New era for the Cyprus limited company

New Era
Substance is of the essence.

The times are changing rapidly in the international tax world, with Governments, Tax Authorities and relevant Regulatory Bodies focusing more than ever on tax concepts like Base Erosion and Profits Shifting.

International financial centres, like Cyprus, long relied on their competitive tax framework and the relatively easy task to claim and retain the tax residency of a company, in order to attract foreign investors for tax planning purposes. As a consequence, tax structuring through international financial centres, was relatively easy to implement and rarely challenged by foreign Governments.

Times though are changing, and foreign tax jurisdictions are now becoming more sophisticated and aggressive in challenging these structures. Phrases and questions like, a ‘conduit company’ and ‘who is the beneficial owner’, are often used and referred to in new legislation to eliminate or look-through such structures. Inevitably these developments are affecting the Limited Company in Cyprus as well.

Taking a step back, as a general principle of international taxation, a company is primarily subject to tax in the country where it is considered tax resident. However the criteria to determine tax residency may vary broadly in various countries. In Cyprus, a company is considered tax resident if its management and control is exercised in Cyprus.

Effective management and control, even though not defined in the Cyprus tax legislation, in accordance with the practice of the Cyprus tax authorities and relevant case law, can be established in Cyprus when the board of directors takes all major decisions for the operations of the company in Cyprus. As such, attributes of effective management and control like the place where the Board meetings are held, the tax residency of the individual directors of the board, and other attributes, if observed and properly executed can safeguard, for Cyprus tax legislation purposes, that the Management and Control of a company is in Cyprus.

As noted above though, foreign tax authorities are nowadays taking their substance requirements a step further. More specifically, they are examining whether a company established in a different jurisdiction, such as Cyprus, and claiming tax residency in this jurisdiction, further to the management and control principle, has “real” substance. This is particularly important in cases where such company is claiming treaty benefits under the relevant double tax convention (“DTC”) between the two countries (e.g. Cyprus – Russia DTC).

Real Substance of a company is a subjective term, and its definition can change depending on the activities and operations of each company. There are various non-exhaustive lists of attributes that can indicate real substance for a company in its jurisdiction of tax residency. However, it appears that the single most important attribute is whether the foreign intermediary entity is the one which determines the further economic destiny of income received.

In an effort to determine who the beneficial owner is tax authorities, such as the Russian Ministry of Finance, are issuing circulars and draft legislation to examine whether the beneficial owner is indeed the intermediary company. Recently the Russian Ministry of Finance even included specific examples in a letter issued in April 2014, where it clarified that where a company receives dividends, interest or royalties, from a Russian source which it then transfers onwards to another company partially or in their totality will be ignored for Russian tax purposes, assuming the final recipient company does not have an equivalent or more advantageous DTC with Russia for the specific income.

The Cyprus Limited Company, for years was used as a Special Purpose Vehicle (“SPV”) on specific transactions of financing nature, holding of investments and for back to back royalty streams. In light of the recent developments described above, such structures can nowadays be challenged very easily by foreign tax authorities given that the Cyprus Company was always obliged to re-distribute the earned interest, dividends or royalties to another foreign entity.

It is therefore time to re-consider the mission of the Cyprus Company and its usefulness in international tax structuring. Undoubtedly, Cyprus still offers one of the most advantageous tax frameworks and a business friendly environment. In order to utilise these, and minimise the risk of challenge by foreign tax authorities, the Cypriot Company should move from the role of the SPV, to the role of the financing/holding/management centre of a Group.

To give an example (see figure 1), where a Group of companies operating internationally needs to finance various projects and investments, the Cyprus Financing Centre should have the funds available to it to finance these projects.

 Image 1 - Financing Group Cypco

Notes:

[1] Base erosion and profit shifting (BEPS) refers to tax planning strategies that exploit gaps and mismatches in tax rules to make profits ‘disappear’ for tax purposes or to shift profits to locations where there is little or no real activity but the taxes are low resulting in little or no overall corporate tax being paid. (www.oecd.org, Retrieved June 2014) 

[2] Russian Ministry of Finance Letter No. 03-00-Р3/16236 of 9 April 2014