TRANSFER PRICING EFFECTS ON TRADING AND FINANCING CYPRUS COMPANIES AND SOLUTIONS By Marios Efthymiou Managing Director
DEFINITIONS Base erosion and profit shifting (BEPS) refers to tax avoidance strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations. The BEPS (base erosion and profit shifting) initiative is an OECD initiative, approved by the G20, to identify over a period to December 2015, ways of providing more standardised tax rules globally. The Organisation for Economic Co-operation and Development (OECD) is an intergovernmental economic organisation with 35 member countries, founded in 1960 to stimulate economic progress and world trade.
Changes in the Income Tax Laws- Notional interest Currently, interest paid is deducted in arriving at the taxable income only when such interest is actually incurred on a loan or other credit facility obtained. The deductibility of the interest expense depends on whether the funds for which the interest is paid have been used to finance taxable operations of the company and to acquire assets considered to be used in the business.
Changes in the Income Tax Laws Notional interest Interest paid to finance intercompany loans is deductible, provided certain minimum margins were kept at the level of the Cypriot tax resident company It should be noted that interest paid on loans to finance the acquisition of investments is only allowed in the case of 100% subsidiaries acquired after 1 January 2012 in proportion of the business assets held by the subsidiary
Notional interest Before the new law Country with low/0% taxation Loan Interest Loan Interest Creditor / Third country
Notional interest Before the new law The Cyprus company that is in a back-to-back loan is taxed in Cyprus with some predetermined minimum profit margins based on the amount of the loan: Amount of loan Profit margin % < 50m 0.35% 50m 200m 0.25% > 200m 0.125% With this law the Cyprus company had the option to receive very low income and had no risks.
Notional interest The problem In practice the use of back to back loans could create beneficial ownership issues for the use of DTT (Double Tax Treaties) In the above example the transaction could have been challenged by the foreign tax authorities of the Creditor/Third country that the Cyprus company is not the beneficial owner of the income.
Changes in the Income Tax Laws Notional interest Cyprus introduced provisions to allow notional deduction of interest in cases where funds are introduced to the company in the form of equity instead of interest bearing or interest free loans. Similar provisions exist for years in other competing jurisdictions. The main provisions of the new law are: Deemed interest deduction will be allowed on new equity funds introduced into a Cyprus tax resident company and which funds are used for the operations of the company.
Changes in the Income Tax Laws Notional interest The deemed interest will be calculated on the basis of a reference interest rate. This rate is equal to the yield on the 10 year government bond of the country where the new funds are invested, plus 3%, with the minimum rate being the yield on the 10 year government bonds of Cyprus (currently around 4%), plus3%. New equity means any equity funds introduced into the business after 1 January 2015, but do not include capitalization of reserves resulting from the revaluation of movable and immovable property. Equity includes both share capital and share premium (ordinary or preference) to the extent that it has been actually paid. The consideration for the issue of the shares can also be assets (other than cash) in which case the consideration cannot exceed the market value of the assets contributed (the valuation to the satisfaction of the Tax Commissioner).
Changes in the Income Tax Laws Notional interest Other forms of equity contribution are not acceptable. The notional interest to be deducted cannot exceed 80% of the taxable income of the company for the year, before the deduction of this notional interest. Obviously, in the year of tax loss such, a benefit will be lost The deductibility of the deemed interest will be subject to the same rules as actual interest paid, i.e. will be tax deductible only if it relates to assets used in the business. Claiming of the notional interest is at the discretion of the tax payer on a year by year basis, so, if not beneficial, the tax payer can avoid the claim.
Changes in the Income Tax Laws Notional interest anti-avoidance Anti-avoidance provisions A number of anti-avoidance provisions are included in the legislation, in order to ensure that there is no abuse of the new benefit granted, such as dressingup old capital into new capital, claiming notional interest twice on the same funds through the use of multiple companies or where the arrangements introduced lack valid economic or commercial reasons
Changes in the Income Tax Laws Notional interest anti-avoidance In the case where the amounts of new capitals of a business carried out by a company resident of Cyprus is derived directly or indirectly from amounts of new capital of another business carried out by a company resident of the Cyprus Republic, the allowance on the new capitals is granted only to one of the said companies. For example, if the shareholders of Company A contributed 100.000 as equity, and Company A contributed the same amount as equity of Capital B, the notional interest deduction can be claimed by either Company A or Company B
Changes in the Income Tax Laws Notional interest anti-avoidance (3) In the event that amounts of new capital are derived directly or indirectly from loans for which a discount regarding interest is granted, in accordance with the first or second provisions to paragraph (15) of Section 11 of the tax laws, the amount of interest discount on new capital is reduced by the amount of the interest granted to another company. For example, BVI Co granted a loan of 100.000 to Cyp Co 1 carrying interest at 6% and Cyp Co 1 invested as equity this amount to its 100% subsidiary Cyp Co 2, assuming the 10 year government bond yield is 5%, then Cyp Co 2 can claim notional interest at the rate of 2% (5% + 3% - 6%)
EXAMPLE A - Country with low/0% taxation Equity Dividends Loan Interest C - Creditor / Russian Co.
