Business fragmentation: legal optimization or a tax crime?

According to official statistics only 16% of business fragmentation cases in court end in favor of taxpayers. Over the years, this figure only decreases along with the chances of winning a case. Almost any business can be exposed to artificial fragmentation if certain criteria are present.

In general, any company aiming to cash out under the general taxation system must pay around 55% of its profit, which includes:
  • up to 40% in taxes (Value added tax (VAT) + profit);
  • 15% personal income tax (PIT).

If you earn 100 million rubles ($ 1,3 million), you are expected to pay 55 million ($ 730 000). Of course, if you invest in business development, the picture is much more optimistic, but that's not the focus right now.

Under the simplified tax system, you only need to pay 6% of your turnover, and in some regions, there is a preferential rate of 1% instead of 6%, so the money is yours (especially if you are an individual entrepreneur). Without much thought or careful examination of the documents, business owners resort to the most clumsy scheme of business fragmentation — creating one individual entrepreneurship after another. They achieve maximum revenue in the first quarter and then switch to the next individual entrepreneurship in the second quarter. This is bad because it is done thoughtlessly.

It is important to understand that tax authorities are not fools and quickly recognize what is happening. Soon enough, additional charges can be expected on the entire revenue:
  • 20% VAT;
  • 15% PIT (after deducting the already paid 6%);
  • penalties and fines.

In the current situation, maximum penalties can be expected because the support is given to honest businesses, while the improper use of schemes is considered illegal. So, what exactly is business fragmentation according to tax authorities? Essentially, it is an attempt to divide a business by creating new individual entrepreneurships or private companies with limited liability when the company's turnover approaches the maximum threshold under the simplified taxation system. The goal is to remain under the simplified tax system, paying only 6% or 1% (for individual entrepreneurs). In such cases, we are talking about artificial business fragmentation with the aim of evading taxes.

5 key indicators of business fragmentation

In practice, there are dozens of business fragmentation indicators from the perspective of the Federal Tax Service. Let's consider the 5 key indicators that the tax authorities pay attention to first of all:
Presence of a single controlling person;
Fragmentation of a unified process;
Lack of autonomy among controlled entities for making decisions;
Use of shared resources (employees, fixed assets, intangible assets) and common counterparties;

Formal distribution of resources and their gratuitous provision.

It is extremely difficult to determine independently, whether your business shows signs of fragmentation or not. To identify tax risks and protect yourself from the risks of business fragmentation, order a tax check-up service. Objective and comprehensive assessments will be conducted by 3–5 experts, including former Federal Tax Service employees, who will identify all tax risks and recommend measures to ensure business security.

High-profile cases and liability for business fragmentation

In 2023, some criminal cases related to business fragmentation created a nationwide stir.
  • Elena Blinovskaya was accused of business fragmentation resulting in tax reassessments and fines amounting to 918 million rubles ($ 12,2 million), leading to criminal charges under Part 2 of Article 198 and Part "b" of Article 174.1 of the Criminal Code of the Russian Federation.
  • Valery Chekalina was accused of tax evasion amounting to approximately 311 million rubles ($ 4,15 million), resulting in criminal charges under Part 2 of Article 198 of the Criminal Code of the Russian Federation.
  • There is information about some planned audits of other well-known bloggers regarding artificial business fragmentation.

In that particular year 2023 even ordinary citizens became aware of what business fragmentation entails, thanks to high-profile cases involving prominent bloggers. However, since 2017 the tax authorities have been actively identifying the individuals who attempt to save on taxes in such a way.

In cases of business fragmentation, violators can be prosecuted under the following articles:
  • Article 54.1 of the Tax Code of the Russian Federation — limits on exercising rights in calculating the tax base and/or tax amount, fees, insurance contributions;
  • Article 122 of the Tax Code of the Russian Federation, paragraph 3 — non-payment or incomplete payment of tax amounts;
  • Article 198 of the Criminal Code of the Russian Federation — evasion of tax payments.

