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Taxation and expropriation - the destruction of the Yukos oil empire.

 I. INTRODUCTION

 II. THE RISE--YUKOS IN THE ERA OF COWBOY CAPITALISM
 A. The Yeltsin Period--1990 to 1999
 B. The Putin Period--2000 to 2008

III. THE FALL--EXPROPRIATION BY LITIGATION

 IV. THE AFTERMATH--LITIGATION EVERYWHERE
 A. Russian Claims on Foreign People and Property
 B. Attacking the Yukos Transactions in National Courts
 C. International Adjudication

 V. IMPLICATIONS FOR THE GLOBAL ECONOMIC ORDER

 VI. CONCLUSION


I. INTRODUCTION

The rise, fall, and death agony of the Yukos conglomerate have all the elements of great literature. The tale features strong personalities, sudden twists of fate, and profound clashes of principle. The arc of the plot tracks Russia's deepest struggles in the two decades since the demise of the Soviet Union and Soviet Communism. Real individuals have suffered, one dying horribly in prison. The events have inspired books and movies, and the story is not close to ending. (1)

This article does not have literary aspirations, but it does press the importance of the Yukos affair as a window into contemporary Russia and, more generally, modern efforts to impose order on the world economy. It focuses not on the human drama of the story, great though it is, but rather on the episode's significance in the ongoing struggle over economic freedom and state sovereignty. Most importantly, the Yukos story indicates the limits to the international rule of law.

In a nutshell, the rise and fall of Yukos illuminates four narratives about the modern world economy. First, it exposes the challenges--some might say insuperable barriers--to creation of a liberal society on Russian soil. Second, it shows the deep problems with top-down law reform in societies undergoing rapid and wrenching political, economic and social change. Third, it demonstrates how renationalization works in a particularly high-stakes context. Finally, it reveals the capabilities and limits of international dispute settlement through courts, arbitration, and diplomacy when confronting profound conflicts between private rights and fiercely guarded national interests.

As for the first point, one must carefully distinguish liberalism from democracy. A democratic society gives the population power and influence through effective mechanisms that translate the popular will into government policy. Liberalism entails the maintenance of institutions, both public and private, that check government power and open up a space for private transactions and expression. Russia since the fall of Communism has enjoyed a robust if imperfect democracy. By every conceivable indicator, President Putin enjoys widespread popular support, with his actions against Yukos in particular bolstering his approval. But democracy does not necessarily lead to constraining the state, as the Yukos affair demonstrates. The voice of the polis can call out for and cheer on the destruction of over-mighty private actors: In Russia, it did. (2)

Law reform was a worldwide growth industry in the 1990s, the era that spawned the Yukos empire. The transition from totalitarian and authoritarian states with government monopolies over economic activity to something that might resemble liberal democracy inspired many to look to law as the midwife of a new order. Foreign specialists, myself included, flocked into the former Warsaw Pact countries in hopes of building new institutions, with law as the bricks and mortar. But for many of the reasons that liberalism did not take to Russian soil, legal reform all too often became a tool for expanding, rather than constraining, state power. The Yukos story is an exemplary tale of the perversion of legal instruments to empower arbitrary and exploitative bureaucrats to destroy private wealth. It also suggests something more general about the limits of law in shaping social change.

On a technical level, Yukos provides a textbook example of how formal legal requirements, in particular tax law, can lend themselves to a program of renationalization of the commanding heights of the economy. Each element of the case that the Russian authorities brought against the company, in isolation, had an air of plausibility if not inevitability. Yet, once assembled as a whole, the case seemed preposterous. The government pursued two profoundly differently goals simultaneously, maintaining a veneer of legality while communicating clearly to the private sector that the state could act ruthlessly whenever it wished. At the end of the day, Yukos ceased to exist as a legal entity, a great energy empire ended up in government hands, and the Yukos shareholders (many of whom were foreign portfolio investors, not oligarchs and their minions) received nothing in return. In style if not in substance, these events resemble Falangist Spain's destruction of Barcelona Traction, a chestnut of international investment law. (3)

Finally, the death throes of Yukos have spawned an extraordinary array of litigation in many national and international forums. More than a billion dollars in liquid assets resided outside Russia at the time of government's attack on the firm. Much of this became a war chest to fund lawsuits and arbitrations. Although the company has enjoyed considerable success in these ventures, the main purpose of the litigation seems to have been to clarify the extent of the Russian government's audacity and impropriety, with the possibility of a global settlement in the background. To date, however, the government has defended itself fiercely, if not always successfully.

