Headline-making case of Oriflame and its consequences for Russian subsidiaries of foreign companies

The decision of Moscow City Arbitration Court concerning the dispute between Oriflame Cosmetics LLC and the Department of the Federal Tax Service of Russia for Moscow (case No. А40-138879/2014) stood the appeal.

The point of dispute is the fact the taxmen denied the Russian company the right to keep cost and tax deduction accounting in regard to licensed payments (royalty) for the usage of the trademark and know-how rights paid to their Dutch founder. Now the company is obliged to pay over 530 million RUB of profit tax, VAT and penalty interests.

The inspection and courts (of three authorities now) found that all business of Oriflame Cosmetics, LLC in Russia is conducted specifically in the interests of the right holder company in Luxembourg which is impliedly a license holder. The judges believe that in such a case the evidence of a ‘dependent agent’ and ‘permanent establishment’ of the foreign company appears. In other words, Oriflame Cosmetics is not a separate and independent legal entity but a representative office of the foreign company. Consequently, it not logical to allow reducing the profit of Oriflame Group in Russia in the cost of what was used up as an object of exclusive rights after the commercial release of Oriflame products.

Despite the fact the district arbitration court tried to assess and refute all significant evidence provided by the company in the cassation appeal, theoretically Russian Oriflame Cosmetics can regain its reputation in the Judicial Chamber of the Supreme Court of the Russian Federation. Even without the legal assessment of the approach to the tax liabilities evaluation, the deficiency of the judicial decision is considered to be the lack of investigation of the tax liability change of royalty recipient and the influence of such tax changes on the whole Group. The attitude of the Tax Service to the possible resettlement (decreasingly) of the excess royalty VAT paid by the tax agent should also be clarified.

Apparently the uncertainty in the present status of Oriflame Cosmetics, LLC and its foreign owners – the taxpayers in Russia – explains the comment of the Federal Tax Service source stating that all similar tax audits will be held with the approval of the FTS central office. This suggests that after the Oriflame case there is no need to expect taxmen’s issues with the royalty expenses of subsidiaries of foreign companies (it is believed that this case may lead to the exclusion of royalty costs but also other expenses of subsidiaries in favour of the parent company).

Thus, the applied approach is just a method to point out the inadmissibility of the bad-covered manipulations with the profit of the Russian subsidiaries. But it is not the ground for massive repressions.

In this case it is risky to advise subsidiaries of foreign companies to urgently review their license agreements with the parent companies as well as the submission of a revised tax declaration based on the attitude of the courts. Besides there is no common royalty practice yet.

Arbitral Procedures similar to ‘Oriflame case’

Until present time the practice of similar cases was setting with taxpayers. The case of ‘Monetka’ is among the most notorious disputes (see Table 2).

In all these cases the courts determined the connection between the expenses incurred within the operations with the foreign parties and the taxpayer’s main activity as well as their influence on profit earning.

However, over the last years the practice of royalty payment to foreign companies that have interdependent relationships with the Russian company is setting against taxpayers (see Table 1).

Meanwhile the courts also directed attention to the fact that the information relayed under the licensed agreement can not be considered as know-how.

Table 1. Adverse Practice

Case	Inspection’s opinion	Court Judgment
Judgment of Ninth Arbitral Court of Appeal dated 25.02.2015 No. 09AP-56340/2014	‘Equant’ LLC incurred royalty expenses under the licensed agreement for the right to use intellectual property. The inspection found that ‘Equant’ and ENSIL belong to one holding company. The funds transferred from Equant, LLC to the account of ENSIL were redistributed to the organization that was a parent company in regards to Equant, LLC. The inspection excluded the royalty expenses paid to the Irish company group of ENSIL.	The courts supported the conclusion that the licensed agreement was meant not for pursuing a rational business goal but the creation and participation in collaboration with a number of affiliated companies in the plan on fund release overseas providing there is no tax burden, which means the receiving of ungrounded profit. Both the inspection and the courts pointed out such circumstances as: the lack of the transaction subject – the intellectual right (know-how), the affiliation and interdependency of the parties of the license agreement, the coordination of their actions; the common knowledge of the information relayed under the license agreement, and the lack of commercial value of such information.
Decision of Supreme Court of the Russian Federation dated 27.08.2014 for the case No. 305-ES-853	The inspection concluded that the taxpayer unlawfully overstated the expenses in calculation of the profit tax for the sums of the paid royalty to the foreign company under the agreement of using the know-how.	The courts and inspection relied on the fact that the license agreement details are well-known and not the know-how. The inspection prepared enough evidence indicating the taxpayer’s intention to minimize the tax burden during the fund distribution in the holding company between the affiliated persons.

