CHANGES REQUESTED BY THE RUSSIAN FEDERATION
As it is known already, the Russian Federation has sent an official notification to the Republic of Cyprus asking for the renegotiation of the Double Tax Treaty (DTT) agreement between the two countries. In effect the Russian Federation is requesting to increase the withholding tax rates on dividend income from 5% or 10% (subject to conditions) to 15%, and on interest income from 0% to 15%. Details on the new wording and what changes are being requested can easily be found in various publications on the internet.
What should be the next actions and what can Cyprus do to maintain some competitive advantage over other jurisdictions in light of the proposed changes?
In this report we put forward our suggestions on some negotiating points that Cyprus can suggest during the renegotiation stage as well as suggestions on possible changes in our local tax legislation that will improve the country's position as an international business centre, taking into consideration the new realities in the global tax environment.
OUR SUGGESTIONS ON RENEGOTIATING THE TREATY
Changes to make the Cyprus Tax laws more competitive
Primarily, we believe that the Russian Federation will not just renegotiate the Cyprus DTT but will proceed with the renegotiation with other EU countries such as the Netherlands, Luxemburg, Malta as well as other countries with favourable withholding tax rates such as Switzerland. Therefore, we doubt that there will significant differences in the withholding tax rates renegotiated between these jurisdictions.
To secure the above, the obvious thing to do is to try and negotiate an inclusion of a most favoured nation clause in the treaty that will ensure that the rates applicable in the Cyprus-Russia DTT will be the lowest available. A similar provision was included in the Cyprus-Ukraine DTT and it would be very beneficial if the same is achieved for the Cyprus-Russia DTT.
New rates to apply only to Cyprus Companies controlled by Russian Tax Residents
In addition to the above, the Cyprus government should suggest that the increased withholding tax rates should apply only to Cyprus companies which are ultimately controlled by at least 25% by individuals which are tax residents of the Russian Federation. For all other situations the existing provisions of the DTT to apply.
In our view, the objective of the Russian Federation is not to block completely any outside foreign investment into the country – something that would be damaging the Russian economy in general, but to tackle the Russian investments routed through foreign structures into Russia with the principal purpose of taking advantage of the reduced withholding tax rates based on the DTT agreements. By accepting this term, the Russian Federation will still be open for business for foreign investors but will tax any unwanted outflow of Russian money into Europe.
For Cyprus, this negotiated change will enable the country to continue to be regarded as an attractive regional headquartering jurisdiction within the European Union, where global investors can set up their regional headquarters, relocate part of their management team to Cyprus and conduct their regional business activities – not only with Russia, but also with other jurisdictions such Europe, Asia and the Middle East.
Having in mind the existing incentives that promote the relocation of individuals and businesses to Cyprus we believe that with this negotiated change, Cyprus can remain or even enhance its position as a jurisdiction were regional headquarters can be set up.
Exempt listed companies and Alternative Investment Funds from the increased rates.
An additional point that can be negotiated is for the existing rates to continue to apply to companies listed on a recognised Stock Exchange as well as to Alternative Investment Funds (AIFs) when managed by external authorised Alternative Investment Fund Managers (AIFM) as per the provisions of the Alternative Investment Fund Managers Directive (AIFMD) of the European Union. The existing rates should apply, provided that more than 50% of the ultimate beneficial owners of the investors/unitholders are non-Russian tax residents.
Again, the above negotiated point will ensure that Russia will remain open to foreign investments and will not completely block fresh foreign money entering the country's economy, and on the same time put adequate safeguards by restricting these benefits to listed companies and AIFs. With these restrictions in place, the benefits of the double tax treaty between Cyprus and Russia will not be easily exploited.
From the Cyprus perspective, this proposed change can give an additional boost to our continuously evolving Funds industry as well as enhancing the position of the Cyprus Stock Exchange as an important regional player. The general competitive advantages of Cyprus in these fields, such as the strategic location, the cost of achieving and maintaining such structures, the availability of qualified human capital resources and many others will continue to play an important role and maybe give us a competitive edge against other jurisdictions with similar clauses in their treaties.
Any changes that may be needed in the "Non-Discrimination" clause of the DTT in order to accommodate the above changes should also be reviewed.
OUR SUGGESTIONS ON THE CHANGES NEEDED IN THE LOCAL TAX LEGISLATION
In addition to the above points to negotiate, the Cyprus Tax Laws can be amended to adjust to the imminent changes and mitigate their effect and also to prevent similar renegotiation requests from other jurisdictions.
Changes to enhance Cyprus' position as an International Business Center
The global tax environment has changed significantly the past few years and more changes are continuously being introduced in an international effort to combat base erosion and profit shifting, treaty shopping and treaty abuse. Conduit entities are been attacked from all angles and dimensions, including banking, AML and anti-tax avoidance initiatives.
