Import of technological equipment: new difficulties to investors

-- December 8, 2008 --

According to article 150 of the Tax Code of the Russian Federation the import of technological equipment in the form of capital contribution to the domestic company by a foreign shareholder is exempt from VAT. The rule appears very attractive but it has never been easy to implement in practice.

The Federal Law N 224 which comes into force in January 2009 sends a clear message to customs officials of what they have already known for years but did not dare to say aloud, the exemption is nothing but an unfortunate mistake used to avoid paying tax!

The exemption established by the article 150 of the Tax Code has been restricted by the new law. Now import of technological equipment as contribution to capital of the Russian company will be VAT free only if 'the analogues of the equipment are not manufactured on the territory of the Russian Federation according to the list approved by the Government of the Russian Federation'.

Customs considers it a matter of honour to make import as difficult as can be

It is in Russia's interests to attract investments in the form of equity contributions to domestic companies rather than in the form of loans to local subsidiaries. A loan can be repaid almost tax free while equity contribution will, generally speaking, be returned to investors through heavily taxed dividends. More importantly however is that Russia desperately needs technological equipment. Putting Friedman's drop of money into the Russian context, machinery must be dropped from helicopters.

Customs, however, seems to have a different view on the subject and considers it a matter of honour to make import as difficult as can be. It guards the gates so well that one would think twice before venturing the equity contribution route.

The first line of defence is the question of what is the correct procedure for contributing assets to capital of a company. Ironically, the matter is rather straightforward and well established in law. However, when customs gets involved this comparatively simple issue becomes complicated and vague. The legal position of customs itself remains subtle and changeable.

The next line is the question of security for customs duties. Ervin Ltd filed the declaration for a bus as the capital contribution from a foreign shareholder to the Pskov customs. Although such contribution is exempt from VAT the customs officials demanded security for payment of (omit the customs duties. Federal Arbitrazhniy Court of the North - West Region in decision N A52-3446/2006/2 of 13 April, 2007 found the demand illegal because absence of the liability to pay the tax means that there is no obligation to provide security for. Common sense isn't it?

This case is interesting for two reasons. Firstly, because of the unusual stubbornness of the investor involved.

Secondly, because of the interesting logic of the customs officials. It is worthwhile recalling that VAT on imported goods is in fact a loan to the state repayable to the taxpayer by its customers when they pay the price of a product or service because the price contains VAT collected by the company on behalf of the state. Therefore, exemption from customs duties on imported machinery does not make it cheaper in a general sense but allows domestic companies not to freeze extra funds in the Treasury's accounts. The well established principle of interpretation of legal acts is to assume that the legislator acts sensibly with a clear purpose in mind. Obviously, the idea that the will of the legislator is to freeze the taxpayer's money in the form of security instead of VAT would be self contradictory.

The third line of defence is the difficulty of judicial appeal against the actions of the customs authorities. For instance, in 2007 the Central Excise Customs was reorganised and regional customs became branches of the Moscow office. The regional customs now claim that they are 'not separate legal entities' and therefore local courts have no jurisdiction over appeals against their actions. Surprisingly enough this lame argument is often admitted by courts and appeal against, say, the Saint-Petersburg Excise Customs must be filed in court in Moscow. Another complicating factor is that appeal does not eliminate the obligation of the taxpayer to pay substantial storage fees for the goods while the appeal is being considered.

Next, there is an interesting concept of 'inappropriate use of imported goods'. The legal nature of the concept is unclear but in practice it means that machinery imported as capital contribution and as such exempt from customs duties cannot be leased out unless the customs duties are paid in full. Although the concept of 'inappropriate use' does not appear to be well grounded in law (see i.e. A.A. Nikiforov 'Inappropriate use in capital contribution: do the customs duties need to be paid', 'Nalogoved', #7 / 2004) the risk of disputes with the customs over the matter is substantial.

The difficulty of judicial appeal forces some importers to pay security for customs payments. In theory such security must be returned to the company when it completes the procedure of increasing of the company's share capital and registers amendments to its founding documents. However, in practice the return of security can be a long and burdensome venture. For instance, a St. Petersburg company 'Avtobusy ee Spetcialnaya Technika Plus' imported buses as capital contribution and deposited security for the customs payments. After registration of the vehicles in the relevant registration body (GIBDD) and on the company's accounts it applied to the customs, asking to credit the security against future customs payments. The company, however, did not have any success and in 5.5 months afterwards it had to appeal to the Moscow Arbitrazhniy Court.

The court however did not support the company. In her decision of September 25, 2007 Judge O.Y. Nemova pointed out that 'although the company had fulfilled all the conditions required to obtain exemption from the tax, it does not mean that the company met conditions to receive the security back'.

The customs officials see tax exemption for capital contributions as a potential threat

The company leased the buses to various transportation companies in other regions. The St.Petersburg customs sent requests to the regional customs to investigate that the vehicles were 'appropriately used'. The requests were sent nearly 6 months after the company filed the application to the customs and when the company had already appealed to the court. By the time the hearing took place the results of the investigation were not available and the court decided that there were no sufficient grounds to credit the security payment against the company's customs tax liability. The result is devastating: the attempt to return the security took over 7 months, involved legal actions in the Moscow court but eventually had no success.

The customs officials see tax exemption for capital contributions as a potential threat and treat those who dared to go for it with suspicion. However, customs clearance 'with minimisation of customs payments' - or evasion of the customs duties through illegal schemes - has become very common. In fact such 'schemes' is the real problem, and the customs fight with capital contribution is just a distraction from the real issue.

According to 'Russkiy Reporter' with references to sources within customs 'it is often that those who do customs clearance legally get problems with delays. Customs officials start 'playing fools', trying to keep the process as slow as possible. Why would they need 'white' companies?' (V. Dyatlikovich, ''Shut' the general.' Russkiy Reporter, #4 (34)/7 February 2008).

A fear of misusing the tax benefit on the import of the equipment is a war with phantoms. According to the forecast of the RF Ministry of Economic Development for 2009 the industrial growth in Russia will be - 2,4%, investments in the capital of the domestic companies - 5%. The reality most probably will be much worse. Trying to earn money for the Treasury on investments then is like taxing unemployment benefit - indecent and silly.