For decades tax authorities have refused deduction of input VAT and recognition of costs because of suppliers involved in tax evasion schemes. The legal ground for such refusal is provided by Article 54.1 of the Tax Code. According to it, a company is only eligible for tax deduction if its contracting party fulfils the transaction terms using its own resources. If the contractor engages third party resources informally, without entering into agreements with its subcontractors, the requirement of Article 54.1 of the Tax Code is not met and the taxpayer is not eligible for tax deduction. The company can also suffer from its own insufficient checking on the contracting party, being the reason why the company was not aware of the contracting party’s malicious intent.
In its Letter No. БВ-4-7/3060 “On enforcement of Article 54.1 of the Tax Code of the Russian Federation”, the Federal Tax Service announced its less rigid approach, stating that tax deduction should not be refused a company which had no intent to evade tax and exercised due care when selecting its contracting party. Nevertheless, in practice tax authorities often disregard taxpayers’ due diligence efforts and refuse them tax benefit. To protect yourself against losses from refused tax deduction incurred due to the acts of the contractor, you should include tax clause in your agreements. According to such clauses, in the event of tax claims against the customer all its damages must be reimbursed by the supplier.
According to the emerging relevant case law, damages incurred by a taxpayer due to refusal of VAT deduction and recognition of expenses may be recovered from its contracting party. If such refusal is due to illegal acts of the contractor (e.g., the contractor misled the customer about resources available to it or provided misrepresented reports or was engaged in a tax scheme), the contractor may be ordered to reimburse damages, as in the case of Taimyr Fuel Company, No. А33-3832/2019. The right to claim damages is expressly provided by the Civil Code and therefore can be exercised even in the absence of any tax clause. However, such defense will only work if the contracting party was directly involved in creation of a tax scheme and the taxpayer can prove this fact (e.g. by producing a relevant decision of the tax authority).
The chance for the customer to receive reimbursement of tax damages will increase considerably if its agreement includes a tax clause. The clause should set in detail the contracting party’s obligations to meet the requirements applicable to a bona fide taxpayer and to refrain from any actions that may entail refusal of tax deductions. These provisions are so-called ‘representations regarding circumstances’. If they are breached, damages can be recovered from the breaching party even if such party was not the organizer of a tax scheme. Such tax clause can provide sufficient protection to the customer, as the entire risk is borne by the contracting party.
Although the titles of the clauses may seem similar, the legal mechanism for reimbursement of losses essentially differs from reimbursement of damages. Reimbursement of losses is a relatively new mechanism of the civil legislation. It provides that one party to an agreement should reimburse the other party for any pecuniary losses, even if incurred by the latter otherwise that through the fault of such other party. Thus, to shift the taxpayer’s tax losses on its contracting party, it is sufficient for the taxpayer to define the grounds (such as refusal of tax deductions claimed by the contracting party) for reimbursement of tax losses and the method of calculation thereof in such clause.
Such variant of a clause is certainly more rigid for a supplier. So, when assuming such obligations, the contracting party should pay special attention as to in which instances the customer incurs losses: when a claim is submitted by a tax authority or when the taxpayer loses a legal dispute over such claim. Of course, while the second scenario requires more effort on the customer’s side, it allows the supplier to protect itself against invalid claims.
How a tax clause is viewed by the Federal Tax Service
Recently the Tax Service has taken on board the idea of implanting a losses clause. It proposes to create a kind of ecosystem where biggest taxpayers will require that their suppliers assume a tax loss reimbursement obligation and will allow the Federal Tax Service to publicize information on tax gaps in their supply chains and will agree to reimburse such losses to their suppliers based just on a notice of discovery of such gap from the Service. Accordingly, first-tier suppliers will mirror such tax clause in agreements with all their contractors and so on and so forth.
In such as way, in the opinion of the Tax Service, a tax claim should come down to the immediate organizer of a tax scheme and be its own problem, while the Tax Service will no longer have to prove the taxpayer’s guilt of tax evasion and its role will be just to perform arithmetical checks of input VAT and output VAT flows. On the balance, the entire responsibility for implementation of this project is imposed on businesses. Such scenario does not take into account that the risk of insolvency of any of chain suppliers will end up with the customer. Apart from that, no regulation is provided to allow participants of such ecosystem to dispute the validity of tax claims. So, implementation of this proposal of the Federal Tax Service “as is” will hardly contribute to the stability of civil commerce or eradication of illegal business schemes.
To crown up, before signing an agreement with a tax clause, the parties thereto should understand how such clause works and especially how reimbursable tax losses are determined. It is obvious that such legal mechanism will only work if the taxpayer itself does not evade tax. If however a court finds that the taxpayer was involved in a tax scheme, reimbursement of its tax losses will be refused. It should also be kept in mind that no clause can protect an affected party against insolvency or ‘disappearance’ of its contracting party.