Criteria for Distinguishing Royalties from Services
Prada Kazakhstan LLP (hereinafter referred to as the “Partnership”) filed an administrative claim against the Department seeking the annulment of the notification on the results of the tax audit and recognition as unlawful of the actions related to the preparation of the tax audit report.
By a judgment of the Specialized Interdistrict Administrative Court of Almaty dated 16 November 2021, the Partnership’s administrative claim was dismissed, while the Partnership’s claim for recognition as unlawful of the actions related to the preparation of the documentary tax audit report was returned by a court ruling. By a resolution of the Judicial Collegium for Administrative Cases of the Almaty City Court dated 5 May 2022, the judgment of the court was upheld.
By Resolution of the Judicial Collegium for Administrative Cases of the Supreme Court of the Republic of Kazakhstan No. 600122-00-6ап/1293, 6001-22-00-6ап/1293(2) dated 28 February 2023, the judicial acts were set aside.
It follows from the case materials that the Partnership is part of the Prada Group of companies, which is managed by Prada SpA, operating under the laws of Italy (hereinafter referred to as “Prada SpA”).
The Company’s principal activity is the retail sale (resale) of knitwear, hosiery, footwear and accessories.
The Department conducted a comprehensive tax audit of the Partnership to verify the correctness of the calculation and timely payment of taxes and other mandatory payments to the budget. The audit period covered the period from 1 January 2017 to 31 December 2019.
The tax audit report and the notification were served on the claimant’s representative on the date of their issuance. Furthermore, on the date of issuance of the tax audit report, 14 June 2021, Chief Specialist A.T. Aibekova was included in the audit team on the basis of an additional order.
The lower courts concluded that the findings of the Department based on the documentary tax audit, as well as the notification issued by the Department, were consistent with the applicable legislation of the Republic of Kazakhstan and corresponded to the factual circumstances of the case.
The Judicial Collegium considers these conclusions to be unfounded for the following reasons.
Subparagraph 10) of paragraph 1 of Article 158 of the Tax Code requires that the tax audit report contain a detailed description of the violations identified, with an indication of the relevant provisions of the legislation of the Republic of Kazakhstan whose requirements were violated.
An examination of the tax audit report established that it did not contain a comprehensive analysis of the types of services provided by the Supplier to the Recipient under the agreement and service agreement concluded between them.
Pursuant to the Service Agreement dated 24 June 2013, the Supplier, Prada SpA, and the Recipient, Prada Kazakhstan LLP, are companies within the Prada Group.
Sections E and F of the aforementioned agreement set out the list of services provided by the Supplier to the Purchaser, including information technology services, sales organization services, corporate services, media planning services, technical maintenance services, procurement organization services, financial services for organizations, logistics services, communications services, e-commerce services, and other services, which are described in greater detail in the annex to the agreement.
Furthermore, on 28 February 2014, an outsourcing services agreement was concluded between Prada Rus LLC and Prada Kazakhstan LLP covering the provision of information technology management, technical support, human resources management, legal support, logistics, retail, and repair services.
Thus, the Judicial Collegium considers that, when making erroneous conclusions in the tax audit report concerning the transfer of intellectual property, the Department failed to fully examine the list of services provided to the Partnership. This demonstrates the lack of substantiation of the conclusions reached by the tax authority following the audit.
The Partnership’s argument concerning the absence of the signature of the second auditor, A.T. Aibekova, in the tax audit report also merits consideration.
Pursuant to paragraph 2 of Article 158 of the Tax Code, a tax audit report shall be prepared in at least two copies and signed by the officials of the tax authority who conducted the audit.
Under subparagraph 10) of paragraph 2 of Article 152 of the Entrepreneurial Code, an act on the results of preventive control with a visit to the controlled entity (facility) and/or an inspection shall contain the signature of the official(s) who conducted the preventive control with a visit to the controlled entity (facility) and/or the inspection.
Accordingly, disagreeing with the conclusions of the lower courts, the Judicial Collegium considers that the presence of the signature in the tax audit report is a mandatory requirement established by the Tax Code and the Entrepreneurial Code.
