Cyprus: The Process Of Harmonisation With The EU Law And Practice

The International Business Sector In Cyprus And The Process Of Harmonisation With The EU Law And Practice

Speech delivered by Andreas Neocleous Managing Partner of Andreas Neocleous & Co. at the IHM Conference on 24 February 2000 in Nicosia

Firstly, I would like to congratulate the Education Committee of the Institute of Certified Public Accountants and the company, IMH Creative Solutions Consulting Ltd, on organising this seminar.

Its theme is closely connected with the global issue of "harmful tax competition" which has been raised by the most powerful international organisations, the G 7, the United Nations and more particularly the EU and the OECD.

For a couple of years now this issue has been at the top of the agenda of most governments, international bodies and professional associations and is attracting the greatest interest of a lot of discussion groups and the very considerable attention of the media - both national and international.

It has the potential to upset completely the economy and perhaps the standard of living of a lot of countries, especially the small ones, as well as the structure of a large number of productive sectors and professions.

The question of tax harmonisation in its new form - harmful tax competition - has raised serious concern among a lot of countries and many governments, organisations and professional bodies, as well as many productive sectors likely to be affected. All these have embarked on a serious consideration of the whole matter. They have set up special working groups, they have appointed experts and they have designed, or they are designing their strategy so as to be the least adversely affected or the most benefited.

Cyprus, I am afraid, has once again found itself unprepared to face the events which are likely to follow.

It is true that the original attitude of Cyprus towards the EU accession process as well as the approach of the EU towards the so-called "offshore" centres have both changed fundamentally over the last 2 or 3 years. The time when Cyprus claimed that it would be granted access to the EU without being forced and compelled to adjust or alter its "so-called" offshore regime to implement the acquis communautaire has gone for good.

Looking back over the period since the early 1970s, Cyprus has always maintained excellent and privileged relations with the EU. The Republic of Cyprus was among the first countries to sign an Association Agreement with the then European Economic Community which marked the official opening of the negotiations with the Community. Following the signing of the Association Agreement between the two parties, the European Commission, whose opinion was endorsed by the Council in 1995, declared Cyprus eligible for membership and confirmed that the Community was ready to start the process which should lead to the eventual accession of Cyprus into the EU.

The International Business sector of Cyprus is undoubtedly a sensitive sector and will be a controversial issue in the accession negotiations.

This sector is the most profitable (and perhaps the only profitable) sector of the Cyprus economy and contributes to the GDP of Cyprus an amount of about CYP 250 million or 5% per annum. Its contribution, however, is much larger if the high quality tourism which is connected with international business activities in Cyprus and the indirect benefits to other related sectors of the economy are taken into account. Apart from the direct and indirect financial benefits, the international business sector also offers to Cyprus substantial political, economic and social benefits.

The political benefits are obvious. Cyprus is nowadays known because of its international business sector. The many business interests of the international entrepreneurial community also act as a shield to Cyprus against the possible aggressive intentions and plans of Turkey.

The economic benefits are also manifest. Import of know how and new technology, attraction of foreign investments etc. And the social benefits are innumerable - improvement of standard and quality of living, improvement of education and culture, more jobs, etc.

Anyone is able, therefore, to predict the severe repercussions on the Cypriot economy and on Cyprus generally of a possible abolition of the International Business sector of Cyprus.

  • Thousands of jobs will be lost.
  • Hundreds of lawyers, accountants, bankers, insurers, consultants and others will be out of business.
  • Cyprus which stood up on its own feet despite a big catastrophe like the Turkish invasion will face decline and depression.

The harmonisation within the EU has not progressed much since the Timbergen Report of 1953 which was followed by various other reports including the Neumark Report and the Ruding Report.

