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The court brought the company to tax liability for repurchasing its own shares from the sole shareholder of the offshore company

On 23 October 2018, the Arbitration Court of the West Siberian District dismissed the complaint of Melnik JSC without satisfaction, confirming the position of the appellate court. We remind you that on 24 July 2018, the Seventh Arbitration Appeal Court adopted a very significant ruling that changed court practice regarding the income qualification in case of repurchase of shares from the sole shareholder of an offshore company. Previously, such transactions did not arouse interest in the tax authorities and were not checked deep enough.

Case background. In July 2014 the foreign company Hudson River Russia Limited, registered in the offshore jurisdiction of St. Kitts and Nevis, became the sole shareholder of the Russian Melnik JSC with a 100% stake. However, already in December of the same year, the company submitted an application to Melnik JSC for the acquisition by the company of its own shares. Melnik JSC has concluded an agreement with its sole shareholder and paid for the shares.

Later, the Interdistrict Inspectorate of the Federal Tax Service of Russia for the Largest Taxpayers of the Altai Territory established that the JSC did not fulfill the duty of the tax agent to withhold income tax when making payments to a foreign organization, provided for by paragraph 1 of Art. 310 of the Tax Code of the Russian Federation. The tax authority considered this a tax evasion scheme through share repurchases. At the time of the share buy-back from Melnik JSC there was a significant amount of retained earnings, which, if distributed, would be subject to taxation in accordance with paragraph 1 of Art. 309 of the Tax Code of the Russian Federation, since there is no international treaty on the avoidance of double taxation between Russia and the Federation of Saint Kitts and Nevis. And in order to evade this tax, Melnik JSC has repurchased shares from its sole shareholder, a foreign organization, since this operation is not taxable by virtue of paragraph 2 of Art. 309 of the Tax Code of the Russian Federation. In the opinion of the Federal Tax Service, the consistency of the actions of the company and its sole shareholder, in which proof the Federal Tax Service referred to the circumstances of the signing and execution of the contract of sale and purchase, testified about the imaginary operation. The conclusion reached by the Federal Tax Service Inspectorate was that the foreign company Hudson River Russia Limited did not benefit from this transaction and is not the actual recipient of income.

Court of First Instance. The court of first instance took the side of Melnik JSC, indicating that the transaction was not fictitious and complied with the current legislation, had legal consequences stipulated by the contract of sale, was taken into account in accordance with its actual economic sense.

The Court of appeal. The Seventh Arbitration Court of Appeal by decree of 24 July 2017 in case No. A03-21974/2017 reversed the decision of the first instance and concluded that Hudson River Russia Limited was not really the actual recipient of the income, and the buyback of the shares in essence masked the payment of dividends, as evidenced by a number of circumstances, such as:

  • Melnik JSC for a long time did not distribute dividends;
  • The sole source of income for the shareholder company was income received from Melnik JSC, and the shareholder company did not have a de facto right to the income received, since the shareholder had limited authority to manage the income and did not decide on its use or further transfer – this conclusion of the court It is of interest because this is the first time that the concept of the actual income recipient was used not in a dispute over the application of a double tax treaty, but as in recognition of the transaction to the scheme for tax evasion;
  • The activities of Melnik JSC and the shareholder company were controlled by one person who had the opportunity to influence the approval of the transaction from both parties;
  • Shortly before making a deal to repurchase own shares, a reorganization was carried out, as a result of which the offshore company Hudson River Russia Limited became the sole shareholder of Melnik JSC;
  • The person who signed the contract for the sale of securities on behalf of the shareholder company did not directly relate to it and confirmed that the representation had a formal character.

The Court also noted that an unjustified tax benefit may also occur as a result of evading the duty of a tax agent, and therefore Melnik JSC is a beneficiary under the share repurchase transaction.

Court of Cassation. On October 23, Melnik JSC was also unable to defend its position in the cassation instance: Arbitration Court of the West Siberian District dismissed the cassation appeal.

Foreign experience. Such an approach to buying out own shares (buyback) by a company is new to Russian judicial and tax practice – previously, buying back own shares was not considered as a tax optimization scheme. However, in other countries (for example, in the United Kingdom, Australia or South Africa), legal provisions are in force in which situations such a ransom is recognized as payment of dividends, and in which such retraining is unacceptable. The main guideline is the business purpose of the repurchase and what it is – in the distribution of profits, reducing the risk of hostile takeovers, increasing market capitalization, changing the ownership structure or evading taxation. Thus, in accordance with article 658 of the Companies Act 2006 of the United Kingdom, the repurchase of own shares is legitimate if the company acquires its securities to reduce its share capital or the obligation to repurchase is entrusted to the company by virtue of a court decision.

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