Promoting Russian Sales by Incentivising Distributors and Resellers

In today's economic downturn, it has become critical to defer accounts payable, optimise cash flow and cut various costs to improve financial efficiency.  Companies more than ever have to focus on promoting sales to keep revenues at the desired level.  While previously in the booming market unnecessary tax costs could be ignored, nowadays they are deemed an unacceptable luxury for businesses.

In the product distribution, software, retail and services industries, taxpayers are restructuring their sales operations for the optimal tax effect.  Incentives (sometimes also viewed as earn-backs, credit notes, bonuses, rebates or discounts) payable to Russian distributors (with whom foreign suppliers would have direct contractual relationships) and even downstream resellers have become one of many rather popular measures in the Russian market aimed at promoting local sales operations.

1. VAT on credit notes and discounts

A. Compatibility of concepts

Russian civil law does not recognise the concept of credit notes.  This term, however, did start to appear some time ago in commercial documents executed between foreign and Russian companies and it has already been interpreted in Russian case law.  Basically, from a Russian commercial law perspective, a credit note should be viewed as a discount (whether a volume discount, a discount granted upon performance of certain obligations or occurrence of certain events, a discretionary discount, etc.).  In other words, it is viewed as a reduction of the purchase price.  It goes without saying that for a credit note to be treated as a discount and not as a bonus, it should be contractually linked to a particular distribution agreement and specific products.  Discounts can apply to either prior or future shipments, depending on the contractual arrangements between the parties.

B. Retroactive discounts

If the parties agree that discounts which the distributor is entitled apply retroactively i.e. to products already shipped and for which the distributor could have already paid, the distributor would be deemed to have acquired those products at a lower price.  The legal treatment would not change even though, from a cash flow perspective, the discount could be credited against future payments and the distributor would subsequently pay less to the foreign supplier.

This credit note mechanism, which has retroactive effect, normally results in significant additional paperwork for Russian distributors.  Since such a discount would apply to prior shipments and reduce the purchase price paid in previous tax periods (a calendar quarter for VAT and a calendar year for corporate profits tax purposes), the distributor would have to make corrections in its tax and accounting books for those prior periods and file amended VAT returns (and profits tax returns) each time it receives such a rebate.  Moreover, for each filing of amended tax returns resulting in lower VAT payable to the budget, the distributors would automatically be subject to a tax audit and all their sales operations would attract the closer scrutiny of the Russian tax authorities.

C. Upfront discounts

The above disadvantages may be avoided if the parties develop a contractual mechanism that makes provision for discounts simultaneously with periodic payments or, alternatively, agree that such discounts have a legal effect of upfront rebate and regularly reduce the purchase price of products supplied in future periods.  In this respect, due attention must be paid to the wording of the relevant contractual provisions.  While the economics of a credit note policy could be preserved intact, this alternative would relieve distributors from the obligation to correct their books and file amended tax returns.

2. VAT on incentives

A.   Taxable event for VAT purposes

Incentives or bonuses are often granted in addition to discounts.  Depending on the manner in which the incentives are granted, they may trigger Russian VAT and reporting obligations for the local recipients of the incentives (the "recipients").  In this case, the latter would expect the foreign grantor of the incentive payments to pay this VAT in addition to gross incentives.  Alternatively, incentives could be inclusive of Russian VAT (if applicable), but in this case the distributors/resellers would economically receive lower incentives.

In any event, such VAT would not be recoverable by (and instead constitute a dead weight cost for) foreign suppliers if they have no taxable presence in Russia.  They would incur the economic burden of the Russian VAT, which they would be unable to deduct even for income tax purposes in their home jurisdiction.  There are ways, however, to mitigate the effect of Russian VAT on the incentives.

Under the Russian Tax Code, VAT is charged on sums received as payment for goods sold (with respect to which legal title has passed), services provided and/or works performed.  Other money transfers among legal persons, if made with no connection to the sale of goods (works, services), are not subject to Russian VAT.  For example, donation of funds/cash gifts would be VAT exempt under Russian law.  Accordingly, incentive payments from a supplier to its distributors/resellers do not per se constitute a taxable event for Russian VAT purposes, unless they could be qualified as:  (i) consideration for services provided to the supplier by the distributors/resellers; or (ii) a portion of the price (e.g. in the form of a retroactive discount) paid by the recipient to the supplier for its products.

The Russian Tax Code does not expressly prescribe the conditions under which incentive payments may be subject (or not subject) to VAT.  Both situations that trigger the VAT liability have been clarified in numerous guidance letters of the Russian Ministry of Finance and the Federal Tax Service.  These documents are not legally binding.  However, Russian courts have typically taken a similar position and have even referred to these documents in their cases, and the Russian tax authorities normally act in line with them.