The Partnership’s arguments also merit consideration that, according to the annexes to the service agreement and agreement with Prada SpA and Prada Rus LLC, the services do not involve the use, assignment or granting of rights to use intellectual property, including, without limitation, copyright-protected works (software), know-how and/or trademarks.
In this case, the following classification of types of income should be made.
Subparagraph (i) of paragraph 2 of Article 5 “Permanent Establishment” of the Convention between the Government of the Republic of Kazakhstan and the Government of the Italian Republic for the Elimination of Double Taxation with Respect to Taxes on Income and the Prevention of Fiscal Evasion (hereinafter referred to as the “Italy–Kazakhstan Convention”) provides for the provision of consulting services by a non-resident through employees or other personnel hired for such purposes. Where such services are provided in the territory of the Republic of Kazakhstan for more than 12 months, this results in the creation of a permanent establishment (PE). The income of such PE is subject to taxation in the Republic of Kazakhstan pursuant to Article 7 of the Italy–Kazakhstan Convention and the Tax Code.
Similar provisions are contained in the Convention between the Government of the Russian Federation and the Government of the Republic of Kazakhstan for the Elimination of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and on Capital (hereinafter referred to as the “Russia–Kazakhstan Convention”).
For services for the purposes of Article 5 of the Conventions, the following criteria may be identified:
- such type of income is actually received by the non-resident through the involvement of employees / personnel / subcontractors;
- as a rule, the personnel provide services at the request of the client in the Republic of Kazakhstan;
- man-hours and timesheets may be used to determine the final cost of the services;
- the services are provided either during business trips or remotely, but by specific personnel;
- the services are accepted (or not accepted) by the client, and certificates of completed work (services rendered) or another document substantially equivalent thereto are signed;
- there is a tangible result of the service in the form of a report, resolution of a technical problem (information services), representation of the client’s interests in court or in negotiations (legal services), or the search, interviewing and selection of a specific candidate (human resources services).
At the same time, where the non-resident has created copyright-protected works, such right has been registered with the authorized body and is exclusive, the payments received by the non-resident should, in such case, be treated as royalties.
Article 12, paragraph 3 of the Russia–Kazakhstan Convention provides the following definition of “royalties”: payments of any kind received as consideration for the use of, or the right to use, any copyright in literary, artistic or scientific works, including computer programs, cinematographic and television films, video recordings or recordings for radio or television broadcasting, any patent, trademark, design or model, plan, secret formula or process, or for information (know-how) concerning industrial, commercial or scientific experience, and payments for the use of, or the right to use, industrial, commercial or scientific equipment.
Accordingly, the characteristic criteria of royalties are as follows:
- the existence of registered copyright;
- the provision of information having value, generally without the involvement of personnel. At the same time, pursuant to paragraph 4 of Article 6 of the Law “On Copyright and Related Rights”, copyright does not extend to ideas, concepts, principles, methods, systems, processes, discoveries and facts as such;
- payments may be fixed or may depend on the profitability of the business (which is characteristic of a comprehensive franchise licence). As a rule, there is no dependence on the man-hours expended; rental of specialized equipment;
- in the dispute under consideration, the non-residents provided services aimed at improving the efficiency of product promotion in the relevant market, sales and distribution strategy consulting, financial planning, human resources management, financial services, accounting, tax accounting, legal services, and repair services. At the same time, the suppliers did not transfer the copyright to the relevant reports.
In confirmation of this fact, the claimant submitted, in particular, the following reports pursuant to the court’s request:
- a report on the work performed in organizing an event for loyal customers (organization of customer dinners at the Ritz-Carlton restaurant);
- reports on personnel recruitment and maintenance of personnel records;
- reports on payroll calculation and preparation of orders, where a subcontractor in the Republic of Kazakhstan (an outsourcing company) was involved, as well as employment orders;
- reports on the replacement of the façade marble and insulation works on the external façade, where a subcontractor in the Republic of Kazakhstan was involved;
- reports on the procurement of the current collection of models;
- reports on training sessions conducted by O.V. Timofeeva;
- reports on the arrangement of external window displays, where a subcontractor in the Republic of Kazakhstan was involved;
- reports on the list of goods and packaging purchased (payments for goods are not payments for services or royalties).
