Mar. 11, 2005
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Italy's ERG and Shell to Develop LNG Terminal
Construction of the 8 bcm capacity LNG regasification terminal in Sicily is scheduled to begin in 2007 and be operational in 2010.

02.03.2005, 18:56

Roxar, TNK-BP Sign Deal
TNK-BP buys Roxar reservoir management and production optimization software for engineering R&D.;

02.03.2005, 18:45

ChevronTexaco Announces First Condensate
ChevronTexaco Corp. has announced first condensate production from the Sanha Field in Angola.

02.03.2005, 18:33

ExxonMobil Sells Sinopec Stake
ExxonMobil has completed the sale of its 3.7 percent stake in China Petroleum and Chemical Corporation(Sinopec.)

02.03.2005, 18:25

BJ Services Wins Cementing Contract
Marathon Petrolum Company has contracted with BJ Services for cementing services for a number of its wells offshore Norway.

02.03.2005, 18:19
2 March 2005 BJ Services

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YUKOS Tax Case Offers a Few Lessons

Salman Mannan, Sergei Teryoshin, Deloitte

The YUKOS tax case has been headline news in Russia since mid-2003. This is the largest claim ever brought by tax authorities in Russia since the fall of the Soviet Union. Besides high profile political shock waves and the effect on the world oil markets, this case is extremely interesting from a tax perspective.

This article does not seek to express any opinion on the YUKOS case in terms of fairness and its compliance with Russian law. It does however seek to highlight the main issues raised in this case and the lessons that all tax professionals should consider in future tax planning.

Below we analyzed publicly available technical information in respect of the claims of the tax authorities for the year 2000, as the essential aspects of the claim are common to all the years subjected to the tax audits.

What Is Under Attack?

It should be noted that taxes payable under the Russian tax legislation are divided into three parts: federal, regional and local. Under the legislation effective up to Jan. 1, 2004, regional authorities were entitled to grant allowances in respect of the regional and local parts of some taxes to enterprises investing in the regional economies (so-called “investment allowances”). These allowances were usually granted for profits tax. The regions, which granted such allowances are commonly known as “internal offshores”: Among them were constituent Russian regions (e.g. Kalmykia, Mordovia, and Dagestan) and ZATOs or closed administrative-territorial areas (e.g. ZATO Sarov, ZATO Tryokhgorny, ZATO Lesnoi).
Profit-making oil companies were quick to spot the opportunities associated with such allowances and a simple scheme was soon in place to save very significant amounts of taxes. It is well known that, in addition to YUKOS, some other Russian oil giants also used this simple tax-saving scheme.

The essence of the scheme is as follows: oil-producing subsidiaries sold crude at low prices to companies (traders) registered in low tax regions. The prices were so low that producing subsidiaries were sometimes loss-making. From a strictly formal point of view such companies were independent from the vertically-integrated groups they were actually working for.

Strict formal independence was crucial for avoiding the need for potential transfer pricing adjustments by ensuring that the transacting parties were not related parties under the strict definition of the Russian tax legislation. As we will show later, tax authorities did not even try to make an adjustment. Moreover, the strictly formal independence of traders did not prove to be a guarantee against an unfavourable court decision.

The traders, after having acquired the title to the crude, exported it or processed it in refineries belonging to the same group of companies and sold the resultant oil products to third parties. The parent company of the group might act as an agent in such schemes, facilitating exports or processing of the crude and the on-sale of oil products, earning a commission fee. The trading scheme was constructed so that traders earned the most of the profits within the value chain and, therefore, the group’s profits were subject to the lowest effective tax rate. However, in order to benefit from the regional “investment allowances”, the trading companies should have had some real substance. In YUKOS’ case it was stated in court that the amount of investments was sometimes below one percent of the allowances utilized by a trader.

Tax Authorities’ Position
The tax authorities’ position in this case is understood to follow the principle recently stated by some Russian officials: if a transaction does not have any other commercial reason except for saving taxes, this transaction should be deemed to be an unlawful tax evasion. This is a principle commonly recognized in more developed tax jurisdictions. However, there is no explicit reference to it in the Russian legislation. Moreover, to date the practice has been to adopt a strictly formalistic approach to the interpretation of the legislation, which would most likely have led to the transaction as being treated as lawful as it was correctly constructed.

