Outcome of tax audit of intra-group loans in a cash pooling arrangement: 2.5 billion rouble loss deduction disallowed

9 January 2024
Tax Messenger
Russian court cites 2020 OECD Transfer Pricing Guidance on Financial Transactions in ruling on intra-group loans made through a cash pooling system in 2016-2018

Summary and conclusions

The Ninth Arbitration Appellate Court of Moscow (“the Appellate Court”) upheld[1] the position of Interdistrict Inspectorate of the Federal Tax Service for Major Taxpayers No. 1 (“the Tax Authority” or “the Inspectorate”) in a dispute with BSH Bytovyie Pribory LLC (“the Company”, “Bosch” or “the Taxpayer”) regarding the wrongful deduction of interest expenses on intra-group loans obtained from various companies of the Robert Bosch international group (“the Group”) via a cash pooling arrangement in light of the declaration of multi-million rouble losses.

After conducting an audit for the period from 01.01.2016 to 31.12.2018, the Tax Authority came to the conclusion, based on Articles 54.1 and 252 of the Tax Code of the Russian Federation (“the Tax Code”), that the principal effect and purpose of the intra-group loans raised through the cash pooling system was to create a situation of permanent indebtedness, which generated regular losses as a means to minimise tax liability, and thus to enable the artificial redistribution of profit out of Russia in favour of the parent company BSH Hausgerate GmbH without taxes being paid by Bosch in Russia. The Tax Authority therefore:

1. Assessed the following amounts:
  • 22,072,374 roubles – Profit tax
  • 16,029,078.95 roubles – Penalties
  • 2,176,570 roubles – Fine

2. Increased profit tax losses for 2016 by 211,682,992 roubles

3. Reduced profit tax losses for:
  • 2017 by 1,250,245,738 roubles
  • 2018 by 1,236,410,592 roubles
The Appellate Court confirmed that the loan arrangements between the related parties had been made for the purpose of artificially causing funds to be borrowed in the form of loans and, accordingly, artificially bringing about a permanent shortage of working capital in the form of “cash gaps”, which arose by reason of the longer settlement periods under Bosch’s contracts with independent customers in Russia relative to settlement periods between Bosch and its suppliers, which were Group entities.

Since Bosch paid Group companies for supplies before it received revenue from its independent customers in Russia, the business model in question, consisting in the use of amounts of intra-group loans, was designed principally to serve the Group’s financial interests (to benefit the Group financially), since profit derived from the sale of goods within Russia was subsequently paid to Group companies in the form of interest on intra-group loans.

This indicates that there was a co-ordinated arrangement designed to enable the Group to receive additional income in the form of interest on intra-group loans, which is not taxable in Russia, and to provide Bosch with a tax saving by reducing the profit tax base by amounts of interest on loans.

The Appellate Court also concluded that:

  1. The intra-group loans did not have a proper economic basis, i.e., they were not based on market mechanisms and would not have taken place between unrelated entities;
  2. The benefit from participation in the cash pooling system accrued at the level of the foreign lenders within the Group, whereas Bosch, by reason of its permanent indebtedness, had regular losses which caused its tax liability to be minimised.
In adopting its decision, the Appellate Court refers to the approaches of the OECD and cites provisions of the OECD Transfer Pricing Guidance on Financial Transactions (Section C2 – Cash pooling) (“the OECD Transfer Pricing Guidance on Financial Transactions”):

  • Cash pooling by means of the pooling of cash balances forms part of a short-term liquidity management arrangement;
  • The cash pool member is likely to be participating in providing liquidity as part of a broader group strategy, an arrangement in which the member can have a credit or debit position, which may include among its aims a range of benefits that can only be achieved as part of a collective strategy involving the pool members, done for the benefit of all of the pool participants.
  • No member of the pooling arrangement would expect to participate in the transaction if it made them any worse off than their next best option.
  • A multinational enterprise can obtain benefits as a member of the cash pool other than an improved interest rate.

It may be concluded from the above that the Russian tax authorities and courts, in addressing administrative matters and disputes relating to the application of Article 54.1 of the Tax Code, base their approach on the transfer pricing principles and toolsets (country-by-country reports, business activity analysis and financial analysis of comparable companies, use of calculators to evaluate borrowers’ individual credit ratings, analysis of realistically available alternatives and opportunities where intra-group transactions were concluded, etc.) which are set forth in the provisions of the OECD Transfer Pricing Guidance on Financial Transactions, also applying them to tax periods preceding the date of publication on the OECD website.
Details of the case