In its written submissions, the claimant also referred to reports concerning the provision of legal support (approval of powers of attorney, preparation of draft agreements, analysis of the applicable legislation), data storage on a server, data transmission, support for access to the SAP program, technical maintenance, electricity costs, business travel expenses, and product repairs.
A number of services were provided by the non-resident with the involvement of Kazakhstani subcontractors. At the same time, in order to comply with transfer pricing requirements, given that the cost of the services was invoiced by a related company within the PRADA Group, a markup (margin) was also added to the cost of the services invoiced to the claimant. However, the respondent’s position was set out in the tax audit report, in which no issues were raised regarding the justification for obtaining the services in the above manner.
In these circumstances, the Judicial Collegium concludes that, in the absence of a proper examination in the tax audit report of the types of services provided, the Department’s conclusions regarding the withholding of tax on income in the form of royalties and the corresponding assessment of corporate income tax (CIT) cannot be considered lawful.
Given that the lower courts failed to provide a proper legal assessment of the circumstances of the case concerning the claimant’s challenge to the notification on the results of the tax audit, and committed errors in the assessment of evidence and in the interpretation and application of substantive and procedural law, the Judicial Collegium considers that the judicial acts should be set aside and a new decision issued granting the Partnership’s claim.
The Judicial Collegium considers that the judicial acts of the lower courts concerning the return of the claim insofar as it sought recognition of the documentary tax audit report as unlawful should be upheld, since, in the administrative claim filed, the Partnership challenged both the notification on the results of the tax audit and the actions related to the preparation of the documentary tax audit report.
In these circumstances, the Partnership’s cassation appeal is subject to partial satisfaction.
Conclusions
The encumbering administrative act in this category of cases is the notification. At the same time, it is based on the tax audit report. The report itself is not subject to challenge, as it constitutes evidence in the case and does not, in and of itself, produce encumbering legal consequences. However, this does not mean that such report is not required to be signed by the auditors where this is expressly provided for by the Tax Code.
In judicial proceedings, an administrative body is limited to the arguments set out in the administrative act. Accordingly, in the present case, the court cannot engage in a debate as to the specific margin at which the foreign offices should have invoiced their services to the claimant. At the same time, it is unequivocal that, in conducting a documentary tax audit, the auditors were required to examine the primary documentation. An analysis limited to the agreements, invoices and brief certificates of completed work was insufficient, since no actual assessment was made as to what specific services had been received (access to an intellectual property product or access to services provided at the client’s request).
Pursuant to subparagraph 4) of paragraph 2 of Article 19 of the Tax Code, tax authorities are required, within their competence, to provide explanations and comments concerning the emergence, performance and termination of tax obligations. Such explanations and comments, as well as methodological recommendations, including those issued by the authorized body, do not constitute regulatory legal acts. They are subject to assessment by the court, taking into account their compliance with the provisions of tax legislation.
Tax policy (a set of measures aimed at establishing new taxes and payments to the budget and abolishing existing ones, changing tax rates, taxable items and items related to taxation, and the tax base for taxes and payments to the budget) is implemented by the authorized body in the field of tax policy.
Where an international treaty ratified by the Republic of Kazakhstan establishes rules other than those contained in the Tax Code, the rules of the respective treaty shall apply (paragraph 5 of Article 2 of the Tax Code). Pursuant to paragraph 3 of Article 4 of the Constitution, the procedure and conditions for the operation within the territory of the Republic of Kazakhstan of international treaties to which Kazakhstan is a party are determined by the legislation of the Republic.
Where a ratified international treaty grants the Government of the Republic of Kazakhstan the right to impose taxation, but such right has not been implemented in national legislation (i.e., a tax exemption is provided), the national legislation shall apply.
