Tax reclassification of royalties paid for rights to use know-how as dividends under art. 54.1 of the Russian Tax Code

In May 2021, a court of first instance issued a judgement in the Johnson Matthey Catalysts LLC (JMC) case upholding the decision of the tax authority to reclassify royalties paid by JMC to its ultimate parent company - Johnson Matthey PLC (UK) - under a licence agreement for the rights to use technology (know-how) as dividends, subjecting them to 15% Russian withholding tax.

Intragroup royalties have been the subject of tax disputes a number of times before. However, the JMC case that was considered on the basis of general anti-abuse rules (article 54.1 of the Russian Tax Code) is especially noteworthy.

It appears that the key facts of the case are fairly common and claims of this kind may potentially be brought against a wide range of taxpayers paying intragroup royalties.

In this alert we give an overview of the key aspects of the case and the tax authority's conclusions and arguments that were sustained by the court of first instance.

Summary of the JMC case

As follows from the judgement,¹  in 2014 JMC entered into a licence agreement with its ultimate parent company - Johnson Matthey PLC (UK) (JM) - for the grant of a licence for technology (know-how) for manufacturing and selling products with the payment of royalties at the rate of 6% of JMC's revenues. The licence agreement was retroactively extended to cover 2013.

The tax audit was performed for 2014-2016. The tax authority reclassified the royalties JMC paid in 2014 for 2013-2014 as disguised dividends, charged Russian withholding tax at the rate of 15% and denied the profit tax deduction of this expense. This was done on the basis of article 54.1 of the Russian Tax Code.

According to information set out in the judgement, JMC did not incur any royalty expense for 2015 and 2016 as certain financial indicators stipulated by the licence agreement were not reached.

The court upheld the conclusions of the tax authority regarding the non-performance of the licence agreement (standard claims in relation to the quantity and quality of documents substantiating the feasibility of the transferred technology), the absence of a reasonable business purpose, the atypical nature of the deal for ordinary civil transactions and the focus of the parties on the tax saving, having specifically noted the following:

JMC had been using the know-how before, but on a free of charge basis

• Part of technical information (know-how) was transferred to JMC long before the execution of the licence agreement (starting from the launch of production in 2008) and was therefore used by JMC before on a free of charge basis. After 2014 the technology and process did not change.
• For this reason the court concluded that the main feature of know-how – the fact of it not being known to the licensee prior to the execution of a licence agreement (article 1465 of the Russian Civil Code) – is absent.
• Therefore, as set out in the judgement, when concluding the licence agreement, JMC did not in fact purchase any right that it had not had before then; it only assumed an obligation to pay royalties, which is not in line with the principles of business purpose, could have been done only in the case of the parties being related entities and indicates the intent of the parties to obtain tax savings.

Transfer of the licence to use know-how to JMC is linked to JM's shareholder activities

• It was noted by the court that JMC is not economically independent and is controlled by JM, especially considering JM's involvement in the sourcing and approval of JMC's clients; the use of the same trademark, website, corporate email and software by the group; JM's involvement in the consulting and coaching of JMC's personnel; the consultations between JMC and JM regarding changes to the manufacturing technology, and the fact that JM has access to JMC's annual accounts.
• In the opinion of the court, these circumstances indicate that JM's instructions on changes to the manufacturing procedure, related to the use of know-how, are given to JMC within the framework of JM's shareholder activity and corporate relations and therefore the deductibility requirements of article 252 of the Russian Tax Code for such expenses are not satisfied.

Royalty calculation model

• The condition of the licence agreement requiring that adjustments should be made to the amount of royalties due if JMC fails to reach the arm's-length level of the profitability on sales and assets (which is essentially the knowingly renunciation by JM of part of income under the licence agreement under certain circumstances) is an indication that interdependence of the parties influenced the deal, since such a condition could not have been incorporated in an agreement between non-related entities.

UK tax rate of 21%

• In the opinion of the court, JMC's arguments that the group did not have any tax savings under this arrangement because JM paid tax in the UK at the rate of 21% are irrelevant from a legal perspective in view of the actual non-performance of the licence agreement and the conclusions of the court that the primary purpose of the deal was to obtain tax savings.
• To be more specific, the court believes that the applied UK tax rate of 21% should be compared with the overall tax rate in Russia of 35% (15% withholding tax rate in relation to dividends plus 20% profit tax if royalties are considered as deductible expenses).

Russian dividends withholding tax of 15%

• Especially noteworthy is the tax authorities' position that was upheld by the court saying that the application of a reduced 10% dividends withholding tax rate under the Russia-UK treaty to "royalties reclassified as dividends" is not allowed, since JMC's conduct shall be considered as the abuse of rights.
• In substantiation of this conclusion, which we consider to be quite disputable, the court cited the Ruling of the Supreme Court's Judicial Panel for Economic Disputes of 7 September 2018 in case No. А50-16961/2017 and paragraph 13 of an Overview of the Practice of Determining Disputes Relating to the Protection of Foreign Investors of 12 July 2017.

What to consider

The JMC case shows that in the current Russian tax environment the payment of intragroup royalties remains high risk and requires solid economic and business substantiation, especially in the event of changing the model the group applies for intellectual property rights use, royalty rates, etc.

One should keep in mind that, with the application of the general anti-abuse rules (article 54.1 of the Russian Tax Code), the approach of tax authorities and courts to imposing surcharges in disputes of this kind is becoming more aggressive. To be more specific:

• in the JMC case, disputable royalties were successfully reclassified by tax authorities as dividends, which gave them grounds for surcharging withholding tax (in relation to royalties the JMC case is the first example of such reclassification);
• a standard 15% dividends withholding tax rate was applied in view of the establishment of the fact of an abuse of rights. Earlier such approach was not upheld by the courts. For example, the Russian Supreme Court indicated a number of times that where an unjustified tax benefit is identified, this implies the imposition of a surcharge on the tax payable to the budget (as if the taxpayer had not committed an abuse of rights) rather than the imposition of additional sanctions in the form of the denial of the appropriate tax rate.²

A preliminary assessment of the tax risk level in connection with the payment of royalties and revisions to the terms of existing licence agreements (where necessary) and preparing, long in advance, a ‘‘defence file”, as detailed as possible and containing a substantiation of the business need to pay royalties and the amount of such royalties, are the key recommendations for mitigating this risk.

¹ Judgement of the Arbitrazh Court for the Krasnoyarsk Territory of 7 May 2021 in relation to case No. А33-5437/2020
² Rulings of the Russian Supreme Court's Judicial Panel for Economic Disputes No. 305-КГ17-20231 of 5 April 2018 in relation to case No. А40-176513/2016 and No. 304-КГ17-8961 of 6 March 2018 in relation to case No. А27-25564/2015