Evgeniya Zainchukovskaya, VERBA LEGAL’s Counsel and Head of Tax Advisory and Litigation Practice, and Senior Associate Andrei Sheptiy continue making a series of posts on tax-related nuances of M&A transactions and corporate restructurings in Head of Tax Telegram channel.

The first post dealt with the conversion of debt into equity. The second post is about contributions to property.

In practice, when financing a company through equity, business owners often make contributions to property rather than to the authorized capital. The reason for this is the convenience of the mechanism:

• there is no need to alter the authorized capital and amend the register;

• a contribution to property does not affect the size of the stockholding.

However, shareholders and participants often overlook the tax consequences that contributions to property may entail. Below we give a brief description of the situations that most often arise in reality.

1. Tax neutrality of contributions to property

Contribution to property is a tax-neutral transaction for both the transferring and the receiving parties. For the receiving party, the contribution to property is not subject to income tax, provided that the statutorily prescribed procedure for making a contribution to property has been complied with (subparagraph 3.7, paragraph 1 of Article 251 of the Russian Tax Code).

2. Taxation nuances to take account of when selling a company

For the purposes of taxation of the sale of a company, the cost base depends on who made the contribution to the property and what property was contributed to the company:

• for individuals, expenses in the form of a contribution to property are not taken into account;

• for legal entities, only the contribution in cash is to be accounted for.

3. No cost base for the receiving party

In case of a non-cash contribution, the tax value of an asset for the receiving party is set as equal to zero, meaning that no depreciation will accrue and no costs will have to be accounted for upon the subsequent sale of the received property (paragraph 1 of Article 277 of the Russian Tax Code).

4. VAT for the transferring party

Due to the ambiguity of subparagraph 3.4 of Article 39 of the Russian Tax Code and the negative stance taken by the Ministry of Finance, there is a risk of additional VAT being assessed when making a contribution to the property.

5. No VAT deductions by the receiving party

When making a contribution to the property, the transferring party is obliged to reapply the VAT previously claimed as deductible, while the receiving party does not have the right to deduct it, since paragraph 11 of Article 171 of the Russian Tax Code allows for such deduction to be made only for the purposes of making a contribution to the authorized capital. This brings about the risk of violating the principle of tax neutrality.

Therefore, for the purposes of defining a transaction structure it is necessary to stay mindful of the significant tax differences between a contribution to the authorized capital and a contribution to the property. You may come up with an inefficient solution if you choose what equity financing mechanism to employ without looking into potential tax consequences.

For more information, please visit Head of Tax Channel.