When interpreting double taxation conventions, the general rules of interpretation established by international treaties and the legislation of the Republic of Kazakhstan shall apply, provided that such rules of interpretation are consistent with the provisions of the Vienna Convention on the Law of Treaties, to which the Republic of Kazakhstan acceded pursuant to a Resolution of the Supreme Council.
The resolution of the issue of conducting tax control where a claim for liquidation (recognition of the registration (re-registration) of a legal entity as invalid) has been granted falls within the competence of the tax authority. Only upon the tax authority taking the measures prescribed by tax legislation may the rights and legitimate interests of counterparties be affected; such counterparties are entitled to protect their rights and legitimate interests by challenging decisions, actions (inaction) of tax authorities.
The courts should be clarified that, pursuant to subparagraph 3) of paragraph 2 of Article 49 of the Civil Code, courts may decide to liquidate a legal entity where the legal entity is absent at its registered location or actual address, as well as where its founders (participants) and officials, without whom the legal entity cannot function, have been absent for one year.
The absence, in their entirety, of the above-mentioned characteristics constitutes grounds for dismissing the claimant’s claim, since tax authorities have other means of responding to such circumstances.
State re-registration of a legal entity constitutes an administrative act of the registration authority; therefore, a claim seeking recognition of such re-registration as invalid shall be considered in accordance with the procedure established for administrative proceedings.
The courts should take into account that, since 1 January 2020, participants in tax legal relations, when taking actions during the current tax period in respect of previous tax periods, are not entitled to apply the repealed provision of the Tax Code establishing a five-year limitation period, since under the current provision of the Tax Code the limitation period is three years, unless otherwise provided by the Tax Code.
Tax authorities are not entitled to bring claims against a taxpayer and/or tax agent after the expiry of the limitation period. At the same time, the Tax Code does not limit the accrual of penalties by the limitation period.
The general limitation period, taking into account its suspension during a tax audit concerning transfer pricing, may not exceed seven years.
When suspending an audit on the above-mentioned matters, the tax authority must comply with the requirements of Article 8 of the Law of the Republic of Kazakhstan dated 5 July 2008 No. 67-IV “On Transfer Pricing”.
The limitation period may be suspended upon sending a request, which must meet the following requirements:
- it must be addressed to the competent authority (organization) of the state;
- it must be individualized and prepared in respect of the taxpayer being audited;
- it must concern matters falling within the scope of the audit.
The courts should take into account that, where a request does not comply with the above requirements, such request shall not be deemed to have been duly sent.
With respect to tax claims for the payment of taxes and other payments to the budget calculated and assessed by the state revenue authorities and presented to taxpayers for payment within the limitation period, the expiry of the limitation period does not terminate the tax obligation that has arisen and does not release the taxpayer from its performance.
A distinction must be made between the right of a tax authority to assess or revise the calculated or assessed amount of taxes and other mandatory payments to the budget and the taxpayer’s right to request a set-off and/or refund of taxes and payments to the budget and penalties. Thus, when a taxpayer exercises its right to obtain a refund of taxes from the budget, the tax authority does not assess or revise the calculated amount of taxes; rather, it confirms or refuses to confirm the refund of taxes from the budget.
In this regard, with respect to the taxpayers’ right to request a set-off and/or refund of taxes and payments to the budget and penalties, when calculating the limitation period, the date on which the tax authority receives (registers) the tax application provided for in subparagraph 1) of paragraph 4 of Article 101 of the Tax Code, or the claim for a refund of the excess amount of VAT provided for in subparagraph 2) of paragraph 1 of Article 431 of the Tax Code, should be taken into account, rather than the date on which the decision based on the results of the tax audit, including the notification on the results of the tax audit, is issued.
If the claimant has paid the state duty using an incorrect budget classification code or has paid it in an insufficient amount, pursuant to part four of Article 138 of the Administrative Procedural and Process-Related Code of the Republic of Kazakhstan (hereinafter referred to as the “APPC”), the judge shall point out these deficiencies to the claimant and establish a time limit for their correction.