I employ all these narratives in the course of telling the Yukos story. This article begins with a brief account of the origins of Yukos and its rise to become the largest Russian energy company. The beginnings were sordid, and along the way abuses of corporate governance undoubtedly occurred, but the entity that entered the twenty-first century aspired to provide a new model of transparency and corporate probity for Russian businesses. The article puts the early years of Yukos in the context of the wild and contradictory period of Yeltsin's presidency, a time viewed as inspiring by many in the West and as disastrous by most Russians. It pays especially close attention to the role of U.S. technical advisers, in particular those who contributed to the design of the tax system that became the instrument of Yukos's destruction.

The next section of this article describes Yukos's destruction in some detail, concentrating on the role of Russian courts in ratifying and enforcing the government's program of seizing the company's most productive assets. It follows with an account of the multijurisdictional and multinational litigation that ensued. It concludes with a review of the lessons learned from the affair, focusing on the potential of international law to mediate between private economic power and state interests. At the end of the day, the episode teaches us that the rule of law, both domestic and international, is a more fragile and uncertain enterprise than the optimistic architects of the Washington consensus may have believed two decades ago.

II. THE RISE--YUKOS IN THE ERA OF COWBOY CAPITALISM

Any historical narrative of Russian events must frame them with presidential terms. This is not because Russian Presidents necessarily have any greater discretion or influence than political leaders in other countries, but rather because Presidents serve as the nexus of debate and administrative decisionmaking. It helps that the turnover of leaders was abrupt and specific, with Putin following Yeltsin just as the 1990s came to an end. The arc of Yukos's ascent cuts across both regimes, but took different shape in each. The legal background, especially the law reform project, also differed significantly during the two periods.

A. The Yeltsin Period--1990 to 1999

The first part of the story involves the 1990s, a time when Russia discarded the Soviet Union and embarked by fits and starts on the path of reform. Hordes of international advisors descended on Moscow and received an intermittently attentive audience. Many in the West, first and foremost the leaders of the United States, purported to be impressed with these changes and gave them their blessings as well as significant material support. Ordinary Russians, however, became increasingly disillusioned with a transformation that seemed to produce economic chaos, immiserization and injustice, rather than a better life. The tension between the hopes for reform and the actual practice of powerful actors frames the events around the rise of Yukos.

To understand the pathway of reform in Russia, one must remember the challenges presented by the Soviet legacy. The Soviet economy relied on state ownership and management of nearly all productive activity, using quantitative targets rather than prices to determine outcomes. This system suppressed important information about performance and encouraged widespread corruption and rent-seeking. Not only did Soviet management ensure that the country could not compete internationally (which in turn required autarchy to protect the economy from the outside world), but it facilitated the accumulation of wealth and power among middle-managers that subverted the supposed hierarchy of central command and control. (4)

In theory, reform would entail overturning these structural features. Assets would move from state to private ownership, markets would emerge, and competition and price transparency would direct economic activity towards its most productive possibilities. Lost in the confusion was two profound constraints on the project: Many powerful actors benefitted more from opacity rather than transparency, because they could do better by stealing existing assets than by producing new ones, and the institutions necessary to support transparent market transactions, especially strong and independent courts and a civil society that could investigate and publicize abuses, did not exist. The international advisers, drawn from the international financial institutions (the International Monetary Fund, the World Bank, and the Organization for Economic Cooperation and Development) and the ministries of finance of the great Western powers, initially wielded considerable influence because of the international debt burden that Russia had inherited from the Soviet Union. But they mostly were deaf to these institutional factors. As a result, privatization in Russia became synonymous with kleptocracy. (5)

During the summer and fall of 1995, Boris Yeltsin, a hero abroad but a dismaying and damaged figure in his homeland, faced the consequences of this feckless reform. Most Russians viewed his administration as disastrous, attributing the country's sharp drop in economic output and widespread economic insecurity to the reforms and perceiving its gains as concentrated largely in the hands of a small number of opportunists and insiders. Polls suggested that Yeltsin had lost almost all popular support and had essentially no chance of winning re-election in 1996. (6) Dramatic steps were necessary if he was to retain power.

