A renowned Russian tax lawyer with Moscow-based Avenir Law Partners, and the author of a book on Russian Taxes, Jon Hellevig wrote this article on a special request for The Russia Journal.Business media seem to have been blind-sighted by the discussion over political causes of Russian government’s case against Yukos and its owners. Many lawyers and accountants also seem to have joined in a discussion which has become emotional, and at times, hysterical. The Russia Journal maintains a bloc of media coverage on all Yukos-related issues at www.yukos.trj.ru Considering the level of resonance generated by the case among investors, executives and business leaders and their need to know the exact facts and independent analysis of the case, TRJ requested Hellevig to comment on the merits of the government’s charges against the oil giant and its principal shareholders and the implications of a positive court verdict for the country as a whole.

Peter Clateman, another distinguished legal expert, will comment on the Yukos tax-evasion case in our October issue.

The criminal case against the ultimate shareholders of Yukos and the tax claims against the company have grabbed the headlines for almost a year now. The discussion in media has been emotionally charged. A close scrutiny of the government’s case against Yukos reveals that whatever the political motivations of initiating and doggedly pursuing the cases, prosecutors and the Tax Ministry have some very well-founded claims against the company. A government’s victory in courts will have very far-reaching implications for Russian companies as well as legal and audit firms that advise them on tax-optimization schemes using tax shelters.

The government’s tax-evasion charges center around a claim that Yukos had been involved in minimizing its tax burden through the use of illegal tax shelters. The key word here is the "illegal" in the tax-minimization schemes.

The Russian government is claiming back taxes for undeclared revenues from Yukos. In May, the Moscow Arbitration Court ordered Yukos to pay 99 billion rubles, approximately $3.4 billion, in back taxes for 2000, including interests and fines that have accrued on them. In July, the Tax Ministry, which is litigating the tax-evasion case on behalf of the federal government, made a similar claim for the year 2001. There are news reports that these claims for 2001 and 2002 could amount to, at least, $10 billion.

The charges claimed that Yukos divert revenues from its oil sales to companies located in territories offering beneficial tax treatments. The territories mentioned are the so-called Russian domestic tax havens such as Kalmykia, Mordovia and Chukotka. The scheme seems simple – Yukos subsidiaries sold oil to various companies located in these Russian tax havens at a low price with a minimum profit margin for themselves. These companies, which are not users of oil, then sold it – directly or indirectly – to companies, which, in reality, were Yukos’ contractors for the oil. The profits, which could – and, should – have been earned by Yukos were thus retained by the intermediary companies. The government claims that many of the tax-haven companies did not have independent managements and were simply shell companies used to rubberstamp sham transactions.

The scheme, according to the government, was a blatant scam – untraceable individuals appeared as founders of these companies. State prosecutors also claim that some people whose signatures appeared on corporate documents and contracts had little or no knowledge of the transactions they were involved in. And, except for buying the oil on paper and selling it, such companies had done no value addition.

In a class action suit filed in a New York court, the lawyers for Rothwell Holdings Ltd., a Caribbean-registered investment fund claimed "Yukos engaged in illegal tax evasion scheme by creating fake organizations in the oil and after product movement chain and further by registering these fake organizations in territories with preferential tax treatment". The claim in New York is very similar to the government’s case. It is not known who devised the tax shelters and whether the liability for their illegality has been insured by Yukos.

Yukos’ position, according to reports, has been that all its transactions were legitimate and that it did not owe tax arrears on these transactions nor the profits that accrued from them.

The question that readily comes to mind is why should a major oil company not sell oil directly to its foreign customers. From what we know, the reason would be that an agent or a middleman would bring a better value for the producer. But in this case, the companies used in the schemes had not brought any value, which raises the suspections that their sole purpose was to hide profits from tax authorities and from minority shareholders.

Legal tax shelters are not illegal

When talking about tax shelters and tax optimization, it is important to distinguish the legitimate practice of tax optimization from cases of criminal tax avoidance. In doing so, there is a big difference between Russia and the majority of European Union countries. The difference stems from the fact that the Russian tax legislation offers far more protection to taxpayers as it puts the burden of proving the fact of using illegal tax shelters on tax authorities. Consequently, the tax inspectorate has to take a taxpayer to court to prove that a tax shelter is illegal. Several independent surveys on these issues have shown that tax inspectorates lose more often than they win suits on such cases in Russian courts.

The international fight against illegal tax shelters is getting tighter. In the United Kingdom, for example, disclosure rules have been introduced in order to apprise the Inland Revenue about tax planning schemes in advance. Similar rules already exist in the United States, whereby tax planners must identify and provide details and legal basis for various tax schemes and register them with the authorities well in advance. Such draconian rules do not exist in Russia and we should hope that Russia would maintain its new business-friendly tax code. But at the same time, it would be naive to expect that the government will not prevent illegal tax evasion in the country. Seen in this context, it is in the best interest of investors and taxpayers that want to conduct legal and transparent businesses in Russia that the government goes after illegal tax shelters, but respect legal tax planning and tax-optimization schemes.

In comparison with the case at hand, a legal tax shelter could, for example, be obtained by structuring the production process in such a way that a high value-added component would be produced in a place with a lower taxation burden. The investor could, for example, invest in a plant in Mordovia which would produce the high-value-added component. Multinational corporations frequently use international trade arrangements, domestic tax breaks and special tax-free zones for managing their production and employment to optimize their taxes.

The issue of transfer pricing has also come up in connection with the Yukos case. While the case at hand seems primarily less about transfer pricing, and more about the invalidity of transactions, it is yet a perfect example of legal tax shelters within the limits provided by the law. A fluctuation of up to 20 percent of market prices is allowed for legal transfer pricing. A bigger appetite for price manipulation may well push the company over the brink.

Invalidity of transactions

In the Yukos case, it has been claimed that the transactions through the companies registered in "domestic tax havens" are sham transactions or fictitious. The transactions were claimed to have taken place only "on paper." The court can declare them sham operations, and when that happens, the tax department has an obligation to enforce the collection of the tax thus levied.

From the information available to us, it would seem that the Russian government has a legally valid case in pursuing the invalidity of sham transactions and claiming back taxes from Yukos and its principal shareholders. Russia is often criticized for having a legal and administrative culture that puts form over substance. But "form-over-substance" is not a real legal principle; it is just a result of bad administrative and judicial practice. The law does not provide protection for tax evasion using tax shelters that totally lack substance and are made on paper only. The provisions on invalidity and the right to set the relevant tax consequences as a result of the invalidity are living provisions of the Russian law and not tools of repression.

Talk of politics cannot change illegal tax shelters into legal ones. That the government chooses to close its eyes to these schemes is a different matter altogether.