Bosch filed a petition with the Moscow Arbitration Court (“the Arbitration Court” or “the Trial Court”) against the Tax Authority for the invalidation of the latter’s Decision No. 14-10/20 of 11/04.2022 (“the Decision”), which imposes sanctions on Bosch for the commission of a tax offence. In a Decision dated 30.08.2023 the Arbitration Court wholly rejected the stated claims. Disagreeing with that decision, Bosch filed an appeal against the Decision with the Appellate Court.
It follows from the case files that the Inspectorate carried out a field tax audit of Bosch, covering all taxes and levies, for the period from 01.01.2016 to 31.12.2018. Based on the results of that audit, field tax audit report No. 14-10/7 of 18.08.2021 (“the Audit Report”) was drawn up.
After examining the Audit Report together with the audit materials, Addendum No. 14-10/6 of 29.12.2021 to the Tax Audit Report, materials relating to additional tax control measures and written objections, the Inspectorate issued a Decision according to which:

1. It assessed the following amounts:
  • 22,072,374 roubles – Profit tax
  • 16,029,078.95 roubles – Penalties
  • 2,176,570 roubles – Fine

2. It increased profit tax losses for 2016 by 211,682,992 roubles

3. It reduced profit tax losses for:
  • 2017 by 1,250,245,738 roubles
  • 2018 by 1,236,410,592 roubles

Disagreeing with the contested Decision, Bosch filed an appeal with the Interregional Inspectorate of the Federal Tax Service for Major Taxpayers No. 1. The latter’s rejection of that appeal in Decision No. 2.22-09/11446@ of 11.11.2022 is what prompted the company to file its petition with the Trial Court.

The Trial Court’s Decision dated 30.08.2023[2] rejected Bosch’s claim for the above-mentioned Decision of the Inspectorate to be invalidated.

Disagreeing with this decision, Bosch proceeded to file an appellate appeal. After due consideration, the Appellate Court upheld the Trial Court’s decision and rejected the appellate appeal.

Key conclusions of the courts

In supporting the Trial Court’s decision, the Appellate Court noted that the basis for the adoption of the disputed Decision had been the Inspectorate’s conclusion that the Company, in violation of clause 1 of Article 252 and Article 274 of the Tax Code and with the object of artificially redistributing profit earned from activities in the Russian Federation in favour of the parent company BSH Hausgerate GmbH without paying taxes in the Russian Federation, had improperly included in non-sale expenses amounts of interest charges under the following loan agreements:

  • w/o number dated 13.08.2008 with BSH Hausgerate GmbH
  • w/o number dated 01.01.2013 with BSH Hausgerate GmbH
  • No. 1G5000102 dated 22.10.2015 and
  • No. 1G5000122 dated 15.12.2015 with Robert Bosch Finance Malta Ltd (Robert Bosch Finance Nederland B.V.)
  • No. 1 G8000159 dated 19.12.2018 with Robert Bosch Finance Nederland B.V.
  • No. BSHPB-RB 01-15 dated 15.12.2015 and
  • No. BSHPB-RB 02-15 dated 10.02.2016 and
  • No. BSHPB-RB 03-15 dated 12.04.2015 with Robert Bosch GmbH.

Presented in table form below are the tax authority’s key findings, which are based on facts established in the course of the tax audit and were supported by the courts of both instances.
Bosch’s main arguments:

  1. The court incorrectly assumes that cash shortages are caused solely by the different payment periods under agreements with suppliers and buyers. The court also failed to consider Bosch’s arguments regarding the “cash gap” issue, since the deficiency arose with respect to all current expenses.
  2. The Inspectorate fails to note the fact that in 2020 the global economic situation was heavily influenced by the spread of COVID-19
  3. Around 81% of Bosch’s purchases were made for its own manufacturing operations (the activities of its factory) from independent suppliers which are not Group companies.
  4. The court did not properly consider the matter of the shortage of funds to cover all current expenses, while the Inspectorate’s conclusion was made without due consideration of customary business practices and specific factors involved in the conduct of business.
  5. The Inspectorate criticises debt financing on account of its intra-group nature, disregarding the fact that it would not make economic sense for Bosch, when faced with a genuine cash deficiency, to seek a different source of financing.
  6. If Bosch had raised debt financing from independent banks rather than from intra-group sources, the Company’s interest expenses would have been 502,697,996.41 roubles higher.
  7. Bosch prepares an annual business plan based on which it determines its borrowing needs. Then, when preparing financial forecasts (liquidity management plans / liquidity planners) for the following year, the financial department determines what amount of borrowing Bosch will need.
  8. The payment period for settlements with suppliers is set in accordance with Group-wide policies.
  9. Disagreements with counterparties holding a dominant position on the Russia market and a refusal to work on their terms could have led to losses owing to the termination of contracts.
  10. The court failed to consider the main reasons why indebtedness arose in the audited period and past periods.
  11. Insisting on the acceptance by BSH Hausgerate GmbH of Bosch’s contractual terms would lead to a risk of the flow of goods from that foreign supplier being terminated, which would make it possible for the Company to operate.
  12. The Inspectorate selected the set of comparable companies based on their type of activities without a detailed analysis of their functional profile and risks. This is an improper approach and prevents the formation of reasonable conclusions when subsequently comparing the contractual terms of supplies.
  13. The Company’s decision not to charge customers fines, forfeitures and penalties for late payment and not to seek compensation for overdue payments was motivated by economic considerations in accordance with normal business practice.
  14. The court ignored the argument that all the Inspectorate’s claims are based not on non-compliance with tax law but on an evaluation of the business model and the reasonableness of business activities.
  15. Bosch faced a number of factors which posed a threat to the stability of its business operations and its ability to maintain profitability (the fall in real household income, changes in consumer expectations, etc.).
  16. The Inspectorate unlawfully dictates a different business model to Bosch without considering objective economic factors, thereby encroaching on its freedom of business activity, citing case law, including Constitutional Court Determinations No. 320-O-P and No. 366-O-P of 04.06.2007 and No. 1072-O-O of 16.12.2008.
  17. Relationships between Bosch and independent customers (retail networks) cannot create legal consequences for BSH Hausgerate GmbH.
  18. The provisions of Article 54.1 of the Tax Code cannot be applied in the case concerned.
Features and significance of the court case

