• Cyprus Economic Substance and Beneficial Ownership.15/09/2014


International tax planning is not as straightforward as it used to be. In order to determine where a company is taxable, onshore tax authorities are increasingly looking further than the place where management and control is exercised. They thoroughly focus on the economic rationale behind the use of an offshore company. This has been enforced by the recent cases of Volvo, Google, Vodafone and others, which have used tax ‘efficient’ structures (sometimes through the utilization of an intermediary – flow through company in a tax advantageous jurisdiction) as part of their overall international tax planning strategy to minimize their tax obligations. Due to this the current hot expressions in international tax planning circles are therefore ‘resident’, ‘place of effective management’, ’beneficial owner’ and ‘economic substance’.

Beneficial Ownership

The beneficial ownership requirement is a specific anti-avoidance clause as it has been a feature of the OECD model treaty for a long time. This means a recipient of dividends, interest and royalties has to be the beneficial owner of the dividends in order to benefit from the applicable tax treaty. The most important question here is ‘who is regarded as the beneficial owner?’ For example an intermediary company may not be regarded as the beneficial owner of income (dividends, interest, royalties), if a third party i.e. fiduciary provider or administrator is acting on its behalf and consequently for the ultimate beneficial owners. If this is the case and if proved by the tax authorities of the country of source, then the veil of incorporation is lifted and the company will be taxed in the source country. Specifically, an intermediary company does not classify as the beneficial owner if the right to use and enjoy the dividend is constrained by a contractual or legal obligation to pass the payment on. Each case will be treated and examined on the interpretation of legal documents, facts and circumstances.

Economic Substance

Another important aspect which was considered by the Organisation for Economic Co-operation and Development (OECD) was the concept of economic substance. As countries differ in the extent to which they left anti-avoidance legislation take precedence over tax treaties regarding ‘beneficial ownership’, the direction of economic substance is starting to emerge. If an entity does not have clear economic substance there is an increasing risk that it will not hold upon review by the interested tax authorities and therefore not achieve the intended tax benefits. Therefore, sufficient economic substance should be present at the level of the intermediary Company and therefore allocation of risks should be consistent with the economic substance of that company.

Structuring activities internationally through an intermediary company i.e. via a Cyprus international company, the following important considerations and actions need to be taken into account and perform in order to achieve economic substance:

  1. The Cyprus intermediary company should own the most valuable intangibles and performing the most important functions within a corporate structure and typically to be entitled to the largest share of the profits or losses.
  2. The Cyprus intermediary company should beneficially own the income it receives (dividends under the terms of a double tax treaty) and not receive that income on behalf of another person. The income should arise to the Company itself and be reported in its bank account and financial statements. The company should freely deal with inflow of funds representing the dividend received at its full discretion;
  3. Qualified directors residents in the country of the intermediary company should be appointed, i.e. Cyprus  which will have the ability to make decisions and really understand the nature of the business;
  4. The headquarters of the group should be located in Cyprus, as well as having fully rented and fledged offices with business telephone lines, telephone answering and call forwarding machines, own website and employ full time or part time employees;
  5. Original minutes of conferences, general meetings, electronic mail, general administration, accounting are kept at the seat of the Cyprus international company;
  6. The Cyprus intermediary company should have a more active role by entering into contracts of purchase and sale; ordering of goods or services from third parties; raising of invoices; opening and administering of Cyprus  bank accounts and International bank accounts; acquiring property and share assets;
  7. Investment in associated companies in the form of interest-bearing debt. The transaction should be structured in accordance with the economic and commercial reality of parties dealing at arm's length;
  8. When setting up a Cyprus International Company, it is extremely important not just to demonstrate the initial reasons for forming it but also to continuously demonstrating Cyprus economic substance throughout the Cyprus Company’s lifetime. For example, if one of the reasons for forming a Cyprus Company is to improve cost control and enhance risk management, at all times should provide evidence and demonstrate the new controls and methods of improving cost control. Additionally at all times there should be a review of documents such as articles of association, financial statements, board resolutions, expense information, functions and risks associated to the Cyprus company, loan agreements, license agreements, patent/copyright registration certificates, and agency/ proxy agreements etc;
  9. There are certain cases where even they are largely tax motivated, the treatment of taxation might not be altered by a tax authority. For example the choice between capitalizing a business enterprise with debt or equity, or a person’s choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment,  the choice to enter a transaction or series of transactions that constitute a tax-free corporate reorganization and even the choice to use a related-party entity in an arm’s length transaction;
  10. Avoid setting-up a structure in which directors of the Cyprus International Company or a foreign company are coincidentally the same directors of the source company. In this case almost in all jurisdictions tax authorities will easily consider that in reality all decisions are taken in the source country and not in the foreign company, resulting in a lack of economic substance. Therefore it should be seen clear that the company is in reality operating in itself and not under the supervision or control of the company of the source country;
  11. It might be unlikely that a Cyprus Holding Company be challenged if it is used to hold multiple investments in foreign companies;
  12. Income received in a form of interest from a foreign company and distributed to the source country by a Cyprus company in a form of dividend, might be considered a form of unrelated payment received;
  13. Cyprus Company (finance). Payments in respect of loans between foreign companies, Cyprus Finance Company and foreign source company should be unrelated. Is the beneficial ownership waived due to the fact that interest collected by the Cyprus Company is to meet its obligations under another financing agreement? In such a case identifying the beneficial owner is rather a complex task. The problem even becomes more complex on income arising on securities and financial derivatives. The solution to this might be:
    1. Both transactions shouldn't be made by same counterparties;
    2. Time of execution of transactions should not be the same;
    3. Interest rates should not be similar but instead should be at arms length and related to commercial rates;
    4. Adequate returns (profits) allocated to each company and in relation to risk undertaken;
    5. Same duration of loans might not be the same;
    6. Amount of loans received and loans granted might not be the same
  14. A foreign company assigns intellectual property rights (IP) to a Cyprus Company and Cyprus Company sub – licences the intellectual property rights (IP) to a multiplicity of different foreign companies in foreign countries. Foreign payments from foreign company to a Cyprus Company and from Cyprus Company to multiplicity of different countries should commercially justifiable. In addition the Cyprus Company may incur regular expenditure which may add value to the intellectual property rights (IP) activities;
  15. If possible, transactions should be subject to a statutory or regulatory scheme for example Cyprus funds - International Investment Collective Schemes (ICIS). Shares or units of a Cyprus fund - International Investment Collective Schemes (ICIS) are held by a custodian bank, administered by the administrators and regulated by the Central Bank of Cyprus. The true owner is the beneficial owner even though for safety, control and convenience, shares or units are held by the custodian bank and administered by the administrators;
  16. Another option to consider is listing the Cyprus International Company to the Cyprus Emerging Capital Market. History requirements are minimum;  listing and maintenance costs are not restrictive; no minimum share capital must be dispersed among the general public;
  17. The setting up of a Cyprus International Trust to own the shares of a Cyprus company. If a Cyprus International Trust is a discretionary Cyprus International Trust the beneficiaries will not have ownership or control over the shares of the Cyprus Company.
  18. How we can help

    We can assist you with issues of Cyprus economic substance and beneficial ownership by organising adequate Cyprus substance for your Cyprus business and dealing with matters of beneficial ownership through our services and the usage of our broad network of professional associates.

    Contact us for a free consultation:

    Tel. +357 25258900/ Fax. +357 25258901