Company A No taxation on dividends received EXAMPLE - Benefits Cyprus company Notional interest deduction Maximum deduction 80% of taxable profit 12.5% Tax on profits No Withholding Tax on dividends Company C Russian No Withholding Tax Deductibility of interest
TRANSFER PRICING
INTRA-GROUP FINANCING (BACK-TO-BACK) A circular issued on 30/06/2017 by the Tax Department terminated the application of the pre-agreed minimum profit margins of 0.125% - 0.35% for intra-group financing. As of 1 st July 2017 new rules apply for the taxation of the intra-group financing. The Circular provides for the application of transfer pricing methodology based on arm s length principles.
SCOPE OF CIRCULAR APPLICABILITY The Circular applies to intra-group financing activities where loans are granted by a company financing company to related parties. Two companies are considered Related parties if: One company participates directly or indirectly in the administration or the control or the share capital of another company Or The same persons participate directly or indirectly in the administration, control or share capital of two or more companies
TRANSFER PRICING REQUIREMENTS A financing company will be required to determine its remuneration on the basis of transfer pricing principles by identifying each commercial and financial relationship with related parties and determining the economically significant conditions and circumstances relating to such transactions. An analysis is required of the functions performed, assets used and risks assumed by the financing company.
TRANSFER PRICING REQUIREMENTS Risk analysis An underlying principle of the risk analysis is that a financing company bearing risks must have the financial capacity to manage those risks and bear their financial consequences if the risks actually materialize. Using the relevant methodology, the company should determine the appropriate level of equity that would be needed to assume the risks. Comparability analysis An arm s length remuneration should be determined by carrying out a comparability analysis between the related parties transactions and the transactions between independent parties under similar circumstances on the open market.
SUBSTANCE REQUIREMENTS Financing companies must have an actual presence in Cyprus and qualified personnel to control the risks and transactions entered into. 1. The risk is considered to be controlled if the company has the decision making power to: Εnter into a risk-bearing commercial relationship Ability to address such risks Performs such decision-making functions The daily activities of risk mitigation may be outsourced as long as the company has the capability to take key decisions with respect to outsourcing.
SUBSTANCE REQUIREMENTS 2. The actual presence criteria take into account the following: The number of the members of the BOD that are Cyprus tax residents The number of BOD meetings as well as shareholders meetings held in Cyprus
SIMPLIFICATION REGIME A financing company which meets the substance requirements and is engaged purely in back-to-back loans between related parties, for simplification purposes will be considered to comply with the arm s length principle if it receives a return of 2% after-tax on assets. A company meeting the above requirements: Needs to prepare transfer pricing documentation with minimum requirements For deviating from the above 2% return will need to duly justify an appropriate transfer pricing analysis
TRANSFER PRICING ANALYSIS A transfer pricing analysis with a number of minimum requirements, as specified in the tax circular, will be prepared and submitted to the Tax Authorities by auditors.
GENERAL COMMENTS If a finance company does not comply with the Circular or the transfer pricing analysis is not at the expected quality level then: the financing company may be exposed to beneficial ownership risks in other jurisdictions. On the contrary the Circular does not mention what the consequences, if any, will be in Cyprus. Practice or additional Circulars are expected to clarify the consequences.
DOMICILE/NON DOMICILE DIAGRAM Have you been tax resident for 17 out of the last 20 tax years before the current tax year? YES NO NO Do you have domicile of origin in Cyprus? YES YES Have you been non Cyprus tax resident for the period 1995-2014? NO Do you retain domicile of choice out of Cyprus? NO YES YES Have you been non Cyprus tax resident for any period for at least 20 consecutive years? NO NON DOMICILE DOMICILE