The consequences of business fragmentation for violators include substantial additional charges and fines. In some cases, criminal proceedings result in actual prison sentences of up to 3 years.

Legal business fragmentation: how to optimise your business without consequences?

Certainly, we will not disclose business fragmentation schemes for tax reduction here. There are numerous situations where creating new legal entities or dividing a company is a justified and necessary measure for business development.

There are 3 key conditions that allow to avoid business fragmentation from viewpoint of the tax authorities when optimising a company:
  1. Choosing the right purpose for company division and justifying it convincingly. It is important not only to state that business fragmentation is carried out for the company’s activity optimization or for the entry into new markets, but also to defend this decision.
  2. Selecting different types of activities for different legal entities. Similar or identical types of activities are a key criterion used by the tax authorities to identify artificial business fragmentation.
  3. Severing connections between companies or individual entrepreneurships and ensuring separate management. This should be done not only formally on paper but also in practice. The tax authorities quickly identify interconnections based on IP addresses, counterparties, shared employees, physical addresses, and even minor indirect indicators.

Case law on business fragmentation clearly indicates that defending oneself against allegations of artificial fragmentation is extremely difficult. However, it is possible to carry out effective optimization that leaves the tax authorities with nothing to scrutinise. This requires the assistance of specialists who have a deep understanding of the subject matter.

Order a tax check-up to assess whether your company faces risks of business fragmentation and receive recommendations for the company optimization . A team of 3–5 experts, including former Federal Tax Service employees, will provide a comprehensive assessment, identify all the tax risks and recommend measures to ensure business security.

Examples of criminal cases with negative consequences of business fragmentation

The illustrative examples of business fragmentation from criminal practice are shown below. Each case is accompanied by a list of reasons why the tax authorities focused on the particular situation and held a private company or an individual entrepreneur accountable.
Let's move from general to specific and examine notable examples from legal practice:
(the names of legal entities have been changed for confidentiality purposes)

Example of business fragmentation 1

  • Limited liability company “ABC”
    Reached the limit of potential income. To avoid losing the simplified tax system (STS) status, it partially transferred the sale of meat and meat by-products from large horned livestock to a related entity, Limited liability company “ABC Company”.
    “ABC” carried out livestock slaughter and meat sales, while “ABC Company” handled meat sales with bones. The fragmentation scheme allowed for income control and redistribution, aiming to apply the STS.
  • How they were caught
    The same individuals were founders and managers of both organisations.
    The organisations were registered at the same address.
    The same email address and phone numbers, as well as the same IP address.
    Joint use of assets — only formal separation of production and administrative premises.

Example of business fragmentation 2

  • Entrepreneur Radostnaya A.P.
    Reached the limit of potential income. To avoid losing the STS status, a decision was made to artificially fragment the business by formally transferring the business asset — an automated gas station (AGS). In this case, the AGS was successively leased to an individual entrepreneur (her son) and then to another individual entrepreneur (her sister). Each subsequent transfer of the business asset was accompanied by aligning the income of each scheme participant with the threshold that limits the right to apply the STS. The scheme allowed for the distribution of revenue from retail sales of petroleum products among the participants, enabling each entrepreneur to apply the STS.
  • How they were caught?
    1. Shared cash control equipment.
    2. Participants in the scheme approached the threshold value for the STS (a search marker).
    3. Shared logins in internet banking systems.
    4. Shared IP address and physical assets.
    5. Transferring business activities from one individual entrepreneur to another when approaching the STS threshold, using the same income source.
  • Additional charges:
    PIT for individual entrepreneurs: 1 031 152 rubles ($ 13 700), penalties: 120 002,09 rubles ($ 1600), fines: 206 230,40 rubles ($ 2 750).
    VAT: 3 744 549,40 rubles ($ 50 000), penalties: 998 814,13 rubles ($ 13 300), fines: 435 944 rubles ($ 5 800).
    STS: 611 873 rubles ($ 8 160), penalties: 31 780,37 rubles ($ 424).
    Total: 7 180 345,39 rubles ($ 95 700).

