The Russian tax landscape is going through a period of transformation. The average value of assessments as a result of tax audits is increasing and taxpayers are losing more disputes. Various changes to the tax laws have acted as a contributing factor. The introduction of the anti-abuse concept of “beneficial ownership” in domestic legislation, the development of tax residency and CFC rules, and the enactment of new thin capitalization rules are just a few of the recent changes that are already having an impact on taxpayers in Russia.
The most controversial new legislative development was the introduction in July 2017 of a general anti-avoidance rule (GAAR). The GAAR is the result of almost three years of attempts to codify existing judicial anti-avoidance doctrines. The final, successful attempt, however, was made with lightning speed and practically no consultation with academics or legal practitioners.
As in many jurisdictions, especially those without a codified GAAR, Russian courts have developed their own approaches to situations where a taxpayer formally complies with the rules but gains an illegitimate tax advantage. The concepts of “bona fide taxpayer” and an “unjustified tax benefit” are based on a substance-over-form approach and use of the business purpose test to combat tax avoidance. These doctrines are not without their flaws: the shifting of the burden of proof to taxpayers and the formalistic application of these concepts against their spirit have resulted in many legal disputes. The concept of “due diligence” in particular, which shifts the risks associated with the underpayment of tax on a transaction to a buyer or seller that, according to the tax authorities, failed to establish that its counter-party validly existed and was in a position to actually supply, has become a major problem for Russian taxpayers. But after more than a decade of continuous application and improvements led by the country’s highest courts, these concepts have been polished to the point that they are now broadly accepted.
The GAAR has two major elements. First, it contains a general prohibition against utilizing tax deductions or decreasing the amount of tax payable if done by incorrectly reflecting transactions in taxpayer accounts. This rule is designed to combat artificial arrangements and, according to the clarifications issued by the tax authorities, requires that the taxpayer’s intent be established. Secondly, for tax benefits to be lawfully utilized, the GAAR requires that: (i) the tax benefits should not be the principal purpose of the transaction, and (ii) the counter-party’s obligation under the transaction be performed by that counter-party or by a person to whom the obligation has been lawfully transferred.
Leaving drafting concerns aside, one can conclude that the new GAAR uses a combination of the partly codified “unjustified tax benefit” doctrine, the principal purpose test, and the requirement that the transaction be “real.” This combination can be found in existing judicial doctrines, yet the GAAR is not structured in a way that precludes their application in future.
While we see some positive aspects to the GAAR, such as the possibility of retrospective application of the limitations set by the rule on the tax authorities and the use of the principal purpose test, our main concern is that the GAAR is not flexible enough to take into account all circumstances of a given case and uses quite restrictive language. The latter has already led the tax authorities to issue clarifications rejecting the practice of so-called “tax reconstruction,” which allows for the utilization of benefits based on the substance of a transaction even if its form is challenged, and which had generally been accepted by the courts in recent years. The GAAR, as currently interpreted, precludes the possibility of tax reconstruction and, therefore, puts taxpayers in a worse position compared to judicial doctrines.
Legislators have claimed that the GAAR is meant to increase legal certainty by eliminating the use of subjective categories. It may indeed help taxpayers in a limited range of cases where the tax authorities abusively apply doctrines, which often happens with the “due diligence” concept, for example. However, the vague wording of the GAAR and the fact that, objectively speaking, inherently flexible doctrines defy codification mean that ultimately the GAAR and the doctrines will likely be applied simultaneously in relation to taxpayers. This means that taxpayers should pay much more attention to preparing evidence beforehand that certain transactions have their own legitimate business purpose and are not concluded merely to obtain a tax benefit.
By Alexander Anichkin, Partner, and Dmitry Tolkachev, Senior Associate, Clifford Chance
This Article was originally published in Issue 4.11 of the CEE Legal Matters Magazine. If you would like to receive a hard copy of the magazine, you can subscribe here.