The submission by a taxpayer, within the period established by the Tax Code, of explanations concerning the identified violations that are not specified in paragraph 3 of Article 96 of the Tax Code and that comply with the requirements of subparagraph 2) of paragraph 2 of Article 96 of the Tax Code shall be recognized as compliance with the notification on elimination of violations identified by the tax authorities based on the results of desk (cameral) control and shall not require verification of the substance of the justification for such violations.
By virtue of part two of Article 135 of the APPC (claim for recognition), the claimant may also seek recognition as unlawful of an encumbering administrative act that no longer has legal effect. Therefore, claims challenging an executed notification based on the results of desk (cameral) control shall be subject to judicial consideration.
A claim challenging a notification based on the results of desk (cameral) control shall be considered in accordance with the procedure established for administrative proceedings.
When considering claims challenging notifications on the elimination of violations provided for in subparagraphs 2) and 3) of paragraph 3 of Article 96 of the Tax Code and identified by tax authorities based on the results of desk (cameral) control, the court is required to assess and examine the evidence submitted by the taxpayer confirming the actual receipt of goods, works and services specifically from the legal entity and/or individual entrepreneur whose registration (re-registration) was declared invalid by a court decision that has entered into legal force, in accordance with paragraph 5 of Article 96 of the Tax Code.
In all other cases, it is sufficient for the court to establish whether the tax authority had the statutory grounds for issuing the notification, without examining the substantive validity of its requirements. Otherwise, the results of future tax audits would effectively be predetermined, including those of an unscheduled thematic tax audit concerning non-compliance with the notification issued based on the results of desk (cameral) control.
The tax authority is entitled to issue a decision recognizing a notification as unfulfilled, including where:
- the taxpayer is not required to submit an explanation (paragraph 3 of Article 96 of the Tax Code) and the violations have not been remedied;
- the deadline established by the Tax Code for submitting an explanation or filing a complaint against a notification based on the results of desk (cameral) control has expired, and the violations have not been remedied;
- by a court decision that has entered into legal force, the taxpayer’s claim seeking recognition as unlawful of a notification issued pursuant to paragraph 3 of Article 96 of the Tax Code has been dismissed, and the violations have not been remedied.
A complaint (claim) against a decision recognizing a notification as unfulfilled may be filed by the taxpayer within ten business days from the date of its service (receipt) with a higher-level tax authority and/or the authorized body or with a court.
The taxpayer has the right to choose the authority with which the complaint (claim) is to be filed.
At the same time, it should be borne in mind that, pursuant to paragraph 3 of Article 117 of the Tax Code, no penalty shall be accrued on tax arrears in respect of property tax, land tax and vehicle tax payable by individuals where such arrears arose as a result of the tax authorities’ revision of the calculated tax amounts after the payment deadline for the relevant tax period had expired.
At all stages of challenging the actions and acts of tax authorities, the court should consider the possibility of reconciliation between the parties and the possibility for the tax authority to resolve the dispute independently (for example, by making amendments to information systems where technical errors exist, changing the status of desk (cameral) control notifications to “fulfilled”, and so forth) where administrative discretion is involved.
Pursuant to part six of Article 98 of the APPC, a complaint may not be resolved to the detriment of the applicant. Since a thematic audit under Article 186 of the Tax Code is initiated in the course of considering a complaint filed by a taxpayer (tax agent), the authorized body may not, based on the results of such audit, make a decision assessing additional amounts of taxes, other mandatory payments to the budget or penalties that were not assessed in the contested notification.
A decision of a higher-level authority (authorized body) adopted following consideration of a complaint against a notification on the results of a tax audit may not be subject to judicial challenge, as it does not entail legal consequences. Where the notification on the results of the tax audit is left unchanged, the said notification itself may be challenged in court; where the notification is cancelled in part, the notification on the results of consideration of the complaint against the notification on the results of the tax audit may be challenged.
Pursuant to Article 148 of the Tax Code, an order is the basis for conducting a tax audit.
As an act authorizing a tax audit, an order may be subject to judicial challenge, since it is issued in the exercise of the tax authority’s public powers and entails legal consequences for the taxpayer (tax agent).