The precise details of the arrangement that resulted remain obscure, but the broad outlines are evident. The so-called oligarchs, who had amassed wealth and power during the privatization process, largely through banking and media companies, would throw their weight behind Yeltsin. What this weight entailed, and whether the resulting election was merely bent or an outright fraud, will always be a matter of debate. What they received in return was access at a deep discount to the most valuable assets remaining in state hands. They would obtain these properties through the so-called loan for shares scheme, under which the Russian state would borrow money from the oligarchs and provide security worth many times the amount of the loans. Upon the anticipated default on the loans, the lenders would take over state-owned firms controlling vast natural resources. (7)

These events led to the creation of Yukos as a private company. The transaction by which the government transferred this entity to a consortium led by the Menatep Bank was one of the more prominent, indeed notorious, of the loans-for-shares program. For starters, Menatep also acted as the representative of the State Committee of Privatization, the borrower/seller, and enjoyed an intimate relationship with the Russian Ministry of Finance, which had significant minority interest in the bank. Because of this clear conflict of interest, the possibility that Russia would receive anything like a fair return seemed vanishingly remote.

Other banks challenged Menatep's bid for Yukos, not because these conflicts were illegal (other banks were doing similar things), but because Menatep's creditworthiness was suspect. The transaction nonetheless closed in December 1995 with the consortium acquiring 78 percent of Yukos's shares either directly or as collateral. (8) The price paid indicated that Yukos's equity had a value of roughly $450 million, while a public offering of the stock less than two years later valued the firm at $9 billion. At this point Mikhail Khodorkovsky, the oligarch who had put together and led Menatep, shifted the focus of his activities to the energy company. (9)

Menatep borrowed much of the money needed to consummate this transaction, pledging its shares in Yukos as collateral. Russia's financial crisis in 1998 triggered a rearrangement of Yukos and its assets, largely to defraud Menatep's creditors but also to squeeze out minority investors in Yukos's most valuable holdings. First, Menatep transferred its principal assets to a new company and then destroyed the paper trail that documented the transfer. (10) Second, to erase the value of the security for some of Menatep's debts to foreign banks, Yukos's management hollowed out the company to render its stock worthless. Yukos then consisted principally of its majority stakes in three production companies, Yuganskneftegaz (YNG), Tomskneft (TK), and Samaraneftegaz (SNG). The management orchestrated a massive dilution of the ownership of these entities, resulting in transfer of control to offshore shells, presumably beneficially owned by them, at less than ten percent of actual value. (11) Foreign investors with minority stakes in the production companies sued, but recovered very little. (12) Once the holders of the security interests in Yukos stock settled their claims for a small fraction of their value and the minority investors in the production companies sold out, Yukos retransferred control over YNG, TK and SNG back to itself. (13) By the end of the 1990's, Yukos had become a holding company free from much outside debt with full control over subsidiaries that held enormously valuable oil and gas rights. Menatep correspondingly became a passive shareholder rather than the nexus of Yukos's control and management.

Parallel to the freebooting grabs of state assets, of which the Yukos episode was prominent but hardly unique, there proceeded efforts to build legal institutions that would put business transactions on a more stable basis and, it was hoped, preclude the kinds of larceny that the existing Russian regime seemed to encourage. Western, and particular U.S., advisers, mostly academics, played a role in drafting many of these laws, although the extent of their influence is debatable. (14) Two of the law reform projects had a direct bearing on the Yukos affair, namely the Joint Stock Company Law and the Tax Code.

The principal drafters of the Joint Stock Company Law were Professor Bernard Black of Columbia and Stanford Law Schools and Professor Renier Kraakman of Harvard Law School. These distinguished academics sought to put corporate governance in Russia on a sounder legal basis. They identified as the principal problems with current law a history of insider self-dealing with respect to company assets and weak legal institutions, courts in particular. Their solution was to endow shareholders with strong rights to challenge transactions that satisfied a broad, and perhaps elastic, definition of self-dealing. They believed that clarity in the legal entitlement would overcome the problem of weak courts. (15) The Russia legislature, or Duma, adopted the statute in 1995. (16)

The path to comprehensive reform of the Russian tax system was not as direct and the role of U.S. law professors not as high-profile as with corporate governance. (17) Russia had adopted a variety of tax laws during the early months of the Republic, some while it still was part of the U.S.S.R. In the following years taxes proliferated, as well as loopholes and exemptions. Discussions of folding this welter of legislation into a unified tax code began as early as 1993. On the Russian side, the most important figure pushing for adoption of a code was Sergey D. Shatalov, a physicist who had been elected to the Russian Supreme Soviet (the predecessor of the Duma) during the first wave of reforms in 1990. (18) He was the principal architect of tax legislation up to Yeltsin's dissolution of the Supreme Soviet in 1993. He then served President Yeltsin as Deputy Minister of Finance, concentrating on tax policy, from 1995 to 1998. Shortly after President Putin took office in 2000, Shatalov rejoined the government as First Deputy Minister of Finance, and has held the post of Deputy Minister since 2004. He will feature in the next part of this article, dealing with Yukos's fall.

