The last financial crisis changed the landscape around taxes throughout the world. The world has moved to greater transparency and additional measures were introduced in order to combat tax evasion and tax avoidance.
Many countries, through the exchange of information mechanism with foreign counterparties, have increased their scrutiny on cross border operations in an effort to tackle taxpayers who shift profits to other jurisdictions for obtaining a tax benefit.
Cyprus has received an increased number of requests for information on such cross-border operations from foreign tax authorities. From Cyprus perspective, such requests are handled through the Ministry of Finance and the International Tax Affairs Division. Subsequently, such requests are forwarded to the Cyprus companies which are obliged under local legislation to reply and provide the requested information.
The main purpose of the foreign Tax Authorities, is to evaluate whether a Cyprus company, as the recipient of foreign income (dividends, interest, royalties), is mere vehicle for rerouting profits or whether it was established in order to take advantage of a double tax treaty without a corresponding real physical and economic presence in Cyprus.
Below we will provide an analysis of such requests and provide a comparison of the requests currently received with the requests received prior BEPS introduction. Based on the below analysis it is certain that structures with no substantial operations and economic substance in Cyprus will not survive in the tax battlefield and will most certainly have difficulties in claiming double tax treaty benefits.
Reviewing the past (years up to 2016)
The number of requests received by the Cyprus Tax Authorities in the past from foreign Tax Authorities were limited compared to those received the last few years.
These requests were focused on the type of activities performed by the Cyprus companies, the relationship of the Cyprus companies with the foreign entities or individuals under investigation, the actual execution of the agreements under investigation and the recognition of the agreements in the Cyprus company's accounting records.
In general, an emphasis was given to the legal form of the transactions and the mere recognition in the accounting records rather than the business dimension and relevant substance of the transactions.
In this respect foreign Tax Authorities in many times failed to substantiate their arguments to proof misuse of the double tax treaty or excess deduction of expenses locally.
There is no doubt that the whole picture changed after the OECD issued the final reports of OECD/G20 BEPS1 Project in December 2015 setting the rules and instruments to address base erosion and profit shifting.
During the following years, the foreign Tax Authorities adopted a different approach on the nature of the information requested.
Analysing the last few years
After the introduction of BEPS, the foreign tax investigations became more intensive and focused on tax residency, the place of effective management and control of an entity, economic substance issues and the beneficial owner of the income concept for those claiming treaty benefits. One could say that the Tax Authorities have become more sophisticated with a clearer understanding of the tools available to them to tackle base erosion and profit shifting.
Below we present a sample of requests addressed to Cyprus companies, separated according to the main areas the foreign Tax Authorities were focused:
The company is being asked :
- To provide information about the availability of premises necessary for the company to perform its activities (size of office, number of office equipment etc).
- To provide information as to whether the company has qualified personnel to execute and control the conduct of financial transactions, to provide details about these persons and their experience and qualifications.
- To provide details of the company's employees and specifically if they are Cyprus citizens, perform their duties from Cyprus and if they are paying taxes from their salaries in Cyprus.
- To provide the number of employees as well as their surnames, positions and remuneration amounts, employment contracts and staff regulations.
Beneficial Ownership Concept
The company is being asked :
- To state if it is the ultimate beneficiary recipient of income or just agent, nominal recipient or just mediator of the said income.
- To clarify if the company independently dispose the interest as an ultimate beneficiary (owner).
- To provide details of the usage of the income received from the foreign company and whether these funds are used to pay off payables.
- To inform if the company paid dividends in favour of its foreign shareholder and if yes to provide the relevant decisions.
- To provide Bank statements as a supporting document for the execution of transactions.
Tax residency/Management and Control
The company is being asked :
- To provide copy of any Power of Attorney issued by the company to individuals in order to carry out business activity.
- To provide copy, if any, of supporting documents regarding official business trips of the company's officers in order to represent its interest in the foreign jurisdiction.
- To provide details of the person made the decision to finance the foreign entity in accordance with the credit agreement and to inform if the shareholder of the company participated in the decision-making procedure.
- To state the persons negotiated the contracts under investigation.
- To provide details of the tasks and responsibilities of the company's director.
- To provide details of the persons acting as the company's bank signatories.
- To inform of the authorised person applied for Residence Certificates on behalf of the company for the purpose of evasion of the double taxation of fees/interest/royalty.
- To state whether the company has a permanent home/habitual abode in Cyprus.
- To state whether the foreign taxpayer who provided services to the CY company, has a permanent home/habitual abode in Cyprus.
Other important considerations
Further to the above sample of requests which constitute the most crucial type of requests in a tax investigation letter, the foreign Tax Authorities are also interesting in identifying the commercial rational of the transaction under investigation and evaluate whether the foreign company was used with main purpose the tax benefit:
The company is being asked:
- To indicate the yearly interest rate of the loan agreement and provide details of how the interest rate was set up.
- To clearly indicate if the lender and the borrower are associated.
- To state from which sources the company used funds in order to repay to the foreign taxpayer the loan amount.
- To explain the purpose the company borrowed funds from the foreign taxpayer and to provide information on how the company used the loans received.
- To state why the company agreed to replace a financial instrument (e.g. loan, promissory note etc) with the new one and provide explanations of the reasons, including economical purpose of decreasing rates of interest-bearing financial instruments.
- To explain why the loan agreement did not contain provisions on protection of the lender in case of lack of loan repayment.
- To provide information as to whether the company benefit from tax incentives in Cyprus in the field of intellectual property.
We strongly believe that the implementation of BEPS and the provisions of the OECD Multilateral Instrument adopted by many countries, including Cyprus, and specifically the Principal Purpose Test (PPT) which can be found now in many treaties, will play an extremely important role in preventing base erosion and profit shifting.
Taking into account the global trend towards transparency in tax matters, it is imperative that investors will have to ensure policies and sound structures in place to manage the risks associated with this dynamic environment.
The risks and challenges in maintaining tax residency and enjoying the relevant Treaty and EU Directive benefits are important however, is in our opinion that by adopting an integrated approach on the matter and introducing economic substance at all levels, the risks will be manageable.
1 Base erosion and profit shifting (BEPS) refers to tax planning strategies used by multinational enterprises that exploit gaps and mismatches in tax rules to avoid paying tax.
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.