The Russian Federal Tax Service (the “FTS“) has issued a letter clarifying the provisions of Article 54.1 of the Russian Tax Code on tax avoidance, outlining a methodology for tax inspectorates on how to identify misrepresentations of business operations, check material facts and intent to use sham or “fly-by-night” companies. It also provides taxpayers with criteria for counterparty due diligence, which should eliminate the possibility of their subsequent tax liability.
In addition, the FTS has finally admitted the need for so-called “full tax reconstruction” (a comprehensive reclassification of transactions previously applied only by the courts) and the ability to deduct actual expenses for corporate profits tax purposes and to offset input VAT on transactions with sham companies. However, this is possible only if a taxpayer discloses the actual suppliers and financial terms in such transactions.
The FTS letter in more detail
In its letter1, the FTS provides examples of illegal misrepresentation of business operations for tax purposes and maintains that transactions need to be performed by real counterparties (not by sham companies).
The FTS urges tax inspectorates to stop using a formalistic approach and instead to analyze in aggregate all the circumstances involved in the concluding and performing of transactions, and to trace financial flows. Tax assessments are admissible only if the tax authorities come to an unambiguous conclusion that a taxpayer has engaged in tax avoidance.
The letter also revisits the concept of counterparty due diligence as a means of ruling out taxpayer guilt (negligence). Although this is a positive change, the FTS has now shifted the burden of proof to the taxpayers, including the review of their suppliers’ business reputation, their location and solvency, the availability of necessary resources and experience, and the assessment of default risks. Also, using suppliers with prices below market levels may be viewed as a conspiracy with a non-bona fide supplier.
The FTS directly confirms that inspectors may perform a tax reconstruction (recalculating the tax results of a company’s actual transactions, without the tax avoidance), but only if there is no guilt or negligence on the part of the taxpayer, and if information is disclosed on the actual suppliers and the terms of such transactions.
Given the position of the FTS, taxpayers should collect and save information on suppliers to support their due diligence. This information will be of crucial importance during a tax audit, including for subsequent successful litigation. Therefore, we recommend revising internal policies on the selection of suppliers and on the approach to documenting relevant steps and compliance procedures in light of the clarifications of the FTS.
The new position of the FTS may substantially affect tax practices on a wide range of transactions. In particular, when looking into cases of tax avoidance, inspectors are advised by the FTS to assess not only the overall economic effect of a transaction, but also its separate elements and steps (similar to the “step transaction” approach in certain foreign countries). The new approach may affect not only complex deals inside Russia, but also transactions with foreign companies, which will require companies to more thoroughly plan, justify and document their transactions.
1 Letter of the Russian Federal Tax Service No. БВ-4-7/[email protected], dated March 10, 2021 “On Application of Article 54.1 of the Russian Tax Code.”