatory Beneficial Owner Confirmation

The new requirement for recipients of income to pro-vide confirmation on beneficial ownership rules maybe currently met by either preparing an extensiveform, indicating all sorts of information about thecompany, e.g. value of fixed assets, number of employ-ees, risks borne (default risk, credit risk, etc.) andfunctions exercised (demonstrating the management’sauthority to dispose of the income) in connection withthe income and financial information demonstratingthe absence of conduit payments. All information maybe carefully gathered to form a thick booklet signed bythe representative of the recipient. However, thickbooklets need to be updated. Consistently obtainingthis much information may be overly complicated.And unrelated companies may simply refuse to pro-vide this data.

Hence, in many cases, companies choose to provideshorter beneficial ownership confirmations. Manycompanies have developed their own short beneficialownership forms or get them from legal firms. Theseforms tend to focus on what the Russian Tax Code isactually requesting: confirmation of functions, confir-mation of risks related to the income stream, anddemonstrated absence of the passing of income to an-other party not having access to the same tax benefits.This approach is advocated by lawyers as giving exces-sive information that may limit litigating opportuni-ties if the case goes to court. Although sample formscan be helpful, some tailoring is usually required tomatch a company’s profile and income type.

For example, functions and risks in respect of divi-dends would dictate an emphasis on ownershiprights, voting powers and investment risks, whereasfor interest payments the recipient’s capital structureis more relevant. When funds travel through a chainof companies, with each company playing its ownfunction in a cross-border group and exposed to dif-ferent tax benefits, a bespoke beneficial ownershipconfirmation is needed to provide correct facts and toavoid statements that can be discredited.

Collecting Defence File Data

Shorter forms are easier to maintain, and can be con-sistently applied to various payments and recipients.At the same time, because a Russian payer is respon-sible for tax withholding, it bears liability for tax un-derpayments, and its management may request moredocuments in order to get comfortable with the taxposition and to prepare a ‘‘defence file’’ for tax auditsand potential litigation.

The content of the defence file may need to be tai-lored to a particular type of income, group structure,and other facts and circumstances. Because the de-fence file does not need to be disclosed up front, andits content may be revealed depending on the ques-tions and position of the tax authorities, it is a moreflexible and delicate tool compared to the formal ben-eficial ownership confirmation. Although the contentis mainly dictated by the facts of the case, it may in-clude the following main building blocks:


(i) information on substance, e.g. on employees,office and assets sufficient for maintaining the re-cipient’s operations;

(ii) non-tax business reasons for keeping the recipi-ent in the structure;

(iii) standalone or consolidated financial informationevidencing that the Russian-source payments arereflected as proprietary income on the balancesheet of the recipient and are taxed;

(iv) any suitable information confirming ownershipof the asset, e.g. proprietary funds, statementsfrom trademark registers, etc.; or

(v) evidence that the recipient is not a mere agent ornominee, that it performs functions and bearsrisks, and that it is not transferring income to low-tax jurisdictions that would not otherwise get thesame tax benefits.

It should be borne in mind that the tax agent canonly make its judgment based on pre-payment busi-ness arrangements and surrounding circumstances(which may demonstrate the absence of intentionaltax avoidance), whereas the tax authorities may alsolook at after-payment parameters that may distort thegroup’s original intentions.

Obviously, the more substance, functions and risksthat are demonstrated by the recipient, the strongerthe taxpayer’s position would be under the currentblurred rules, pursuant to the above-cited Heisen-berg’s uncertainty principle. The Russian courts havenot yet developed a position on the appropriate levelof functions and risks for pure holding companies orgroup treasury centers.

There is already an Italian precedent in which thecourt stated that the recipient was the beneficialowner and as a holding company it was not required

to maintain many employees and have multiple op-erations (Decision of the Supreme Court of Italy No.27113, dated December 28, 2016). At some point thesearguments may need to be considered by Russiancourts, who have previously showed little sympathytoward foreign tax cases.

At the same time, the Russian Federal Tax Serviceseems to have restricted the use by local tax inspector-ates of the beneficial ownership arguments in taxaudits, effectively taking it under its manual com-mand. Representatives of the Russian Tax Servicehave confirmed that they are open to arguments onthe absence of the withholding tax reductions, whichis critical for a large number of cross-border struc-tures that have various business reasons for keepingtransactions in separate entities (which may mitigatethe risk that the Russian tax authorities could fail tomake a full reclassification and determine ‘‘true’’ taxobligations).

International groups will be unlikely to go andrevise their entire business models because of thechanges in the Russian beneficial ownership ap-proach; self-declaring a look-through approach withrespect to some holding or financing entities may alsointerfere with the adopted transfer pricing or othertax positions in the group in other jurisdictions, andmay go beyond the responsibility of the Russian sub-sidiaries. Therefore, all of these international taxissues will need to be carefully considered when build-ing a Russian beneficial ownership position, issuingbeneficial ownership confirmations, and building anappropriate defence file.

Kirill Vikulov is a Senior Associate at Baker McKenzie, Russia.


A TAX PLANNING INTERNATIONAL - Baker McKenzie · 2017. 11. 24. · legal planning and tax avoidance. For example, the Russian tax authorities challenged the withholding tax exemption

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