Russia-Cyprus, Russian Appeal Court decided on applicability of beneficial owner and economic substance requirements

On 5 December 2012, the Appeal Court heard case No. ?40-60755/12-20-388 between the Russian branch of Eastern Value Partners Ltd. (EVP Co.), a company resident in Cyprus, and the tax authorities. The tax authorities denied the applicability of the Cyprus - Russia Income and Capital Tax Treaty (1998) on the grounds that the conditions regarding beneficial ownership and economic substance were not fulfilled.
Details as follows.

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(a) Facts. A British Virgin Island (BVI) company granted a loan to a Cypriot affiliated company, which in its turn provided a loan (with the same amount) to EVP Co. (a Cypriot affiliated company) to be used by its Russian branch. The Russian branch paid interest without withholding any tax at source based on the tax treaty.
The Russian tax authorities challenged the applicability of the exemption provided by the tax treaty based on the fact that the interest was transferred by the Russian branch directly to the BVI company's bank account. EVP Co. did not have any economic substance in Cyprus because it did not perform any economic activity except for providing the loan (the company was incorporated a few months before the transaction occurred and had the same representative as the BVI company) and the BVI company (rather than EVP Co.) was the beneficial owner of the interest income.

(b) Decision. The Appeal Court ruled in favour of the taxpayer. It considered that although the payment was made to the BVI company's bank account, for tax purposes, it should be treated as a payment made to EVP Co., since it was made at its request, which is consistent with the Russian legislation. The tax authorities' arguments regarding the absence of economic substance of EVP Co. were overturned as it was not supported by sufficient evidence. Also, the fact that the BVI company and EVP Co. had the same representative was disregarded since the tax authorities did not challenge the fair market level of the interest payment.
Furthermore, it was pointed out that based on the tax treaty, a resident of a contracting state may be denied the tax treaty benefits only if, based on the mutual consultations between the Russian and Cypriot competent authorities, it is decided that one of the main purposes of incorporating the entity was to obtain tax treaty benefits. Since no evidence of such consultations was provided by the tax authorities, the taxpayer should benefit of the tax treaty protection.
Moreover, the tax authorities' argument that EVP Co. was not the beneficial owner of the interest income was rejected because the tax treaty and also the Russian legislation do not contain the beneficial ownership requirement. Also, the Commentaries to the OECD Model Tax Convention are not applicable since Russia is not a member of the OECD. It was considered that this argument was not originally the ground for the tax assessment and the tax authorities put it forward only at a later stage.
Note. The tax authorities have appealed to the Supreme Court, whose decision is pending.
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Russia; Cyprus - Treaty between Russia and Cyprus ﾖ Russian Appeal Court decided on applicability of beneficial owner and economic substance requirements (01 Feb. 2013), News IBFD.