Russia is a challenging market for deal-making

The regulatory and political agenda may continue to make some investors wary, but the opportunities available in the Russian market cannot be ignored. As tax uncertainty remains one of Russia's attributes, investors have to think strategically about the potential impact on the value of tax risk in relation to Russian M&A.

A merger exposes the legal successor to all liabilities of the merged companies including liability for tax violations. An acquisition may prompt closer scrutiny of the target by the tax authorities on the basis that through the new shareholder it may have access to increased resources, making financial claims against the target in relation to past tax violations more likely. The following summarises some of the key areas to consider when structuring M&A transactions in Russia.

A key issue for investors contemplating an acquisition or merger is assessing the transfer pricing risks of a target company that have arisen after January 1 2012. Before this date, the tax authorities were only successful in making transfer pricing adjustments in a minority of cases. This was because of the combination of a safe harbour, which meant that no adjustment could arise provided the actual price paid was within 20% of the market price, the scope of controlled transactions being narrower and the burden of proof being often too high for the tax authorities to substantiate.

The new transfer pricing regime is broadly in line with OECD principles and allows the tax authorities much greater scope for making transfer pricing adjustments and imposing additional tax liabilities if the transaction price deviates from the market price.

There is considerable uncertainty as to how the tax authorities will interpret the new legislation in practice given that the first transfer pricing audits covering 2012 cannot start until later in 2013. Also, while government sources have stated that in their view there is a need for numerous amendments to the rules, the nature and timing of these amendments remain unclear. Therefore, taxpayers have to make huge efforts to prepare for potential challenges and develop copious transfer pricing documentation without full knowledge of what the final transfer pricing regime will be.

The transfer pricing rules provide that certain major taxpayers may apply for an advanced pricing agreement (APA) to fix the pricing mechanism used to determine future tax liabilities related to their controlled transactions. APAs are restricted to legal entities that are registered in Russia (including foreign-owned companies) and the maximum term is only three years. According to publically available information, the tax authorities have, as of February 2013, concluded APAs with only three groups of companies: NK Rosneft, Gaspromneft and Aeroflot.

A key issue in relation to inbound investment is how best to structure the provision of finance. Historically, investors have tended to favour loans over equity. Cross-border loans can be in foreign currency, can be freely repaid and can be governed by foreign law. For tax reasons, loans to a Russian company from foreign sister companies have been preferable to parent-company loans or third-party loans guaranteed by a foreign parent (since the latter are caught by Russia's thin capitalisation rules whereas foreign company sister loans are not). However, a number of developments in the last year have either limited the tax efficiency of loan finance or increased uncertainty as to the extent and timing of interest deductibility.

In 2010, the general limits on the deductibility of interest were changed unexpectedly. The intention seems to have been to encourage the greater use of Russian currency by making loans in other currencies less tax efficient. Interest deductions were limited to:

• 180% of the Russian Central Bank refinancing rate for debt obligations in roubles (14.85% as of February 2013);

• 80% of the Central Bank refinancing rate for debt obligations in foreign currency (6.6% as of February 2013).

These limits were originally applicable until December 31 2012. An amendment extending their application until December 31 2013 was enacted in late 2012.

Taxpayers may instead choose to calculate deductible interest based on the average level of interest charged on third-party comparable loans. However, comparable loans may be hard to identify in practice. Such loans must have been issued in the same tax accounting period (either a month or a quarter), in the same currency for the same term, in comparable amounts and against similar collateral.

In the course of the last two years, Russian judicial interpretation of the thin capitalisation rules has been contradictory and has increased uncertainty for taxpayers. This has led many taxpayers to adopt a conservative position regarding their debt funding, staying within the three-to-one debt-to-equity safe harbour in cases where a strict reading of the legislation would allow them higher levels of debt. The two principal areas of uncertainty are:

• Whether the Russian domestic thin capitalisation legislation overrides any relief in Russia's double taxation treaties;

• Whether loans from a foreign sister company should be treated as within the thin capitalisation rules (where a 2012 court case held they should, the funds having been provided "in substance" by a foreign shareholder).

A decision by the Presidium of the Supreme Arbitration Court (the superior judicial body for the resolution of economic disputes and other cases examined by arbitration courts) in November 2011 supported the tax authorities' view that treaty relief does not override domestic thin capitalisation rules. Most subsequent (lower court) decisions have followed this precedent but not all.

