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By John Helmer in Moscow

When it comes to investigating, Sergei Stepashin, the former prime minister, is like a small dog with a big bone. Transfer pricing, tolling, and related metal trading schemes that evade huge sums of tax are his bone. Stepashin’s problem is that no sooner does he get his teeth into something, than much bigger dogs than he is bark in his ear — and he drops it.

In January, for example, when Stepashin got his teeth into Oleg Deripaska’s aluminium trading business.

At the end of that month, the Accounting Chamber completed its first-ever investigation of the cashflow and trading sheets of United Company Rusal, headed by Deripaska. Letting the Chamber audit his books was one of the conditions Deripaska was forced to accept when he agreed the previous November to a $4.5 billion loan bailout by Vnesheconombank (VEB); that saved him from forfeiting his 25% shareholding in Norilsk Nickel to a syndicate of foreign banks.

The Accounting Chamber has investigated tax avoidance schemes used in Russian aluminium trading before; the Chamber has directly and publicly challenged aluminium tolling contracts, which allow offshore companies to claim arm’s length ownership of Rusal metal in trade, and avoid domestic and export taxes.

In the past, the Chamber has also checked on regional schemes for reducing tax on the aluminium trade in fareastern Chukotka — when Roman Abramovich was both governor and co-shareholder with Deripaska in Rusal. The schemes were unlawful, the Chamber concluded. But not until Deripaska got himself in hock to VEB have auditors been allowed to investigate inside the company – if that is what happened this time. In addition to the Chamber audit team, a parallel team of auditors from the government apparatus, apparently including FSB agents, worked at Rusal on the checks.

A combined report of the findings was presented to the Accounting Chamber Collegium, chaired by Stepashin, on January 30. At that point, all documents, including the report; its recommendations; minutes of the Collegium discussion; even the fact of the Collegium session itself, were stamped secret. Also concealed by this action is the list of government agencies to which the report and Collegium recommendations were sent. Instead, a Chamber source, who was an auditor in the Rusal check, reveals that copies of the reports went to the Prime Ministry; the State Duma; and the Federation Council. It is customary for the Chamber to identify the General Prosector’s Office as a recipient of its reports. In this case, that information is also being withheld.

Five months have passed, and Stepashin is barking again. This time the bone is the Russian coal trade. Following a Collegium session on July 3, the Chamber has now issued a public report of its investigation of transfer pricing violations by coal exporters, including Mechel. In a press release, dated July 6, the Chamber said that at its session last Friday, the collegium considered “the results of a check of the customs control organisation of coal and coal production transportation through the customs border of the Russian Federation, formation of contract prices, correctness of calculations, completeness and timeliness of customs payments in 2008 and the past period of 2009.” The auditor in charge was identified as Sergei Agaptsov.

The Chamber release says that “over 80 percent of export coal volume is carried out through counterparts in the countries having offshore zones. The specified volume of exported coal is undercharged, the prices differ from the general world-level prices from 30 to 54 percent. As a result, the considerable sums of money received from realisation of coal, accumulate at the accounts of the companies registered in offshore zones, and the Russian budget loses a considerable part of tax incomes.” The discrepancy represents about $30 to $50 per tonne; the total revenue stream that is affected exceeds $2 billion.

According to the Russian legal code, transfer pricing amounts to tax evasion when there is a 20% difference or more between the price of coal declared for export at the Russian border, and the price at which the coal is sold abroad by trading companies, which are linked to the coalmines and owned by the same proprietors and shareholders.

The Chamber release does not identify the main coal exporters, or the types of coal and trade transactions that have been assessed. Follow-up reports in the Russian media cite anonymous sources inside the Chamber as identifying the two major thermal coal exporters, SUEK (owned by Andrei Melnichenko and Sergei Popov) and KuzbassRazrezUgol (KRU, owned by Iskander Makhmudov), as the subjects of the investigation, plus Mechel, which is owned by Igor Zyuzin.

Renaissance Capital analyst Boris Krasnojenov, who has been promoting Mechel’s stock price to his bank’s clients for the past month, reports:”we strongly doubt that transfer pricing is part of the sales strategies of the Russian metals and mining companies listed on the LSE and NYSE, including Mechel….In our view, the news is neutral for Mechel and the sector as a whole.”