In general terms, the foreign advisers advocated that Russia simplify and rationalize its tax laws. They proposed consolidating taxes into a valued added tax (VAT), a tax on business profits (profits tax), a tax on individual income limited to a small fraction of the population (income tax), and various excise taxes designed to discourage certain behavior. More fundamentally, the advisers recommended that the Code regulate the authority of sub-national units to levy taxes, cut back on the draconian penalties for tax offenders, and formalize the lines of administrative authority over, and judicial oversight of, the assessment and collection process.

One thread of the discussions between the advisers and Russian authorities was the role of formalism in the interpretation and application in Russian tax law. The 1990s saw an explosion of contractual and organizational forms in the private sector. This arose partly in response to the lifting of the heavy hand of state management of the economy, but mostly to conceal the nature of transactions and to defeat the state requirements, taxation in particular, that survived. The tax authorities had little experience with these new forms and had a tendency to respond woodenly rather than creatively. The advisers wished to supply the authorities with conceptual tools that would allow them to react appropriately to these transactions while honoring the rule of law. Shatalov in particular seemed to appreciate these suggestions.

An example may illustrate the problem. When a merchant sells a product to a consumer, a VAT should impose a charge based on the price paid by the buyer. A VAT normally does not apply, however, to payments representing loan disbursements or repayments, because in either case the change in cash on hand is exactly offset by a change in the payer and payee's net debt owed. Russian VAT taxpayers sought to manipulate these rules by accepting loans from consumers in an amount equal to the sale price of a good, and then having the consumer cancel the loan in return for receipt of the good. Initially, Russian authorities responded to the challenge by arguing that the VAT should apply to all transfers of loan proceeds as well to sales. When confronted with the bizarre consequences of such a stance, in particular the assessment of a significant surcharge on inflows of debt investments from foreign sources, the authorities reconsidered, but had difficulty coming up with a clear conceptual basis for levying a VAT on these transactions.

From a U.S. perspective, at least two techniques exist to solve this problem. First, because the loan and the transfer of the goods were legally interdependent, in the sense that the parties agreed to one transaction only because they agreed to the other, one could collapse them into a single sale of goods for cash. (19) Alternatively, one could treat the discharge of the debt as a payment for purposes of the VAT. (20) Either move rests on a power of the tax authorities, supervised by the courts, to recharacterize the transaction to align the private law aspects with its tax incidents.

When the Russian tax authorities attacked these transactions, they took the first route. The High Arbitrazh Court, the highest court with jurisdiction over questions of tax law, agreed that the intent of the parties, rather than the labels invoked in the documentation, would determine the outcome. (21) Because the parties intended a sale of goods for cash, the taxes applicable to such sales would apply. (22)

U.S. experts encouraged the drafters of the Tax Code to include provisions that would provide a statutory basis for a limited power to recharacterize transactions to achieve the intended results. While Shatalov embraced this proposal, the Duma did not. Ultimately it adopted language that became Article 11(1). This provision states: "Institutions, concepts and terms of civil law, family law and other branches of law used in this Code shall apply in the meaning in which they are used in these branches of law unless otherwise provided by this Code." (23) This meant that the tax authorities could not invoke tax concepts or policy to determine the tax incidents of transactions, but rather had to accept transactions as the civil (private) law determined them. (24) The Duma simply did not trust the tax authorities to wield discretion, and was willing to sacrifice tax enforcement to prevent bureaucratic abuse. (25)

One particular area where private law and tax policy conflict is transfer pricing. When separate legal entities with a common economic interest, such as sibling companies controlled by a common parent, transact, price is a matter of bookkeeping rather than a motivation for the deal. Absent some kind of regulation, taxpayers will choose prices that minimize taxes. Recognizing this problem, most tax regimes have rules that explicitly authorize the tax authorities to restate prices where transactions are not arms-length. The U.S. advisers urged Russia also to incorporate transfer pricing authority into the Tax Code.

The provision that resulted, Article 40 of the Tax Code, broadly conformed to what the foreign advisers recommended. (26) It allows the authorities to challenge the prices of transactions between related parties in cases where the contract price deviates by more than twenty percent from market prices. The provision contains two interpretive ambiguities that might have limited its usefulness: It does not make absolutely clear how its recalculation rules operate when there exist no comparable arms-length market transactions, and it does not expressly provide for price adjustments that benefit a taxpayer, as in the case where increasing one party's profit lowers the counterparty's gains. (27) The provision does indicate, however, that the Duma anticipated transfer pricing issues and sought to provide the tax authorities with the tools needed to deal with them.