It was towards the beginning of the 1990s when the issue of tax harmonisation within the EU came back on the agenda of the European institutions. Fiscal harmonisation is generally defined as being a process of adjusting tax systems of different jurisdictions in the pursuit of a common policy objective, eliminating distortions affecting trade and investments to encourage a more efficient allocation of capital. More or less, the only achievement of the EU in the field of taxation until then was the harmonisation of indirect taxation such as V.A.T. introduced in 1967 and excise duties. Progress had remained minimal until the mid-1990s, although in July 1990 two directives on tax neutrality in the single market were agreed upon by the ECOFIN Council. A possible reason, therefore, for the lack of progression over the years is the result of a number of different factors including:

  1. The great divergence in tax systems in Europe. Culturally, despite being only one continent, Europe is very diverse and this lends itself to a number of different tax systems, catering as they do for a variety of programmes of social welfare and other expenditure which necessarily dictate different ways of raising revenue for the public purse.
  2. The absence of political will. There was then a lack of consensus in so far as the Member States were not politically interested in making tax concessions at the European level and there was actually no provision in the Rome Treaty regarding direct taxation compelling them to do so.

One new issue, however, nowadays is that opportunities for tax avoidance have widened with regard to mobile activities. The situation has changed dramatically over the last three years. Nowadays, the key word in the debate on tax harmonisation is "harmful tax competition", which has been defined and examined by both the EU and the OECD.

On 1 December 1997, following a wide-ranging discussion on the need for coordinated action at Community level to tackle harmful tax competition, the ECOFIN Council adopted a series of conclusions and agreed a resolution on a Code of Conduct for business taxation. This decision is important as it states the Ministers’ intentions to tackle the distortions in the single market. The steps agreed on by the Council were as follows - the so-called "tax package":

  1. To establish a Code of Conduct for business taxation
  2. To establish a review group to identify, assess and comment on harmful tax practices. This was subsequently created by the ECOFIN Council on 9 March 1998.
  3. To introduce measures to eliminate distortions in the taxation of capital income (through a proposed Directive on the taxation of savings income).
  4. The Commission to introduce a Directive eliminating withholding taxes on interest and royalty payments.

The tax package is intended to prevent the rise of new special corporate tax regimes and to roll back existing so-called "tax havens" and others in EU member states and associated territories. Under the EU Code of Conduct, tax measures which provide for a significantly lower level of taxation than the levels which generally apply in the Member State in question are considered as potentially harmful, whether the level of taxation is the result of the rate, the base or any other factor. While assessing whether such measures are harmful, account should be taken of, inter alia:

  1. Whether advantages are accorded only to non-residents or in respect of transactions carried out with non-residents, or
  2. Whether advantages are ring-fenced from the domestic market, so they do not affect the national tax base, or
  3. Whether advantages are granted even without any real economic activity and substantial economic presence within the Member State offering such tax advantages, or
  4. Whether the rules for profit determination in respect of activities within a multinational group of companies departs from internationally accepted principles, notably the rules agreed upon within the OECD, or
  5. Whether the tax measures lack transparency, including where legal provisions are relaxed at administrative level in a non-transparent way.

The EU Code of Conduct is a political commitment and does not affect the Member States’ rights and obligations, or the respective sphere of competence of the Member States and the Community resulting from the Treaty. However, it commits politically the Member States to dismantle existing measures and to refrain from adopting new measures that are harmful to tax competition in the EU. Tax havens and special tax regimes have now become a major object of EU tax policy, which places Cyprus at a crossroads: to be or not to be in the EU, the Cypriot offshore regime finds itself under fire.

The review group created in 1998 was formed under the chairmanship of Dawn Primarolo in order to identify harmful regimes. On 23 November 1999, the Code of Conduct group produced its report on the potentially harmful tax regimes in the EU to the ECOFIN Council. The group has identified 66 tax regimes which potentially may qualify as "harmful".

It is not yet certain when or how the Code of Conduct will apply to third countries and territories. Except for the UK, all the Member States who reported to the ECOFIN Council on 8 November 1999 on the application of the principles of the Code of Conduct to their territories claimed that harmful tax elements have been removed in those territories.

Dawn Primarolo declared in relation to this matter back in November 1999 that her mandate to draw up a list of harmful tax measures had been completed and that the implementation of the code was not within the mandate given to her Group. In her opinion, it was therefore left to the ECOFIN Council to decide whether to publish the final report of the Code of Conduct Group which lists the 66 harmful tax measures in the Member States which ultimately must be removed, and to implement the Code of Conduct.

