Fly-by-night companies: how to reveal a risky counterparty?-Publication

Almost every company that is not careful in selecting a counterparty risks facing a fly-by-night. The relations with such a firm are accompanied by a number of risks: economic, tax and even criminal risks. On the basis of the judicial practice and opinions of practising lawyers, the portal GARANT.RU gained insight into how to reveal a bad-faith firm and avoid contacting it.

What is a fly-by-night?

Despite the commonness of this phenomenon and the extensive judicial practice, the Russian laws do not have a general definition of the fly-by-night company. However, it can be formulated using a considerable number of signs pointed to by courts and government authorities in their opinions and explanations.

Thus, in particular, the Federal Tax Service of Russia believes that in a general sense the fly-by-night is deemed to be the legal entity that is not de facto independent, is established without the purpose of doing business, that, as a rule, does not submit tax reports and is registered at the mass registration address (see, for example, Letter of the FTS of Russia No. ЕД-4-2/13005@ dated 24 July 2015). The agency also names a wide range of signs of the fly-by-night, to which one should pay attention when selecting a counterparty.

They include the absence of personal contacts of the management of the vendor company and the buyer company, the documentary proof of their authority, the information about the counterparty’s actual location as well as the location of warehouses, production or sale areas. Tax authorities also suggest considering the following facts as suspicious: no advertisement in mass media, no recommendations of partners or other persons, no counterparty’s website and no information about the state registration of the counterparty in the Uniform State Register of Legal Entities.

Along with that, the FTS of Russia counts as additional signs, in particular, the inclusion in contracts of the terms and conditions differing from usual and customary business practices, for example, long deferrals of payments, the delivery of large lots of goods with no prepayment or guarantee for payment, settlements via third parties or with bills and many others (Order of the FTS of Russia No. ММ-3-06/333@ dated 30 May 2007 “On Approval of the Concept of the System for Planning Field Tax Inspections”). It is logical to assume that the larger number of signs the doubtful entity matches, the higher the probability that it is a fly-by-night.

Courts, when making a conclusion that a firm has the said signs, rely on several grounds. The key signs pointed to by the tax service in the first place often suffice for courts, they being the ‘mass’ registration address, the ‘mass’ executive or founder (ruling of the Ninth Arbitrazh Appellate Court No. 09АП-28276/17 dated 11 July 2017, ruling of the Arbitrazh Court of the Far-Eastern Okrug No. Ф03-4892/16 dated 21 October 2016 with regard to case No. А73-11012/2015, ruling of the Twentieth Arbitrazh Appellate Court No. 20АП-7868/16 dated 2 June 2017, ruling of the Arbitrazh Court of Moscow Okrug No. Ф05-8423/17 dated 26 June 2017 with regard to case No. А40-137528/2015).

At the same time, courts also pay attention to other signs, for example, no fixed assets, settlement accounts and workers engaged under independent contractor agreements (ruling of the Sixteenth Arbitrazh Appellate Court No. 16АП-1141/15 dated 16 June 2015). Judges also consider as questionable the companies that pay taxes in the minimum amount and are not able to deliver goods (Determination of the Supreme Court of the Russian Federation No. 301-КГ16-17102 dated 21 December 2016). The absence of personnel, own or rented vehicles and premises is also named among suspicious signs (Determination of the Supreme Court of the Russian Federation No. 309-КГ16-2889 dated 19 April 2016).

For that matter, the lawmaker might not see the point of introducing the definition of a fly-by-night exactly because the practice distinguished too many various signs of such firms, and the attempt to combine them in one concise definition will lead to the restrictive interpretation. Furthermore, the practice usually responses to the changes in business more quickly and is able to distinguish new signs of fly-by-nights faster, as they come up.

Why is a fly-by-night dangerous for a good-faith counterparty?

General risks

According to the estimates of Ekaterina Larina, Head of the Committee for the Protection of Consumer Rights in Culture and Sports of the Russian Consumer Association , the activity of such firms is usually focused on cashing in or funds offshoring. The business contact with such a firm threatens a number of risks associated with the economic activity.

