Cyprus: Tax Reforms in Cyprus

Introduction

As a well-established international business centre and a leading candidate for membership of the European Union (EU), Cyprus has come under considerable scrutiny in recent years, particularly in relation to its tax system.

One of its first significant responses was to commit itself in 2000 to the Organization for Economic Cooperation and Development to eliminate harmful tax practices by the end of 2005, and to embrace international standards of transparency, exchange of information and tax competition.

Cyprus, as an aspiring member of the EU, must harmonize its laws and practices with the acquis communautaire. In the fiscal field, it must conform to the EU Code of Conduct and the rules on business taxation, which means a fundamental reform of its tax regime.

New system of taxation

To comply with these requirements, the House of Representatives enacted a series of new tax laws on 1 July 2002, adopting an innovative approach. The main feature is the integration of corporation and withholding taxes with income tax on distributed profits.

This integration contains a uniform corporation tax rate of 10%, payable by local and international business companies alike starting from 1 January 2003. Active international business companies already operating from the island may retain the 4.25% rate until 2005 if their income in 2001 came entirely from sources outside Cyprus and continues to do so for the following four years (‘grandfather clause’). If they opt to retain the 4.25% rate until 2005, they cannot carry forward any tax losses up to 2000 beyond 2005.

Dividends paid to Cypriot tax residents will be subject to a 15% withholding tax, based on a deemed distribution of 70% of the 90% of after-tax profit left after payment of the 10% corporation tax. Dividends paid to foreign corporations and foreign individuals will be exempt from withholding tax.

Thus, the tax integration is achieved through the combination of the 10% corporate tax rate and the 15% withholding tax rate which, at a total of 19.45%, compares favourably with the highest income tax rate of 25% which was applicable to local companies before the tax reforms.

Interest income will be subject to a final 10% withholding tax, payable as a defence levy, but all interest earned by individuals, and 50% of foreign interest earned by companies, will be exempt from income tax.

Taxable income

The old remittance-based concept has been changed to a system of taxation of worldwide income for residents in Cyprus and of Cyprus-source income for non-residents. An individual will be considered to be resident in Cyprus if he stays for more than 183 days in the island during a particular calendar year. For companies the UK rule has been followed which states that a company is resident where its management and control is to be found. As a result of this approach the British offshore model (UK non-resident companies) will come into existence and will replace so called "ring-fenced" vehicles.

Taxation of personal income

Income Band (CYP)

Current

From 1.1.02

From 1.1.03

From 1.1.04

0-6,000

nil

nil

nil

nil

6,001 - 9,000

20%

30%

20%

nil to 10,000

9,001 - 12,000

30%

30%

20%

10,001 - 15,000 @ 20%

12,001 - 15,000

40%

40%

25%

15,001 - 20,000 @ 25%

15,001 upwards

40%

40%

30%

20,001 upwards @ 30%

Personal allowances and deductions are abolished, except the reliefs allowed for life insurance premiums and contributions to pension funds and the Social Security and Welfare Funds.

Taxation of international businesses

The EU Code of Conduct makes it clear that tax advantages can no longer be ring-fenced from the domestic market, and therefore the preferential tax rate of 4.25% has been eliminated. The new system provides a change from the credit method to the exemption method, which will allow international businesses to retain their current advantage of not having to withhold tax on dividends and interest paid to the shareholders as well as to exempt income from permanent establishments abroad. International business companies will be entitled to trade within Cyprus and do business locally with the opportunity to offset losses from abroad against income from Cyprus.

Expatriate employees

Expatriate employees of international business entities have enjoyed the privilege of having their emoluments (salary and allowances, e.g. housing, cost of living, school fees) taxed at a reduced rate or not at all, but these concessions will not be renewed when they expire.

Under the new provisions, expatriate employees will pay income tax at the same rates as Cypriot citizens, they will be required to contribute to the Social Security Fund and their duty-free facilities will be withdrawn from April 2003. Non-resident individuals taking up employment in Cyprus will be entitled to a tax allowance of 20% of their remuneration, with a limit of CYP 5,000 per annum for the first three years, to compensate them for the additional costs of their establishment on the island.

Value added tax (VAT)

The current rate of 10% rose to 13% on 1 July 2002 and will rise again to 15% on 1 January 2003.

New horizons

Worldwide income taxation of foreign-controlled companies will no longer depend on where they are registered but on where they are managed and controlled.

Companies registered in Cyprus but managed and controlled from abroad will only be taxed in Cyprus on their Cyprus-source income. They will enjoy exemption from tax of foreign dividends and interest and income from any permanent establishment abroad as well as all foreign tax credits and offsets of losses incurred abroad. They will not be entitled to benefits under the double taxation treaties, but will not be subject to the exchange of information rules under such treaties.

The new rules will extend the EU Merger Directive to any reorganization involving a Cypriot tax-resident company, with favourable tax treatment to facilitate transfer of assets and tax losses, providing exemption from capital gains tax, income tax, VAT and stamp duty. (Basically, the new law adopts UK legislation on reorganization.)

All the above benefits will make Cyprus an ideal place to locate a holding company with the ability firstly to take dividends out of the operating company free of withholding tax or at a lower rate of withholding tax, either by virtue of the extensive double taxation treaty network which Cyprus has or under the EU Parent/Subsidiary Directive, secondly to enjoy the tax exemption of dividends and capital gains from local tax and thirdly to take dividends out of the holding company without giving rise to any tax charge in the holding company’s jurisdiction, which is generally the most difficult step.

Conclusion

All in all Cyprus is improving its position as an effective and reputable international business centre. It is the first country to be in full compliance with the OECD criteria and EU Code of Conduct and at the same time to offer real and better opportunities for tax-effective international structures and arrangements to the international entrepreneurial community.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.

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