Implications from sanctions: blocked income

1. Russian sanctions

As a result of the war in Ukraine,  the EU has issued several packages of restrictive measures (sanctions) against Russia that range from measures targeted at individuals, the financial sector, the energy sector, the airspace, maritime and transport sector; dual-use goods and advanced technology items and suspension of the Most Favoured Nation treatment of products and services of Russia. It may very well be that even more sanctions will be forthcoming. Belarus has also been targeted with certain sanctions. All in all this means that there are import and export prohibitions, asset freezes and a major halt has been called to financial transactions between EU Member States and targeted countries, companies or persons. This is a very fast-moving area of regulations and laws that needs to be closely monitored to allow for compliance with the sanctions. In addition, Non-EU countries are also issuing sanctions of their own.

The sanctions issued by way of EU Council decisions are binding on EU Member States and  those issued by way of Council Regulations are binding on any person or entity under EU Jurisdiction. They must be implemented by the EU Member States and the EU monitors whether the rules are uniformly applied.

In light of the sanctions, multinational enterprises (MNEs) doing business in Russia (or Belarus) through associated enterprises will undoubtedly question how to deal with the underlying contractual obligations that they have in place with their associated enterprises in those jurisdictions. Compliance with these rules is proving to be challenging largely because the scope of the sanctions is not seen as unequivocally clear.

Generally, MNEs are by law required for corporate tax purposes to treat their associated enterprises at arm's length. In case tax authorities believe associated enterprises in their jurisdiction have not been remunerated at arm's length, they are likely to impose adjustments and penalties. The sanctions regime that has been put in place, may present a dilemma if the sanctions would serve to block income to be received by associated enterprises in Russia.

The US tax practice may serve as an example here, as there is a history of strong resistance by the tax authorities to accept blocked income provisions for tax purposes for what they purport to be: rules that block the making/receipt of payments. Non-compliance with pre-existing contractual or payment obligations in and of itself may very well trigger unwanted consequences, in particular if those obligations are linked to guarantees or other performance related instruments. Adding to that a tax administration that insists on taxing a taxpayer as if payments were made and received despite blocked income provisions will lead to augmented costs and challenges. Therefore, anticipating these challenges and reducing exposure to the consequences can go a long way in preventing them or being able to successfully deflect them.

While it is impossible to predict when and how the Ukraine war will end or if and when the imposed sanctions may be lifted, it is highly likely that there will be a review as to whether the halt of performance and payments under existing contractual obligations between associated enterprises ought to be respected for tax purposes. If the halt of performance or payments will not be respected for tax purposes, absent domestic legislation stating otherwise, there is risk that associated enterprises that are based in or do business with Russia (and Belarus) will nevertheless be taxed on the basis of having performed or deemed to have received payments from their foreign associated enterprises.  

2. Case law on Blocked Income

For transfer pricing purposes, the issue of having to deal with regulations that disallow or limit (the level of) crossborder payments is nothing new. It was in issue in the 1992 Proctor & Gamble case where Spanish restrictions limiting foreign investment precluded a P&G subsidiary in Spain from making royalty payments to its Swiss parent company. It also arose in the 1996 Aramco advantage case, when Saudi Arabia disallowed its production partners to sell oil at a higher price than its predetermined price, to restrain price increases.

Proctor & Gamble

In the 1992 Proctor & Gamble case, Spanish law limiting foreign investment precluded a P&G subsidiary in Spain from making royalty payments to its Swiss parent company. Both entities were part of the Proctor & Gamble group of companies, which ultimate parent company is based in the United States. The Spanish entity manufactured and sold P&G products (synthetic detergents, soaps and toiletries and other cleaning and washing products) in Spain. A Spanish law on monetary crime required governmental authorization prior to making payments to residents of foreign countries, and a subsequent act required government approval relating to foreign direct investment. When P&G applied for approval to hold 100% of the capital of the Spanish company, such was granted but subject to the provision that no payments of royalties (or for technical assistance) could be made. P&G was informed by local counsel that there was no realistic possibility to appeal the decision. Essentially, although royalty payments could be made where the foreign investment provided a substantial impact on the Spanish economy, P&G Spain's relatively small operation apparently did not qualify for such an exemption.

P&G Spain was finally released from this law and successor laws in 1987, after it filed for removal of the imposed prohibitions. The IRS imposed adjustments to P&G (which were relevant for Subpart F purposes) imputing royalty income (as deemed received) to P&G Switzerland for all the relevant years, despite the legal prohibition in place during those years for P&G Spain to make such payments.

In a resulting Tax Court decision it was held that since Spanish law prohibited or blocked the royalty payments from P&G Spain to P&G Switzerland, there was no violation of the arm's length standard. It concluded that P&G Switzerland did not receive the royalty income and could not have received the royalty income by law. 

