- CBDT notifies Cyprus as a non-cooperative jurisdiction for failure to provide information.
- Transfer pricing provisions under the ITA to apply to all transactions that are entered into with a person in Cyprus.
- Withholding tax rate of 40% on interest and redemption premium on debentures.
- No deductions for any payment made to a financial institution in Cyprus or for any expenditure arising from a transaction with a person located in Cyprus to be allowed unless the taxpayer furnishes the requisite information.
- Source of any sum received from a person in Cyprus shall need to be explained satisfactorily - failure of which shall lead to the sum being treated as income for the taxpayer.
On November 1, 2013, the Central Board of Direct Taxes ("CBDT") issued a press release1 notifying Cyprus as a non-cooperative jurisdiction for failure to provide information. This information was requested for under the Exchange of Information ("EoI") provisions under the tax treaty between India and Cyprus ("Tax Treaty").
It is important to keep in mind that Cyprus and India have, over the years, developed commercial and economic relations covering a whole gamut of areas of cooperation including education, trade and tourism. As of August 2013, Cyprus was the 7th largest FDI investor into India with total inflows amounting to around 4%2 of total FDI flows. A key reason for this, apart from certain strategic advantages that Cyprus offers were the favorable provisions in the Tax Treaty which exempt capital gains income and provide a beneficial rate of tax on interest income earned by Cyprus entities f rom Indian investments. Cyprus entities have therefore been popularly used for making investments into Indian companies, particularly in debt heavy secto rs such as real estate and construction.
The recent debt crisis in Cyprus created some apprehension in relation to these investments. Cyprus was required to raise an additional EU 5.8 billion, a significant part of which is being raised by way of charge on bank deposits in Cyprus. Liquidation of the second biggest Cyprus bank has also led to decreasing levels of interest in investors to invest through Cyprus. Investors were apprehensive as to the impact of this charge as well as the viability of investments through Cyprus. This unexpected notification by Indian revenue authorities is likely to cause further concern, not just in respect of investors from Cyprus but also other jurisdictions.
HIGHLIGHTS OF PRESS RELEASE
- Transfer pricing provisions under the Income Tax Act, 1961 ("ITA") shall apply to all transactions that are entered into with a person in Cyprus.
- Withholding tax rate of 30% or such other higher rate as prescribed under the ITA shall be applicable for any payment to a person in Cyprus.
- No deductions shall be allowed for any payment made to a financial institution in Cyprus or for any expenditure arising from a transaction with a person located in Cyprus unless the taxpayer furnishes the requisite information.
- Source of any sum received from a person in Cyprus shall have to be explained satisfactorily - failure to explain shall lead to the sum being treated as income for the taxpayer.
Even though the CBDT has issued the press release notifying Cyprus as a non-cooperative jurisdiction, it has not addressed a number of practical issues which may create ambiguity and doubt in the mind of the taxpayer. Following are some of the critical issues which the taxpayers may face if they transact with Cyprus:
Applicability of transfer pricing provisions3: Transfer pricing provisions shall be applicable to all transactions which are entered into with a person located in Cyprus. This means that the arm's length p rice requirement will need to be met for each transaction entered into between the taxpayer and the Cyprus entity.
As transfer pricing is typically applied in related party situations, it is unclear as to how price adjustment is sought to be undertaken in an independent party context, or the possibility of there being any base erosion in such a situation. This would create additional documentation requirements and administrative compliances and is likely have a direct impact on investment deals with Cyprus.
Withholding tax rate4: The press release provides that withholding tax rate of 30% or such other higher rate as prescribed under the ITA shall be applicable for any payment to a person in Cyprus. In case of any interest pay out or redemption premiums on debentures, the withholding would be 40% (excluding surcharge and cess) due to withholding taxes on rupee denominated bonds. However, in case of NCDs held by an FII/QFI or in case of interest paid on ECBs where the tax rate may be 5% (subject to certain conditions) or 20% (in case of an FII), the withholding will be 30%.
In this regard it must be noted that the press release only provides for a higher withholding, but does not change the applicable rate of taxation for the Cypriot entities. To that extent, if the Cypriot entity is entitled to a lower withholding rate under the Tax Treaty, then it may be able to claim a refund in respect of the excess taxes withheld. However, claiming a refund may be a difficult task and the tax authorities may scrutinize the eligibility of the Cypriot entity claiming the refund on account of lack of substance etc.