After extensive debates and many revisions of the government's proposal, the Duma enacted Part I of the Tax Code in July 1998. (28) This law did not deal with particular taxes, but rather enacts general and transubstantive rules of procedure, interpretation, and delegation of authority. Thus it provides rules of administration, assessment and enforcement for all taxes.

Part II of the Tax Code, which provides a comprehensive set of rules for substantive Russian taxes, proceeded apace. At the time of President's Yeltsin's resignation at the end of 1999, much progress had been made. Final enactment, however, did not come until after Vladimir Putin had assumed power.

Outside of the Tax Code, another tax-related issue relevant to Yukos was the creation of so-called domestic tax havens. These came in two flavors. First, a 1992 law allowed "closed administrative-territorial entities" (ZATO is the Russian acronym) to control fully all taxes collected within their territory, including the authority to rebate the taxes to firms that made contributions to the ZATO's budget. ZATOs were former closed cities engaged primarily in secret national security work, all of which had experienced economic collapse with the end of the Soviet Union. (29) Second, Moscow responded to the problem of ethnically distinct regions, mostly in the middle of the country and the Caucasus, that threatened to break away from the center by granting similar local control over their fiscal powers. (30) All the private energy companies, including Yukos, took advantage of the domestic tax shelters by sourcing profits to thinly capitalized entities located in domestic tax havens. (31)

By 1999, it had become apparent that these tax privileges were a highly wasteful means of encouraging economic development in the targeted areas. Competition among tax havens meant that outside firms were able to obtain significant tax benefits at the cost of only modest contributions to the local budget. The Duma at first sought to rein in the ZATOs, adopting a law in 1999 that limited benefits to firms that had a substantial portion of its capital and work force on the territory of the ZATO in question. Energy companies managed to comply with the new requirements by setting up trading companies that did not need significant amounts of capital or employees to operate. Finally the Duma abolished ZATO tax exemptions altogether, commencing in 2000. Reform of the regional tax shelters, however, awaited later legislation. (32)

B. The Putin Period--2000 to 2008

Although in evident declining health, Yeltsin still shocked the world when he announced that he would step down as President at the end of 1999 in favor of Putin, his recently designated successor. (33) Putin immediately began to establish a new direction in Russian domestic policy, based on the concepts of stability and consolidation of the achievements of the previous decade. He made it clear that he would take no action against those in Yeltsin's entourage who had become rich by feasting on the Russian state, but also indicated that henceforth the new class of Russian super-rich would be expected to give back to the society that had fed their wealth. In the most general terms, he held out the prospect of greater order without Soviet-style repression. (34)

At first Yukos responded to the new regime positively. Having rather outrageously shed claims by others on its assets, either through loans or by minority membership in the production companies, it sought to repackage itself as a new, westernized firm that aspired to be a paragon of transparency and good corporate governance. It tried to draw a line through its past, and to enter the new decade as a model for a new, more civilized form of Russian capitalism. (35) At least superficially, this married nicely with the Putin administration's message of promoting capitalism, but without the robber barons.

During the first few years of the Putin period, Yukos continued to grow and thrive. In 2002 it acquired Rospan, a natural gas company, with Kremlin backing greasing the way. (36) Then, in the spring of 2003, came the firm's apotheosis. It contracted to acquire Sibneft, another energy giant that also arose out of the loans-for-shares episode. The merger was intended to create the dominant energy company in Russia as well as one of the largest in the world. It closed in October, 2003, just as the storm was about to break.

During the fall of 2003, as Yukos danced ever closer to the precipice, it entered into talks with several western oil majors about a possible combination. By integrating Yukos within a western company, not only would its owners have created what effectively would have been the world's largest energy company, but the marriage of private ownership and Russian energy would have become unbreakable. The market seemed to like all this, as shortly before Khodorkovsky's arrest the implied market valuation of the firm was in the neighborhood of $43 billion. (37)

During this first phase of the Putin period, law reform proceeded apace. For purposes of the Yukos story, the most significant event was the enactment of Part II of the Tax Code. This legislation contains detailed rules defining the tax base and taxpayers. In large part it rationalized and clarified the preexisting substantive law of taxation.

Another significant development in tax legislation was first the policing, and then the elimination, of so called domestic tax shelters. As noted above, the privileges accorded ZATOs were wound down at the end of the 1990s. The Duma turned to the designated regions during the Putin years, and ultimately eliminated these privileges entirely as of 2004. (38) With these changes, the incentive to use transfer prices so as to locate all profits inside sales companies would disappear, because domestic firms would face essentially the same tax rules regardless of their location.

