Russia : Beneficial ownership case on capital gains

Russia has produced an interesting case on the application of the beneficial ownership concept in the capital gains article (Article 13) in the Cyprus / Russia double tax treaty.

Article 13, Cyprus / Russia treaty

Article 13 of the Cyprus / Russia treaty, as it stood at the relevant time, was similar to the OECD model treaty.

Paragraph (1) deals with the alienation of immovable property. Paragraph (2) deals with the alienation of movable property forming part of a PE. Paragraph (3) deals with ships or aircraft or road vehicles operated in international traffic.

And paragraph (4) is the residual provision. It says :

"Gains from the alienation of any property other than that referred to in paragraphs 1, 2 and 3, shall be taxable only in the Contracting State of which the alienator is a resident."

As you can see, there is no "beneficial ownership" condition which is expressly stated in paragraph (4). More about that in a moment.

2010 protocol

But let me first deal with some issues which arise from the protocol which was signed by the two countries in 2010. That protocol made two changes which you might think are relevant in this case - but they're not.

The first change concerns amendments to Article 13 itself, to introduce some paragraphs which deal with the alienation of shares in a land-rich company.

However, that change was scheduled to come into force only in 2017, which is 6 years after the facts occurred in this case. Also, in late December 2016, the two countries agreed to further postpone that start date.

The second change concerns the introduction of a "limitation of benefits" article (new Article 29) into the treaty.

However, the new Article 29 has effect only from 2013 (which is 2 years after the facts occurred in this case). Also, the new Article 29 is drafted in a narrow way - it would probably not apply to the facts in this case, anyway.

So, for those reasons, the protocol has no impact in this case.

Fundamental issue

The fundamental issue in the case was this : in determining the availability of the capital gains exemption in paragraph (4) of Article 13 of the treaty, can a "beneficial ownership" concept be used, even though paragraph (4) does not expressly refer to beneficial ownership?

Facts

The starting position was this :

• A Russian company (RCo 2) owns 100% of the shares in another Russian company (RCo 1)
• More than 50% of the assets of RCo 1 consists of immovable property located in Russia

In May 2011, RCo 2 sold all of those shares in RCo 1 to a Cyprus company (CCo) for a price of 100 million rubles. CCo was a subsidiary of a BVI company (BVI Co).

And then, only 4 months later, in September 2011, CCo sold all of the shares in RCo 1 to yet another Russian company (RCo 3), for a price of 900 million rubles.

CCo's profit of 800 million rubles was paid out as a dividend to BVI Co shortly thereafter.

RCo 2, RCo 3, CCo, and BVI Co were all related parties.

The court's decision indicates that the transactions were undertaken to obtain a tax-free step-up in the cost base of the shares in RCo 1.

RCo 3 did not withhold the 20% withholding tax from the 900 million rubles it paid to CCo - its position being that CCo was exempt from Russian tax under paragraph (4) of Article 13 of the treaty, and therefore it (RCo 3) was not required to deduct withholding tax.

Russian domestic tax law : "beneficial ownership" concept

Russia introduced into its domestic tax law, effective in 2015, a "beneficial ownership" concept. This concept allows the determination of the taxpayer in regard to specific income, and permits that taxpayer to be someone other than the actual recipient of the income.

The interesting feature of this case is that the court applied that domestic law "beneficial ownership" concept to conclude that CCo was not the relevant taxpayer in regard to the 800 million rubles profit. I will explain how the court reached that conclusion in a moment.

That conclusion is interesting for two reasons :

• Firstly, there's the retrospective aspect. The domestic tax law provisions introducing the "beneficial ownership" concept became effective only in 2015. The facts in this case occurred in 2011. Nevertheless, the court applied the "beneficial ownership" concept, because (it said) the new provisions merely codified the pre-existing rules - an interesting viewpoint.
• Secondly, there's the interaction between the domestic law position and the treaty position. By determining that CCo is not the relevant taxpayer (for domestic tax law purposes) in regard to the profit of 800 million rubles, the court effectively rendered the Cyprus / Russia treaty irrelevant : CCo is not sought to be taxed, and therefore treaty benefits for CCo are irrelevant.

In regard to the second reason : we have seen this type of analysis in other countries which use domestic anti-avoidance rules to change the relevant taxpayer - Korea is an obvious example. And it is endorsed by the OECD Commentary on Article 1 :

"22. Other forms of abuse of tax treaties (e.g. the use of a base company) and possible ways to deal with them, including 'substance-over-form', 'economic substance' and general anti-abuse rules have been analysed, particularly as concerns the question of whether these rules conflict with tax treaties...

"22.1 Such rules are part of the basic domestic rules set by domestic tax laws for determining which facts give rise to a tax liability; these rules are not addressed in tax treaties and are therefore not affected by them. Thus, as a general rule...., there will be no conflict. For example, to the extent that the application of the rules referred to in paragraph 22 results in a recharacterisation of income or in a redetermination of the taxpayer who is considered to derive such income, the provisions of the Convention will be applied taking into account these changes." [Bolding added]

Court's conclusion on beneficial ownership

Let me return to the issue of how the court reached the conclusion that CCo was not the beneficial owner in regard to the profit of 800 million rubles.

The tax authorities put forward a long list of arguments, the cumulative effect of which was accepted by the court.

Here is the list of arguments :

• Participants in the sale and purchase transactions in relation to 100% of the shares on RCo 1 were related parties
• CCo's director was provided by a local corporate secretarial firm
• Acquisition of the shares in RCo 1 by RCo 3 from CCo had been approved long before CCo acquired the shares in RCo 1
• CCo did not have sufficient funds to acquire 100% of the shares in RCo 1. The transaction was financed by a loan from a related party, who controlled the relevant companies
• During the entirety of its existence, CCo did not own any intangible / tangible assets or financial assets, did not employ any personnel and did not conduct any profit-seeking business operations, other than the purchase and sale transactions of the shares in RCo 1
• CCo's profit from the disposal of RCo 1's shares was not taxed in Cyprus
• CCo's sole shareholder was a company incorporated in BVI, and the quantum of dividends paid by CCo to its sole shareholder was equivalent to the profit derived on the disposal of the shares in RCo 1
• The bank accounts of CCo and BVI Co were opened at the same time with the same Cyprus bank
• The same address was used for both bank accounts
• CCo was liquidated a few years after the sale of the shares in RCo 1

Who is the beneficial owner?

One of the interesting aspects of this case is that, although the court determined that CCo was not the beneficial owner of the profit and therefore was not the relevant taxpayer, the court did not have to determine who the beneficial owner of the profit truly was.

In the absence of a treaty exemption, RCo 3 had an obligation under domestic tax law to deduct withholding tax from the payment which it made to CCo. Based on the court's conclusion that CCo was not the beneficial owner and therefore not the relevant taxpayer, there was no treaty exemption - and thus, RCo 3 was liable for the withholding tax it had failed to deduct.

And so the court concluded the case without identifying the beneficial owner.