Thus, Irina Anoshina, Head of Accounting Department of BDO Unicon Outsourcing, names the following risks for the cases when the fly-by-night is a supplier:

the risk of invalidation of the contract
the failure to supply goods, provide services, perform works
the failure to meet the contract performance deadlines
the low quality of goods, works or services
the failure to return the effected advance payment
the delivery of the pledged goods, property
the risk of loss of reputation before the client.

In addition, she also admitted that the company cooperating with a fly-by-night may be accused of its participation in corrupt practices and money laundering.

Furthermore, among the most severe risks that one can encounter in practical work, Yury Ivanov, Project Manager of Tax Department of the legal firm VEGAS LEX , named the impossibility of performing warranty obligations with regard to the works performed and the goods supplied. He added that the interaction with this kind of firms bears the risk of the further interest on the part of the Ministry of Internal Affairs of Russia and the Investigation Committee of the Russian Federation both in tax, and other crimes, i.e. the illegal banking activity (basically, for the money withdrawal), the illegal incorporation of the legal entity, the forgery and so on. Such interest may be limited by the request of documents, the expert said. However, if it results in searches, seizures and interrogations, this will actually paralyse the company’s activity for an indefinite period.

Tax risks

However, all the experts questioned by the portal GARANT.RU note that the interaction with a fly-by-night may cause mainly tax risks. The FTS of Russia makes it clear that using fly-by-nights in the economic activity is one of the most widespread methods of gaining the unjustified tax benefit (information of the FTS of Russia as of 15 October 2008 “Methods of Carrying out the Financial and Economic Activity with a High Tax Risk”).

The essence is that the taxpayer is suspected of establishing the fly-by-night to gain the unjustified tax benefit. As a result, the good-faith counterparty, according to the experts, may be refused the acceptance of the VAT to be deducted under the transactions with this entity, charged additional amounts of taxes with regard to the resulting tax arrears, or the amount may be excluded from expenses, which will allow to charge the profit tax additionally. The Investigation Committee of the Russian Federation and the FTS of Russia believe that the example of the tax offence committed, which entails the imposition of tax liability in the form of a fine at the rate of 40% of the non-paid amounts (Cl. 3, Art. 122 of the Tax Code of the RF), is the taxpayer’s cumulative action aimed at building corrupted, artificial contractual relations, the simulation of the real economic activity of nominees. For instance, the tax avoidance scheme implies the artificial ‘split-up’ of business to preserve or obtain the taxpayer status under a special tax regime.

What is important is that nominees, according to government authorities, are usually used with intent, and the task of tax and investigative authorities is to reveal and prove that (Methodological Guidelines of the Investigation Committee of Russia “On Investigation and Proving of the Facts of Wilful Non-Payment or Partial Payment of Tax (Due) Amounts”).

By the way, the approach, according to which the taxpayer, when entering into relations with fly-by-nights, acts wilfully and creates an artificial situation, was criticised by Konstantin Aranovsky, the judge of the Constitutional Court of the Russian Federation , in the context of consideration of a certain case. In his opinion to Determination of the Constitutional Court of the Russian Federation No. 1440-O dated 4 July 2017, he stated that business is done and business entities are registered always for a purpose, not everything in business is farsighted and successful, but everything is purposely and in this sense intentional. In his opinion, the ‘creation of an artificial situation, does not produce any offence elements either, in both business, or tax relations, because this is about the purposeful activity with the purposeful entry into the legal relationship, which in any way creates an ‘artificial situation’. Furthermore, he noted that the ‘split-up of business’, let alone the formal one, and bad faith do not produce in themselves the set of elements of a tax offence either.

Nevertheless, as Maksim Khvalibov, Head of Taxes and Dues Department at Arconik , said at the conference “Topical Fiscal Issues” organised by Kommersant Publishing House, good-faith enterprises suffer from the legal relations with fly-by-nights because in courts where taxpayers challenge decisions of tax authorities it is the latter that often ‘win’. They, for example, refer to the fact that the company built up a formal document flow and that there were no real economic operations with its counterparties having the signs of the nominal activity (Ruling of the Arbitrazh Court of Saint Petersburg and the Leningrad Region No. А56-2331/2017 dated 12 July 2017, Ruling of the Arbitrazh Court of the Samara Region No. А55-30226/2016 dated 12 May 2017).

