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Law enforcement practice in taxation and legal methods of tax optimization

Alexander LemchikManaging director

Prado Structure & Tax Consulting

“The Moscow Times”

Tuesday, December 12, 2006. Issue 3559

The second half of this year has seen a number of changes in state tax administration policy and law practice that have had a considerable effect on tax planning. While the adoption of worldwide doctrines on tax planning by courts and tax authorities leads to improved tax regulation and increased conformity with international principles, it also strengthens the role of the courts in enforcing laws that in some cases neglect legal regulations.

More and more attention is being paid to the worldwide doctrine of the «business objective.» The idea infers that all transactions made by the taxpayer ought to have some economic effect and not be aimed exclusively at acquiring tax benefits. Recently, almost every arbitration court decision concerning tax deductions and the validity of expenses contains conclusions about the necessity of observing the business objective principle and the inadmissibility of unreasonable tax benefits. Regulation of the Supreme Arbitrary Court Plenary Session of the Russian Federation No. 53 on “Arbitrary courts’ appraisal of the validity of tax benefits for the taxpayer,” dated Oct. 12, summarizes all the conclusions formed by arbitration courts during the last few years and inherently forms the direction of judiciary practice and the practice of tax bodies for the future.

The problem with law enforcement is that judiciary practice in the sphere of taxation in some cases differs from the Tax Code and burdens the taxpayer with extra duties not stated by the law. In particular, a generally adopted principle of law enforcement practice obliges the taxpayer to observe and take all possible measures to ensure principled and fair tax payments by counterparts. The same requirement is also stated by judicial practice in the Constitutional Court of the Russian Federation No. 169-O and No. 324-O. Presently, tax authorities and regional arbitrary courts refer to the duty to adopt the resolutions, and therefore the taxpayer must abide by the law, even though tax law regulation contains neither the term “unprincipled taxpayer” nor an instruction to check counterparts’ activities and their responsibility toward unprincipled actions.

In precisely the same way, judicial practice influences tax optimization methods. Methods formally based on tax law regulations that do not contradict them can be considered by courts to be somewhat forced and illegal. Specific characteristics of law enforcement practice show that in most cases decisions made regarding truly unprincipled taxpayers will further infringe conscientious taxpayer’s interests who apply the same methods of tax optimization.

Among the latest court decisions an instance regarding the Izhevsk-based servicing company Reduktor-Energo is worth highlighting. The arbitration court supported the conclusions of the tax authorities, which found that the company had used double-entry accounting and had not declared “envelope” wages. Although the decision concerns a single taxpayer, the Federal Tax Service sent a letter dated July 28 to all tax inspectorates to consider all the arguments contained in the court’s decision. As a result, tax authorities filed complaints with all companies where employees earned less than the average wage in the region. Theses actions by the tax authorities are illegal because the minimum wage is established by federal legislation and only noncompliance with federal legislation institutes proceedings.

A decision by an arbitration court in the Tver region dated Oct. 12 has effectively invalidated the out-staffing scheme (personnel outsourcing), an effective tax planning method used in foreign countries. Tax authorities were able to prove that a company had acted illegally when it divided itself into several legal entities and outsourced personnel from each legal entity to the other reorganized entities to optimize VAT payments. This decision was also sent to all tax inspectorates and therefore the out-staffing approach should be associated with high tax risks in Russia .

Numerous examples can be cited, and the fact is clear: Russian law enforcement practice is emphasized more and more by precedents set in court in a way that is only present in the Anglo-Saxon law system. Substantive legal regulations especially in the field of taxation hold secondary position. Thus taxpayers should not only adhere to legal regulations but a court’s perception of his business activities should also be considered. And experience shows that to forecast a court’s position in tax disputes is becoming more and more complicated.