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Oriflame case: is the generally accepted interpretation of the “permanent establishment” concept under threat?


On 4 August 2015, a Russian subsidiary of an international group who lost to the tax authorities at all lower instances in a widely publicised case (case No. А40-138879/14) involving the deduction of expenses for profits tax purposes and VAT on royalties paid to an affiliated foreign contractor, filed a last hope cassation appeal with the Supreme Court of Russia. The challenged ruling was rendered by the Commercial Court of the Moscow District (the “Court”) on 11 June 2015. The June ruling was criticised by a vast majority of experts and the business community, as the Court took an unprecedented approach whereby it re-qualified a legally separate Russian entity (a limited liability company) into a permanent establishment of a foreign affiliate.

If the Supreme Court upholds the Court’s ruling, the generally accepted interpretation of the “permanent establishment” concept in Russia may need to be reconsidered. For international groups of companies, it means they will therefore have to substantially modify their approach as to how they structure and formalise their contractual relations with their Russian subsidiaries.

Background of the case

A Luxembourg company (“LuxCo”) conducts sales in the Russian territory through a distributor, a Russian limited liability company (“RussiaCo”), which belongs to the LuxCo group. RussiaCo acts pursuant to a franchise scheme under which it uses the related trademark, the commercial designation and foreign-developed know-how.

The above intellectual property is ultimately owned by LuxCo, further transferred under a master franchise agreement to an SPV registered in the Netherlands (“HoldCo”) and finally granted to RussiaCo under a sub-franchise agreement (the “Sub-franchise Agreement”).

According to the remuneration scheme established under the Sub-franchise Agreement, up to October 2010, the royalties paid by RussiaCo amounted to 5% of its total revenues. However, in practice, it transferred 98.4% of its total revenues to HoldCo. The Sub-franchise Agreement was subsequently amended, and as a result the remuneration scheme comprised three main components:

  • 2% of the imported goods’ invoice value for the use of the related trademark;
  • EUR 4 million per year for the use of the commercial designation; and
  • EUR 20 million per year for the know-how use.

Position of the tax administration

The tax administration conducted a tax audit of RussiaCo for the years 2009 and 2010. Based on this audit, it concluded that the amount of royalties (equal to approximately RUB 2 billion) that RussiaCo had calculated and treated as deductible for corporate profits tax purposes during the above period represented an unlawful tax optimisation tool. From this perspective, the tax administration considered that the royalties paid by RussiaCo under the Sub-franchise Agreement were solely aimed at (i) unlawfully reducing the corporate profits tax base of the company; (ii) obtaining unjustified VAT refunds from the Russian budget; and (iii) transferring funds abroad.

The above conclusions were made on the basis of a surprising qualification of RussiaCo: the tax administration considered that this company, even though formally being a separate legal entity, constituted as a matter of fact a permanent establishment of LuxCo, the ultimate beneficiary of profit derived in Russia.

Position of the Court

Sadly, the Court rejected the substantial reasoning of RussiaCo and fully supported the position of the tax authorities by applying the doctrines of “lifting the corporate veil” and “unjustified tax benefit”. The Court notably based its qualification of RussiaCo as a permanent establishment of LuxCo on the following arguments:

  • the commercial positioning of RussiaCo vs. LuxCo in relations with final customers was unclear;
  • it was possible for customers to enter into transactions with LuxCo through RussiaCo without any contacts with the former;
  • the scope of rights granted to RussiaCo (in terms of preparation of catalogues, pricing policy, etc.) was very limited;
  • LuxCo’s employees participated in the management of the Russian entity (even without being physically present in Russia);
  • RussiaCo systematically made losses; and
  • neither LuxCo nor HoldCo paid taxes in the respective jurisdictions of their residence on the obtained royalties due to the specifics of local regulations.

Based on the above, the Court ignored the presence of HoldCo in the contractual and shareholding structure and considered the payment of royalties to HoldCo as unjustified from an economic standpoint. Moreover, it concluded that RussiaCo was conducting business on behalf, and in the interests, of LuxCo, which made RussiaCo a dependent agent of the Luxembourg entity and, as such, a permanent establishment of the Luxembourg entity.


It is premature to conclude what impact the June ruling in the above case will have on the Russian tax authorities’ practice in applying the law. For the time being, one may only hope that the Supreme Court will not only decide to carry out a cassation review of the appeal – which it is still examining – but also to reconsider the qualification of lower instances. It is to be noted that the cassation appeals are generally reviewed within two months of the decision on the admissibility of the appeal.

If, however, the cassation appeal filed by RussiaCo is rejected, it cannot be ruled out that the Court’s reasoning will be speculated upon and applied rather aggressively by tax inspectorates. Equally, the tax authorities may possibly try to apply the Court’s rationale in the commented case to types of agreement other than franchise, which are entered into between foreign companies and their Russian subsidiaries.

It is clear in any case that the general de-offshorisation trends in Russia are becoming more and more visible, and this should encourage foreign companies to pay more attention as to how they structure and formalise their contractual relations with their Russian counterparties. To minimise the potentially negative impact of the latest Russian tax authorities’ practice in applying the law on the tax position of businesses conducted in Russia, it is highly advisable for such foreign companies to proceed without delay with the following actions:

  • ensuring compliance with the principles of general economic justification and proper documentation required for Russian corporate profits tax deductibility purposes by notably putting in place documents supporting the operational activities of Russian subsidiaries;
  • conducting an audit of contractual relationships in place and substantiating the position of Russian subsidiaries both from business and legal standpoints; and
  • implementing a proper transfer pricing policy and ensuring compliance with the Russian transfer pricing rules both in terms of notification and documentation.


Anastasia Prozor