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Continental Tires RUS Court Case

The negative Judgment of the Supreme Court No 305-ES17–9969 issued of August 9, 2017 regarding the appeal of Continental Tires RUS LLC was received as a pretty bad news.

The facts of the case:

The taxpayer is a Russian dealer of the manufacturer and distributor of Continental AG — ​a public German business group, established in 1871.

The Russian subsidiary Continental Tires RUS purchased tires from affiliated suppliers on payment term of 1–2 months and sold them to customers with a payment term of up to 6 months. To cover cash gaps Russian entity borrowed funds from the parent company. There appears to be no violation of thin capitalization rules though. Interest rate was also moderate, about 4% on RUR currency loans which is 3–4 times lower than cost of borrowing money from banks. Clearly this was not the case of pushing money offshore through a letterbox company.

Position of tax authorities:

Nevertheless, the tax authorities insisted that the taxpayer could get away from the cash gaps if he balanced the payment terms of his suppliers and his customers. Since the suppliers were affiliated entities, in the opinion of the tax authority, it was easy for them to agree on an extension of payment terms from 1–2 to 6 months. Therefore, according to the tax authorities, there was no need for loans and on the basis of this they refused to allow deduction of interest from the tax base.

The position of the taxpayer:

The taxpayer challenged the allegations of tax authorities, claiming that the terms of contracts with independent suppliers were comparable and there were commercial considerations to provide clients with longer payment terms.

The position of the court:

The court supported the position of the tax authority, considered that lending funds from the foreign parent company was economically unreasonable and refused to deduct interest. The court’s conclusions were upheld by the appellate and cassation judicial instances including Supreme court.

Conclusions and recommendations:

The decision seems insufficiently justified and even dangerous in terms of the consequences. The taxpayer did not violate the special rules for limiting the deduction of interest (thin capitalization). Evidence that the practice of the taxpayer differed from the practice of other tire dealers was not presented.

The reference to unjustified tax benefits concept is also not unconvincing. The rate of corporate income tax in Russia is 20%, and in Germany, whereto the interest was paid — ​30.2%, therefore the motives for tax minimization from the court decision are also not apparent.

The tax authorities and the court appear to have went beyond the scope of financial control issues and decided on business matters of the taxpayer.

Nevertheless, we may long argue about errs of the court decision, but it is confirmed by the position of the Supreme Court and it is necessary to draw practical conclusions therefrom.

And they, obviously, can be the following:

  1. Compliance with the rules of thin capitalization does not guarantee interest deduction by itself. It is necessary to analyze market practice, ideally — ​to minimize the weight of loans from related persons and especially from shareholder in the structure.
  2. If tax authorities suspect an underpayment of tax they will not necessarily investigate the case thoroughly. In case at hand, the tax authorities and the court did not calculate the financial effect of allegedly excessive payment terms for buyers, which would be more correct from an academic point of view, but simply disallowed deduction of all interest on the loan from affiliated structures.
  3. The absence of a tax minimization motive does not guarantee the absence of allegations in tax minimization. In this case, the taxpayer was taxed in a jurisdiction with a tax rate of 1.5 times higher than in Russia, and nevertheless received additional tax adjustments on the Russian side.

Roustam Vakhitov