Daniel Klein’s Legal Line
Each month Daniel Klein fields corporate legal questions posed by Passport’s readers. Do you have a Russia-related legal question you’d like Daniel to address? Tell him about it at: firstname.lastname@example.org
I am the country manager of a Russian limited liability company which is a subsidiary of a western public company. We have been on the market for over 15 years and have already weathered a downturn during the last crisis so we know that the losses that we may incur can be used to offset future profits in terms of tax obligations. We have a large debt with headquarters and net assets approaching zero. I know that Russian tax regulations are quite complex and sticky; is there any reason for concern for this subsidiary?
First off, it is good to see companies with long term views on Russia and fortunately, so far, we have not heard of too many western companies barreling towards the emergency exit as was the case in 1998. In accordance with Russian tax law it is possible to carry forward losses for up to 10 years, so in that regard, it sounds like your losses can effectively be used to offset future profit taxes for those purposes. As a general matter during normal times, loss-making companies can attract the attention of the tax inspectorate sometimes triggering company audits. The public policy behind this is that the government is suspicious of companies that continually lose money; due to money laundering concerns. However, since there are a lot of companies losing money in this crisis, this reason to conduct a tax audit is less frequently applied, at least temporarily.
One concern that comes to mind with the financial profile of your subsidiary is that if your debt is too great, the debt service that you have used in past years to reduce your tax obligations may be in part invalidated if your company is found in violation of the so called “thin capitalization rule.” This rule was enacted in order to prevent companies from taking on oversized or even fictitious mother company obligations with disproportionate debt service obligations, wherein said debt obligations were used to offset profits and hence profit tax obligations. This rule applies to subsidiaries where the lender has more than 20% of the subsidiaries shares. If the tax authorities deem, according to their formula, that the debt service was disproportional to the companies assets, they can rule on a retroactive basis that some part of prior debt payments were a repatriation of profits in disguise, and hence treat them as dividends. As your firm is part of a public company I would be particularly concerned about compliance issues. Another concern that also comes to mind is that if the net assets of your company fall below the charter capital this can be a reason for the tax authorities to liquidate your subsidiary.
In this regard you might consider looking at your charter capital, the company’s net assets, the cost of your operations and reconsider your debt obligations with respect to headquarters. This is probably an ideal time to see how your company can reduce the cost of operations as much as possible either through staff reduction or other methods. If you can turn your company back to profitability this is a great time to do so since the government just dropped, at the beginning of this year, the already low profit taxes, from 24% to 20%. This drop in taxes was actually enacted as a temporary emergency-type anti-crisis measure and these rates may be pushed back upwards in the medium term. Once you return to profitability your company can reduce some of its debt and hence increase its net assets in order to help stave off a potential liquidation due to having net assets less than the company’s charter capital. Also if it turns out that there is a thin capitalization issue, reducing parent debt might be something to consider as well.
Daniel Klein is a partner at Hellevig, Klein & Usov. His column is intended as commentary and not as legal advice.