Debt Financing in the Current Environment: Beware of Tax Pitfalls

1. Debt Financing in the Current Environment: Beware of Tax Pitfalls American Chamber of Commerce 2008 Annual Tax Seminar Moscow, 29 October 2008

2. Debt Financing: Common Pitfalls Leading to a Bad Tax Answer • Overlooking the fact that debt-related expenses other than interest can also qualify as interest for tax purposes • Making the wrong assumption that keeping interest within the technical “tax-deductible” threshold is sufficient to ensure tax deduction: the rules are more complex than they appear • Underestimating the importance of justifying and documenting the necessity of obtaining debt and the purpose of the borrowing • Underestimating how broad the scope of Russian thin capitalization rules is: thin cap rules are not limited to • intra-group debt, • loans from a foreign party • disallowance of interest expenses

3. Debt-Related Expenses Deemed the Same as Interest for Tax Purposes • Bank commission • Likely to be considered interest if commissions are contractually linked to the principal amount • Factoring commission • Factor’s service fee • Financing fee • If classified as interest, a tax deduction could be disallowed Where a problem may hide: • Commissions and similar one-time payments in your loan agreement

4. Interest in Excess of “Standard” Threshold • Achieving comparability of loans – is it a solution? • Balancing opportunities and risks • Comparable loans - factors to consider • Term • Currency • Amount • Collateral Where a problem may hide: • Your accounting policy – potential problem? • Early repayment - is it a risk?

5. Justifying the Business Need to Obtain Debt • Need to demonstrate that debt is taken to finance income - generating activity • Do I really need to do it? • If yes, how hard should I try and what serves as good evidence? Where a problem may hide: • Lending at a lower rate than you borrow at • Lack of a (documented) business reason to obtain debt • Borrowing for purposes that may be considered as not related to income-generating activity

6. Thin Capitalisation Rules – Russian Specifics • Relatively new concept • The version amended as of 2006 remains largely untested by tax authorities and courts, but this is changing • Unexpectedly broad scope of debt transactions subject to thin cap limitations may lead to tax exposure even on third party domestic borrowings, where you normally do not expect thin cap rules to apply • Both interest disallowance and WHT tax exposure • Exposure to the lender, if the lender is a Russian company

7. Thin Capitalisation: Simple Things

8. Thin Capitalisation: It Gets More Complicated… Covered Loans: Intragroup loans #1 and #3 Bank loan with guarantee A and C Not covered Loans: Intragroup loan #2 Bank loan with guarantee B

9. Where a Problem May Hide: Several Issues to Consider • Are you sure that your list of thin cap affected loans is complete? • Have you considered loans you have taken from a third party but which are guaranteed or otherwise secured by another company within your group? • Have you considered withholding tax implications for the borrower and the lender on the thin cap affected borrowings, particularly from a Russian lender? • Do you re-calculate your mid-year interest deduction limit at year-end? Should you? • Can tax treaties help you?