B.   Service-related incentive payments

According to the Russian Finance Ministry and the Federal Tax Service, incentive payments should constitute consideration for services provided to the supplier by distributors/resellers where such payments are aimed at promoting goods by such recipients of the incentives.  If according to the underlying agreement, the recipient is entitled to incentive payments subject to performing certain activities with respect to the products purchased (e.g. placing such products in the most attractive way in its stores, recommending the goods out of the assortment to customers, etc.) and these activities purport to attract customers' interest to the products, such activities would be regarded as advertising, marketing, sales promotion or similar services.  In this case, the incentive payments would be treated as payments for such services for Russian VAT purposes and VAT would apply.

To avoid this risk, the incentive payments should not be conditioned by any reciprocal obligations imposed on the recipients of incentive payments.  However, such payments may be provided (with no Russian VAT applicable) subject to the amount of goods (whether linked to a number of products or the total price paid) or assortment of goods purchased by the distributor/ reseller for a fixed period of time or to similar conditions.  One-off "sign-on" bonuses for entering into a contract, for including goods in the assortment of newly-opened stores or for similar actions would not be regarded as service-related either and would not, therefore, trigger Russian VAT.

C.   Price-related incentive payments

Incentive payments could potentially be regarded as a portion of the price paid by the recipient for goods purchased.  This would apply if the incentive payment results in changing the overall sum payable by the reseller (e.g. if the supplier provides a discount or discharges a portion of the distributor's debt).  If the incentive payment does not affect the initial contract price of the goods, VAT should not apply.

In the majority of situations it would be fairly difficult to determine whether incentive payments influence the price of goods since they, in any case, reduce the economic burden of purchasing the goods for the distributor/reseller.  Under existing case law, the determining factor should be the wording of the agreement between the parties.  If the agreement expressly provides that all payments and discounts form an integral part of the price of the products, such incentive payments would be subject to VAT.  If, however, the agreement does not contain such a clause or even expressly sets out that the incentive payments are unrelated to the price of goods, it would be good evidence to show the Russian tax authorities and courts, unless the provisions of the agreement provide otherwise.

D.   Treatment of incentives under Russian civil law

From a Russian civil law perspective, a gratuitous transfer of money (which is necessary for preserving the VAT-exempt status of incentives) constitutes a gift or donation.  Under the Russian Civil Code, a donation or gift is prohibited between commercial legal entities.  Russian recipients could potentially rely on this provision of the Russian Civil Code in order to make distributors convert the incentive documentation into a services arrangement subject to Russian VAT.  This approach would encourage the recipients to take a more conservative approach when negotiating the VAT issue with the supplier.

If this approach to incentive payments were adopted, it would not be fully compliant with the doctrine of Russian civil law.  Russian courts have developed the understanding that since incentive payments are conditioned by certain contractual provisions (e.g. acquisition of a certain amount of goods over a fixed period of time) and are generally aimed at deriving additional profits by the seller, such payments may not be treated as gratuitous and, therefore, may not be characterised as gifts or donations.  Moreover, in practice, in cases where the Russian tax authorities attempt to characterise incentive payments as gifts or donations, the purpose of such re-characterisation (usually refused by the courts) is to additionally assess profits tax for the seller, rather than to invalidate the transaction itself.

Further, in line with the doctrine of Russian civil law, this particular mandatory prohibition in the Russian Civil Code can be overridden if the supplier's documentation underlying the payment of incentives is governed by a foreign law that permits donations among legal entities.

In any event, despite the civil law arguments on this matter, even if a position is taken that incentives (as bonuses or other forms of gratuitous payments or donations) may not be paid by virtue of Russian civil law, in most cases it is unlikely that there would be any interested party to challenge the incentive transaction.  Such an approach would imply that the transaction is invalidated with the subsequent restitution of rights, i.e. the return of the incentives.  In other words, the recipients of incentives are not likely to be interested in taking such an approach.  It is unlikely that the Russian tax authorities would attempt to invalidate the transaction either, since this would not result in any extra taxes payable to the budget.  Attempting to reclassify it into a services arrangement would require the Russian tax authorities to prove that the recipients of the incentives provided some services to the supplier in order to be eligible for the bonus.  Legally, this would be a separate task.  Furthermore, under the Russian Tax Code, collecting additional taxes based on reclassified agreements is possible only through court proceedings.

Overall, if there is an intention at the level of foreign suppliers to provide earn-backs or discounts to Russian distributors and/or resellers with an optimal VAT outcome, it may be advisable to use upfront discount mechanisms and incentive payments that are not price or service related.  The implementation of a particular earn-back scheme may certainly face commercial difficulties when negotiations with Russian business partners take place.  However, they may be overcome with proper business and legal argumentation, and practical tax risks in Russia should be mitigated through properly drafted documentation and by way of being well prepared for tax audits.

 

This article is based on a report which appeared in Tax Planning International, January 2009.