Cyprus: Welcome To The World Of "Substance"

Last Updated: 15 June 2017
Article by Andreas Mylonas

Even if you've been here before, there's always a new aspect of this world to discover. Cyprus, located at the Eastern Mediterranean Sea, at the cross roads of Europe, Asia and Africa, is an ideal place for your permanent residence, or you can choose it for holidays or investment. Cyprus is well known as an international business center for its highly attractive tax and corporate regime.

Cyprus has one of the lowest corporate tax rates in Europe on a flat rate of 12.5% and offers significant tax advantages to companies and corporations that purpose to structure their holding Companies in Cyprus. Cyprus is a member of the European Union since 2004 and a member of the Eurozone since 2008.

The taxation of companies is based on residence. All companies that are tax residents in Cyprus are taxed on their worldwide income accrued or arising from sources both within and outside Cyprus. Non-resident companies are taxed in Cyprus only on income derived from a permanent establishment or immovable property in Cyprus. A company is resident of Cyprus if it is managed and controlled in Cyprus (the place where the key management and commercial decisions that are necessary for the contuct of the entity's business).

A comprehensive network of double taxation treaties has been integral to Cyprus's success as a financial centre. Cyprus has concluded tax treaties with more than 55 countries, whereas even more treaties are under negotiation, or awaiting ratification.

Most of the Treaties follow the Organisation for Economic Co-operation and Development (OECD) model and their objective is that of reducing or eliminating the double taxation payments imposed by the Contracting states on cross border transactions.

Foreign investors have the opportunity to facilitate investments and trading through Cyprus, with a country that Cyprus has a treaty with, allowing for a reduction or elimination of the withholding taxes. It is also undeniable that Cyprus maintains a very competitive tax regime for dividends, gains from the sale of shares and margins on back-to-back loans and much more.

In the recent past, most Cyprus companies could successfully claim double taxation benefits under the relevant DTT just by the fact that they were incorporated in Cyprus. In practice, the Cyprus company would simply apply for a tax residence certificate from the Cyprus Tax Authorities which they would then present to the foreign tax authority. Based on this tax residence certificate, the foreign tax authority would allow the Cyprus company to claim DTT benefits on receipt of dividends/interest/royalties from the foreign entity.

Since the OECD presented their action plan on 'Base Erosion and Profit Shifting (BEPS) the importance of the topic of 'substance' has significantly increased. Under the BEPS initiative the OECD counters harmful tax practices, not only of multinational companies, but also of small and medium sized firms that are internationally operational.

For some other sophisticated tax jurisdictions, such as the United Kingdom, Switzerland and Austria, already had substance requirements as a pre-requisite to allowing Cyprus companies to claim treaty benefits. Therefore, for the tax authorities in such jurisdictions, the mere fact that a company is incorporated in Cyprus does not mean than this company is automatically entitled to claim the favorable provisions of the relevant DTT.

Over the last few years, the global changes of as the CRS and FATCA driven by the OECD and the fact that the most of the foreign tax authorities tried to find ways to increase their tax, including Greece and Russia, are becoming more sophisticated in their approach when it comes to the treaty interpretation related to the articles of dividends, interest and royalties that are paid to companies in other tax jurisdictions.

As part of this development, the mere fact that a company is incorporated in Cyprus and pays taxes in Cyprus on its worldwide income (and therefore able to obtain a Tax Residence Certificate from the Cyprus Tax Authorities) is no longer sufficient for a business to guarantee that a Cyprus company can access the full treaty benefits offered through the expanding and favorable DTT network that Cyprus has to offer.

The incorporation of a company is viewed as insufficient to ensure that it will be considered a tax resident company. To demonstrate substance, among others, an active board of directors (and, as appropriate, employees), suitable financing, and office facilities are needed.

The result of the above global changes is that, tax jurisdictions will examine whether the Cyprus company which claiming tax benefits has substance in Cyprus.

CFC Rules

CFC rules tax the income of controlled foreignh subsidiaries in the hands of resident shareholders. For most countries, they are used to prevent shifting of income either from the parent jurisdiction or from the parent and other tax juristictions. Some countries which give more importance to the principle of territoriality do not currently applu CFC rules. However, where countries have worldwide tax systems, they may also be concerned about long-term deferral and therefore their rules may have broader policy objectives.

What is finally Substance?

Substance can be defined as the various characteristics, notably resources, which demonstrate that the company does indeed have its activities based in the country where it is tax resident, and is not merely a "shell" company formed to avoid paying (usually much higher) tax in the country where the underlying business is based. A strong prove for a company in order to achieve that is managed and controlled in Cyprus, is to show that the majority of directors are residing in Cyprus and the board of directors is holding Meetings in Cyprus.

Minimal substance for withholding tax, etc:

  • bank accounts;
  • properly held meetings;
  • composition of the board;
  • actively acting as a shareholder in lower tier subsidiaries;
  • minor material substance.

More material substance for double taxation agreements, etc:

  • appropriately qualified employees and payment of the relevant payroll taxes;
  • full paper trail of reporting and basis for major decisions on investment;
  • divestment, restructuring etc;
  • preferably own offices with infrastructure etc;
  • the holding company acting as platform for other investments;
  • the registration of utilities such as water and electricity in the name of the company;
  • the payment of local professional rates and taxes;
  • existence of a telephone number, e-mail and fax in the name of the company;
  • existence of a company website, company logo and company stationery;
  • bank statements showing local expenditure (eg. for any of the above);
  • the use of local professionals (IT support, courier services etc);
  • accounting records and other records such as agreements, contracts, invoices etc being located in Cyprus.

A Cyprus company being able to demonstrate that is has substance in Cyprus, as well as management and control in Cyprus, will be in a much stronger position to claim the benefits of DTTs and take advantage of the favorable Cyprus tax regime compared with one that does not have substance.

It is important to note that foreign tax authorities do not only examine whether a Cyprus company has substance in Cyprus and exercises effective management and control from Cyprus. They go beyond that to also investigate at whether the same Cyprus company maintains 'substance' in their own -foreign- jurisdiction, e.g. maintains a Permanent Establishment through which it carries out its business, or it is managed and controlled in that jurisdiction, through individuals that undertake the effective decision-making and formulation of the company policy from there. Undoubtedly, a Company shall be regarded as managed and controlled outside Cyprus if the majority of its directors are non Cyprus residents and the board of directors does not meet regularly in Cyprus, or even it doesn't have any operational office in Cyprus and generally there is no management of the day to day operations of the company in Cyprus.

It is important to understand that in the event that they find substance or management and control of the Cyprus company in their own jurisdiction, not only they will not allow the company to enjoy the relevant DTT benefits, but they may also tax all or part of the income of the Cyprus company as income arising in their own jurisdiction.

From now on, tax jurisdictions are looking for substance and not just the figment of a tax planner's imagination.

Setting up fully fledged offices in Cyprus

As a result of the above, the international business industry in Cyprus is now being transformed. Many companies that are Cyprus tax residents but may have had their operations based abroad are now relocating their operations to Cyprus. At the same time, they are closing down any presence they may have had in foreign jurisdictions. Smaller companies that do not require full-time employees are hiring locally part-time employees or managers to take care of the company's day-to-day affairs.

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.

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