Should We Pay Any Tax At Home?


 

The right way to interpret double tax treaties is far from settled. In theory, an international agreement trumps domestic law. The reality is more complex; where exactly the jurisdiction of a treaty ends is shrouded in mist.

The problem is not peculiar to taxation and is well-known to practitioners of international private law. The Vienna Convention on the Law of Treaties 1969 requires that the treaty be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of their object in purpose. On the other hand, article 3(2) of the Model Tax Treaty specifies that any term which is not defined is to have the meaning assigned to it under the domestic law of the State concerned, unless the context requires otherwise.

What is meant by ‘context’ here, or what meaning is to be assigned to a term if the context excludes the domestic meaning is anything but clear.

The case recently referred to the Supreme Commercial Court relates to the conflict between domestic tax legislation and the provisions of double tax treaties.

Under Russian thin capitalization rules set out in Articles 269(2) to (4) of the Tax Code, interest paid on loans from foreign related parties in excess of the debt-to-equity ratio is treated as a dividend. The rule applies where a foreign creditor holds more than 20% of the issued capital of the Russian company. For a Russian payer, the rule means that the reclassified interest cannot be deducted as expenses for income tax purposes.

Certain tax treaties, on the other hand, like those with Switzerland or Cyprus, contain article 24(3) which reads that ‘interest … paid by an enterprise of a Contracting State to a resident of the other Contracting State shall … be deductible under the same conditions as if they had been to a resident of the first-mentioned State.’

It seems that the domestic thin capitalization rule should not apply to a loan granted by a non-resident who is entitled to benefit from a double tax treaty concluded by Russia which contains a non-discrimination clause.

This is anything but normal. It actually means that a Russian company with a Cyprus or Swiss parent can keep its taxes as low as it wishes: you just pay your profit offshore in the form of interest.

When EU countries include provisions like that, timidly hidden in the non-discrimination clause, it is understandable if not reasonable: they, after all, build a common market. It escapes any rational mind why Russia should shift the power to tax to another country.

It escapes any rational mind why Russia should shift the power to tax to another country
 

It seems that the Supreme Commercial Court does not approve the practice. According to the ruling in the case A27-7455/2010 the thin capitalisation rule applies even if the relevant tax treaty unequivocally stipulates that it doesn’t.

The judges have said that the question of what expenses are deductible for income tax purposes lies in the jurisdiction of domestic laws and that lower courts, which ruled against the taxmen, assigned too much weight to international treaties.

They stated that, ‘in the opinion of the panel of judges the above provisions of the treaties are not concerned with the methodology or procedure for calculating profit tax (including the procedure for deducting expenses for profit tax purposes) of the contracting state. Neither do they rule out the application of Article 269(2) of the code, which establishes a limit on deductible interest paid on debt obligations to companies that hold a major share in the capital of the Russian taxpayer.’

The decision is not final. It has still to come through the presidium of the Supreme Commercial Court which usually follows the opinions of the judges referring a case to its attention.

When this case is upheld, double taxation treaties in regards to thin capitalisation will be disregarded and the days of unlimited deduction of interest paid by Russian companies to their offshore parents will be over.

picture: © caraman - Fotolia.com

 

 

When this case is upheld, double taxation treaties in regards to thin capitalisation will be disregarded and the days of unlimited deduction of interest paid by Russian companies to their offshore parents will be over.
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