The Supreme Court of the Russian Federation is to consider the case of Lukoil Oil Company and decide whether a business may take into account expenses for construction in progress in order to reduce the amount of tax deductions. The Federal Tax Service believes that it is not, and therefore additional tax was charged to the company. Arbitration courts sided with the tax authority.

Fyodor Petrik, Senior Tax Consultant at Tax Compliance, commented on the key aspects of the dispute between the oil company and the Federal Tax Service in an article for Kommersant.

The issue of expense recognition of the cost of liquidated construction in progress has always been the subject of clarifications by the tax authorities, tax audits and disputes. The tax authorities have consistently opposed the possibility of deducting these expenses from taxable profit, but taxpayers continue to take them into account due to the absence of a formal prohibition in the tax legislation. Any expenses may be recognized if they are documented and incurred for the purposes of carrying on activities aimed at generating income.

Law enforcement practice

Against accounting of disputed expenses: 

• Letters of the Ministry of Finance of the Russian Federation from 07.07.2023 N 03-03-06/1/63568; from 22.04.2022 N 03-03-06/3/3/36595;
• Resolution of the Arbitration Court of the Moscow District from 15.01.2024 N F05-30188/2023 on the case N A40-281861/2022;
• Resolution of the Arbitration Court of the Moscow District from 24.11.2023 N F05-28328/2023 on the case N A40-288396/2021

Accounting of disputed expenses is legitimate:

• Ruling of the Arbitration Court of the North-Western District from 22.01.2019 N F07-16106/2018 in the case N A56-9767/2018
• Resolution of the Arbitration Court of the Ural District of 18.01.2018 N F09-8546/17 on the case N A60-15584/2017

The list of non-operating expenses is open, and they may include any expenses of the organization, which are incurred for the purpose of obtaining income (subparagraph 20, paragraph 1 of Art. 265 of the Tax Code of the Russian Federation). In practice, such justified expenses include expenses for the construction of facilities that were subsequently liquidated. The main thing in this case is to substantiate the existence of a plan to generate income in the future through the use of the EHS facilities being erected, as well as good reasons for their liquidation and their inability to be used in income-generating activities.

Positions of the parties

Lukoil Oil Company arguments are justified from an economic point of view, since at the time of construction of the NZS facilities, the organization planned to use them to generate income, but later decided to liquidate them. The organization's position may be further supported by a business plan and other similar documents. The tax authority's position is based on formal grounds and the impossibility of reclassifying previously incurred expenses for the creation of fixed assets as other non-operating expenses. An additional argument of the tax authority is the activation of these expenses in previous periods prior to the decision on liquidation, in which these expenses can formally be recognized as current. However, the 3-year period for making adjustments to prior periods has already expired. 

The position of the Federal Tax Service is fully in line with the current clarifications of the tax authorities and court practice, but contradicts the economic essence of entrepreneurial activity and the realization of risky projects, which are not always guaranteed to result in income from the use of constructed facilities. If the company presents in court a detailed economic substantiation of the disputed expenses' focus on income generation and refusal to complete construction, it will increase its chances of successfully defending its own position. However, formal restrictions on the adjustment of the tax base of previous periods may prevent the organization from defending the right to account for the disputed expenses.

Significance of the case

This court decision will be important for both oil companies and other industries, especially manufacturing. As large companies often invest in opening new production facilities and lines of business that are not always profitable and may be subject to liquidation before being utilized. Even in case of a negative decision, many companies will continue to take into account such expenses for the purposes of reducing taxable profit, as each situation is unique and in each case the relationship of the expenses to future profit generation will be assessed differently by the tax authority and the courts.