Counterparty Due Diligence for Foreign Trade in Russia

November 30, 2023

BRACE Law Firm ©

International trade transactions require entrepreneurs to interact with foreign partners under specific conditions. To minimize potential adverse risks in foreign trade, entrepreneurs must exercise due diligence toward future partners and conduct comprehensive verifications.

The Tax Code of the Russian Federation does not contain the concept of due diligence. However, the Plenary Ruling of the Supreme Arbitration Court of the Russian Federation No. 53 dated October 12, 2006, On the Evaluation by Arbitration Courts of the Validity of a Taxpayer Obtaining a Tax Benefit, introduced this term into the practice of tax dispute resolution. Pursuant to this Plenary Ruling, a counterparty’s violation of its tax obligations does not, in itself, prove that the taxpayer received an unjustified tax benefit. Tax authorities may recognize a tax benefit as unjustified if they prove that the taxpayer acted without due diligence and caution, and that the taxpayer should have known about the violations committed by the counterparty, particularly due to interdependence or affiliation between the parties. Tax authorities may also deem a tax benefit unjustified if they prove that the taxpayer, its interdependent persons, or its affiliates conducted operations primarily with counterparties that fail to fulfill their tax obligations. The standard of diligent behavior requires verifying a counterparty’s business reputation, its ability to perform obligations, and its solvency. This standard aims to prevent potential losses caused by a counterparty’s failure to perform or improper performance of contract obligations. If management fails to meet this standard, they may face liability in a lawsuit brought by the organization for damages resulting from a breach of the duty to act in the best interests of the legal entity in good faith and reasonably.[1]

Furthermore, existing commercial court practice suggests that courts view due diligence as the taxpayer taking all possible measures when selecting a potential counterparty. These measures include confirming that the counterparty is not subject to insolvency (bankruptcy) proceedings, verifying that the counterparty possesses the necessary resources to fulfill contractual obligations, checking business reputation, and obtaining copies of incorporation documents, extracts from the Unified State Register of Legal Entities (the "USRLE"), and copies of the director's passport.[2]

Generally, entrepreneurs should conduct due diligence on foreign partners during the preparation phase of a foreign trade transaction to assess the partner’s reliability and the feasibility of contract performance.

The simplest method of verification involves requesting documents directly from the prospective counterparty. A refusal or delay in providing such documents may indicate the foreign partner’s bad faith. Typically, requests for documents include:

• incorporation documents of the organization;
• the powers of the director;
• an extract from the state register confirming the status of the legal entity;
• bank details of the company;
• tax reporting and confirmation of resources necessary to perform the foreign trade contract (in certain cases).

When verifying a counterparty, entrepreneurs also examine the partner’s registration, financial capacity, and commercial reputation. Investigating these aspects allows one to conclude whether it is feasible to execute and perform a foreign trade contract with minimal risk. Modern counterparty verification services allow for the analysis of these areas to inform decisions on further cooperation.

Notably, modern technology permits the receipt of requested documents in electronic form. Most Russian and foreign government services provide the ability to obtain necessary supporting documents electronically.

However, while electronic documents are quickly accessible, such information is often for reference purposes only and may not constitute official government-standard supporting documents. Consequently, requesting up-to-date information directly remains a critical aspect of interacting with foreign partners.

Foreign partners must provide all information in their native language, English, or Russian. Moreover, information presented in different languages must be identical.

Stages of Due Diligence for Foreign Companies

To ensure full cooperation, entrepreneurs evaluate prospective foreign partners in several key areas:

• Legal Aspects of the Foreign Counterparty’s Activities.This area includes verifying the partner’s registration, the representative’s authority, and the presence of any representative offices in the country. It also involves confirming the accuracy of bank details, permits, and licenses. Additionally, entrepreneurs analyze court records involving the counterparty, including potential bankruptcy, liquidation, or reorganization proceedings, as well as any lawsuits filed against the partner.
• Financial Analysis of the Company.Financial statements are a vital component of the verification process. This analysis checks the company’s actual assets, debts, the absence of bankruptcy litigation, and the fulfillment of financial obligations, as well as any affiliated persons. This information is accessible through public sources or by requesting the company’s accounting reports directly from the counterparty.
• Physical Verification and Site Visits.A comprehensive assessment may require a visit to the production site in the manufacturer’s country. This method is frequently used to evaluate Chinese manufacturers, such as garment factories. Such visits confirm the actual existence of the foreign partner beyond the digital space. However, one should be cautious of "entrepreneurs" who provide services for allegedly existing factories with working staff; this is particularly common among manufacturers of mass-produced goods, such as certain Chinese partners.