Aramco advantage case

Four US oil companies (Chevron, Texaco, Mobil and Exxon) that together were the core production partners of ARAMCO (the Arabian American Oil Company) complied with the rules set by the Saudi government as it related to crude oil during 1979-1981. The formally set price ($4 to $6 a barrel) was below the market price ($35) at the time and the production partners were required by the Saudi government to pass the price savings on to customers. This price cap lead to a competitive advantage for Aramco at the gas pump. The Internal Revenue Service maintained that the restrictions from the Saudi Arabian government did not make use of a higher transfer price impossible, and that the oil companies should have accounted for the crude oil as if it had been sold at prices higher than the mandated official Saudi price. In essence the taxable profit should have been calculated using the market price for a barrel of oil at the time.

The Tax Court rejected the IRS' income allocation in a 1993 decision, stating that the restrictions from the Saudi Arabian government made a higher transfer price legally unfeasible.

3. How to treat Blocked Income for Transfer Pricing purposes

While the two cases mentioned eventually were decided in favour of the taxpayer, they evidence that tax authorities may consider that government-imposed restrictions do not necessarily influence the income allocation between associated enterprises for tax purposes.

The referenced case law resulted in inclusion of so-called "blocked income" rules in the US domestic transfer pricing regulations that in particular focus on whether the imposed restrictions rise to the level of a qualifying legal restriction and on whether the funds could have been remitted in any (other) form (including as a dividend). It also resulted in inclusion in the OECD Transfer Pricing Guidelines (OECD TPG) of provisions on the effect of government policies.

While the US blocked income regulations have notably been challenged by two MNEs, namely Coca Cola and 3M, who argue that there is no obligation to engage in "self-help" and declare dividends that upon receipt are to be treated as (arm's length) payments, the risk remains that a taxpayer may be required by tax authorities to, at arm's length, secure alternative means to make a payment if such is available in cases of blocked income.

It is recognized in the OECD TPG that a taxpayer will have to consider that an arm's length price must be adjusted to account for government interventions such as price controls, price cuts, interest rate controls, controls over payments for services or management fees, controls over the payment of royalties, subsidies to particular sectors, exchange control, anti-dumping duties or exchange rate policies.

To make a persuasive case for compliance with the rules blocking payments, for transfer pricing purposes it will be key to determine and establish that the blocked income provisions apply consistently to associated enterprises and independent enterprises. This is because for transfer pricing purposes, the actions of an independent enterprise would generally be considered guiding. In that case, the expectation is that the income that is blocked will be deferred and will be included into taxable income in the year that it becomes unblocked.

The OECD TPG (p. 1.132-1.136) provide in relevant part that an independent enterprise would likely not be prepared to produce, distribute or otherwise provide products or services on terms that allows it no profit. Independent enterprises would probably not engage in a transaction subject to government interventions.  However, to the extent the contractual arrangements and transactions subject to the blocked income provisions were already in place before the blocked income provisions were issued, that guidance is not very helpful. Three options provided in the OECD TPG are:

a) Treating blocked income for tax purposes as nevertheless having been made between the associated enterprises. The rationale for this approach would be that an independent enterprise in similar circumstances would have insisted on payment by other means. The party to whom the blocked payment is due can in this case be treated as rendering a service to the MNE Group;

b) Alternatively, the income inclusion and related relevant expenses can be deferred. At the same time, the payor cannot claim a deduction in its tax computation for the blocked payment until the blocked income is eventually paid.

Dutch transfer pricing guidance in this respect (p. 2.5 of the Dutch TP Decree of 2018) provides further that while any payment related to contractually agreed performance may have to be included in taxable income or treated as a receivable, the value thereof may be eligible for depreciation based on prudent merchant's usage. Another approach would be to treat the the payment due as a (deemed) capital contribution.

The US interpretation has so far been that taxpayers may also pay a dividend, and recharacterize such payments upon receipt as payments due to be made/received under the contractual arrangements in place between the parties.

4. Closing observations

As companies review their contractual obligations vis-à-vis Russian counterparties generally in light of the myriad of sanctions that are being issued, it is highly recommended to:

(i) document the respective sanctions' scope and reach in detail to be able to maintain that the blocked income provisions apply consistently to associated enterprises and independent enterprises. Absent a clear showing that such is the case, deferred accounting treatment may be permitted but some governments may also maintain that alternatively a (non-deductible) dividend could have been made to satisfy the payment obligation and therefore the income will have to be taken into account for tax purposes;

(ii) consider (and document) whether the deferral of the blocked income will be treated as an intercompany loan or whether non-payment will (and can) be treated as a (deemed) capital contribution;

(iii) consider (and document) whether the payment due ought to be depreciated.

There is little doubt that contemporaneous documentation of any of the above decisions is highly likely to serve as persuasive evidence in case of future tax challenges.

Please do not hesitate to reach out to Monique van Herksen or Nick Skerrett if you wish to discuss further.