It is not a secret that in the past few years, the Russian Tax authorities have successfully disputed the right of Cyprus (and other) Companies to claim Double Tax Treaty benefits based on the beneficial ownership concept, on the grounds that the Company did not have sufficient substance in the specific jurisdiction and that the company acted as a mere intermediary with the objective of rerouting profits to zero tax jurisdictions.
Having the above in mind, we are suggesting some very important and bold changes needed in the local tax legislation that will definitely improve the position of the Country as an international business centre. We even suggest that during the renegotiation of the Cyprus-Russia DTT, in order to obtain the best results possible the Cyprus Government will commit to the below changes:
Introduction of a strict substance test before issuing double tax residency certificates
In these new global tax realities, we believe that the time is right for Cyprus to leave the past behind and introduce a stricter test with minimum substance requirements that will need to be satisfied before issuing a tax residency certificate. These minimum substance requirements may (in addition to the existing requirements) include, evaluation of the qualifications of the Board of Directors, minimum number of employees which may be linked to the size and activities of the company as well as actual office spaces for the applicants.
By introducing a more strict approach on the matter we will increase our credibility as a jurisdiction, since Cyprus companies will not be easily regarded as mere intermediate companies with inadequate economic substance. This may, also prevent any future renegotiation attempts by other countries with which Cyprus have a beneficial double tax treaty agreement. We might also be able to attract serious organisations that will really want to invest in setting up a solid regional headquarter in Cyprus, from which all the decision making will be taking place.
Introduction of withholding tax on payments made to non-cooperative jurisdictions
An additional step needed is the introduction of withholding taxes on outgoing dividends, interest and royalties when these are being paid to OECD/EU non-cooperative jurisdictions or to other zero tax jurisdictions.
Again, such an action will act as a disincentive to those who would like to use Cyprus structures as mere intermediary vehicles with the principal purpose being the abuse of a treaty that Cyprus has signed with other jurisdictions. Our local tax law is so beneficial and provides for good incentives so that the use of such jurisdictions is not required.
Changes needed to make the Cyprus Tax laws more competitive
Expand the ability to claim tax credit on taxation paid abroad
As it is well known, the Cyprus Tax system allows for a tax credit to be granted on the foreign tax paid abroad (including withholding taxes), provided that the same income is subject to taxation in Cyprus. The tax credit is granted up to the extent that the foreign tax credit will not create a tax loss (i.e. the foreign tax credit is restricted to the amount of the local taxation on that specific income).
In respect to interest income, which is a taxable income under the Cyprus Tax Law, when a Cyprus entity will pay the increased withholding tax on the interest income it receives from Russia, it will be possible to claim a foreign tax credit on the Cyprus taxation applicable on that interest income subject to the above restrictions.
Having in mind the Cyprus Tax rules on the deductibility of interest expense as well as the availability of Notional Interest Deduction on capital it seems that such companies will not suffer any additional taxation on their interest income in Cyprus since the available tax credit generated from the withholding tax paid in Russia will be enough to offset any Cyprus tax expense.
In relation to dividend income however, the situation is different than above. In the majority of cases, dividend income is not subject to taxation in Cyprus, which makes it impossible to claim foreign tax credit on any withholding tax paid abroad. This means that the increased withholding taxes that are going to be paid on the dividend income will not be utilised (fully or partly) in Cyprus.
Our suggestion is to amend the Income Tax Law to allow foreign tax credit to be set off against tax expense generated from other types of taxable income in the same company in the same tax year.
Therefore, if a Cyprus Company is engaged in multiple activities, for example it has one subsidiary in Russia and receives dividend income which is not taxable in Cyprus and also conducts trading activities and receives trading income which is taxable, to be able to use the foreign tax credit on withholding tax paid on the dividend from Russia and set it off against the tax expense generated from the trading activities.
This change will ease the overall tax burden that such companies will face and will, in some extent, mitigate the effect of the increase in the withholding tax rates in the DTT.
THE TIME FOR CHANGE IS NOW
It is now clearer than ever that it is time to really think outside the box and be ready to sacrifice the successful models of the past and adopt our strategy and vision as a country to reflect the current needs and requirements. By insisting in a model that has served its purpose well in the past but is simply inadequate now will be catastrophic for this important sector of the Cyprus economy.
Government and Professionals, must collectively be ready to take bold decisions that may have been unthinkable and unimaginable few years back, but now seem to be the best way forward, and make sure that everyone who is involved in this industry follows the same strategy and vision.
As Charles Darwin said:
"It is not the strongest of the species that survive, nor the most intelligent, but the one more responsive to change."
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.