Therefore, it is essential to verify the counterparty not only on paper but also to confirm its physical existence, production facilities, and capacity to perform the foreign trade contract. Ultimately, the provided information must align with the organization’s actual operational indicators.

Verification Services for Russian and Foreign Partners

Given the need to verify various aspects of a foreign company’s activities, entrepreneurs utilize diverse services to obtain a comprehensive opinion:

• databases of tax authorities in the foreign partner’s country;
• public databases;
• databases of representative offices and branches registered in the partner’s country.

Additionally, entrepreneurs use paid services that provide full information on counterparties. For instance, the Chamber of Commerce and Industry of the Russian Federation issues business reports on Russian legal entities. These reports include registration data, foundation dates, legal status, contact information, data on charter capital, founders, subsidiaries, accounting reports, financial stability analysis, and a conclusion on the feasibility of cooperation.

To verify a foreign partner that has previously interacted with Russian entrepreneurs, one should use information regarding Russian commercial court cases and enforcement proceedings involving that partner.

The Federal Tax Service (the "FTS") of Russia website provides information on the tax authorities of CIS member states:

• Azerbaijan – Ministry of Taxes of the Republic of Azerbaijan;
• Armenia – State Revenue Committee of the Government of the Republic of Armenia;
• Belarus – Ministry of Taxes and Duties of the Republic of Belarus;
• Kazakhstan – Tax Committee of the Ministry of Finance of the Republic of Kazakhstan;
• Kyrgyzstan – State Tax Service;
• Moldova – State Tax Service of the Republic of Moldova;
• Tajikistan – Tax Committee of the Government of the Republic of Tajikistan;
• Turkmenistan – Main State Tax Service of Turkmenistan;
• Uzbekistan – State Tax Committee of the Republic of Uzbekistan;
• Ukraine – State Tax Administration of Ukraine.

The FTS Russia website also provides links to public databases for other foreign states, including Great Britain, Germany, India, Ireland, Italy, Canada, Cyprus, the Netherlands, New Zealand, Slovakia, Finland, France, the Czech Republic, Switzerland, Sweden, and individual US states.

The Bank of Russia recommends exercising due diligence toward counterparties. In its Letter No. 59-4/29017 dated June 10, 2021, On Sending Methodological Recommendations for Entrepreneurs 2.0: What to Do if the Bank Has Restricted Account Operations, the Bank listed the following services for verifying Russian counterparties:

• Transparent Business – a service by FTS Russia;
• Information on legal entities with tax arrears and/or those failing to submit tax reports for over a year;
• Suspension of bank account operations by FTS Russia;
• Court case verification;
• The official resource of the Federal Bailiff Service of the Russian Federation;
• The SME Business Navigator portal.

Furthermore, portals for checking trademark ownership and intellectual property rights may be used, as these factors can impact the performance of a foreign trade contract.

Verifying a foreign counterparty can be time-consuming, requiring interaction with various supervisory authorities and organizations to obtain reliable information. Consequently, most entrepreneurs engage specialized organizations or professionals who manage international trade transactions to conduct these verifications.

Potential Risks in Interacting with Foreign Partners

The goal of any verification is to confirm that the organization acts in good faith, conducts real business, and can enter a contract without risks of negative tax or other consequences, which include:

• Risk of Violating Tax Legislation.Even if a Russian entrepreneur is a bona fide taxpayer, a foreign partner’s failure to comply with tax laws can adversely affect the Russian entrepreneur’s activities.[3]
• Reputational Risk.This involves the potential failure to perform other obligations that depend on the foreign partner.
• Financial Risk.Although all business involves financial risk, thorough due diligence can help avoid unforeseen circumstances during contract performance. A partner’s financial stability is critical for the full performance of the contract. Bankruptcy, external debts, tax arrears, and seized accounts or property create significant financial risks in foreign cooperation.
• Risk of Counterparty Bankruptcy or Liquidation.An entity undergoing bankruptcy or liquidation is an unreliable counterparty. Additionally, one must verify the authority of the individual signing the foreign trade contract, as the transaction could subsequently be declared invalid.

