Economic substance for a Cyprus company

Introduction

The term economic substance is not used officially in double tax treaties, but it is becoming an essential part to any international tax planning procedures. Appropriate economic substance solutions should be found for each case based on the substance requirements of the foreign country.

The term economic substance refers the tests that various tax authorities around the world are using to check whether the foreign company is entitled to tax treaty benefits. The Double tax treaties are valid for transactions between persons that are tax resident of the treaty parties, and the income is beneficially owned by the treaty parties. Tax resident means that the company is taxed in a treaty party based on the tax rules of that party. The term “beneficial owner” means that the company receiving the income is the true owner of the income i.e., the income is not received on behalf of a third party, or it subsequently actually transferred to a third party. For example, a company based in Cyprus is receiving interest income from a company based in a treaty country (“foreign company”) and then this interest income or significant part of it is transferred to a Belize offshore company. These loans are more commonly known as “back-to-back” loans and are very popular international tax planning structures. However, in modern international tax and based on the current tests that the tax authorities in various countries are using, it will be very difficult to prove that the Cyprus company is the beneficial owner of the interest income. The Belize company will be considered as the beneficial owner of the income and therefore the foreign tax authorities (i.e., the tax authorities of the country in which the company paying the interest to the Cyprus company is resident) will deny applying the treaty benefits under the Double tax treaty with Cyprus. In this case the payment will be treated as payment from the foreign country to Belize with which the foreign country will have no Double tax treaty. The result will be that standard rate withholding taxes of that foreign country will apply with huge cost to the beneficial owner.

So, the test for substance is the test that the foreign tax authority will use to determine whether the company receiving the interest income is the beneficial owner of the income. The test will check whether the company receiving the interest income is not just a shelf company created to avoid taxes but it is a company that undertakes the risks of providing a loan, it has the appropriate procedures in place for checking the creditworthiness of the counterparty, it has employees with appropriate experience, it has the decision power as to whether to provide the loan or not and finally it has the resources to provide such a loan or to be involved in such an activity. If the above, do not exist then the foreign tax authorities will consider that the Cyprus company (or a company in any country receiving income from the foreign country) is not the beneficial owner of the income and therefore tax treaty benefits will not apply. The above does not mean that the foreign tax authorities will check all transactions, however in case of tax investigation the foreign company should be able to prove the business reasons behind the transaction and in some cases the business substance of the counterparty.

Therefore, a company without substance is not consider that it is a tax resident of the treaty party or that it is the beneficial owner of the income. As a result, the source country may deny giving the treaty benefits which may result in a huge cost. Many countries have their own substance requirements, and someone should be fully aware of those requirements before determining appropriate tax substance solutions.

Appropriate economic substance solutions should be based mainly on the following factors:

• The company should have appropriate functions and undertaking business risks
• The company should have employees
• The company should have directors with appropriate decision-making powers
• The company should have appropriate premises and assets

At G D Panayiotides & Co Ltd we are offering economic substance solutions based on the needs of each client since the substance requirements differ from country to country and are affected by the nature of activities of the company. For example, the substance requirements of a financing company as described above will differ from the substance requirements applicable to a trading company. Also, the substance requirements for a holding company are much less that the requirements of a financing company. Therefore, the incorporation procedure of a Cyprus company or the formation of a company to trade or derive income from the most countries in the world should consider the substance requirements.

How can we help

We can assist with:

• Registration of your Cyprus company or re-domicile your Company in Cyprus
• Assistance for renting premises and purchasing appropriate furniture and equipment
• Assistance for preparing business procedures
• Assistance in providing directors and employees (can be part-time) with relevant knowledge and experience
• Assistance in preparing company web site
• Assist on compliance with tax and other obligations for the individual and the Cyprus company