Cyprus: Tax Treatment Of Intra-Group Back-To-Back Financing Arrangements In Cyprus

Last Updated: 7 August 2017
Article by Philippos Aristotelous and Alexandra Spyrou

Introduction

Earlier this year the Cyprus Tax Department announced that the so-called minimum margin scheme, under which a deemed margin is imputed on "back to back" intra-group loans for the purposes of assessing taxable income, would be abolished and replaced with new detailed transfer pricing rules with effect from July 1, 2017. The new rules have now been published in the form of a circular.

The provisions of the circular cover all Cyprus-resident entities undertaking intra-group financing transactions. The circular makes clear that activities related to holding of participations are not intragroup financing transactions. They also apply, mutatis mutandis, to companies tax resident abroad which have a permanent establishment in Cyprus. The term intra-group financing transaction refers to any activity consisting in the granting of loans or cash advances remunerated by interest (or which should be remunerated by interest) to related companies, financed by financial means and instruments, such as debentures, private loans, cash advances and bank loans. Companies are considered to be related if they meet the conditions set out in Article 33 of the Income Tax Law (ITL) of 2002.

Under the new rules, intra-group financing transactions will be evaluated to ensure that the agreed remuneration complies with the arm's length principle (that is to say, it corresponds to the price which would have been accepted by independent entities in comparable circumstances, taking into account the economic nature of the transaction). An appropriate comparability analysis must be carried out in order to determine whether transactions between independent entities are comparable to transactions between related entities.

The arm's length principle is already incorporated in Article 33 of the ITL, which allows the tax authorities to adjust reported taxable profits in the event that transfer prices agreed between related parties differ from the prices that would have been agreed between independent entities.

Comparability Analysis

The comparability analysis should consist of two sections:

  • Identification of the commercial or financial relationship between the entities concerned and determination of the conditions and economically relevant circumstances attaching to those relations in order to accurately describe the transaction;
  • Comparison of the conditions and economically relevant circumstances of the transaction with those of comparable transactions between independent entities.

A group financing company may grant loans or advances to related entities for purposes such as financing of fixed assets, financing of current assets, long term strategic financing and other financing. The circular regards these as the economically significant characteristics of a financing transaction, and the first part of the comparability analysis should contain a full analysis of the terms and functions of the transaction, the assets used and the risks assumed by the related entities. The extent to which the comparability factors are economically significant for a particular transaction depends on the extent to which it would be taken into consideration by independent entities assessing the terms of the same transaction, if it were concluded between them.

For the purposes of the comparability analysis the conduct of the parties is more important than any written terms. Even when a contract is formalized in writing, if the actual conduct of the parties differs from what was contractually agreed, it is the actual conduct of the parties that must be taken into account. While the functions assumed by the lender in connection with granting loans or cash advances to related entities are comparable to those assumed by independent credit institutions subject to the supervision of the relevant regulatory authorities, there could be substantial differences in their application in practice. An effective functional analysis involves an understanding of the decision-making process regarding the origination and the subsequent management of the loan, in particular in terms of corporate strategy and risks and the respective legal rights and obligations of each party, and how this impacts upon the outcome in terms of pricing. In a free market, higher risk generally implies higher pricing. Economically significant risks related to financing transactions should be assessed based on the facts and circumstances of each individual case.

In order to confirm that the management and control of the lender company are exercised in Cyprus, it is imperative that a group financing company must have an actual presence in Cyprus, and that the main management and commercial decisions are taken in Cyprus based on the tax residence of board members, and that Cyprus is the location of board meetings and shareholders' meetings. The company must also have the qualified personnel to control the transactions it undertakes.

Once the transaction has been accurately characterized it is necessary to compare its terms with the terms of similar transactions on the open market. The circular requires the process of identifying such transactions to be transparent, systematic and verifiable. The search should be conducted using all sources of information available at the time of the undertaking of the transaction. The circular adopts a return on equity of 10 percent after-tax as a benchmark arm's length remuneration for the financing and treasury functions based on the current market practice of regulated companies. It makes clear that this is based on current market conditions, and that it will be regularly reviewed.

The circular also deals with the eventuality that no comparable open-market transactions can be identified or, indeed, that the transaction concerned is devoid of any commercial rationale, to the extent that independent parties would not have agreed to enter into such an arrangement. In this event the entire transaction and the associated tax consequences will be disregarded to ensure full compliance with the arm's length principle.

Simplified Basis

As a simplification measure the circular provides that transactions undertaken by a Cyprus tax-resident group financing company which pursues a purely intermediary activity, granting loans or advances to related entities which are financed by loans or advances granted by related entities, will be deemed to comply with the arm's length principle if the company earns a return of 2 percent after-tax on assets in relation to the transactions concerned. This percentage will be regularly reviewed by the Tax Department based on relevant market analyses. In order to benefit from this simplification measure, entities should indicate in their annual tax return that it has been used for the corresponding fiscal year.

This simplified basis is only acceptable for the limited types of transactions specified. Where the nature of the transactions is different, a full transfer pricing analysis must be performed in order to determine arm's length remuneration.

Contents Of Transfer Pricing Analyses For Advance Pricing Agreements

The circular requires all transfer pricing analyses to be prepared by what it describes as a "transfer pricing expert," but does not define what qualification is required. It also requires a licensed auditor to examine the analysis before it is submitted to the Tax Department and to confirm the quality of the transfer pricing analysis, which must cover all the following matters:

  • A description of the computation of equity allocation required to assume the risks;
  • A description of the group and the inter-linkages between the functions performed by the entities participating in the controlled transactions and the rest of the group, together with a description of the value creation in the broad sense within the group by the entities participating in the transactions;
  • The precise scope of the transactions analyzed;
  • A complete list of the searched potentially comparable transactions;
  • A rejection matrix for rejected potentially comparable transactions together with justifications of such rejections;
  • The final list of comparable transactions which have been selected and used to determine the arm's length price applied to the intra-group transaction;
  • A general description of market conditions;
  • A list of all previous agreements on transfer pricing concluded with other countries in relation to the transactions in question;
  • A list of all the previous agreements concluded with the entities under analysis which are still in effect at the time of the submission of the request; and
  • A projection of the income statements for the years covered by the request.

The issuance of tax rulings or advanced pricing arrangements, and the use of the simplified basis described above are subject to the exchange of information rules contained in the EU Directive on Administrative Cooperation (Council Directive 2011/16/EU as amended by Council Directive Council Directive (EU) 2015/2376).

Effective Date

The new arrangements apply from July 1, 2017 for all existing and future transactions, irrespective of the date of entering into the relevant transactions and regardless of any earlier tax rulings. Any earlier tax rulings on transactions within the scope of the circular will no longer be valid for tax periods from July 1, 2017. Any transfer pricing studies undertaken before July 1, 2017 to support existing intra group financing transactions will continue to be accepted only if they comply with the new requirements.

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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Philippos Aristotelous
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