Mechel spokesman Ilya Zhitomirsky told CRU Steel News that the company is not commenting on tax issues.
Michael Kavanagh,coal analyst for Uralsib Bank, sounded a warning for investors. Referring to the attack on Mechel for price gouging and collusion in the domestic coking-coal market, launched in July of 2008 by Prime Minister Vladimir Putin, Kavanagh now says: “We believe that this problem will be solved differently from Mechel’s case last year. We calculate that the most Russian coal producers will be loss-making this year, and will therefore pay either minor or no income tax. Moreover, the coal Industry is struggling to obtain state support this year rather than to pay additional taxes. If the state tries to withdraw this money from the industry right now, it may cause very serious damage, and even several bankruptcies. Therefore, we are likely to see strict rules going forward rather than big penalties today. However, any harsh comments from high-ranking officials may be a short-term negative for the sector’s names.”

Mechel reports identifyfour offshore subsidiaries with trading functions — HBL in Germany; Mechel Trading Ltd. and Mechel International Holdings in Switzerland; and Mechel Metal Supply in Liechtenstein. According to Mechel’s Form 20-F report to the US Securities and Exchange Commission on June 24, no income tax or profit tax was payable in Liechtenstein. In Switzerland, the income tax rate chargeable for Mechel’s operations in 2008 was 10.4%, less than half the Russian tax rate. However, a loss of $4.9 million was reported in Mechel’s Swiss accounts for the period. A loss of $22.4 million was also reported for the same period in the British Virgin Islands, though no Mechel subsidiary is identified as registered there.

Mechel reports have warned before of the risk that transfer pricing claims may be made by the Russian authorities. In the latest filing to the SEC, Mechel says that “recent events within the Russian Federation suggest that the tax authorities are taking a more assertive position in its interpretation of the legislation and assessments and as a result, it is possible that transactions and activities that have not been challenged in the past may be challenged.”

The report also notes that a lawsuit has been lodged against Mechel in Russia, charging that transfer pricing of coal exported abroad has deprived minority shareholders of their share of profit on sales. The suit was brought inAugust 2008 by minority shareholders of theTomusinsk Open Pit Mine. Mechel says it owns 74.5% of the shares of this mine company; 24.5% belong to others. According to Mechel, “as the claims contain no substantial economic and legal arguments, Mechel expects a favorable outcome of the case.”
This statement was issued by Mechel on June 24. The Accounting Chamber issued its findings on transfer pricing onJuly 3.

Thesehardly make a new bone to chew on. In a March 2006 investment review of the leading Russian coalmining companies, theCentre Invest Group of Moscow considered two closely held coalmining groups, KRU, which is based in the Kemerovo region; and the Russky Ugol group, based in the Rostov region. The report warned that their transfer pricing practices were so pervasive at the time — resulting in exaggerated loss-taking at the minehead, and profit concealment at the end of the offshore trading process — that standard accounting measures were unreliable indicators of profitability and enterprise value.

Ananalysis of KRU by the same group a few months earlier, had estimated that transfer pricing of coal exports from minehead to offshore selling unit generated a revenue multiple of 5; the after-tax income multiple was much greater. Thus, sales of coal by KRU were reported at $13 per tonne, for a total revenue of $540 million; Ebitda of $57 million; and net income of zero. By contrast, KRUTrade reportedly sold at $64/tonne, for revenue (on higher tonnage) of $1. 3 billion; Ebitda of $235 million; and after-tax income of $214 million. See: http://www.skrin.com/analytics/reviews/documents/kru_110105_eng.pdf?3dab0db4051f40af8d9c3ccab3aa984d
Alexander Yakubov, the author of this report, confidently claimed that Mechel had achieved “full elimination” of transfer pricing in November-December 2004.

Nine months later, an attempt was made by the Kemerovoregional authorities to curb transfer pricing by Makhmudov’s KRU; this took the form of office tax raids in September 2005. But the incidents appear to have been demonstrations of administrative power, not serious attempts to deal with transfer pricing. And they didn’t stop it — or so the Accounting Chamber is now saying.

Stepashin is trying again. The stockbrokers are betting his jaws aren’t strong enough.

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