Anton Kulakov, Junior Tax Consultant at Tax Compliance, talks about the position of courts regarding the use by taxpayers of the "debt push down" mechanism.  

The "debt push down" instrument is a method of financing an M&A transaction in which a loan raised by an investor for the acquisition of a target company is transferred to the target company and serviced out of its operating income.

An example of an M&A transaction using the "debt push down" tool:

What is the tax effect?

The acquired company's taxable income is reduced by the amount of interest accrued on the borrowing.

Court positions on debt push down

The tax law does not restrict a taxpayer's possibility to include interest on debts attracted for the acquisition of an asset into the expenses. At the same time, law enforcement practice has developed a negative attitude towards business structuring schemes, which cause damage to the budget. 

The key disputes in which the court sided with the tax authorities in considering the economic feasibility of interest expenses include the following cases: Kvartal 674-675; Polar Lights Company; Radius-Service. Using the above cases as examples, we will analyze the main conclusions of the courts regarding the use by taxpayers of the "debt push down" mechanism.

Case "The Quarter 674-675" №А40-47086/22-183-883 

The claim of the tax authorities 

The tax authority disputed the expenses of the LLC "Kvartal 674-675" for the interest payment on the loan, as well as the resulting amount of negative exchange rate differences. Besides, the inspectorate concluded that the loss of LLC "Belaya Ploshchad" received by "Kvartal 674-675" as a result of its reorganization was unreasonable for including it in the income tax base.

Court's Position

The court upheld the conclusions of the tax authority that the group of companies used the scheme of transferring its debt obligations to "Kvartal 674-675". In reaching their decision, the courts were guided by the following: 

- The group of transactions was made by interdependent persons. The planned structure of the transaction had been disclosed in advance to the third-party investors at the time of entering into the agreements with them.

- Belaya Ploshchad LLC was created not long before the acquisition of the shares in Riniole and had no real financial or economic activity. 

- The chain of transactions and reorganizations used by the group lacked economic substantiation.

- Merger of LLC "Belaya Ploshchad" with LLC "Kvartal 674-675" resulted in considerable accounts payable of the latter and made the activity of LLC "Kvartal 674-675" on the whole unprofitable.

- The Company's transfer of interest to Kinevart is a disguised payment of dividends to Afelmore.

- The exchange of Afelmore's interest in Quarter 674-675 LLC for Riniole's shares constitutes an offset of counter obligations not of equal value, with Afelmore remaining the actual owner of 100% of Quarter 674-675 LLC's authorized capital stock.

Polar Lights Company Case №А40-74261/19 

Claim by Tax Authorities 

The tax authorities challenged Polar Lights' interest expense deduction because the entirety of the abovementioned transactions was designed to shift the Cypriot shareholder's expenses for acquiring a stake in the company to the company itself. The interest expenses were economically unjustified for the company.

Court's position

The courts ruled in favor of the tax authorities. At the same time, the courts took account of the following circumstances indicating the receipt of an unjustified tax benefit:

- Participation in the transaction of interdependent persons (coordination of actions).

- Promissory notes issued against a debt transfer were presented by affiliated companies belonging to the same group of companies, and the 0.1% interest on the notes is not comparable to the 9% interest on the loan.

- Trisonnery Assets was unprofitable, did not conduct any business activities and did not have sufficient assets to purchase the company and repay the loan (the assets amounted to 1.5 million dollars), therefore, the promissory note issued to it actually had no real security.

- The transfer of the debt obligations to Polar Lights actually caused it to incur additional expenses unrelated to the company's business activities.

Radius-Service case №А50-17405/2016 

Claim of tax authorities 

The tax authorities challenged Radius-Service's deduction of interest expenses due to the fact that the main purpose of the transaction structure in question was to shift the costs of financing the transaction to the company itself and create additional expenses not aimed at generating income

Court Position

The courts have ruled in favor of the tax authorities. In so doing, the courts took account of the following circumstances that indicated the receipt of an unjustified tax benefit:

- Participation in the transaction of interdependent persons (coordination of actions).

- The non-market conditions of the loan agreement (lack of a repayment schedule and collateral, the borrower's inability to fulfill its obligations).

- Preliminary negotiations and purchase of shares from individuals were carried out by Schlumberger B.V.

- Upon accession, only the loan obligation actually transferred from Smith International. 

- The transfer of the debt obligations to Radius-Service actually caused it to incur additional expenses unrelated to its business activities.

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These cases demonstrate the negative approach of the Russian tax practice to the use of the mechanism of "debt push down" by the taxpayers. In this connection, the tax authorities willfully recognize a group of transactions as "fictitious" if the following attributes are present: (1) the main participants of the transaction are interdependent; (2) the company involved in the transaction is specially created for the acquisition of an asset; (3) one of the participants in the transaction obtains loan financing; (4) one of the group companies subsequently merges with the object of purchase.