In another case the court also took the side of the tax authority and ruled that the VAT deduction was made for the purposes of the unjustified tax benefit as the company did not act with due diligence when selecting counterparties. At that time the tax office revealed the transit nature of cash flows as cash circulated among the same entities that bore the signs of fly-by-nights (Ruling of the Arbitrazh Court of the Perm Krai No. А50-4720/2017 dated 26 May 2017).

However, at the same time the FTS of Russia believes that the taxpayer shall be held liable on the basis of the totality of circumstances. It explained, for example, that the establishment of the fact of signing of documents on behalf of the counterparties by the persons denying their signing is not an unconditional and sufficient basis for making the conclusion that the taxpayer did not act with due diligence and care when closing the transaction with the counterparty in dispute. Therefore, the Service recommends tax authorities to take account of other factors as well in the course of inspections, and specifically investigate the matters as to whether the selection of the counterparty differed from the ordinary course of business or the practice established by the taxpayer itself (Letter of the FTS of Russia No. ЕД-5-9/547@ dated 23 March 2017 “On Revealing Circumstances Related to the Unjustified Tax Benefit”).

It is fair to say that sometimes companies succeed in proving that they are good-faith taxpayers and courts uphold their position pointing to the absence of malice aforethought (Ruling of the 8th Arbitrazh Appellate Court with regard to case No. А70-15635/2016 dated 14 July 2017). As a rule, in similar cases, judges note that tax offices should estimate the totality of circumstances to declare the tax benefit as unjustified, and some of them refer to the above mentioned letter of the Federal Anti-Monopoly Service of the Russian Federation dated 23 March 2017 (Ruling of the Arbitrazh Court of the Volga Okrug with regard to case No. А57-17335/2016 dated 26 June 2017, Ruling of the Arbitrazh Court of the Nizhny Novgorod Region with regard to case No. А43-6538/2017 dated 4 August 2017, Ruling of the Arbitrazh Court of Moscow with regard to case No. А40-224912/16-20-2017 dated 9 August 2017).

Nevertheless, despite a certain probability to win the case from the tax authority, in general, it is better not to enter into the relationship with fly-by-nights in order to avoid litigation and related costs. Practising lawyers said what actions should be taken to secure oneself against a questionable firm in advance.

How a good-faith company can avoid contacting with fly-by-night firms

Practising lawyers recommend companies to make enquiries about the counterparty in advance. First of all, it is necessary to find out whether or not the company has the ‘mass’ executive and whether or not it is registered at the ‘mass’ address.

Then, one should check when the firm was registered (fly-by-nights, as the name implies, do not ‘live’ for a long time), whether it submits tax returns, whether it has employees and no debts. Thus, Maksim Khvalibov thinks that the period of state registration of a reliable supplier shall be at least one year, the amount of fixed assets at least RUB 100,000 and the average headcount at least four persons.

Dmitry Yastrebov, Chief Research Adviser of Capital Legal Services, PhD in Law stresses that it is also important to find out whether the counterparty has a licence, if its activity is subject to licencing. Furthermore, if the contract specifies that the counterparty will perform the obligations only on its own, then the expert thinks that it will also be useful to obtain from the firm the statement saying that it has enough production capacities, sale areas, vehicles and other resources that are required to perform its obligations.

Of course, to have a proof of the other information about the counterparty, it is necessary to request relevant documents from the company, including annual financial statements and the articles of association, the resolution on the appointment of the executive, the power of attorney issued on behalf of the entity, the information related to fixed assets, etc. Also, it would not be inappropriate to obtain the electronic extract via the FTS of Russia’s resource egrul.nalog.ru, it can be done on one’s own, without requesting the counterparty and free of charge.