Example of business fragmentation 3

  • Limited Liability Company "Torgzal"
    When reaching the limit of 150 sqm for the sales area to apply the unified tax on imputed income (UTII), "Torgzal" transferred a portion of its premises through a sublease agreement to individual entrepreneur Stein D.D. Based on the agency agreement, "Torgzal" receives revenue from Stein D.D. at the store's cash registers and subsequently transfers it to the subtenant. This scheme formally allowed the participants to divide the sales area in such a way that each participant had no more than 150 sqm, for the purpose of applying UTII. This is a fairly common business fragmentation scheme in the Russian Federation.
  • How they were caught?
    1. Formality of the lease agreement: absence of essential conditions (property not specified), absence of a condition regarding the lease of commercial equipment and furniture;
    2. Unified entrance, signage, operating hours, and cash operating unit;
    3. Shared utility, residential, and storage spaces, with no partitions separating the sales areas;
    4. All the areas were perceived by customers as a single space;
    5. Employees effectively performed their functions throughout the store, regardless of the employer whom they had an employment relationship with ;
    6. Settlements at a single cash register with a single receipt;
    7. Expenses for maintaining the stores were not divided.
  • Additional charges:
    Profit tax - 12 610 459 rubles ($ 168 000);
    UTII - 1 705 174 rubles ($ 22 700);
    VAT - 28 986 315 rubles ($ 386 000); penalties - 11 166 407,57 rubles ($ 149 000); fines - 13 414 818,51 rubles ($ 179 000).
    Total: 67 883 174,8 rubles ($ 905 000).

Example of business fragmentation 4

  • Limited liability company "City Rent"
    Engaged in the rental of its own real estate, the company implemented business fragmentation by incorporating several controlled private companies under the STS. These included limited liability companies "GorodB" and "Gorod-Stroitelstvo", a joint stock company "E-Nedvizhimost," limited liability companies "SMSH", "Rent-A", "Port-B", "Office-C", "Gorodok-Stroy", "Dohodny Gorod" and "Center Gorod". The controlled private companies under the STS, in turn, provided real estate for sublease based on sublease agreements. The combined income of all controlled entities exceeded the maximum values set by tax legislation for the application of STS, namely, the maximum income limit of 45 million rubles ($ 600 000) and the residual value of fixed assets of 100 million rubles ($ 1,3 million).
  • How they were caught?
    1. Single founder;
    2. Payments on behalf of each other;
    3. Interest-free loans to each other;
    4. Shared employees.
  • Additional charges:
    VAT and profit tax - 77 954 781 rubles ($ 1,04 million);
    Penalties - 29 535 305,51 rubles ($ 394 000);
    Fine - 5 808 722 rubles ($ 77 500);
    Total: 113 298 808,51 rubles ($ 1,5 million).

Example of business fragmentation 5

  • Limited liability company "Pereprava-Sever"
    The company operated in the field of cargo transportation services, and the unified tax on imputed income (UTII) was applied for this type of activity. As the number of vehicles increased during business development, they approached the tax legislation limit of 20 vehicles. To maintain the right to apply UTII, the decision was made to fragment the business by creating new legal entities, namely, limited liability companies "Pereprava-Sever", "Pereprava Sever", "Pereprava SeverAVTO", "Pereprava-LOG", and “Pereprava-AT". This scheme allowed them to preserve the right to apply UTII.
  • How they were caught:?
    1. Mr. Ostrov directly participates in all of the companies mentioned above, and his share exceeds 25%. Mr. Ostrov was a participant (50% at the time of creation, later 100%) and the head of all these companies;
    2. Conducting financial and economic activities at a single legal address;
    3. Shared employees.
  • Additional charges:
    Profit tax - 13 273 200 rubles ($ 177 000), penalties - 2 512 002 rubles ($ 33 500), fine - 1 214 460 rubles ($ 16 200);
    VAT - 28 583 745 rubles ($ 381 000), penalties - 7 546 209 rubles ($ 101 000), fine - 2 002 604 rubles ($ 26 700);
    Corporate property tax - 391 265 rubles ($ 5 217), penalties - 135 643 rubles ($ 1808),
    under Article 126 of the Russian Tax Code - in the form of a fine of 13 500 rubles ($ 180).
    Total: 55 672 628 rubles ($ 742 000).

