The method of transferring of funds free of charge, used by many foreign investors to finance their Russian subsidiaries, is again threatened by adverse tax consequences.

The receipt by a Russian legal entity of funds free of charge has always been linked to various possible tax, civil and other risks. Although a gratuitous transfer of funds can be qualified as a donation, which is prohibited by Russian law in relations between commercial organizations, many foreign investors use this method of financing their Russian subsidiaries as an alternative to granting a loan or making a charter capital contribution. Investors must have a clear understanding, however, of the tax risks that may arise in connection with a gratuitous transfer of funds.

Many will recall how RF Constitutional Court Ruling No. 169-O dated April 8, 2004, created the risk of a taxpayer not receiving a VAT deduction due to the taxpayer’s lack of "actually incurred expenditure" on tax. As an example of the lack of "actually incurred expenditure," the RF Constitutional Court referred to the payment of VAT to a supplier of goods, works or services by means of transfering funds previously received free of charge by the taxpayer.

In addition to the VAT-related risk, the RF Ministry of Finance has recently outlined another risk arising from the use of funds received free of charge, this time in relation to profit tax: Letter No. 03-03-06/1/173 of the Ministry of Finance dated March 27, 2007, contains a reference to the fact that a taxpayer’s expenses paid using funds received free of charge are not taken into consideration for taxation purposes. This effectively cancels out the provision set forth in Article 251 (1.11) of the RF Tax Code, which states that when calculating the tax base, revenue in the form of assets received by a Russian organization free of charge from an individual or legal entity is not taken into consideration if over 50 percent of the recipient’s charter capital consists of a contribution from the party transferring the assets, and the assets received are not disposed of by the recipient within one year.

It should be noted that the Russian tax authorities have, from time to time, made attempts in the past to deny taxpayers the recognition of expenses incurred using funds received free of charge. However, where disputes have arisen, the courts have sided with the taxpayers. The Ministry of Finance has also, on a number of occasions, provided explanations on issues regarding the application of Article 251 (1.11) of the RF Tax Code, interpreting this provision in a number of instances not in the taxpayers’ favor.

As compared with the Ministry of Finance’s previous explanations, Letter No. 03-03-06/1/173, contains a much broader interpretation of the consequences of a gratuitous transfer of funds – the inability to reduce taxable profits by the sum of expenses paid using such funds, irrespective of the period during which such expenses are incurred by the taxpayer. Furthermore, the Ministry of Finance clearly fails to take into consideration the fact that when any funds are credited to a taxpayer’s account, such funds can no longer be identified, and, in practice, it is extremely difficult to determine which funds have been used for which expenses. The fact that Letter No. 03-03-06/1/173, contains an explanation regarding funds to be transferred by an individual to a Russian organization should not have any legal effect, since the tax consequences should be identical to those in the case of the transfer of the funds by a legal entity.

Since Letter No. 03-03-06/1/173 is not based on any legislative provisions on taxes and levies, the validity of the position it sets forth raises serious doubts. Notwithstanding this, taking into account that the Ministry of Finance provides explanations on issues of the application of legislation on taxes and levies which are binding on taxpayers, the probability of this letter being applied by the tax authorities in resolving the issue of the correct assessment by taxpayers of the profits tax base is high.

It is remarkable that these explanations have been issued by the Ministry of Finance shortly after the recently adopted Ruling of the Plenum of the RF Supreme Arbitration Court, No. 53 dated October 12, 2006, which explicitly states that the validity of the receipt of a tax benefit, which unquestionably includes the reduction of taxable profits by the sum of expenditure, cannot be dependent upon the methods of raising capital for economic activities. Whilst no extensive practice of the application of this Ruling by the arbitration courts has yet been established, there are grounds to believe that in the event of a dispute with the tax authorities regarding the tax consequences of receiving and using funds received free of charge, the courts would rule in favor of the taxpayers.

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