Regarding the question of whether loans from a foreign sister company should be treated as within the thin capitalisation rules, the Naryanmarneftegas case is expected to have wide-ranging consequences, as such financing is very widely used to finance subsidiaries in Russia. Certain circumstances that increase tax risk may be deduced from the court's rulings in the case. Unfortunately, the circumstances in question often arise in the cases of joint ventures and consortia (for example, the terms of loans being established in the shareholders' agreement rather than through negotiations between the parties to the loan and requests for additional funds being subject to shareholder approval rather than being granted at the sole discretion of the lender).

The long-established practice in Russia is that interest is deductible in the tax period in which it accrues, regardless of the date of payment. Such practice has been repeatedly confirmed by the fiscal authorities. However, in the 2009 SaNiVa case, the recognition of an interest deduction on an accrual basis was successfully challenged. However, in that case, the loan agreements stated that no interest was to be paid until after the loan had been repaid. This provided grounds for the view that the unprecedented decision in the SaNiVa case arose from the specific facts of the case rather than suggesting the existence of a more general principle by which accrued interest could be disallowed. Following the case, the fiscal authorities issued a number of official clarifications confirming that, in their view, interest was still generally deductible on an accrual basis.

However, in late 2012 the Russkaya Nedvishimost case and the Nastyusha Chernosemie case again cast doubt on the availability of a tax deduction for accrued interest, causing concern for investors. In these cases, interest was due for payment during the term of the loans, but later than the tax periods in which interest had been accrued. The courts held that no tax deduction was available on an accruals basis.

The decisions in the Russkaya Nedvishimost and the Nastyusha Chernosemie cases seem to irrevocably dispel the view that the court decision in the SaNiVa case arose from the particular wording of the relevant loan agreement and did set a more general precedent.

The potential implications of these cases are very broad, but at this stage, investors are advised to carefully review wording in loan agreements to ensure there is nothing that could support interest deductions being disallowed in the periods the interest accrues, for example clauses that could be interpreted as meaning the borrower's interest liability for the use of funds received arises at a later date than the commencement of the loan. It must be clear from the terms of the loan that irrespective of when interest payments are to be made interest expenses are incurred and properly accrued from the tax period in which indebtedness to the lender first arises.

Since January 1 2012, the provision of loans (including interest-free loans) has been covered by the transfer pricing rules as well as the thin capitalisation rules. This was not previously the case. Interest-free loans, a common method of funding within Russian groups, are no longer possible without the risk of taxable income being imputed on the lender.

One of the key areas for M&A activities in the near future is likely to be the exploitation of mineral resources on Russia's continental shelf. The key players will be licence holders (limited to a handful of Russian-majority state-owned companies), operators and contractors. Participation by international oil companies (IOCs) is likely to be restricted to acquiring minority interests in operators engaged to provide services to licence holders and providing loans including carries. A number of IOCs are at various stages of negotiating joint ventures with Russian licence holders to take on projects on the continental shelf through some form of operating contract. Many other foreign companies are actively pursuing opportunities to act as contractors or to supply equipment for such projects.

In April 2012, to enhance the investment appeal of new projects for the development of offshore hydrocarbon deposits, the Russian government issued a regulation envisaging special tax and customs benefits for offshore oil and gas projects. The regime proposed in the regulation will apply to projects in which commercial extraction will commence after January 1 2016 and which are not already eligible for tax benefits or exemptions from export duty. The regulation defines four project categories, according to the degree of technical difficulty, natural and climatic conditions, ice conditions, sea depth, the geological difficulties of current and potential fields, the distance from shore and the availability of coastal infrastructure.

The rate of mineral extraction tax (from 5% to 30%) and the period of tax stability guaranteed under the proposed regime (from five to 15 years after production begins subject to specified cut-off dates) for a project will depend on its category. The regulation envisages a number of other benefits, notably exemption from export duties on hydrocarbons extracted from offshore deposits and the carry-forward of tax losses for a period of 70 years.

The regulation does not specify the extent to which the tax and customs regime prescribed is intended to apply to operators or other contractors, although there could be some implications once the draft legislation is released. Nor does the regulation outline how foreign organisations' shelf activities are to be taxed (the Tax Code does not envisage the possibility of a foreign organisation being subject to profits tax on income attributable to a place of activity on the continental shelf outside Russian territorial waters).