As of mid-2003, then, Russia seemed reconciled to the excesses of the 1990s, although also determined not to permit their repetition. Optimists hoped that the Putin regime would accept the new economic order, characterized by significant concentration of ownership balanced by fair contributions to state and society, mediated largely by the tax system. Perhaps nothing gave advocates of the rule of law in Russia greater hope than the restoration of Valery Zorkin as chairman of the Constitutional Court in February 2003. Zorkin, the first head of what in some sense is Russia's highest legal body, had lost that position (but not his place on the Court itself) following Yeltsin's overthrow of the Court and the then Duma in 1993. His restoration as chair seemed to capture a mood of stability based on a shaky, but growing, legal order.

III. THE FALL--EXPROPRIATION BY LITIGATION

Russian history can be told largely as a series of false dawns followed by crushed hopes. 2003 was no exception. Whatever the odds were at the beginning of the year that Russia under Putin might nurture an emerging liberal order based on property rights, social solidarity, and a government committed to the maintenance of ordered freedom, within twelve months these prospects seemed to be receding rapidly into the distance. The Yukos affair crystallized the turnaround in hopes for liberalism.

Much of what captured the popular imagination in this story concerns the fate of Mikhail Khodorkovsky, the company's head, and Platon Lebedev, a leading figure in Menatep, who were arrested in October and July 2003, respectively. (39) Without belittling the personal fate of these figures, along with that of other Yukos officials arrested and imprisoned by Russia, the heart of the story involves what happened to the company itself. The cases against Khodorkovsky and Lebedev doubtlessly involved abuses, as even the remarkably gun-shy European Court of Human Rights has acknowledged. (40) But, from an international perspective, as least as important as the mistreatment of Russian nationals through the criminal law is the destruction of property, much of it foreign investment, through a spectacular perversion of the tax system. The attack on Yukos itself not only affected foreigners, many of whom enjoy traditional protection under international law, but indicated a profound unreliability about the core governmental institutions on which private economic activity rests.

In theory, the Russian government might have sought simply to undo the privatization of Yukos. As noted above, the transaction involved deep conflicts of interest, resulting in robbing the state of a valuable asset. But to take on the loans-for-shares affair directly would implicate Yeltsin, which in turn would cast a shadow over Putin, Yeltsin's creature. An alternative theory was necessary to justify destroying Yukos without undoing the parallel privatizations of that period.

The government found its answer in tax enforcement. The criminal charges against Khodorkovsky included participation in corporate tax evasion. In December 2003 the tax authorities announced that it would re-audit Yukos for the tax year 2000, and three weeks later announced that they had uncovered underpayment of $2.27 billion in taxes. The following April the authorities imposed a total assessment of $3.4 billion and simultaneously went to court to obtain enforcement. The next day the court issued a freeze order forbidding the company from alienating or encumbering its property. (41)

The legal theory behind the new assessment comprised elements that, standing alone, had some plausibility, but, once assembled, defied credibility. (42) In essence, the company followed industry practice in limiting the profits-tax exposure of its production companies by running sales through trading companies located in domestic tax havens. (43) The trading companies typically were not owned directly by Yukos, although Yukos managed most of their activities through a series of agency relationships. The production companies sold their output to the trading companies, which in turn either traded among themselves or sold to an independent broker, in most cases a foreign one. The production companies sought to avoid any profits tax by selling the product at cost, while the trading companies took advantage of the profits-tax exemption provided by the current domestic tax haven legislation. Yukos, as a holding company, owed nothing, because it was not a party to any of these transactions. Significantly, none of this affected the net VAT liability for these sales. The tax haven exemptions did not apply to the VAT, and Russia's law, like that of every VAT in the world, used a zero rate for exports. (44)

A numerical example can illustrate the stakes. Suppose YNG spent 100 to produce oil that had an objective market price (putting aside how one might arrive at this figure) of 200. Further assume that half of this cost involved the purchase of inputs subject to a twenty percent VAT, and that the profits tax applicable to YNG was forty percent of its net income. If YNG were to sell the oil to a trading company for 100, and the trading company in turn were to sell the oil to a foreign customer for 250, YNG and the trading company would both pay a profits tax of zero. YNG would have no profit, and the trading company would have enjoyed an exemption for its nominal gain of 150. YNG initially would have paid a VAT of 10 on its inputs through surcharges imposed by its suppliers, and then would have collected a surcharge of 20 on the sale to the trading company, with a net payment to the government of 10 after taking advantage of the credit due for its input VAT. Upon export, the trading company would have gotten a refund for its input VAT of 20. Overall, the government would have collected no profits tax and no net VAT.

