Russia's Thin Capitalisation Rules in light of the Russia-Cyprus Double Tax Treaty

Russian thin capitalisation rules do not permit a tax deduction for excessive interest payments between related parties. The rules set a maximum debt to equity ratio of 3:1 meaning that if the amount of the controlled debt is three times greater than the borrowing entity's own capital as of the last day of the relevant reporting/ tax period, then Russia's thin capitalisation rules are applicable.

A controlled debt under loan obligations accrues in the following cases:

1) the Russian entity is indebted to a foreign entity controlling more than 20% of the Russian entity's registered capital;

2) the Russian entity is indebted to a Russian entity recognised as an affiliate to the above foreign entity under Russian law; and

3) the above affiliate and/ or foreign company is/are a surety or guarantor for a debt obligation of a Russian entity or otherwise undertake to ensure the performance of its debt obligation.

If all of the conditions for applying these rules are met, a Russian entity may recognise interest as an expense only within limits established by the Russian tax legislation.

Russia's double tax treaties with countries such as Germany and the Netherlands expressly provide for unlimited deductibility of expenses such as interest, i.e. Russian companies which pay interest to German or Dutch creditors may recognise such interest payments as expenses without any limitations. Accordingly, the thin capitalisation rules are not applicable, as the rules would contradict the provisions of the relevant double tax treaties.

However, the Russia-Cyprus double tax treaty does not include a similar provision, potentially rendering the thin capitalisation rules applicable to interest payable by a Russian company to a Cyprus creditor. Nevertheless, on the 23rd September 2009, the Federal Arbitration Court of Moscow issued a decision 1 on the unlimited deductibility of expenses in relation to the Russia-Cyprus double tax treaty based on the anti-discrimination provisions (Clauses 3 and 4 of Article 24 of the Russia- Cyprus Double tax treaty).

According to these provisions the income payable by a Russian company to a company registered in Cyprus for the purpose of determining the taxable profit of the Russian company should, as a rule be deducted on the same basis as if this income had been paid to another Russian company. Further, Russian companies whose capital is fully or partially, directly or indirectly owned by one or several Cypriot companies should...