Example of business fragmentation 6

  • Limited liability company "Zapad Fasad"
    The company dealt with wholesale trade of building materials. They worked under the general taxation system, but created an individual entrepreneurship to sell their goods under the terms of UTII. This scheme allowed "Zapad Fasad" to reduce its taxable base due to the expenses on the sale of goods by the individual entrepreneur. The individual entrepreneur, in turn, sold the goods to individuals. In fact, one of the business fragmentation schemes was applied.
  • How they were caught?
    1. The individual entrepreneur (IE) and the director of the limited liability company is the same person.
    2. Registration at the same address.
    3. Employees of the limited liability company act as representatives of the IE based on the power of attorney.
    4. The limited liability company is the main supplier for the IE (98% of purchases are made by the IE from this company).
    5. Loan of 18 million ($ 240 000) from the limited liability company.
  • Additional charges:
    VAT - 6 202 312 rubles ($ 82 700);
    Profit tax - 14 280 572 rubles ($ 190 400);
    Unified tax on imputed income (UTII) - 449 245 rubles ($ 6000);
    Penalties - 8 301 400,80 rubles ($ 110 700), and a fine - 369 896 rubles ($ 4900).
    Total: 29 233 529,8 rubles ($ 390 000) were additionally charged due to improper fragmentation.

Example of business fragmentation 7

  • Open joint stock company "Mineralny "M-S"
    The company was engaged in the production and sale of carbonated water under the trade name "M-S". After conducting tax optimization (underreporting their own production and sales volumes), the business was fragmented: a controlled entity was created to handle the sale of the finished products of limited liability company "Reg Vostok."
  • How they were caught?
    1. Lack of office and warehouse premises at the legal address of the controlled entity.
    2. According to the income tax declarations, expenses are maximally aligned with the revenues.
    3. VAT deductions exceed 99%, meaning there is no economic benefit.
    4. The tax burden for the audited period is 16% for the entity under control.
    5. Raw materials and finished products are not actually transported; the movement of products between the parties involved in the transaction is only documented due to the fact that all production facilities and warehouses used for bottling mineral water belong to "Mineralny "M-S."
  • Additional charges:
    VAT - 58 051 408 rubles ($ 774 000), VAT penalties - 23 220 519 rubles ($ 310 000), and corresponding penalties for VAT underpayment.
    Total: 81 271 927 rubles ($ 1,08 million) + penalties.

Example of business fragmentation 8

  • Limited liability company "Promdostroy"
    The company rented its own movable and immovable property. The limited liability company, subjected to the simplified tax system (STS) and approaching the maximum income threshold for applying STS, carried out a reorganisation (in fact, fragmenting the business) by establishing a new limited liability company "Domtorgservice" under the STS.
  • How they were caught?
    1. Lack of business purpose in the reorganisation.
    2. It is part of a unified production process.
    3. The same founders and representatives.
    4. The same IP address.
    5. Shared contract forms and unified pricing policy.
  • Additional charges:
    Taxes - 25 398 332 rubles ($ 339 000),
    Penalties - 9 840 517,39 rubles ($ 131 000),
    Fine - 964 489,14 rubles ($ 12 800).
    Total: 36 203 338,53 rubles ($ 482 000).

As you can see, there are many ways to dishonestly fragment a business.

At the same time, the regulatory authorities are aware of the existence of such schemes, and the experience of tracking new fragmentation schemes is constantly growing.