A plausible line of attack by the tax authorities would have been to insist, pursuant to transfer pricing rules, that YNG and the trading company be taxed as if YNG received 200 for the oil. As a result, at a hypothetical profits tax rate of forty percent, YNG would face a liability of 40 on its gain of 100. This adjustment would not change the amount of VAT collected, however, as any upward increase on the VAT imposed on the sale by YNG to the trading company would be exactly offset by a credit received by the trading company on the export sale.

In the Yukos assessment, the Tax Ministry did not invoke this logical and obvious strategy. Instead, it constructed an unprecedented and one-off theory that doubled the imputed liability and assigned it to Yukos rather than YNG. The Tax Ministry asserted that, for every tax purpose but one, all of the trading company transactions should be attributed to Yukos. Yukos, not located in a domestic tax haven, thus would pay a profits tax on the difference between the low price paid the production companies and the arm's-length price paid by foreign brokers. But, because the production companies were the owners of record, Yukos never had filed on its own behalf for application of the zero VAT rate to the export sales. This failure to file barred Yukos from claiming the zero rate, thus obligating it to treat all the sales as if they were to domestic customers and thus subject to a full VAT. (45)

In effect, the Ministry simultaneously (1) insisted on a strong substance-over-form story to attribute profits, formally earned by the production companies and the trading companies, and the resulting profits tax, to Yukos, and (2) insisted on an extremely formalistic argument as to why Yukos had to pay a full VAT on goods that indisputably had been exported and thus qualified for the zero rate. The double punch had an enormous impact on the total owed: The VAT assessment, as well as interest and penalties associated with the nonpayment, was a large portion of the total liability for 2000. Taking into account the additional assessments for 2001 through 2003, all levied in the run up to the December auction of the company's most valuable asset, the VAT bill substantially exceeded that related to the profits tax. (46)

Because Article 11(1) of the Tax Code required the tax authorities to tax transactions in accordance with their civil law characteristics, the tax authorities needed a civil law argument to justify attributing all of the trading company activities (other than the filing of documents for the zero VAT rate) to Yukos. The one chosen was so weak that the Russian government abandoned it when later confronted with international arbitration, but it did the trick at the time. The Tax Ministry noted that Article 209 of the Civil Code describes what powers the owner of property exercises. (47) It argued, and the courts agreed, that this provision implied that anyone who possesses these powers must be an owner. Yukos, through consignment contracts and other agency agreements, could carry out sales on behalf of the trading companies, and thus possessed these powers. Ergo, it must have been the owner.

If all the actions of the trading companies were attributable to Yukos, what about the documentation presented by those companies to justify a zero VAT rate for export sales? The documents, it turned out, had a fatal deficiency: They claimed that the trading companies, and not Yukos, did the exporting. Because the documents did not name Yukos as the owner, they failed to meet the statutory requirements for receiving a zero rate. (48)

Even a modest knowledge of how civil law works would suffice to expose the absurdity of the tax authorities' argument. Russia's Civil Code, like that of any country with a comparable body of private law, recognizes an array of agency relationships, pursuant to which a non-owner can exercise powers on behalf of an owner. The delegation or assignment of these powers does not change the fact of ownership. Article 209 does not identify who should be considered an owner. Rather, it specifies, once it is determined who is an owner, what that owner can do.

The Civil Code does deal with phony transactions, where the asserted form does not reflect reality. Article 170 treats as void transactions "made only for appearances without the intent to bring about the corresponding legal consequences" or "made for the purpose of hiding another transaction." (49) The authorities might have tried to argue that the transactions between the production companies and the sales companies lacked substance, because the parties never intended the trading companies to act as buyers or sellers of oil. Yukos doubtlessly would have responded that the companies did intend to carry out these transactions, and that trading for one's account does not require either significant hardware or numerous personnel (unlike, say, refining crude oil). Perhaps because this response seems compelling, the authorities never invoked Article 170. (50)

The proceedings against Yukos arose while Shatalov was the leading tax official in the Russian government. Some persons associated with Yukos accused him of orchestrating the case, although direct evidence of this does not exist. (51) Given his earlier interest in substance-over-form doctrines developed in the United States, and his dissatisfaction with the legislative politics that led to the incorporation of Article 11(1) in the Tax Code, it would not be surprising if he seized on the opportunity presented by a political mandate from above to destroy Khodorkovsky to move tax law in what he perceived as a sound direction. It also would not be inconsistent with his background, which included great experience with tax policy and enormous conceptual intelligence but also no formal training in civil law, for him to approve a superficially plausible legal theory that lacked any substantial basis in the Civil Code. At the end of the day, however, one can only speculate about these matters. (52)