To reduce risks associated with bad-faith partners, the Order of the FTS Russia No. MM-3-06/333@ dated May 30, 2007, approved the Concept of the System for Planning Field Tax Audits. Pursuant to Paragraph 12 of this Concept, taxpayers should investigate the following indicators when assessing tax risks related to certain counterparties:

• the absence of personal contact between the management (authorized officials) of the supplier and the buyer during contract negotiations or signing;
• the lack of documentary evidence of the counterparty’s director’s authority or copies of their identity document;
• the lack of documentary evidence of the counterparty’s representative’s authority or copies of their identity document;
• the lack of information regarding the counterparty’s actual location or the location of its warehouse, production, or retail space;
• the lack of information on how the counterparty was identified (e.g., no media advertising, no partner recommendations, no website), especially if information about other market participants offering similar goods or services at lower prices is readily available;
• the lack of information regarding the counterparty’s state registration in the USRLE (accessible via the FTS Russia website).

The presence of such indicators suggests a high risk that tax authorities will classify the counterparty as problematic (a "shell company") and view transactions with them as suspicious.

The following circumstances further increase these risks:

• the counterparty possessing the above indicators acts as an intermediary;
• contract terms differ from established business customs (e.g., long payment delays, delivery of large batches without prepayment or guarantees, disproportionate penalties, settlements through third parties or promissory notes);
• the absence of obvious evidence (e.g., copies of documents confirming production capacity, licenses, qualified personnel, or assets) of the counterparty’s ability to perform the contract, or reasonable doubt regarding such ability given the time required for production or delivery;
• purchasing goods through intermediaries when such goods are traditionally produced by individuals who are not entrepreneurs (e.g., agricultural products, scrap metal, forest products);
• the lack of actual attempts by the taxpayer (or the counterparty) to collect debts;
• an increase in debt while continuing to supply large batches of goods or services to the debtor;
• the issuance or purchase/sale of promissory notes with unclear liquidity, or the provision/receipt of unsecured loans, particularly those without interest or with repayment terms exceeding three years;
• a significant share of expenses from transactions with "problematic" counterparties relative to total costs, especially where there is no economic justification or positive effect from the transaction.

The position of the tax authorities is clear: when choosing a counterparty, the taxpayer must exercise due diligence and caution by requesting a package of documents (the specific contents of which are not legally defined). [4]

Tax authorities maintain a position where the taxpayer’s right to a tax benefit is determined by evaluating the counterparty’s "good faith." This often leads to the unjustified assessment of additional taxes. Commercial court practice is extremely strict, setting standards for proving good faith that may have been non-existent at the time the contracts were signed.

Entrepreneurs must evaluate risks related to international trade comprehensively by studying the full spectrum of a foreign partner’s activities. This affects contract performance and the Russian entrepreneur’s compliance with national laws. Executing a foreign trade contract entails obligations not only under the contract and international law but also under national customs, tax, and currency legislation.

To collect comprehensive information, entrepreneurs often engage specialists who conduct research and prepare reports covering all aspects of a prospective foreign partner’s business.

____________________________

References

[1] Letter of the Federal Tax Service of Russia No. BV-19-7/126@ dated April 25, 2023.

[2] Letter of the Office of the Federal Tax Service of Russia for the City of Moscow No. 14-16/179534 dated November 3, 2017.

[3] Resolution of the Arbitration Court of the Volga District No. F06-8899/2023 dated October 18, 2023, in Case No. A57-34008/2022, On Recognizing a Decision of a Tax Authority as Invalid. During the trial, the court found that the tax authority assessed additional VAT and interest after concluding that the taxpayer and its counterparties acted in bad faith. The court denied the claim because the taxpayer created formal document turnover, the counterparties did not perform freight transportation, and the taxpayer’s inclusion of VAT deductions from invoices provided by these counterparties constituted intentional actions aimed at reducing tax obligations.

[4] Letter of the Federal Tax Service of Russia No. ED-4-2/9521@ dated May 18, 2018.