In recent years, cross-border contracts attract more and more attention of the tax authorities of the Russian Federation, which successfully reclassify transactions under various kinds of contracts with foreign companies as payments of dividends or other forms of passive income. One of the most common options for tax transformation of contractual structures of the Russian taxpayer and its foreign counterparty is the qualification of payments for the use of intellectual property objects as payment of dividends.

In this regard the Decision of the Arbitration Court of the East Siberian District from 09.12.2021 № F02-6634/2021 in case № A33-5437/2020 (Johnson Matthey Catalysts case) deserves special attention.

In 2014, DMK LTD. (hereinafter also the "Company") entered into the contract with Johnson Matthey PLC group (UK). Current contracts concerns granting the Company a license for technology ("know-how") and royalty with the right for DMK LTD. to use technical information for the production, use, sale of products (automotive catalysts for low power gasoline engines, high-power diesel engines) and for further research, development, improvement, adaptation and individualization of products.
In the course of the audit, the tax authority concluded that the taxpayer had in fact obtained access to technical information before the agreement with the foreign company was concluded, in connection with which the parties extended the agreement to an earlier period.

Also, according to the contract concluded by the parties, the occurrence of the obligation to pay royalties and the amount of the royalty had been made conditional on the Company's operating profitability, market margin, operating profit, and market return on assets. On this basis, the court concluded that the licensor knowingly refused income from the transaction if the licensee failed to achieve certain economic indicators, determined, among other things, depending on the licensee's profit, which in itself indicates that the conclusion of the contract on such terms could only be carried out if the parties had been interdependent.

The court agreed with the position of the tax authority that the transfer of funds by the Company to Johnson Matthey PLC had been made in the absence of a counter submission, that is, without compensation, and the amount of costs, by which the tax base for income tax is reduced, in violation of Art. 252 of the Tax Code of Russian Federation, has no economic rationale.

Also, referring to the provisions of Art. 54.1 of the Tax Code of Russian Federation, the court agreed with the conclusions of the tax authority concerning the presence of grounds for taxation of the disputed payment’s transactions at a tax rate of 15%, as dividends, due to the presence of the signs of exceeding the limits of rights to reduce the tax justification in the actions of the Company and its mutually dependent foreign counterparty.

The court considered that the arguments of the Company concerning the amount of the tax burden, as well as on the actual payment of tax by Johnson Matthey PLC in the UK, have no legal significance.

Thus, the Resolution of the Arbitration Court of the East Siberian District, Irkutsk on 09.12.2021 is not an isolated example of the case law.
For instance, in the case of Rusjam Steklotara Holding LTD. the payments in favor of a foreign company under the contract of rendering consulting services on technology of production of glass bottles, as well as other issues of production and management had been qualified as dividends. In the course of the audit the tax authorities came to the conclusion that the services had not actually been rendered by the foreign company, and the concluded agreement had been used as a cover for distributing profits abroad.

Moreover, in the case of Galo Polimer Kirovo-Chepetsk LTD., Galo Polimer Kirovo- Chepetsk LTD. also paid for services of a Canadian resident company, which, as the tax audit revealed, were not actually rendered by the foreign company. The tax authorities proved that this income of a Canadian resident should be taxed at the source in Russia at the rate of 20% as "other" income in accordance with Art. 21 of the Agreement between the Government of the Russian Federation and the Government of Canada of 05.10.1995 "On avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and on property".

The similar court decisions are reflected in the case of Holding Mining Company LTD., the case of Mondalis Rus LTD., the case of Nei Oil CJSC.

Consequently, there is a certain tendency in Russian Federation of reclassification of payments exercised from Russia to foreign companies as dividends and additional tax percentage accrual in cases when there are grounds to doubt business purpose or reality of services rendering. Judicial practice shows that the likelihood of success in challenging such actions of tax authorities in court of Russian Federation is extremely low. Therefore, it is recommended to prepare and execute contracts and agreements responsibly in order to exclude any legal and factual circumstances under which the transaction under the contract may be qualified as a «withdrawal of capital abroad».

Olga Tsokhorova

Head of Tax Practice

Valeriia Rzianina

Junior Associate