It should be noted, that YUKOS’ case is not unique as frequently represented by the media. In 2002-2003, tax authorities successfully attacked tax allowances utilized by the companies registered in one of the low tax regions – Baikonur (a territory rented to Russia by Kazakhstan). Usually companies registered in Baikonur leased some property (e.g. equipment) to actually producing companies. The former paid tax at a lower rate on the lease income, the latter claimed a tax deduction for the lease payments generating savings at higher tax rate. In this case, the courts supported the tax authorities in applying a “substance over form” approach and declared tax-saving transactions to be a sham. In particular, LUKOIL was mentioned by the media as having had to pay more than $100 mln as a result of similar claims from the tax authorities.

In YUKOS’ case there was one difficulty for the tax authorities: if a claim was brought against traders residing in “internal offshores,” it was extremely unlikely that the traders would have been able to pay it. In fact, such claims would have only demonstrated that the scheme did in fact help the actual beneficiaries avoid any liability.

Therefore, the claims were brought against YUKOS in the following manner and comprised included several statements by the tax authorities:
• Traders were not entitled to the allowances. The major argument in this respect was that the amount of investments was not in any way comparable to the amount of tax allowances utilised and traders did not actually conduct any activity in these regions.
• The traders did not, in fact, participate in the transactions. Despite the fact that the traders held a legal title to the crude, it was the YUKOS parent company, acting formally as the agent, that actually controlled and conducted all the transactions with crude and oil products along the whole value chain.
• The traders were affiliated with YUKOS. As in many cases there was no straightforward argument in favor of this statement, like direct or indirect ownership by YUKOS, the following was taken into consideration: (1) the management of traders were in some cases the same people; (2) the accounting of all traders was carried by companies affiliated with YUKOS; and (3) the settlement of mutual liabilities was carried out in banks affiliated to YUKOS, by offset or notes.

The above considerations supported two important statements by the tax authorities:
1. The first statement was not actually new for Russian practice, because a similar one had been made in respect of lessors registered in Baikonur. The tax authorities argued that the only purpose of the traders’ participation in the above scheme was tax evasion, therefore transactions entered into by the parties should be declared void for the purposes of Russian tax.
2. The second one was indeed a new one and quite unfamiliar to Russian practice. The tax authorities decided that since the YUKOS parent company (formally an agent in most of the transactions) actually controlled and carried out the transactions and controlled the traders themselves, this company should be considered as the actual owner of the crude and oil products, and, in consequence, a taxpayer in respect of the income from these transactions and a beneficiary of the illegally utilized allowances.

As a result of these considerations, the YUKOS parent company is liable to reimburse the state for tax allowances said to be utilized illegally. The tax authorities’ claims have been supported by three instances of court.

Another additional interesting issue has arisen from this case. The $3.4 bln tax claim included a fine in the amount of approximately $700 mln. From a technical point of view (and this has been strongly supported by practice), this fine should not have been imposed on the taxpayer for the year of 2000 after Jan. 1, 2004, since the three-year statutory limitation period provided by the legislation in such circumstances had already expired by that date. The tax authorities’ decision was issued after Jan. 1, 2004, so the court should have denied claim in this respect. However, we see that in all three court hearings YUKOS’ fine was not dropped. As we understand, the court denied YUKOS the right to refer to this provision of the Russian tax legislation on the basis of YUKOS’ delinquency.

In conclusion, there are several important lessons that can be learnt from this case:
1. The appearance of the “substance over form” approach in Russia. From a practical point of view, this means that transactions should be considered in terms of both their legal form and their substance as they may be contested if their purpose is solely or mainly avoiding tax.
2. Tax professionals should also bear in mind that the tax authorities may argue that tax liabilities should be transferred from one company, which is not able to pay taxes, to another one, the true beneficiary of a tax-saving scheme.
3. There is an increasing trend for the authorities to argue and the courts to accept that taxpayers not acting in good faith are not protected by the Russian tax legislation when it comes, for example, to the three-year limitation period for imposing fines.

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