Cyprus is building an investment fund sector which will reinforce its role as a tax-effective offshore headquarters.

NEW FUNDS LEGISLATION ADDS NEW DIMENSION

The Central Bank of Cyprus has changed its policy to allow, under exchange control laws, the registration of offshore collective investment schemes. The move into the offshore investment fund sector has already been accompanied by interesting public offerings which have attracted investors from abroad.

The growth of a competitive fund manage-ment sector will complement established offshore companies and trust sectors and provide further flexibility in channelling invest-ment through Cyprus to various regions including eastern Europe.

As early as 1997, offshore collective investment schemes could be established in Cyprus either as public investment companies with fixed capital or as unit trusts. The Central Bank of Cyprus final draft legislation allows the registration of public investment companies with a variable capital. The legislation will also include investment limited partnerships and other features:

i) Tax rate of 0.425% on mutual funds (ie 10% of the normal tax rate applicable to offshore companies).

ii) Tax exemption for fund management companies based in Cyprus.

Under the terms of the Central Bank permit, the issue and transfer of shares can be made without prior approval. This is conditional on becoming listed within a specified time on a recognised stock exchange.

The main purpose of these companies must be the investment of funds, with the aim of spreading risk and giving members benefits resulting from efficient and profitable fund management. Companies will have to satisfy the relevant stock exchange require-ments. The Central Bank will not, normally, insist on additional requirements to enable them to qualify as investment companies. The Central Bank will take into account the status of the promoters, nature of the scheme, parties involved in day-to-day operations of the scheme, and any other relevant factors. The Registrar of Companies has confirmed that offshore public companies may be registered with their capital denominated in foreign currency if it exceeds a certain minimum - currently US$1m.

Cyprus Law defines a collective invest-ment scheme as an arrangement relating to property of any kind including money. The Central Bank requires that the promoter is a first-class name in the international financial sector. Promoters will have to realise their objectives outside Cyprus although they may base their management, control or administration on the Island. All financial needs must be funded from external sources, and are required to advise the Central Bank regarding the foreign exchange they convert and spend in Cyprus every year and submit annual audited statements.

The manager and trustee must both obtain prior written consent from the Central Bank of Cyprus before they assume duties.

Today there are more than 38,000 entities registered in Cyprus, as a result of the demand for offshore companies and international trusts.

Offshore entities pay low income tax rates (4.25%) on the net profit of an offshore company; nil tax for an offshore partnership and either of these rates for an offshore branch depending on whether it is managed and controlled in Cyprus or overseas. In addition the after-tax profit can be distributed to the foreign shareholders without any deduction of withholding tax.

Cyprus has a broad double tax treaty (DTT) network. Investment funds, companies and international trust structures can be designed to benefit from the DTT network. There are examples in many Cyprus treaties, provisions for low or zero withholding tax, tax credits and "tax sparing" credits. These provisions are attractive to foreign investors in that tax spared (exempted) in Cyprus, is credited against investors' tax liabilities in the country of residence as if it was actually paid there.

Two countries, which do not have a mutual DTT or an agreement with high withholding tax rates, can profitably do business through Cyprus if one has a DTT with Cyprus. A company in the country with a Cyprus DTT can then reduce or elimiate the withholding tax paid to a fraction of that generated by direct payment.

Cyprus international trust and loan arrangements can reduce tax liabilities.

Cyprus international trusts are for settlors and beneficiaries who are not permanent residents in Cyprus (except charities). They should have no financial dealing with Cypriot residents and at least one trustee must be resident in Cyprus. Income, gains and profits are exempted from income, capital gains, special contribution or any other taxes in Cyprus. There is no estate duty or inheritance tax or exchange control regulations in Cyprus.

An international trust provides solid protection unless it can be proved it was set up to defraud creditors (onus of proof is on the creditors). Otherwise it is not affected by any country's succession provis-ions, neither by bankruptcy, creditor legal action or repossession of the settled property.

The trust can last up to 100 years and can change its governing law at will conditional only on the necessary recognition under a foreign law. There are provisions for making variations and tight confidentiality including the absence of a requirement for registration. This makes it impossible to estimate the volume of assets managed under Cypriot trusts.

International trusts, offshore companies and investment funds enjoy an increasingly sophisticated synergy in Cyprus. As the new investment funds law attracts growing international business, possible combinations of tax savings and operational efficiency will broaden. An investment fund, for example, might be structured as a company (or other form) to benefit from the DTT network and its individual investors might use a further trust and corporate entity to additionally enhance their net gains.

THE NEW DOUBLE TAX TREATY WITH RUSSIA

A new treaty between Cyprus and Russia has been signed. This will come into effect on the 1st January of the year following the ratification by the Russian parliament. If the treaty is ratified during 1999 it will become effective on 1st January 2000. Until such time the old treaty applies. The new treaty differs in that the request for some withholding tax on dividend payments. Any withholding tax deducted is provided as a credit in the other country. Thus in cases of Cyprus IBCs the 5% withholding tax on dividends paid in Russia will be enough to cover the tax liability in Cyprus (4.25% on net profit). Some features of new treaty are:

Withholding Tax Rates

i) If the recipient of the dividends invested more than US$100,000 in share capital of the paying company the withholding tax rate is 5%. Otherwise the rate is 10%.

ii) The rate on royalties paid from one country to the other is zero.

iii) The rate on interest paid from one country to the other is zero.

Irrespective of treaty requirements, Cyprus IBCs are not required to deduct any withholding tax on interest, dividends or royalties paid anywhere in the world.

Tax Credit

Each country shall allow a credit for any tax paid in the other country. For dividends the credit must include the withholding tax and the company tax paid by the company that makes the dividends distribution.

Tax Sparing Credit

A tax credit in Cyprus shall be deemed to include tax which would have been payable but for the tax incentives granted under the laws of Russia and which are designed to promote economic development.

Application to IBCs

The double tax treaty applies to local as well as international business companies (IBCs). An IBC subject to income tax at 4.25% on net profits will also benefit.

The treaty will be particularly beneficial to those that use Cyprus IBCs to enter the vast Russian market; or Russian entrepreneurs/investors that have activities outside Russia, especially in countries that have no treaty with Russia.

Cyprus IBCs receiving dividends from Russia will be subject to the applicable withholding tax at source. There will be no extra tax payable in Cyprus by the Cyprus IBC as they will receive a tax credit in Cyprus (for withholding tax paid in Russia).

Cyprus IBCs will also be exempt from the need to deduct withholding tax irrespective of treaty 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.

This article also appears in the 'International Offshore and Financial Centres Handbook 1999/2000'. For further information about this highly informative guide to offshore centres, or to order your copy, please phone +44 (0) 207 820 7733 or send an email to iofch@mondaq.com