Table 2. Positive Practice

Case	Inspection’s opinion	Court Judgment
Judgment of Federal Antimonopoly Service of North-Western District dated 12.04.2010 for the case No. А56-22761/2009	The inspection excluded the royalty expenses from the cost structure for using the trademarks under the license agreement with the foreign company. The conclusion of the tax authority was based on the circumstances indicating the interdependence of the company and the foreign company.	The courts acknowledged the inspection’s opinion as non-effective. In judges’ opinion, the company concluding the license contract acted in accordance with its statutory activity directed to making profit and increasing its figures. The acquisition of trademark rights is necessary for keeping and increasing sales, canvassing of customers, service and goods promotion under the unique and recognizable trademark. Also the courts pointed out that the inspection did not prove the incurred expenses for license payments for the right of using the trademarks were not directed to receive profit by the taxpayer. The inspection did not demonstrate how the interdependency affected (or could affect) the conditions and economic performance of the contract.
Judgment of Federal Antimonopoly Service of Moscow District dated 10.12.2012 for the case No. А40-33064/12-115-6	According to the Inspectorate of the Federal Tax Service (IFTS), the taxpayer unlawfully used the VAT deductible and took into account the royalty expenses in favour of foreign companies under the agreements of non-exclusive license of Castrol and BP trademarks as they are not economically justified. The fact that he contacted the right holder for authorization indicates that the royalty payment was not a compulsory condition of his activity.	The court recognized the opinion of the IFTS as unlawful and stated that the taxpayer received sales profit of goods with trademarks. Consequently, the royalty expenses were unavoidable providing that without them it would be impossible to conduct business of engine oil realization under the corresponding trademarks. Thus, such expenses can be economically justified. The appeal to the right holders means they did not have to give the trademark rights; however, without such rights it would be impossible for the company to conduct its business, thus, the cost accounting of obtaining such rights is legal.
Judgment of Federal Antimonopoly Service of Ural District dated 17.05.2012 No. F09-3637/11	The IFTS declared illegitimate the fact that the expenses of fund transfer to the Cypriot company concerning the trademark were included in the cost structure. The inspection indicated that these funds were transferred by the foreign company in the form of loans for the organizations which were interdependent with the taxpayer, and after that they were refunded to the taxpayer through the chain of interdependent organizations. Thus, the objection of the transactions was not the economic benefit in the form of trademark profit but the tax avoidance of some part of it.	The courts rejected the inspection’s conclusions and stated that the taxpayer proved the economic justification of the expenses and its focus. Besides, the courts came to the conclusion that the tax authorities did not provide proper evidence of interdependence between the taxpayer and the licensor.
Judgment of Federal Antimonopoly Service of Ural District dated 29.12.2011 № F09-8395/11	The Inspection declared illegitimate the fact that the expenses for the ‘Monetka’ trademark were included in the cost structure (under the sublicense agreement). The inspection came to the conclusion that the payments were formal, their aim was to minimize the profit. The Russian taxpayer and the designated persons of the interdependent companies conducted such transactions for the ungrounded overstatement of expenses and not the profit-making.	The courts rejected the inspection’s opinion. Entering into a sublicense agreement, the company acted in accordance with its statutory activity directed to making profit and increasing its figures as well as the development of ‘Monetka’ retail chain. The inspection did not demonstrate how the interdependency of contractual parties affected the conditions and economic performance of the contract.
Judgment of Presidium of the Supreme Arbitration Court of the Russian Federation dated 28.10.2010 No. 8867/10 for the case No. А40-41114/09-151-229	The IFTS and three courts excluded from the cost structure accounted for profit taxation the expenses for the license payments for using trademarks. The inspection and courts indicated that the trademarks were actually used by another organization and not the taxpayer. The royalty payment on the cost of tobacco products realized by the independent distributor caused the overstatement of these payments.	The Presidium of the Supreme Arbitration Court of the Russian Federation declared illegitimate the courts’ findings based on the fact that the justifiability of expenditures can not be assessed from the perspective of their advisability, expediency, effectiveness and the result. The change of the contractual structure within the holding company conducting both production and realization of tobacco products through the organizations – separate taxpayers – and the license payment forwarded from the factory to the taxpayer’s company does not contravene the tax law requirements. It does not matter if there is interdependence between the factory and the company providing the IFTS has no evidence of tax benefit from using the trademarks. Moreover, the IFTS partially accepted the expenses concerning trademark operations and by that recognized them as profit-making.