The theme of harmful tax regimes was on the agenda of the ECOFIN meeting on 10 and 11 December in Helsinki. ECOFIN did not reach an agreement on the tax package as described earlier (delays are due to the hurdles with respect to the Savings Directive) but it decided that a high level working group will try to produce solutions for all elements of the package. The working group’s report is due to be presented to the ECOFIN meeting in Portugal in June 2000. Unanimity on the current work on the tax package may not be reached by that time and it might be a long time before harmful tax regimes are phased out in the EU.

Initiatives to combat harmful tax competition have also emerged at OECD level. The OECD has long been involved in the development of international fiscal harmonisation. In 1996, the OECD embarked on a two-year project focusing on how to combat the effect harmful tax competition has on distorting tax bases in OECD member countries. After the two-year period, the Report was approved on 9 April 1998 and subsequently presented at the annual OECD Ministerial meeting in Paris on 27-28 April 1998. This Report, entitled "Harmful Tax Competition: An Emerging Global Issue" was endorsed by 27 out of the 29 OECD Member countries (except Luxembourg and Switzerland, they being of the opinion that the Report was limited only to financial activities and that it was not binding on them). The main focus of the OECD’s work is financial and other services, the reason being that these activities are the most geographically mobile. Notwithstanding the non-binding nature of the Report, the OECD is urging member countries to endorse the proposals of the Report.

The Report distinguishes between tax havens on the one hand and harmful preferential regimes in otherwise high tax countries on the other. To determine whether a country is a tax haven, one should ascertain that it levies no or only nominal taxes. The other key factors are the following:

  1. The jurisdiction seems to be a place to be used by non-residents to escape tax in their country of residence. The solution is therefore ring-fencing in so far as it excludes resident taxpayers from the benefits, or it prohibits enterprises benefiting from the regime to operate in the local market.
  2. There is no effective exchange of information with other countries.
  3. An obvious lack of transparency, whether the result of statutory regulations, practices or a lack of enforcement of the law in the said jurisdiction.
  4. Absence of requirement that the activity be substantial.

The virtual absence of taxes, combined with minimum business presence requirements as well as a lack of legislative and administrative transparency (including bank secrecy) are the key elements describing a tax haven.

On the other hand, the Report is clear: a harmful preferential tax regime requires a low or zero effective tax rate on the relevant income, combined with a ring-fenced regime, the lack of transparency and/or the lack of effective exchange of information with other countries. Additional identifying factors, such as the exemption of foreign source income or secrecy rule, are also set out in the Report.

In addition to recommendations at a national and bilateral level concerning only the OECD countries, the Report sets out non-binding Guidelines for Dealing with Harmful Preferential Tax Regimes applicable within the framework of international cooperation, inter alia:

  1. To refrain from adopting or extending harmful tax practices,
  2. To undertake a review of national tax regimes and practices and report to the newly created Forum of the OECD within two years,
  3. To remove identified harmful measures within five years extended to 2005 for taxpayers benefiting from any such measure in 2000,
  4. To request examination by the Forum of measures not included in the self-review,
  5. To co-ordinate national and treaty responses vis-à-vis other countries,
  6. To make efforts to associate non-OECD member countries with the guidelines.

The OECD has identified 47 small communities (temporary list of tax havens), including Cyprus, which are under review and run the risk of punitive action in the form of financial sanctions by the world’s major nations, if classified in the tax haven category. It has, on the other hand, ignored large OECD economies, such as Luxembourg, Ireland, Switzerland and others. The OECD report presented to the Committee of Fiscal Affairs is not yet publicly available: it is thought that most tax havens will be categorised as "in dialogue" with the OECD. April is the deadline for self-review of member countries and June for dialogue with non-OECD members. The OECD has decided to crack-down on tax preferential jurisdictions outside the EU, such as Cyprus. The dilemma for Cyprus is becoming more crucial: will Cyprus continue to step up the tax competition race or help with international efforts to build some new rules for the race?

