19 мая 2020 г.
By Maria Semenova, ACCA, PhD
Professionals engaged in M&A support the need to reflect in financial models both tax implications of the deal financing and leakages related to the target’s historic tax risks resulting from financing arrangements. Recent developments in the Russian tax legislation and the court practice increased a number of new threats that could compromise the transaction efficiency in these two areas.
Justification of interest deduction
Under the Russian tax legislation interest expenses are deductible for profits tax purposes if they are economically justified, relate to income generating activities and properly supported by primary documents. In addition, the tax deduction of interest could be limited under transfer pricing and thin capitalization rules.
The Russian tax authorities tend to pay specific attention to economic rationale and justification of any expenses relating to financing of M&A transactions. In particular, the taxpayer’s right to deduct interest expenses could be forfeited merely by the fact that a deal resulted in a loss. For example, in a number of court cases the tax authorities successfully denied deduction of interest relating to loans received to finance an acquisition of the target that was subsequently sold with a loss (cases #А70-5222/2018 АО “Sibneftemash”, А70-8615/2018 АО “GMS Neftemash”, А50-6340/2018 ООО “Electrotyazmash “Privod”).
Recommendation: to justify the tax deduction of interest the taxpayer could prepare a defense file outlining the expected economic effect of the contemplated transaction. In case the probability of making a loss is high, it is advisable not to take tax deduction of interest as granted and to evaluate the transaction results in a financial model as if no tax deduction is available with regard to the deal financing.
Reclassification of intercompany debt into capital
The Russian tax legislation contains neither criteria to classify shareholders’ loan into equity nor specific provisions relating to deductibility of interest on hybrid loans. However, according to the current court practice, the tax authorities could reclassify the shareholder’s debt into equity (see cases (cases # А40-18786/13-140-58 ZAO “Investproekt”, А16-343/2016 ООО “Hemen-Dalnyi Vostok”, А51-25978/2016 ООО “Novaya Dryzba”, А09-429/2017 ООО “NK Russneft-Bryanks”).
The tax authorities could reach such conclusion by proving that the parties to the loan agreement do not undertake actions aimed at the proper performance of their contractual obligations and the legal framework of a loan does not correspond to the actual economic substance of the transaction. In other words, these parties have business relations other than provision of a loan.
In particular, if the shareholder is not taking actions to claim the interest payments from the subsidiary in a timely manner (or loan repayment terms are not clearly stated) and/or the shareholder reduces interest rates and plans to subsequently forgive the outstanding debt, the tax authorities could claim that the loan agreements in fact represent investments in the subsidiary’s capital. In this case, the tax authorities could disallow the profits tax deductions relating to interest charged on such debt by the subsidiary for profits tax purposes.
Recommendation: establish the market terms of intercompany loans and strictly observe repayment deadlines to avoid any doubts on investment nature of the loan. Pay specific attention to drafting intercompany loan agreements and establish realistic loan repayment deadlines for the borrower. If the borrower fails to meet the established repayment schedule, consider restructuring the loan in a way that could be applied to an independent borrower.
Pre-sale restructuring as a deal-breaker
During the last two to three years the Russian tax authorities consistently challenge tax deductions claimed on intercompany loans issued to finance M&A transactions where both the seller and the purchaser are companies under common control (e. g., members of a multinational group of companies).
In particular, if a Russian target is sold by a foreign company to a Russian company and the purchaser’s obligation under the SPA is novated into interest bearing loan, the tax authorities argue that such arrangements have artificial nature as the main purpose of structuring intergroup M&A in this way is merely establishing a mechanism that allows to strip cash from Russia abroad and claim artificial tax deductions with regard to interest expenses.
In case the Russian purchaser is subsequently merged with the target to enjoy the debt push down, such merger is considered as a sham transaction aimed at receiving unjustified tax benefit (А50-17405/2016 ООО“Firma “Radius Servis”).
The tax authorities claim that such restructuring within an international group does not have any proven economic rationale as the ultimate parent of the group exercises control over the seller, the purchaser and the target regardless. Furthermore, the group could achieve the restructuring goals by means of capital contributions that do not give rise to interest bearing obligations and tax deduction of interest expenses at the level of Russian borrower.
Apart from challenging the interest deduction as stated above, the tax authorities seek to disallow the application of the reduced withholding income tax rates under the double tax treaties with regard to interest income payable abroad to group companies by reclassifying such interest into dividends payable to the ultimate shareholder of the group (see cases #А11-6203/2016,А11-16028/2018 ООО “Mon’delis Rus”, А40-118135/19-75-1540 ООО “Agroaspekt”).
Recommendation: avoid inter-group restructurings in a form of leveraged acquisitions as a part of pre-sale structuring of the target. In case the Russian target was subject to such restructuring within the statutory limitation period, evaluate the resulting historic tax risks and either consider cancellation of the contemplated transaction or seek SPA protection.
Disclaimer: the views and opinions expressed in the article are those of the author and do not necessarily reflect the position of CFA Association Russia.
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