Draft legislation based on the issued regulation was meant to be prepared by October 1 2012, but no draft had been published at the time of writing. We understand that work on the proposals continues.

Recent court practice demonstrates that the Russian tax authorities have become more adept at applying international tax concepts such as permanent establishment (PE), in particular challenging the non-commercial status of foreign companies' representative offices. The range of tools used by the tax authorities has expanded in recent years. They have successfully used international exchanges of information and interviews with representatives of counterparties, as well as more established methods, such as interviewing a taxpayer's employees and carrying out analyses of internal documents and correspondence. A number of foreign organisations have failed to appreciate that carrying out the main business activities of an organisation via a representative office can give rise to a PE even if the negotiation and concluding of sales contracts are carried out elsewhere. It is clear that attention should be paid to managing PE risks, particularly when evaluating the tax exposures of targets with a Russian representative office.

Last year, Russia ratified amendments to its tax treaties with Cyprus, Luxembourg and Switzerland. The changes will be of considerable interest to inbound investors into Russia. The key amendments are summarised in the table below.

Key treaty amendment	Cyprus	Luxembourg	Switzerland
Elimination of withholding tax on interest
Minimum tax rate on dividends decreased from 10% to 5%
Unambiguous statement that the provisions of the articles “dividends” and “interest” do not override domestic thin capitalisation rules
Capital gains derived from the sale of shares in property-rich companies may be taxed in both states	1
New information exchange provision (in line with the OECD model)
Treaty benefits may be denied when conduit companies are used
The definition of a permanent establishment has been broadened
In cases of dispute, the "place of effective management" of a taxpayer to be determined by mutual agreement of the competent authorities
1 From January 1 2017

Cyprus was removed from Russia's black list (effective January 1 2013), and the most important practical consequences of this removal are:

• A zero-profits tax rate now applies to dividends received by Russian companies from their Cypriot subsidiaries; and

• Transactions between Russian and Cypriot unrelated parties are no longer automatically subject to transfer pricing control.

Removal from the black-list will make Cyprus a much more appealing holding company location for outbound investors. New tax treaties with Argentina, Latvia and Chile have also been ratified by Russia.

The changes occurring and proposed in Russia in the last year could substantially affect investors' assessment of the tax risks and benefits of investing in Russia. It will take time, audits and case law decisions to reduce tax risk/liability uncertainty. In our view, the increased application of OECD principles is a positive trend that should allow multinationals, including outbound investors, to benefit from greater consistency with other jurisdictions in which they operate.

The views reflected in this article are the views of the authors and do not necessarily reflect the views of the global Ernst & Young organisation or its member firms.

Maureen O’Donoghue
		Executive director, tax Ernst & Young Tel: +7 495 228 3670 Mobile: +7 985 991 0129 Email: maureen.odonoghue@ru.ey.com Maureen O'Donoghue is an executive director in the transaction tax group in Ernst & Young's Moscow office. Maureen moved to Russia in 1997 after several years working for Ernst & Young in London. She has extensive experience in the areas of structuring cross-border transactions, joint ventures and other forms of in-bound investment, including evaluating tax risks and advising on Russian domestic tax issues. She also has considerable experience in tax due diligence work in connection with proposed listings and acquisitions. Maureen graduated from Cambridge University. She is a Chartered Accountant and a Chartered Tax Adviser. Maureen is the editor or Ernst & Young's monthly Russian Tax Brief and a regular contributor to international tax publications on Russian tax issues.

Sergey Pogorelov
		Senior, transaction tax Ernst & Young Tel: +7 495 755 9700 Mobile: +7 926 579 4867 Email: sergey.pogorelov@ru.ey.com Sergey Pogorelov is a senior tax consultant in the transaction tax services group in Ernst & Young's Moscow office. He has more than five years' experience of providing tax advisory services, mostly related to M&A activities and structuring investments in Russian assets. Sergey has advised on numerous transactions in the Russian oil and gas, utilities, mining and real estate industries, including acquisitions and incorporation of joint ventures. He also has substantial experience of providing international tax planning services to Russian and multi-national clients. Sergey participated in a large number of tax advisory projects for the largest Russian state owned companies.