However, there is also positive practice:

Example 1

  • Limited liability company "Rimskaya Apteka"
    The company traded with pharmaceutical, medical, cosmetic, and perfume products. A network of limited liability companies was created and involved in similar activities. The tax authority insisted that limited liability companies "Rimskaya Apteka 3", "Rimskaya Apteka 4", "Rimskaya Apteka 5", and "Rimskaya Apteka+" were engaged in fictitious activities aimed at obtaining profit through tax optimization. From the perspective of the tax authority, there were signs of business fragmentation.
  • How their innocence was proved?

    1. Each limited liability company has its own suppliers.
    2. Individual cash registers and equipment for each company.
    3. Separate profit and expense allocation.
    4. Individual IP addresses.
    5. No shared employees or representatives.
  • Attempts of additional charges:
    VAT - 17 102 120,16 rubles ($ 228 000), VAT penalties - 5 049 462,36 rubles ($ 67 300), and a fine - 1 583 622,80 rubles ($ 21 000);
    Profit tax - 30 611 836,65 rubles ($ 408 000), profit tax penalties - 8 999 459,65 rubles ($ 120 000), and a fine - 3 061 183,65 rubles ($ 40 800);
    Property tax - 4 414 094 rubles ($ 58 800), property tax penalties - 1 160 119,16 rubles ($ 15 500), and a fine - 441 409,40 rubles ($ 5 900).
    Total: 72 423 307,83 rubles ($ 965 600).

Example 2

  • Limited liability company "TK Caravella"
    The company dealt with wholesale trade of food products. The tax authorities were suspicious about its connection with an individual entrepreneur (IE) who simultaneously acted as a counterparty, founder, and director of "TK Karavella". In most cases, this is a direct indication of a business fragmentation scheme.
  • How their innocence was proved

    1. Documented evidence of product sales.
    2. Separate accounting.
    3. Independent activities.
    4. Refund of all advances.
    5. Payments from the IE were reimbursements for unsold goods and contributions to the assets of the limited liability company.
  • Attempts of additional charges:
    Profit tax - 15 779 615 rubles ($ 210 400), profit tax penalties - 3 664 418 rubles ($ 49 000), and a fine - 1 577 961,50 rubles ($ 21 000);
    VAT - 911 997 rubles ($ 12 000), VAT penalties - 337 111,73 rubles ($ 4 500).
    Total: 22 271 103,23 rubles ($ 300 000).

Example 3

  • Closed joint stock company, industrial and commercial firm "Pechka"
    Within the holding company, 6 entities were created between 1998 and 2009: limited liability companies "Pechka1", "Pechka2", "Pechka3", "Pechka LTD", "Ambar", TD "Pechka"). In 2020 the tax authority considered this a business fragmentation scheme . All controlled companies were engaged in retail trade, implemented a unified personnel policy, and were registered at the same address
  • How their innocence was prove

    • The limited liability companies were genuinely conducting business activities (purchasing and selling goods, hiring personnel).
    • There was a reasonable and genuine economic purpose.
    • Absence of evidence of unjustified tax benefits.
  • Attempts of additional charges:

    VAT - 17 463 755 rubles ($ 233 000), VAT penalties - 3 179 296,46 rubles ($ 42 400), and a fine - 51 501,30 rubles ($ 687);

    Profit tax - 11 768 504 rubles ($ 157 000), profit tax penalties - 1 064 914,87 rubles ($ 14 200), and a fine - 273 375,80 rubles ($ 3 600);

    Property tax - 1 932 031 rubles ($ 25 800), property tax penalties - 754 090,68 rubles ($ 10 000), and a fine - 94 310 rubles ($ 1 260).

    Total: 36 581 779,11 rubles ($ 488 000).

Cases of successfully avoiding additional charges are possible, and entrepreneurs' frustration regarding tax authorities' claims is understandable. The fact is that the presumption of innocence does not apply here.

Once you come under scrutiny, you will have to explain the nature of financial flows and prove the absence of improper tax optimization.

In such situations, it is better to seek help from experts. You may be completely right, but it is knowledge of the details and subtle nuances that can turn the situation in your favour. A professional always knows whether there is a liability for specific actions and knows how to ensure compliance with the law.

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