The Yukos syndrome

Graham Povey is a partner in the Moscow office of Deloitte & Touche, where he leads M&A services for the firm and the Deloitte consumer & industrial products industry group across the CIS, as well the corporate tax practice. He can be reached at gpovey@deloitte.ru.

In July 2004, the Russian government charged Yukos Oil Company with the evasion of around $7 billion in taxes. Yukos had allegedly misused Russian tax havens throughout the 1990s, although many speculated that the government's decision to prosecute was motivated by the political activities of Yukos's owner, billionaire Mikhail Khodorkovsky. The company, one of the largest private oil companies in the world in its heyday, filed for bankruptcy two years later and was ultimately dismembered. Khodorkovsky was convicted of tax evasion and sent to Siberia.

Four years later, Yukos remain a cautionary tale for many, warning foreign investors to invest in only the most pristine of companies. For these investors, the taxation environment remains a major concern. For private equity investors, that concern has several aspects. They need to determine whether it is possible to find targets clean enough to invest in, how to factor tax efficiency into the deal, and whether the combination of past and future tax risks will turn today's profitable investment into tomorrow's loss maker.

?It is possible to do deals in Russia with the right planning and a healthy understanding of the issues you will come up against. Indeed, there is currently an overall trend in Russia toward transparency, and a move away from the aggressive tax structuring of the past. This is an ideal moment for PE firms to invest in companies that are already convinced of the need to structure their tax affairs.?

Certainly, tax is an area to focus on intensively when looking at a Russian deal, both in terms of avoiding risks and generating efficiencies. But the central message of this article is that it is possible to do deals in Russia with the right planning and a healthy understanding of the issues you will come up against. Indeed, there is currently an overall trend in Russia toward transparency, and a move away from the aggressive tax structuring of the past. This is an ideal moment for PE firms to invest in companies that are already convinced of the need to structure their tax affairs sensibly.

First, a very brief overview of the Russian tax system. Headline tax rates are low (e.g. 24 percent corporate income tax, 18 percent VAT, 13 percent flat rate personal income tax) and, as might be expected with low rates, tax incentives are also limited. There is currently no tax consolidation in Russia; each entity pays tax on its individual profits. Transfer pricing legislation is limited and relatively ineffective. In terms of the wider tax environment, Russia's tax enforcement process continues to improve in terms of its consistency and the tax authority's approach to taxpayer. The court system is relatively objective, surprisingly fast, and more than two thirds of cases are decided in favor of the tax payer. Nonetheless it is certainly the case that tax has been used as a weapon in political challenges or criminal investigations, and that trend is likely to continue.

On the deal side, our experience of tax due diligence in the Russian environment has certainly thrown up some interesting case studies, including examples where the value of evaded taxes was higher than the equity value of the business, or groups with literally hundreds of entities in a web of affiliated party transactions. But a key point is that in tax terms not all businesses are the same, and not all sectors are the same. The biggest issues we see are definitely in young, entrepreneurial businesses, in sectors such as consumer goods and services. In these types of companies we look for signs that not all income is recorded or that salaries are paid off the books. Often we see a series of linked events, for example the non-recording of income or the creation of fictitious expenses, with the resulting free cash used to pay salaries or distributions to the owners.

However, as companies become larger and more public, and start to look to debt or capital markets for financing, they are forced to become more transparent. They need a Big 4 audit, and therefore the likelihood that they have major tax issues decreases. Sectors also change over time. A good example is the consumer electronics retail sector, where the percentage of goods imported through grey structures has fallen dramatically, and where the big players have a strong vested interest in the move to full legal importation. Another example is real estate, a sector which has made considerable progress in cleaning up its act over the last few years as its financing needs have increased.

In other sectors, the issues are very different. For example in a big oil or natural resources company, we would not generally expect to see significant optimization of taxes within Russia. We would however be looking at the foreign trading companies of such groups to understand if the margins they record make sense relative to the trading activities of those entities. Similarly, in a bank, due to the close supervision from the Central Bank, we would not generally see very aggressive tax optimization in the bank entity itself. However, we would look carefully to understand what transactions are taken out of the bank's balance sheet into other group or affiliated entities.

