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Tax Hit on Japan
// Japan Tobacco owes Russia $79 million
Business and Government
Yesterday the Ninth Arbitration Court of Appeal in Moscow agreed with the tax authorities' arguments and upheld a decision of the Moscow Arbitration Court to recover tax arrears for 2000 from ZAO JTI Marketing and Sales (a wholly owned subsidiary of Japan Tobacco Inc.). The company must pay $79 million in taxes, fines, and penalties. The appeal court's decision could have very serious consequences not only for the Japanese company, whose office if already expecting the arrival of bailiffs, but also for other large tobacco market participants.
Japan Tobacco International (JTI) owns the Petro factory (St. Petersburg) and JTI-Elets. The main brands are Camel, Winston, Salem, and Petr I. According to data of the Business Analyst research company, in November of last year, the company was in second place in volume of cigarette sales on the Russian market in monetary terms (18.4 percent of the market), pushing British American Tobacco (BAT) to third place with 18.2 percent of the market. On the results of November 2004, the company was in fourth place in volume terms, controlling 16.2 percent of the market, trailing Philip Morris (26.3 percent), Gallaher (17.1 percent), and BAT (16.7 percent). The company's sales volumes in 2004 retail prices amounted to nearly $1.2 billion. All of JTI's sales in Russia are through ZAO JTI Marketing and Sales.
Immediately after the court announced its decision, JTI distributed a press release, in which it announced it would appeal the decision in a court of appeal. “Although JTI understands that appeal court decisions are generally pronounced in favor of orders issued by lower courts, nevertheless, the company expected that its arguments would prevail,” the document states. “More than ever, we do not understand this decision.”
The tax authorities had several claims against the JTI subsidiary. The most important of these was that ZAO JTI understated the VAT on sales of the Petro factory's products, with which it was connected by an agency contract.
The following arbitrary example serves to illustrate the essence of the Federal Tax Service's claims. Under a commission agreement, ZAO JTI sold cigarettes produced at Petro for 10 rubles. This amount includes ZAO JTI's commission of 2 rubles. Petro paid VAT on the selling price (i.e., 10 rubles), while ZAO JTI paid it on its commission prices, that is, 2 rubles. However, the price used in internal documents was the so-called discount price of a pack amounting to 5 rubles, or “the value used for management accounting purposes,” as ZAO JTI representatives called it. Lawyers from Salans, the firm representing JTI's interests, maintain that the discount value was used for the convenience of internal document flow. It did not appear in accounting source documents and has nothing to do with tax payments. But officials of Tax Inspectorate No. 41 of the Ministry of Taxation believe that ZAO JTI expressly understated VAT and in reality must pay taxes on the difference between the discount price (i.e., 5 rubles) and the price of cigarettes supplied to distributors (10 rubles). In other words, the basis for calculating VAT is not 2 rubles but 5 rubles.
In addition, the tax authorities maintain that deliveries of goods for ZAO JTI in the first quarter of 2000 were made under two contracts simultaneously, namely, an agency contract and a sale contract. That is, the same goods were sold twice. JTI lawyers replied that the agency contract was in force in the first quarter of 2000, and then the sale contract entered into force. Nevertheless, the court refused to allow the company's appeal and upheld the decision of the Moscow Arbitration Court of September 23, 2004 on recovery of taxes, fines, and penalties for 2000 amounting to 2.4 billion rubles ($79 million) from the JTI subsidiary.
Most taxation experts had difficulty reaching a consensus on the interpretation of yesterday's court decision. Yury Vorobyev, a partner with MKA FBK-Law noted that “it's one thing if the discount value appeared in the accounts. But if it existed only as an abstract figure, then of course, JTI is right.” According to Kommersant's information [JTI's lawyers have confirmed it], the ill-fated discount value appeared in the accounts only once, on ZAO JTI's off-balance account. In the opinion of Eldar Nazmutdinov, a lawyer with IK Prospect, this situation could have arisen due to a software peculiarity. “Bookkeeping and management accounting have many similarities and a company frequently uses the same software for them. It's not inconceivable that management accounting materials slipped out in the bookkeeping data during the installation of some wiring,” he said.
The reaction of tobacco market experts was more unequivocal. Sergey Shelekhov, the head of the Grandtabak Association, noted that “these court decisions spoil the investment climate.” “I would understand if JTO had made an obvious error or miscalculation. But here we're talking about extremely ambiguous things that still need to be examined,” he said.
There is indeed something to examine. Petro and ZAO JTI used the same payment scheme to the end of 2004. So in future, the tax authorities could levy similar fines against the company for 2001-2004. If this occurs, according to the most modest estimates that do not consider an increase in the company's sales, the tax authorities could demand additional payments of $320 million. It would not be easy to pay them. As Andrey Sterlin, the head of Business Analyst, noted, “even $79 million is a lot of money for ZAO JTI, and in order to make the payments, the Russian subsidiary would probably have to turn to the parent company for help; but $320 million is an enormous amount of money.”
In addition, the scheme under which JTI operates in Russia (the factory–marketing firm link) is used by nearly all large tobacco companies. For example, all of Philip Morris's sales in Russia pass through Philip Morris Sales and Marketing, and BAT's sales go through a company called ITMS. Neither company is officially commenting on the situation. In private conversations, their representatives told Kommersant categorically that there was no discount value in their documentation.
Besides an appeal in a court of appeal, JTI intends to file an application to suspend the court decision. However, according to a source in the company, a meeting was held in JTI's office yesterday, at which options for possible actions if bailiffs appeared were discussed. What is more, the problem with the bailiffs is not the only one. As Kommersant has already reported (see the issue of January 21), in September of last year, the investigative committee of the Ministry of the Interior instituted a criminal case against ZAO JTI on charges of tax evasion in 2000.
Dmitry Dobrov
All the Article in Russian as of Feb. 04, 2005
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