Business Fragmentation: Signs, Tax Implications, and Legal Defenses

Understanding Business Fragmentation: Signs, Liabilities, and Defenses

Business fragmentation refers to the artificial division of a single business into multiple legal entities, often to gain unjustified tax benefits. Tax authorities in Russia closely monitor such schemes, which can lead to severe financial and legal consequences.

Key Signs of Business Fragmentation

Tax authorities consider the following indicators when assessing whether a business has been artificially fragmented:

• Application of Special Tax Regimes: Multiple entities applying special tax regimes.
• Total Revenue Threshold: Total revenue of companies exceeding RUB 200 million.
• Single Production Process: Carrying out different, yet inseparably connected lines of activity that constitute a single production process aimed at a common result.
• Identical OKVEDs: Shared or highly similar OKVED (Russian National Classifier of Economic Activities) codes.
• Commonality of Employees and Counterparties: Employees or business partners being common across multiple entities.
• Rapid Establishment: Scheme members established over a short period, just prior to expanding capacity or increasing staffing levels.
• Cross-Bearing of Costs: Scheme members bearing costs on each other's behalf.
• Affiliation of Business Participants: Close affiliation between founders, managers, or other business participants.
• Shared Infrastructure: Use of the same signboards, designations, contacts, Internet site, physical addresses (offices, warehouses, production bases), banks for settlement accounts, cash control equipment, and terminals.
• IP Address Match: Transactions originating from the same IP address.
• Sole or Common Supplier/Customer: One participant acting as the sole supplier or customer for another scheme participant, or suppliers and customers being common to all participants.
• Unified Services: Shared services for accounting, personnel record keeping, recruitment, supplier/buyer relations, legal support, logistics, etc.
• Common Representation: Same persons representing interests in relations with state authorities and other counterparties.
• Performance Indicators Near Limits: Performance indicators (e.g., employee count, occupied area, income) being close to the limits for applying a special taxation system.
• Decreased Profitability: Accounting data, considering newly established organizations, indicating a decrease in production profitability and overall profit.
• Tax System-Based Allocation: Allocation of suppliers and purchasers among scheme members based on the taxation system they apply.
• Lack of Autonomy: Absence of autonomy and independence of companies, and lack of a clear business purpose for the fragmentation.

Legal Liabilities for Business Fragmentation

If illegal business splitting is proven, significant sanctions are imposed:

Actions by Tax Inspectors:

• Additional Tax Assessment: Tax is calculated on the income of all parties as if they were a single company, with additional VAT charges.
• Market Value Taxation: For purchases and sales between related parties at non-market prices, tax will be calculated based on the average market value of goods.
• Cancellation of Tax Benefits: Unjustified tax benefits or subsidies will be canceled and must be returned to the budget.
• Penalties: In addition to penalties on underpayment, a fine of 40% of the unpaid taxes amount will be imposed (Article 122, Paragraph 3 of the Tax Code).

Criminal and Subsidiary Liability:

• Bankruptcy Proceedings: If a company cannot fulfill its tax obligations, tax authorities may file for bankruptcy.
• Subsidiary Liability: In such cases, participants in the scheme will be held subsidiarily liable, meaning all debts incurred due to the split will be distributed among individuals.
• Criminal Liability: If the amount of arrears exceeds 15 million RUB, participants may face criminal liability (Article 199 of the Criminal Code of the Russian Federation). If the company's assets are insufficient to cover tax debts, the director, chief accountant, and other responsible persons may be held liable.

Favorable Court Practice for Taxpayers

Taxpayers have successfully defended against business splitting claims in various court cases, demonstrating that not every separation is illegal. Key arguments that have helped organizations win disputes include:

• Case № А46-213/2021: Companies operated in distinct market segments, had different employees, and largely different suppliers and customers. Inter-company loans were repaid.
• Case № А27-1559/2021: Three companies and an individual entrepreneur, though related in activity and interdependent, shared an IP address for reporting due to a single accountant working under power of attorney. However, other employees were distinct, and accounting, personnel, and warehouse records were separate. Each company owned its property and rented different premises. Funds were not redistributed.
• Case № A55-11590/2021: A company with a dealership agreement for original spare parts created a separate entity for non-original parts to avoid losing profits and customers, indicating a clear business purpose for the separation.
• Case № А52-5932/2021: An organization providing tourist accommodation and catering services opened a separate café because tourists often stayed for less than a day and didn't need three meals. Entities had different staff and activity types. Order transfers via agency contracts and shared bank accounts were not violations.
• Case № А12-443/2022: Three relatives traded at the same address, but each sole proprietor engaged in a different type of activity. Employee and cash flows did not overlap. Shared chief accountant and common discount card did not negate independent business operations.

Mitigating Circumstances for Reduced Liability

According to the Federal Tax Service's letter № BV-4-7/7751@ dated 12.05.2020, certain circumstances can mitigate liability for business fragmentation, potentially reducing fines by half:

• Difficult Financial Situation and Social Role: The company's challenging financial situation and active participation in public and charitable activities in the region.
• Voluntary Payment: Self-payment by the taxpayer to the budget of arrears, penalties, and fines accrued as a result of a tax audit.