Deductions5: Section 94A further provides that no deduction shall be allowed:
- for any payment made to any financial institution located in Cyprus unless the taxpayer furnishes an authorisation in Form 10FC6 in the manner as laid down in the Income Tax Rules ("Rules") authorising the Board or any other income-tax authority acting on its behalf to seek relevant information from the said financial institution on behalf of the taxpayer; or
- for any other expenditure or allowance (including depreciation) arising from the transaction with a person located in Cyprus unless the taxpayer maintains such other documents and furnishes such information as may be prescribed, in this behalf.
- In this regard, the Rules provide that in addition to all the information and documents that the taxpayer needs to maintain under the transfer pricing provisions of the ITA, the taxpayer is also required to:
- disclose the ownership structure of the Cyprus entity including name and address of individuals or other entities, whether located in Cyprus or outside, having directly or indirectly more than ten per cent shareholding or ownership interests;
- provide a profile of the multinational group of which the Cyprus entity is a part along with the name, address, legal status and country of tax residence of each of the enterprises comprised in t he group with whom the taxpayer h as entered into a transaction;
- description of the business of Cyprus entity and the industry it operates in; and
- any other information, data or document, which may be relevant for the transaction with the Cyprus entity.
This information needs to be kept and maintained for a period of eight years from the end of the relevant assessment year.
Since many funds that have invested through Cyprus, may not be comfortable with sharing such information, which may involve disclosing details of their limited partners ("LPs"), the Indian Company may not be able to claim deduction in respect of the interest (including redemption premium) paid to Cypriot entities. Such treatment will not only have an impact on the Indian companies making payments to Cypriot entities, but also have an impact on the returns of the funds which mostly compute the deductions availed by the Company in their financial models. To the extent that the interest has accrued and deductions have been claimed, the press release should not impact. However, where the interest accrual has been deferred or in cases of redemption premium that will be claimed as revenue expenditure on a going forward basis, the tax authorities are likely to require withholding at 40% on the entire accrual irrespective of the fact that part of such a ccrual is pro-rated for years pri or to the press release. Further, neither the ITA nor the press release provides for the definition of financial institution. This may lead to ambiguity as to what would qualify as a financial institution.
Explanation about source of money from Cyprus7: Section 94A (4) further provides that in a situation where the taxpayer has received or credited any amount of money from any person located in Cyprus but fails to provide any explanation about the source of the said money or the assessing officer is not satisfied with the explanation of the taxpayer then such amount shall be deemed to be the income of the taxpayer for that year.
Again, since such information may involve disclosure of the LP details of the funds investing from Cyprus, such funds may not share such information with the tax authorities. To that extent, any investments or loans by Cypriot entities to the Indian investee companies may be included in the total income of the Indian companies.
From a substantive perspective, this notification could significantly impact current structures which have made investments through Cyprus. With the arm's length pricing requirements between unrelated entities, withholding rate being increased and possibility of expense disallowance, there could potentially be serious cash flow issues. Fund managers may also not be comfortable disclosing the ownership structure of the Cyprus entity as the ultimate entity holding more than ten per cent shareholding or ownership interests will also be needed to be disclosed.
More importantly, on the procedural front, this release is in continuation of the Indian revenue's focus on exchange of information and transparency. Over the last few years there has been a major drive to enter into exchange of information agreements as well as domestic provisions introduced to ensure detailed disclosure by Indian tax payers. In July this year, a notification was released stating that India was considering blacklisting jurisdictions which haven't shared information – some of the countries named included Switzerland, United Arab Emirates, Hong Kong and Singapore. While Cyprus was not one of the countries named at this point, it has been under pressure for information disclosure from the OECD and other European countries as well.
What is unfortunate however, is the ad hoc manner in which the information was relayed and the lack of a consultative process with the treaty partner.
On Friday night, the Finance Ministry of Cyprus has by way of a press release clarified that the Tax Treaty has not been terminated and that its benefits shall still be available. Moreover, the press release of the Finance Ministry of Cyprus also states that the Cyprus Government is in direct contact with the Indian Government and is exerting every effort to clarify and resolve the situation that has been created and has directly affected the business communities in both countries. Reports do state that the countries are working together to resolve the issue, and it is hoped that an amicable resolution will be reached that will provide more certainty in respect of Cyprus.
Further, on a going forward basis and until further clarity is received on the negotiations, fund managers may either suspend payouts on debentures, or in cases where the Cypriot entity or its affiliates also hold equity, consider taking returns on equity by way of dividends. Migrating from Cyprus to any other jurisdiction keeping in mind the General Anti-Avoidance Rules which are to come into effect from April 1, 2015 may also be considered.
1 Notification No. 86/2013 dated November 1, 2013
3 Section 94A(2) of the ITA
4 Section 94A(5) of the ITA
5 Section 94A(3)(a) of the ITA
6 Section 94A(3)(b) of the ITA
7 Section 94A(4) of the ITA
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.