Signs of splitting up the business: the Federal Tax Service has summarised the positions taken by the courts
Background
Courts regularly consider disputes between the Federal Tax Service of the Russian Federation (FTS) and taxpayers in connection with splitting up of a business. Business splitting is an artificial distribution of income between several persons (entities), which covers the actual activity of one business entity that does not meet the statutory conditions for the application of a special tax regime (for the sake of brevity we will write ‘USN’).
The Federal Tax Service has summarised numerous court practices and provided examples of illegal business splitting, some of which we will consider below (Letter of the Federal Tax Service of Russia dated 16.07.2024 No. BV-4-7/8051@).
Creation of new companies under the simplified taxation system when expanding a business
The expansion of a business by creating new legal entities under the simplified taxation system solely for the purpose of obtaining tax benefits is an artificial split.
A management company under the simplified taxation system performed the functions of CEO (general director) in a number of companies (also under the simplified taxation system) which provided apartment building management services. New companies in this structure were created as the volume of work increased. Both the management company and these companies had one founder who exercised control over them.
The courts concluded that the sole purpose in choosing the appropriate business structure was to obtain a tax benefit through the application of the simplified taxation system by the companies.
Artificial separation of a part of a unified business
Artificial separation of a part from a single business with its subsequent transfer to a controlled person applying the simplified taxation system is also an artificial splitting.
A hotel on the simplified taxation system leased a building. When income approached the limit value under the simplified taxation system, 2 floors in the building were formally leased to interdependent persons, without any actual changes in the hotel's activities.
The court concluded that the hotel continued to provide hotel services as part of a single production process, and the participation of interdependent persons was aimed solely at preserving the hotel's simplified taxation system.
Interdependent persons have artificially divided a production process
Interdependent persons carry on business within a single production process with a common economic result but have formally divided it between themselves for the purposes of tax benefits is also considered as a form of splitting.
A sole proprietor spouse sewed clothes, but only one spouse actually produced and sold them. In addition, the employees of both spouses worked in one team - and the total number of employees exceeded the limits for maintaining the simplified taxation system for each spouse.
The court concluded that the spouses split one business in order to avoid the spouse as the main participant in this process from calculating and paying VAT and personal income tax.
Are there other signs of business splitting?
The Federal Tax Service in its letter indicated also other signs of business splitting, including:
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entering into transactions with interdependent persons in order to understate the income received;
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reallocation of part of income by a taxpayer under the general taxation system to taxpayers with the simplified taxation system;
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conducting business by a company with a founder-IP and/or a manager-IP, if this is aimed at minimising tax liabilities, etc.
Business splitting may also be established by the Federal Tax Service for other reasons. It is important, as it is punishable by fines, not to engage in business splitting for the sole purpose of evading tax.