The debt financing arrangements referred to in this court case, which result in interest expenses being included in non-sale expenses, thereby reducing the taxable base and the amount of tax payable to the budget, are a classic example of intra-group debt financing transactions in the transfer pricing context between a Russian company and foreign related entities.

To minimise the risk of tax challenges in such situations it is essential to carry out a thorough analysis of operating and/or procurement and supply models which are created and implemented by foreign multinational groups in the Russian Federation, taking account of all intra-group transactions that take place in order to avoid situations in which distributors have permanent indebtedness, i.e., the use of operating models that are not geared towards the derivation of profit at the level of the Russian companies of multinational groups.

The court case described above emphasises the importance of:

  1. Designing operating models and procurement and supply models which are in keeping with market and industry practices and are based on market conditions for the conclusion of intra-group transactions
  2. Concluding intra-group financial and non-financial transactions which are priced in line with market price ranges
  3. Compliance with the principle of economic justification in deciding on the conclusion of all types of intra-group transactions in the context of the general operating model which is used for the conduct of business
  4. Compliance with the provisions of Russian transfer pricing law and the approaches set out in the OECD Transfer Pricing Guidance on Financial Transactions.
How can B1 help?

B1 has many years of experience in providing tax advice in the area of transfer pricing and advice on improving and transforming business operating models which entail various kinds of financial and non-financial intra-group transactions.

B1’s experts are ready to provide support in the following areas:

1. Review and transformation of existing and assistance in the development of new operating and procurement and supply models, including:

  • Detailed financial analysis and analysis of interaction between structural subdivisions in concluding intra-group transactions and transactions with unrelated entities
  • Analysis of existing business processes and identification of factors giving rise to transfer pricing and unjustified tax benefit risks
  • Design, financial modelling and implementation of target operating and procurement and supply models
  • Analysis of key tax implications of the implementation of target operating and procurement and supply models
  • Analysis of the procedure for the targeted allocation of profit and economic benefits in operating and procurement and supply models, and development of transfer pricing policies.

2. Development of the documentary infrastructure of operating and procurement and supply models, including:

  • Development of regulations and responsibility assignment matrices, description of business processes, development of new or adjustment of existing job descriptions related to the conclusion of intra-group transactions and related party transactions.

3. Conduct of comprehensive benchmarking studies of market prices and financial ratios for various kinds of financial and non-financial intra-group transactions which take place in the context of operating and procurement and supply models.

4. Assistance in the preparation of Notifications and TP Documentations for various kinds of financial and non-financial intra-group transactions (the main purpose being to confirm that transaction prices are at market level for taxation purposes), taking account of other tax risks which may arise in this connection.

  • Preparation of Defence Files and calculations demonstrating that transactions are priced in accordance with their economic substance, including for the purpose of minimising the risk of the reclassification: of debt as capital - Debt-Capacity analysis; of various payments as disguised dividends, etc.
  • Support during pre-audit processes, tax and transfer pricing audits, and in litigation proceedings on transfer pricing matters.
  • Assistance in concluding advance pricing agreements and applying for mutual agreement procedures with tax authorities.

Authors:
  • Yuriy Mikhailov
    Director
    Transfer Pricing Services for Financial Institutions and Financial Transactions
  • Evgeny Korabelnikov
    Manager
    Transfer Pricing Services for Financial Institutions and Financial Transactions
  • Polina Rachkova
    Advanced Staff
    Transfer Pricing Services for Financial Institutions and Financial Transactions
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