Certainly the impetus has gained pace with recent ECOFIN, OECD and G7 reports (a recent G7 meeting was held in Japan at which the OECD’s attempt to curb harmful tax competition was encouraged). However, it remains to be seen what time period is required for the initiatives at these meetings to be implemented.

As we have seen, the need for tax co-ordination in the EU as well as the willingness of the member states to go down this road has now become manifest. However, the process will be lengthy and some say that it will not be completed for many years due to the absence of a political union. Tax harmonisation involves the sovereignty of member states as well as basic changes in the tax systems and rates of the member states, to ensure removal of all preferential tax regimes and distortions.

Cyprus appears to be quite determined to be a full member of the EU as soon as possible. To this end, Cyprus should make all necessary changes in its legislation so as to bring it into harmony with EU legislation. This means that should it be established - and certainly it will be established - that some of the features of its existing tax regime need to be brought into line with EU requirements, the acquis communautaire, it will be obliged to carry out all the necessary changes.

There is no doubt that Cyprus’ way to the EU will be a lengthy one full of difficulties and tough negotiations.

The position of Cyprus as an International Business centre could be either jeopardised or further enhanced and strengthened.

In the very limited time which is left to me, I would like to make some general suggestions:

  1. First of all, Cyprus has to prepare and design carefully a strategic plan setting out short-term and long-term goals in respect of each important sector of the Cyprus economy likely to be affected by the accession - the agricultural sector, the industrial sector and the services sector.
  1. In the process of preparation Cyprus has to secure the full and active participation, not only of the various Government Departments and bodies, but also of all those who contribute to the island’s economy through and in conjunction with the relevant professional bodies, trade unions and associations.
  2. A scientific study of all the developments which are taking place currently in Europe should be carried out, with a view to formulating a strong and effective stance during the accession negotiations.
  3. Most importantly, Cyprus has to re-design the legal framework of its International Business sector so as to bring it in line with the acquis communautaire.
  4. Such a re-designing should provide for the abolition of the IBC in its present form. There should be only one type of company which can carry out activities inside Cyprus or outside Cyprus and which will be treated tax-wise with uniformity with one tax rate, for instance 10% with a tax allowance for income generated outside Cyprus.

I expressed earlier some pessimism and concern as to whether the Cypriot Government and other professional bodies and associations are prepared to become involved in this preparatory work. For instance, I am informed that so far the Bar Association of Cyprus has not made any recommendation (although it was asked to do so) to the Government on any of these issues. Moreover it has not even convened a meeting to examine the issues although all the lawyers in Cyprus, to a greater or lesser extent, will be adversely affected by the oncoming events.

Another example: 2 months ago I conveyed to a top government official my anxiety regarding the OECD’s inclusion of Cyprus in the temporary list of tax havens and its threat to include it in the permanent list. The answer of the top official was "don’t worry, Greece is a member of the OECD and will see that Cyprus is not included in the list".

To my knowledge a small working group was formed to help the Chief Negotiator which includes or is assisted by two expert academics, one Cypriot and one Englishman. With all due respect to the working group and the academics, I am of the opinion that this group should be a powerful group assisted by a team of experts who are mostly practitioners, lawyers, accountants and not purely academics.

A lot of lawyers are associated with colleagues in Europe who are experts in European law and are advising on tax matters as well as on accession negotiation problems. The Bar Association should set up a special ad hoc committee, comprising expert lawyers in Cyprus and expert lawyers in the EU countries, to give its recommendations as soon as possible before it is too late - if it is not already too late. The same course of action should also be taken by the Accountants, although to my knowledge they have studied the matter and have presented their views to the appropriate authorities.

The banking sector, although it enjoys the lion’s share of the income generated from the International Business sector, seems to be quite relaxed. Have they done their homework? Have they set up a working group with experts to study the matter deeply, and have they submitted their findings and recommendations to the government?

Let’s not forget, however, that there could be another version which is spread around in certain circles. Cyprus has to join the EU, and the International Business sector has to be sacrificed. "We will not allow", they say "the interests of a few lawyers, accountants, bankers and consultants to be an obstacle." Is this the version of all those who believe that the Cyprus Stock Exchange is a panacea for all Cyprus’ problems, present and future?

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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