Unscheduled audits may not be initiated or conducted in the absence of the grounds listed in paragraph 3 of Article 145 of the Tax Code and paragraph 3 of Article 144 of the Entrepreneurial Code. Such audits are subject to being declared invalid, and the acts authorizing them are subject to being declared unlawful and cancelled pursuant to paragraph 1 and subparagraph 1) of paragraph 2 of Article 156 of the Entrepreneurial Code, as having been issued in the absence of grounds for conducting the audit.
Based on Article 159 of the Tax Code, under which the decision based on the results of a tax audit is the notification on the results of the tax audit issued by the tax authority, where a taxpayer (tax agent) disagrees with the assessed amounts of taxes and other mandatory payments to the budget, obligations to calculate, withhold and transfer mandatory pension contributions and mandatory occupational pension contributions, the calculation and payment of social contributions and/or contributions to mandatory social health insurance, and penalties, the reduction of losses, the failure to confirm for refund amounts of excess VAT and/or corporate (individual) income tax withheld at the source of payment from non-residents’ income, only the notification is subject to judicial challenge. The court shall examine the legality of the assessment of the contested amounts, taking into account the findings set out in the tax audit report.
A tax audit report may be challenged where the taxpayer disagrees with its findings that did not produce the above-mentioned consequences but nevertheless affect the taxpayer’s rights and obligations, including in future tax periods. A challenge to the tax audit report shall be carried out in accordance with the procedure established by the legislation of the Republic of Kazakhstan for challenging the actions of officials of tax authorities.
The performance of a notification on the results of a tax audit does not deprive the taxpayer of the right to challenge the performed notification in accordance with the procedure and within the time limits established by the Tax Code.
The content of a tax audit report must comply with the requirements of paragraph 1 of Article 158 of the Tax Code. The findings of the tax authority concerning a violation by the taxpayer (tax agent) of the tax and other legislation of the Republic of Kazakhstan must be set out with references to the relevant provisions of legislation, with substantiation of the arguments and disclosure of the circumstances evidencing the violations.
Pursuant to part three of Article 129 of the APPC, when considering a claim challenging the results of a tax audit, the tax authority may refer only to the findings and reasoning evidencing a violation by the taxpayer of tax and other legislation, as reflected in the tax audit report.
Pursuant to the principle of certainty of taxation established by Article 6 of the Tax Code, taxes and payments to the budget of the Republic of Kazakhstan must be certain.
Certainty of taxation means establishing in the tax legislation of the Republic of Kazakhstan all grounds and procedures for the emergence, performance and termination of a taxpayer’s tax obligation, as well as the tax agent’s obligation to calculate, withhold and transfer taxes.
The burden of proving the circumstances that served as the basis for the tax authority’s adoption of the contested act rests with the tax authority.
Taking into account the provisions of Article 128 of the APPC, the tax authority bears the obligation to submit to the court evidence demonstrating the unlawfulness of the taxpayer’s receipt of a tax benefit.
35. Where a taxpayer challenges a notification on the results of a tax audit or a tax audit report on the grounds that the tax authority violated the procedure and time limits for conducting tax audits established by Paragraph 2 of Chapter 18 of the Tax Code, the court should proceed from an assessment of the nature of the violations committed and their impact on the legality and validity of the audit results. In particular, the results of an audit conducted without an order, which pursuant to Article 148 of the Tax Code constitutes the basis for conducting a tax audit, or on the basis of an order subsequently declared unlawful, shall be declared unlawful.
The same consequences shall arise where, in violation of paragraph 1 of Article 146 of the Entrepreneurial Code, an order to conduct a tax audit, except for a counter-audit, was not registered with the authorized body in the field of legal statistics and special records.
Abbreviations
APPC – Administrative Procedural and Process-Related Code
CPC – Civil Procedure Code
Tax Code – Code of the Republic of Kazakhstan “On Taxes and Other Mandatory Payments to the Budget”
DGD, Department – Department of State Revenues
UGD, Administration – State Revenue Administration
CC – Criminal Code
CPCr – Criminal Procedure Code
CIT – Corporate Income Tax
VAT – Value Added Tax
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