Recently, the Ministry of Finance (MoF) issued a Guidance Letter (No. 03-03-06/1/87340) and clarified the application of domestic thin capitalization rules in the context of tax treaties. According to a statement by the MoF, interest paid by a resident company under loans qualified as controlled debts is subject to the thin capitalization rules.

According to the article 269(2) of the Tax Code (TC), controlled debts apply in the following situations:

i) If a loan is approved by a nonresident company or a person who is in contact with a Russian debtor under the transfer pricing rules and who directly or indirectly holds at least 25% of the borrower’s capital;

ii) If a loan is granted by a company or natural person associated with the above-mentioned non-resident company or natural person; and

iii) If a loan is granted by a third party, but guaranteed or otherwise secured by one of the above companies or individuals.

In addition, article 269(3) provides that interest is only partially deductible where the controlled debt-equity ratio exceeds 3 to 1, which is increased to 12.5 to 1 for companies carrying out banking and leasing activities.

Article 269(4-6) of the TC provides that a Russian company must calculate, on the last day of each reporting period, the limit of the allowed deductible interest on a controlled debt transaction with a non-resident creditor. Any excess amount is treated as a deemed dividend for which withholding tax must be paid.

The letter further clarifies that the Ministry of Finance’s position is that because an interest payment in excess of the limit would be considered a deemed dividend for Russian tax purposes, it is also considered a dividend for the purpose of an applicable tax treaty and the provisions of the treaty article covering dividend payments would apply.

Article 7 of the TC stated that provisions of tax treaties take precedence over conflicting national legislation. Therefore, interest income which is reclassified as dividends under Article 269 of the Tax Code will be taxed in accordance with the dividends rule under the relevant tax treaty.