By Christopher Owen
When Malta and Cyprus were admitted to the European Union on 1 May 2004, two more beneficial tax systems were added to the list of favoured EU tax planning jurisdictions, alongside the Netherlands, Dublin and Luxembourg. Both islands offer an advantageous tax regime, to all taxpayers investing in or through them, allied to an extensive network of tax treaties. And although both were previously recognised as hosting “offshore” regimes, neither is now classified by the Organisation for Economic Co-operation and Development (OECD) as a tax haven.
Accession to the European Union obliged Cyprus to reform its tax system to remove the “discriminatory” elements and bring it into line with EU requirements and the OECD initiative against harmful tax practices. The Income Tax Law of 2002, which came into force on 1 January 2003, introduced a single corporation rate of taxation of 10% for all companies registered in Cyprus – the lowest such rate in the EU.
Under the previous regime, first introduced in 1975 to promote Cyprus as an international centre for business and professional services, incentives were principally available only to non-residents. International business companies (IBCs) and their foreign employees were subject to preferential rates of tax, provided that the entity was wholly owned, directly or indirectly, by non-residents and its income was derived entirely from sources outside Cyprus.
This regime, coupled with an extensive network of favourable tax treaties, enabled Cyprus to develop into one of the most successful financial centres in Europe. In particular, it capitalised on the good political and economic relations that it enjoyed with members of the former Soviet bloc to become the principal conduit for foreign investment in and out of Central and Eastern Europe. And although the tax rate for international companies has now effectively more than doubled, Cyprus is no longer classified as tax haven and is now well-placed to play a similar role for investment in and out of the EU and the Middle East.
Nor has development been purely geographical in its scope. Cyprus’s strategic location and tax-efficient environment are accompanied by a modern commercial infrastructure and, as a former British colony, a common law legal system. These factors have enabled Cyprus to generate substantial business in structured finance, royalties, trading, shipping and portfolio investments, in addition to being a prime jurisdiction for holding companies.
The success of this transition is evident from the tax revenues collected between January and September 2005, which showed an unexpected 8.9% year-on-year increase, from CYP 413.3 million to CYP 450.2 million, boosted by capital inflows and deposits from offshore companies. According to the Cyprus Inland Revenue Department, the increased activity by offshore companies contributed to a 16.5% increase in corporate tax revenues and a 20.8% increase in the “special defence contribution” (SDC) tax, which is levied on corporate dividends and interest paid on deposits.
It is also reflected in the figures for new company registrations. In 2002, 8,496 new companies were registered. In the following two years 9,080 and 11,586 respectively were added to the register and, as at the end of September in 2005, new registrations stood at 9,870.
Under the new Income Tax Law, all distinctions between local and international business companies have been removed. A “grandfathering” period, during which existing IBCs were permitted to continue to apply the preferential tax rate of 4.25%, expired at the end of last year.
The taxation of companies is now based on residence. Resident companies – those whose management and control are exercised from Cyprus – are taxed in Cyprus on their worldwide income. Non-resident companies are taxed in Cyprus only on income derived from a permanent establishment or immovable property in Cyprus. Registration or incorporation in Cyprus is not sufficient to render a company liable to tax in Cyprus.
The holding company regime, now one of the most advantageous in the EU, is probably the most attractive feature of the Cypriot tax system. A holding company is generally set up as an ordinary company resident in Cyprus. There is no geographical limitation on the exercise of a company’s activities and its income may be derived from any source, including a Cypriot-based source. There is also now no restriction on the ownership of a company’s shares.
Generally a 15% SDC tax applies to dividend income paid to Cypriot residents, but there is a full international participation exemption from local taxation of dividends received by a holding company from a foreign subsidiary, provided that the Cypriot company’s holding in the foreign company exceeds one per cent. And as a EU member, Cyprus levies no withholding tax on dividend payments from EU subsidiaries to a Cypriot holding company, provided that the shareholding is at least 20%.
Trading gains and capital gains made by a Cypriot holding company from the sale of shares in a foreign subsidiary enjoy a full exemption, with no minimum participation threshold required. Gains from local subsidiaries are also exempt, although gains from shares in companies owning immovable property in Cyprus are not.
Outgoing dividends remitted by a Cypriot holding company to its ultimate parent company are not subject to withholding tax in Cyprus. And now that the EU Interest and Royalties Directive has been incorporated into Cypriot domestic law, there is exemption at source of interest for a beneficial owner that is non-resident in Cyprus but resident in an EU member state.