Based on the size, age and sector of a given target, plus some initial analysis of publicly available information, an auditor can usually glean the type and extent of tax risks we are likely to find in the due diligence process. An auditor can also indicate how difficult or costly it will be to remove such issues post-acquisition. For PE firms looking at a pipeline of possible investments, an understanding of the different risks they are likely to see for different targets is invaluable and is important to develop in-house as well as through external advisers.

Nonetheless, given that tax risks do continue to exist in Russia, it is important also for a PE firm to decide up front its approach to investment in such an environment. If a firm is only willing to invest in completely clean companies, then its scope of investments will be very limited. If a firm is open to investing in a business with a clear road map of how to bring its tax practices into line over the coming years, then the firm will have a wider selection of targets, as well as the potential for upside as the clean business increases in value four or five years down the line.

In terms of structuring the deal, there are two parallel priorities ? to minimize risks wherever possible, and to factor in tax efficiency. Traditionally the focus has been on the former, at the expense of tax efficiency, but that picture is gradually changing.

In terms of avoiding risks, the key point is first to understand what the risks are ? through a rigorous but pragmatic due diligence process ? and, vitally, to understand where in the existing structure the risks are focused. The next question is to understand exactly which parts of the business you need to buy. Much Russian tax structuring is accomplished through complex group structures and use of affiliated entities. Do you need to pick up all those entities with their associated risks? Or are you actually only interested in personnel, IP and specific assets? Because of the high incidence of tax risks, one common structure which has developed is to require the seller to move relevant assets and people into a new, clean company which the buyer then purchases through its off-shore holding structure. This is not always possible ? for example in an asset intensive or very complex business ? but certainly it is likely to be viable in small to mid-size transactions in the consumer sector, i.e. exactly in those companies with the most tax issues. Often one sees a combination asset and share deal, with certain assets and personnel moved into a clean entity, with some existing group entities also purchased, but others left behind.

The ability to leverage the acquired business in a tax efficient manner has been key to private equity's success in many markets. The Russian tax code has no specific rules which litigate against push down of debt, nor that would specifically prevent interest deductions after a merger or group reorganization. But it does have a general overriding principle that expenses must be ?economically justified? and aimed at the generation of profit in order to be deductible, and also an emerging concept of ?sham? transactions, or transactions designed purely to generate tax benefit. Such principles are open to interpretation, and there has been little in the way of guidance or litigation relating to interest expenses. In parallel with such tests, Russian thin capitalization rules have developed over the years and now do need to be taken into consideration.

Nonetheless our view is that it is possible to achieve strong leverage in a Russian investment, and we have seen many transactions where this has been accomplished. Probably the best case for an interest deduction to be reasonably secure is when debt is placed in an existing operating entity and a clear business purpose for the financing can be demonstrated, even where the amounts of such financing are substantial. In terms of interest rates on debt, specific caps exist in the legislation, but it is certainly still true that market interest rates are higher in Russian than in many jurisdictions, which leads to some flexibility depending on the PE firm's international financing cost.

Looking forward, tax legislation in Russia keeps developing. Group consolidation for tax purposes is on the books for 2009, and could hugely change the tax landscape. The trend for low tax rates looks likely to continue, and there is discussion of lowering the VAT rate, which in turn lessens the incentives for businesses to evade taxes. At the same time the tax authorities are becoming more sophisticated, and better equipped to look at the substance of transactions rather than just their form.

In conclusion, tax in Russia is likely to remain more of a focus in the deal process than in more mature tax environments. But it is definitely possible to pick out the right targets from a tax perspective early in the acquisition process; it is generally possible to structure the deal to minimize the tax risks; and tax is usually no longer such an issue that it overwhelms the commercial attractiveness of the target.