Development of court practice of determining direct capital investment for the purpose of applying the 5% withholding tax rate when paying dividends to a Cypriot company

by Dentons
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On 3 May 2017 the Commercial Court of Chelyabinsk Region rendered a decision in case No. А76-20508/2016 under the claim of Chelyabenergosbyt PJSC (the “Company”).

This case considered the issue of the validity of the Company's application of the 5% withholding tax (“WHT”) rate when paying dividends to a Cypriot company under the Agreement between Cyprus and the Russian Federation for the avoidance of double taxation dated 5 December 1998 (the “DTT”).

According to the decision, in November 2011 a Cypriot company (the “Shareholder”) purchased on the secondary market and actually paid for a shareholding in the Company valued at more than US$100,000. When paying the Shareholder dividends in 2012 the Company applied the 5% WHT rate, believing that the criteria of Article 10(2)(a) of the DTT concerning the Shareholder’s making of an at least US$100,000 equivalent “direct investment in the capital” of the Company had been met.

In the opinion of the Interdistrict Inspectorate of the Federal Tax Service of Russia for Major Taxpayers of Chelyabinsk Region (the “Inspectorate”), the Company should have applied the 10% WHT  rate according to Article 10(2)(b) of the DTT, because the Shareholder had not made a direct investment in capital, the shares had been acquired exclusively to move their ownership to an offshore zone and the only purpose of the chain of transactions was just to take advantage of a benefit under the DTT, due to the existence of the following circumstances accompanying the acquisition of the Company’s shares:

  • An RF citizen who is in the same group as the Company in the terms of Russian antitrust law was actually entitled to dispose of 100% of the Shareholder’s shares.
  • The source of financing for the Shareholder’s purchase of the Company’s shares was borrowed funds provided to the Shareholder a few days before the transaction by a company incorporated in the British Virgin Islands (the “Lender”).
  • The Lender, in turn, not long before the transaction had received partial repayment of funds under a loan provided to another Russian entity in an amount comparable to the loan disbursed to the Shareholder.

Thus, the funds “directly invested” by the Shareholder in the Company’s capital were Russian in origin and were received as a loan via related parties, which evidences that the criteria for applying the preferential 5% WHT rate provided by the DTT had been met only formally.

The court disagreed with the Inspectorate’s position and declared its decision unlawful, stating that the Shareholder’s acquisition of the shares in the Company on the secondary market for an amount exceeding US$100,000 should be considered “direct investment in capital” for the purpose of applying the DTT, and the funds received by the Shareholder under the loan agreement are in a sole ownerhip of the latter. Accordingly, there were no legal grounds to ignore these circumstances to find that it was necessary to apply the 10% WHT rate.

In general, the interpretation of the provisions of the DTT on making a “direct investment in capital” cited in this judicial act as applying to cases where Russian companies’ shares are acquired on the secondary market is consistent with the many years of practice of applying the laws. Nevertheless, in our view the fact that the court took such a literal interpretation in light of the arguments made by the Inspectorate about the source of the investments, information about the Shareholder’s activity and its controlling bodies in the context of the extremely negative practice of applying benefits under international double taxation treaties while there is a full-blown deoffshorization campaign going on is worthy of particular attention.

The lawyers of Dentons’ Tax practice have considerable experience advising Russian and international companies on applying international tax treaties and would be happy to provide you with comprehensive legal support in drafting documents substantiating the right to apply them.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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