A very important decision was issued on 2 August 2017 by the Commercial Court of the Kaliningrad District of the Russian Federation concerning the application of the beneficial ownership concept.
The case involved a Russian company, which received a loan from a Hong Kong company with an annual interest rate of 4%. The loan was later on assigned by the Hong Kong company to a Cyprus company, with the interest rate increasing at the same time. Interest paid on the loan was always claimed in full as tax deductible expenses by the Russian company.
The Russian Tax Authorities claimed that the practice followed by the Russian company was not correct because the loan, as per the Tax Code, was considered as a “controlled debt”. It was therefore subject to thin capitalization rules, and any excess interest should be treated as dividend for income tax purposes.
The Tax Authorities further claimed that the beneficial owner of the interest was not the Cyprus company (the registered shareholder of the Russian company) but the Jersey company, which was on top of the Cyprus company. The claim of the Tax Authorities was based on the following factors:
- the Jersey company was the top holding company of the group;
- all actions of the group companies were coordinated by the Jersey company, which took decisions and accepted risks and responsibilities, including those related to the fulfilment of obligations by direct and indirect subsidiaries;
- the interest on the loan was attributed to the income of the Jersey company from an economic point of view; and
- the financial statements of the Russian company were included in the consolidated financial statements of the group.
The Tax Authorities concluded that the Double Tax Treaty between Cyprus and Russia (which provides for 5% or 10% withholding tax on dividends and 0% on interest) should not apply. Therefore the transactions should be taxed based on domestic rates, namely 20% on interest and 15% on interest considered as dividends under the thin capitalization rules.
The Russian company did not object the fact that the loan constituted a controlled debt. With regards to the beneficial ownership issue, it claimed that the Cyprus company was the actual recipient of the payments it made and as such the provisions of the Double Tax Treaty between Cyprus and Russia should apply.
The Commercial Court ruled in favour of the Russian company, using the following arguments:
- the Cyprus company spent the income received by the Russian company to cover its operating expenses and not to make any payments to its parent company in Jersey;
- taxes were paid in Cyprus on interest income received by the Cyprus company from the Russian company;
- even before the loan to the Russian company was assigned to it, the Cyprus got engaged in the business of investing and providing finance to companies throughout the world;
- the Cyprus company had a sufficient number of employees;
- it was not proven by the Russian Tax Authorities that the Cyprus company was not in a position to use or dispose of the income received from the Russian company as it wished;
- there were no limitations or any indication in the loan documentation evidencing that the Cyprus company acted as an agent, commissionaire or a fiduciary;
- the claim of the Russian Tax Authorities that the Jersey company had accepted risks and responsibilities, including those for the fulfilment of obligations by other group companies was not founded;
- the Russian Tax Authorities could also not prove that the Jersey company had initially supplied the funds for the loan provided to the Russian company;
- the financial statements of the Jersey company did not indicate that the Cyprus company was controlled or non-autonomous; and
- the fact that the companies were members of the same group could not be used as the basis for claiming that the loan was controlled by the parent company of the group.
Based on the above, the Commercial Court decided that the Cyprus company was a genuine economic entity and the beneficial owner of payments made by the Russian company.