It is also recommended to check the authority of the persons who sign documents. Anna Kondakova, Leading Legal Council of Alta Via and Anastasia Chislova, Legal Council of the same company, suggest one should check the authority not only at the time of closing the transaction, but also on the date of signing the documents proving the contract performance. David Kapianidze, Head of Tax Department of BMS Law Firm, advises fixing personal meetings with the counterparty’s officials. Yury Ivanov thinks it to be useful to visit the counterparty’s offices and production premises directly. In general, according to the expert’s estimates, the formal collection of documents of title and even the restrictions to interact with new firms alone will not be able to ensure the efficient fight against fly-by-nights.

Therefore, along with the collection of documents, experts recommend studying the counterparty’s web-site, advertisements and references. David Kapianidze advises saving the contact details of the persons who directly perform work, and if your company uses access control, always keeping the applications for the permits for the counterparty’s workers. In case of the supply of goods, he thinks it is important to obtain the documentation reflecting the movement of the goods from the seller to the buyer and notes that, if there are warehouses, it is necessary to obtain the consignment notes proving that the goods were shipped from the seller’s warehouse. Irina Anoshina even recommends companies to introduce the regulations for checking counterparties as part of the document flow schedule in the company.

Dmitry Yastrebov suggests one should check the data on the counterparty’s litigation periodically, for example, every quarter or month. In particular, this can be done via the State Automated System ‘Justice’ or the Commercial Case File.
In other words, lawyers advise providing oneself with as many documents as possible when interacting with counterparties, which will serve the evidence of the company’s due diligence, should a dispute arise. However, along with this it is important that one should take active practical actions when gathering the firm-related information to be sure that it really can perform the work, provide the service or deliver the goods.

How does the government fight against them?

The government fights against fly-by-nights aggressively and, according to official data, quite efficiently. This March, the FTS of Russia announced on its official website that the number of fly-by-night firms had reduced 2.5 times from 1.8 mln in 2011 to 700 thous. in 2016. The reduction, as the Service believes, was supported by the large-scale work on the cleaning of the Uniform State Register of Legal Entities. In 2016, 650 thousand legal entities bearing the signs of a dummy company were stricken off the Register, which is 3.5 times higher than in 2015. Yet in the 1st semester of 2017, the share of companies with the signs of unreliability in the Uniform State Register of Legal Entities decreased by over 20%. For the six months, over 230 thousand unreliable companies were stricken off and over 300 thousand entries about the unreliability of information related to firms were made.

It is reasonable to assume that the further work of the FTS of Russia with suspicious companies will be supported by the recent legislative developments. Since the 1st of September of the current year, there has been a working regulation. It says that if the legal entity does not correct the unreliable information about itself included in the Unified State Register of Legal Entities, due to which the entry about the unreliability of such information is made to the register, this legal entity will be stricken off the Register (Art. 2 of Federal Law No. 488-FZ dated 28 December 2016 “On Amendments to Certain Legislative Acts of the Russian Federation”). According to the new regulations, the statement of reply of the legal entity, the rights of which are affected by the decision to strike the legal entity off the Uniform State Register of Legal Entities, shall be well-grounded.

Ekaterina Larina thinks that one of the methods of fighting could also be the change-over to online cash desks. Let us recall that using the new cash register equipment implies that the unaltered information shall be sent by the taxpayer to the fiscal data operator, and by the latter to the FTS of Russia (Part 2, Art. 4.5 of Federal Law No. 290-FZ dated 3 July 2016 “On Amendments to Federal Law ‘On the Application of Cash Register Equipment in Effecting Cash Payments and/or Payments using Payment Cards’ and Certain Legislative Acts of the Russian Federation”).

Therefore, before closing a transaction with a certain company, one should, wherever practical, obtain all the important information about the potential counterparty, certainly, in a lawful manner. Despite the fact that the government is taking a number of actions to reduce ‘fly-by-nights’, companies should be careful and attentive, first, to protect their business from losses, and, second, to avoid problems with public authorities.

Source: garant.ru