Litigation - Russia In many cases where the business activities of a group of companies are enhanced by valuable intellectual property, such as trademarks, a structure involving the payment of royalties or a licence fee is employed within the group for tax purposes. The structure involves an agreement between affiliated companies whereby the licensee agrees to pay a royalty or fee to the licensor in exchange for the right to use the latter's intangible property, thus allowing the licensee to claim a tax deduction in the state in which it pays tax on its corporate profits.
Such structures have been widely adopted by companies with subsidiaries in Russia. However, they have recently come under scrutiny and their validity is increasingly being challenged in the courts on the grounds that they constitute transfer pricing mechanisms between related companies and lack economic substance.
Tax deductions claimed by a licensee may be challenged on the grounds that the transfer price paid for the licensed property is excessive. Article 252 of the Russian Tax Code permits an organization to offset its expenses against its income and thus reduce its profit tax liability, provided that such expenses are economically justified and properly documented in monetary form. If the transfer price is deemed unreasonable or in excess of fair value, the tax authorities may adjust the deduction claimed by the licensee.
In October 2005 the Federal Arbitration Court of the North-Eastern Circuit issued a decision which has set the pattern for subsequent court practice in this area of law. It adopted a new method of determining the market price for the fee paid under a licensing agreement and adjusted the deduction claimed by the licensee. Article 40 of the code defines the 'market price' as "the price prevailing on the basis of the interaction of supply and demand on the market for goods (including work and services) under comparable commercial conditions". However, no significant previous court decision had applied this approach to the determination of the market price for the use of a trademark - in this case a beverage trademark - under a licensing agreement.
The court obtained an independent appraisal and a transfer price study carried out by experts from the Social Sciences Department of the Academy of Sciences. After carrying out a discounted cash-flow analysis the experts concluded that the average licensing fee for beverages on the market was between 2% and 5% of sales income - considerably lower than the licensing fee of up to 30% in the agreements at issue. Thus, the transfer price was found to be above market value and the court ordered the payment of penalties and additional tax calculated on the basis of the lower market price.
The courts have increasingly ruled against such structures on the basis that they lack economic substance - that is, the licence provides no economic benefit to the licensee. In a case(1) in February 2007 that attracted considerable attention, in which the licensee produced beer under its trademark and the licensors were trading companies which sold the beer, the Ninth Appellate Court of Arbitration decided to impose penalties and additional tax on the main rights holder. The licensing agreement indicated payments for trademark use of between 4% and 10%, although the licence fee in sub-licensing agreements was only 0.1%.
Despite the licensors' assertion that they needed the right to use the trademark in order to distribute and advertise the product, the court referred to Article 23 of the Law on Trademarks, Service Marks and the Appellation of the Origin of Goods in holding that a party need not be a rights holder in order to distribute and advertise a product which has been put into circulation in the Russian territory by or with the agreement of the trademark owner. Therefore, the court found that there was no economic substance in the licensors' activities; furthermore, the payment for the licence under the primary licensing agreement deprived the licensors of any reasonable possibility of profit.
This case is an example of the Russian courts' increasing tendency to reject or reduce tax deductions claimed by licensees for payments under inter-company licensing agreements. Taxpayers must be prepared to establish an economically justified price for the right to use intangible property in Russia and may wish to consider obtaining an independent appraisal or a transfer pricing study to justify their inter-company charges.
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