Not satisfied with a dubious legal theory, the tax authorities employed ferocious tactics to undermine any judicial resistance to enforcement of their assessment. One judge who tried to overturn the asset freeze was removed from the case, and then fired; another judge who fully backed the government's case won an award, and then promotion. The company's legal department, in turmoil due to the arrests of Yukos personnel, was given exceptionally short deadlines to respond to the government's case and no effective opportunity to review the government's evidence. Most extraordinarily, the government relied on the asset freeze to bar any payment of the assessment. Between its Sibneft stock and Menatep's holdings of Yukos stock, there existed more than enough liquid assets to satisfy the government's claim. But the government insisted on payment only in cash, not in property, and used the freeze to bar Yukos from converting its liquid assets into cash.

Throughout the summer of 2004, the government rang up victory after victory in the Russian courts. In July it identified its real objective by announcing its intention to sell off Yukos's YNG stock. YNG owned the majority of the production under Yukos's control, so severing it from Yukos would effectively cripple the company.

During the fall of 2004, as the deadline for the YNG auction approached, the government upped the ante by bringing new assessments for the 2001 through 2003 tax years. (53) Ultimately the total amount claimed came to more than $24 billion, a figure that exceeded what even a fair sale of YNG could bring in. The auction of YNG in December 2004, however, failed to satisfy even minimal standards of fairness. Based on proven reserves and its recent history of production, YNG probably was worth somewhere between $15 and $20 billion. Baikal Finance Group (BFG), a shell company created two weeks before the auction, put in the only bid above the reservation price and acquired YNG for $9.35 billion. Rosneft, a state-owned energy company, then acquired YNG from BFG with financing provided by the China National Petroleum Corporation. (54)

Stripped of its most valuable asset and crippled by the remaining tax assessment, Yukos limped along a little longer. Beginning in 2005, Rosneft filed several suits against Yukos for nonpayment for oil purchases as well as for YNG's tax liabilities. Bankruptcy proceedings began in March 2006. Rosneft and the Tax Ministry rejected a proposed restructuring in July, and final liquidation of the company occurred in the fall of 2007, with Rosneft receiving most of the remaining assets and Promnefstroy, a former Rosneft subsidiary, obtaining a claim to Yukos's Dutch subsidiary Yukos Finance B.V. Remarkably, once the liquidation got under way, YNG's tax liabilities somehow disappeared. At the end of the day, all of the assets of Russia's largest energy company had passed into the hands of a state-owned holding company, without any compensation to its owners or any outlay by the Russian state. (55)

Throughout the debacle, the lower courts in Russia played a crucial role in confirming the government's theories and mechanisms, most importantly including the outrageous tax assessment for 2000, the asset freeze, and the auction of YNG. Interestingly, however, the highest courts in the system, while not risking any intervention, mostly kept their distance from the mess. The High Arbitrazh Court limited its involvement to a determination, made long after the YNG auction, that the three-year statute of limitations applicable to the collection of penalties (but not the underlying assessment) did not apply to Yukos's 2000 tax year because of its supposed noncooperation with the audit. (56) The Constitutional Court first ducked this question on a procedural ground, and then, over the dissent of three members of the Court, reached the same conclusion as did the High Arbitrazh Court. (57) Then in 2006 the Plenum of the High Arbitrazh Court issued general guidelines to the lower courts on the interpretation of tax law that, in general, disapproved the kinds of arguments that had worked in Yukos. (58) Overall, the leading courts, while recognizing their powerlessness to stop a politically determined outcome, sought to erect barriers against infection of the legal system with essentially unreviewable government discretion to reassess taxes and seize taxpayer assets.

Whatever the diffidence expressed by some figures in the legal system, however, the brute facts of the case remain. What in 2003 was a political and personal dispute with the leading figures of Yukos became, in 2004, an all-out assault on the company itself. The Russian government, using a groundbreaking legal theory and intimidation of the reviewing courts, invented an enormous tax liability and then barred the company from paying it. This allowed the government to take over one of the largest production companies in Russia at virtually no cost, meaning without any compensation to Yukos or its shareholders. It was not enough for the Kremlin to destroy Khodorkovsky and his wealth: It also wiped out all outside investment in Khodorkovsky's enterprises.
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Title Annotation:I. Introduction through III. The Fall - Expropriation By Litigation, p. 1-27
Author:Stephan, Paul B.
Publication:Houston Journal of International Law
Date:Jan 1, 2013
Words:7398
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