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 avoidancestrategies that exploit gaps and mismatches in tax rules to artificiallyshift profits to low or no-tax locations.

• The BEPS (base erosion and profit shifting) initiative is an OECDinitiative, approved by the G20, to identify over a period to December2015, ways of providing more standardised tax rules globally.

• The Organisation for Economic Co-operation and Development(OECD) is an intergovernmental economic organisation with 35member countries, founded in 1960 to stimulate economic progressand world trade.

Changes in the Income Tax Laws-Notional interest

• Currently, interest paid is deducted in arriving at the taxable income onlywhen such interest is actually incurred on a loan or other credit facilityobtained.

• The deductibility of the interest expense depends on whether the funds forwhich the interest is paid have been used to finance taxable operations ofthe 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 theCypriot tax resident company

• It should be noted that interest paid on loans to finance theacquisition of investments is only allowed in the case of 100%subsidiaries acquired after 1 January 2012 in proportion of thebusiness assets held by the subsidiary

Notional interest – Before the new law

Country with low/0% taxation

Creditor / Third country

Loan

Loan Interest

Interest

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:

• With this law the Cyprus company had the option to receive very low income and had no risks.

Amount of loan€

Profit margin%

< 50m 0.35%

50m – 200m 0.25%

> 200m 0.125%

Notional interest – The problem

• In practice the use of back to back loans could create beneficialownership issues for the use of DTT (Double Tax Treaties)

• In the above example the transaction could have been challenged bythe foreign tax authorities of the Creditor/Third country that theCyprus 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 interestin cases where funds are introduced to the company in the form ofequity instead of interest bearing or interest free loans. Similarprovisions exist for years in other competing jurisdictions.

The main provisions of the new law are:

• Deemed interest deduction will be allowed on “new equity” fundsintroduced into a Cyprus tax resident company and which funds areused 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 interestrate”. This rate is equal to the yield on the 10 year government bond of thecountry where the new funds are invested, plus 3%, with the minimum ratebeing the yield on the 10 year government bonds of Cyprus (currentlyaround 4%), plus3%.

• New equity means any equity funds introduced into the business after 1January 2015, but do not include capitalization of reserves resulting fromthe revaluation of movable and immovable property.

• Equity includes both share capital and share premium (ordinary orpreference) to the extent that it has been actually paid.

• The consideration for the issue of the shares can also be assets (other thancash) in which case the consideration cannot exceed the market value ofthe assets contributed (the valuation to the satisfaction of the TaxCommissioner).

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 thetaxable income of the company for the year, before the deduction ofthis notional interest. Obviously, in the year of tax loss such, a benefitwill be lost

• The deductibility of the deemed interest will be subject to the samerules as actual interest paid, i.e. will be tax deductible only if it relatesto assets used in the business.

• Claiming of the notional interest is at the discretion of the tax payeron a year by year basis, so, if not beneficial, the tax payer can avoidthe 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 notionalinterest twice on the same funds through the use of multiplecompanies or where the arrangements introduced lack valideconomic 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 carriedout by a company resident of Cyprus is derived directly or indirectlyfrom amounts of new capital of another business carried out by acompany resident of the Cyprus Republic, the allowance on the newcapitals is granted only to one of the said companies.

• For example, if the shareholders of Company A contributed 100.000as equity, and Company A contributed the same amount as equityof Capital B, the notional interest deduction can be claimed byeither 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 orindirectly from loans for which a discount regarding interest isgranted, in accordance with the first or second provisions toparagraph (15) of Section 11 of the tax laws, the amount of interestdiscount on new capital is reduced by the amount of the interestgranted to another company.

• For example, BVI Co granted a loan of 100.000 to Cyp Co 1 carryinginterest at 6% and Cyp Co 1 invested as equity this amount to its100% subsidiary Cyp Co 2, assuming the 10 year government bondyield is 5%, then Cyp Co 2 can claim notional interest at the rate of2% (5% + 3% - 6%)

EXAMPLE

A - Country with low/0% taxation

C - Creditor / Russian Co.

Equity

Loan Interest

Dividends

EXAMPLE - Benefits

Company A

• No taxation on dividends received

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 1st 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 aregranted by a company – ”financing company” – to related parties.

• Two companies are considered “Related parties” if:

➢ One company participates directly or indirectly in theadministration or the control or the share capital of another company

Or

➢ The same persons participate directly or indirectly in theadministration, control or share capital of two or more companies

TRANSFER PRICING REQUIREMENTS

• A financing company will be required to determine its remunerationon the basis of transfer pricing principles by identifying eachcommercial and financial relationship with related parties anddetermining the economically significant conditions andcircumstances relating to such transactions.

• An analysis is required of the functions performed, assets used andrisks assumed by the financing company.

TRANSFER PRICING REQUIREMENTS

Risk analysis

An underlying principle of the risk analysis is that a financing companybearing risks must have the financial capacity to manage those risks and beartheir financial consequences if the risks actually materialize.

Using the relevant methodology, the company should determine theappropriate level of equity that would be needed to assume the risks.

Comparability analysis

An arm’s length remuneration should be determined by carrying out acomparability analysis between the related parties transactions and thetransactions between independent parties under similar circumstances onthe open market.

SUBSTANCE REQUIREMENTS

• Financing companies must have an actual presence in Cyprus and qualifiedpersonnel to control the risks and transactions entered into.

1. The risk is considered to be controlled if the company has the decisionmaking 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 thecompany has the capability to take key decisions with respect tooutsourcing.

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 transferpricing analysis is not at the expected quality level then:

• the financing company may be exposed to beneficial ownership risksin 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 theconsequences.

Do you have domicile of origin in Cyprus?

Have you been non Cyprus tax resident for the period 1995-2014?

Do you retain domicile of choice out of Cyprus?

Have you been non Cyprus tax resident for any period for at least 20 consecutive years?

DOMICILENON DOMICILE

Have you been tax resident for 17 out of the last 20 tax years before the current tax

year?

YES

NO

YES

YES

NO

NO

NO

NO

YES

DOMICILE/NON DOMICILE DIAGRAM

YES