On November 18, 2019, the Supreme Court of the Russian Federation transferred the cassation complaint by Krastsvetmet OJSC to the Economical Disputes Collegial Body for examination, thereby giving hope to all taxpayers who suffer from tax liability for actions of their bad faith contractors.

We should note that as of today, the situation where a taxpayer bears liability for actions of its contractors of the first, second and subsequent tiers has become typical, regardless of the clear-cut position of the Russian Supreme Court concerning every entity being independently responsible for its tax obligations. [1]

The case is being examined following a filing by Krastsvetmet OJSC (the “Company”) on deeming invalid a decision of the tax inspectorate, whereby the Company was denied a VAT deduction, which then resulted in accrual of a tax shortfall, interest and fine for a total amount of over 2.5 billion rubles.

The Company had acquired precious metals from another company (the “vendor”) and accordingly applied VAT deductions based on the commercial invoices. However, it turned out that the vendor had arranged a formal document turnover which reflected purchase of precious metals through a chain of controlled companies which did not pay VAT, but issued commercial invoices. Therefore, based on the finding regarding bad faith of the Company’s vendor, the tax inspectorate came to the conclusion that the Company was also participating in the tax evasion scheme.

The first instance court sided with the taxpayer, deeming groundless the actions of the tax inspectorate on accruing additional VAT by transferring the tax obligations of the vendor and its controlled entities to the Company.

When cancelling the decision of the lower court, the appeal court noted that the Company’s independent liability follows from its participation in and control over the tax evasion scheme by using the formal document turnover created by the vendor. In such a way, in the judges’ opinion the Company had no right to claim a VAT deduction, irrespective of the later actual sale of part of the jewelry goods on the domestic market. The circuit court supported the conclusions of the appeal court.

The Company, while disagreeing with the approach taken by appeal and cassation courts, filed a cassation claim with the Supreme Court of the Russian Federation.

Even though the problem of tax authorities imposing claims on bona fide taxpayers without revealing the real beneficiary of the scheme and the organizer of the formal document turnover has become common for business, the Company’s claim was transferred to the Collegial Body of the Supreme Court, which is a very good sign meaning that someone is ready to listen to the taxpayers.

The arguments for a “positive” outcome for the taxpayer could be, among other things, a so-called trend in the application of the principle of good faith administration. [2] Indeed, an unmotivated refusal to collect unpaid taxes from the beneficiary of the scheme violates the good faith principle in the work of the tax authority, which is worthy of the Collegial Body’s attention. An entity which fulfilled its obligations properly and in full should be able to rely on not bearing liability for third parties’ violations without even an effort on the part of the tax authority to hold such third parties liable.

However, as a rule, the inspectorate that reveals the tax evasion scheme does not pass the information to the territorial body of the organizer’s place of registration and is not interested in searching for the actual beneficiaries of the scheme and in synchronization of the work of all the inspectorates, which is in direct conflict with the principle of unity of the tax body system. [3] Instead, the tax authority demands voluntary adjustment of obligations from the end buyer of the goods, works and services, who is in no way connected to the document turnover created by their contractor and who has fully performed their tax obligations.

The decision on whether such transfer of tax liability to bona fide taxpayers is lawful and allowed will be adopted on December 25, 2019.

At the same time, even if the Supreme Court adopts a decision in favor of the Company in this case, one should not expect a drastic change in the position of tax administration and the methods for replenishing the state budget. Companies will in each case need to remind the tax authority that this approach is unjustified and not allowed.

[1]    See, e.g., Ruling No.308-КГ-15-18629 of the Russian Supreme Court dated February 01, 2016.

[2]    See e.g. Ruling No.305-ЭС19-14421 of the Russian Supreme Court dated November 14, 2019, Decree No.17АП-18548/2017-АК dated February 19, 2018 on case No.А60-11800/2017.

[3]     Clause 1 Article 30 of the Tax Code of the Russian Federation