Even if the target company is located in a tax haven, dividends from the company still may be tax-exempt in Cyprus. Under the Controlled Foreign Company (CFC) rules, provided that 50% or more of the activities of the target company can be regarded as active, the Cypriot dividend exemption applies. And even where this is not the case, if the target company is located in a jurisdiction with an effective income tax rate of 5% or more, dividends from that company remain tax-exempt in Cyprus.
There are no thin capitalisation rules in Cyprus, but there are certain indirect restrictions. Interest paid in the course of a company’s normal trading activities, including any amount in relation to the acquisition of assets used in the business, is an allowable deduction. Back-to-back financing transactions must be undertaken on an “arm’s length” basis, such that the borrowing and on lending should not result in a loss to the Cypriot company.
Interest received by a Cypriot holding company which is deemed not to be from or closely related to its ordinary business activities will be subject to 10% income tax on 50% of the interest received and to SDC tax at 10% on the whole amount of the interest received, to give an effective total tax burden of 15%.
The gross amount of any royalties derived from Cyprus is subject to income tax at 10%. In cases where an intellectual or industrial property right is granted for use outside Cyprus, the royalty will be deemed not to be income derived from Cypriot sources and will be exempt. Cypriot companies can therefore continue to be used as intermediary licensing vehicles for the routing of royalties out of countries with which Cyprus has concluded tax treaties.
Cypriot companies are therefore still advantageous for holding, financing, licensing, trading or other operations. The absence of dividend withholding tax offers a tax-free exit for dividends from the EU and the low effective tax rates that can be achieved in Cyprus also make it an appropriate jurisdiction for European holding activities.
It has been suggested that the EU is unhappy about Cyprus’s corporate tax rate and might seek to implement changes, but the Cyprus government does not believe there are any plans to harmonise corporation tax rates. “As far as the Cyprus Tax Regime is concerned,” he said, “it fully complies with EU legislation and the Code of Conduct for Business Taxation. Moreover, all harmful tax measures were abolished before Cyprus joined the EU.”
Under the new regime, the tax authorities will generally be prepared to give an advance ruling if certainty is required. This may be of particular importance for international business purposes and will further improve Cyprus’s reputation as a favorable jurisdiction for setting up tax-efficient structures.
A comprehensive network of double taxation treaties has been integral to Cyprus’s success as a financial centre. It has concluded tax treaties with more than 40 countries, and treaties are under negotiation, or awaiting ratification, with half as many more. All such treaties apply the credit method to the taxation of dividends and interest, by allowing tax payable in the other country as a credit against tax payable in Cyprus, including the SDC. As a result, the taxpayer only pays the higher of the two rates of tax and is not taxed twice on the same income.
According to Mihalakis Sarris, who was appointed as Finance Minister on 31 August last year, Cyprus will continue to expand its treaty network. Two treaties are currently pending signature. Negotiations are in progress for the revision of five existing treaties – three with EU Member States and two with former Soviet republics – and for five new treaties with EU Member States. In addition, negotiations are about to start with three countries and draft agreements to serve as the basis for negotiations have already been agreed with at least 12 countries.
If Cyprus’s credentials as a tax-efficient jurisdiction are not in question, there is one issue in particular that has dogged its reputation – close ties to former Eastern Bloc countries. Despite EU membership and a clean bill of regulatory health from the OECD and FATF, there is still a perception that it may be in some way compromised. This is a perception that the Minister of Finance is keen to allay.
“It is a fact that, historically, Cyprus always had close political cultural and religious links with Russia,” said Sarris. “It is also a fact that, due to the favourable terms of the existing tax treaty between Cyprus and Russia, Cyprus plays a very important role as regards direct investments into Russia. This has led a number of companies from third countries but also from Russia itself, to establish a presence in Cyprus. Moreover, Cyprus has always been and still remains, an attractive tourist destination for Russians.
“These factors may make the physical presence of Russian individuals and entities in Cyprus, relatively “visible” to third parties. But for those people who are aware of the above facts the so called “Russian involvement” in Cyprus is not considered to be extraordinary and is viewed in the same context as the equally, if not more, important “Russian involvement” in the UK or the USA,” he added.
The abolition of the exchange controls in May 2004 has had a further positive impact on inward foreign investment in Cyprus. Following the tax reform and the gradual liberalisation of the exchange control legislation since 2000, there has been a continuous upward trend in interest from foreign companies to register in Cyprus. The anticipated participation the Euro-zone by 2007 will lead to the complete integration of Cyprus’s economy with the Euro-area. This will create more opportunities for Cyprus but also more challenges and competition for all the areas of the economy.
European “passporting” has already had a major impact on the banking sector. Since EU accession, Cyprus has adopted the relevant provisions of the European Consolidated Banking Directive into its national legislation. Three Cyprus-incorporated banks have so far exercised their passporting rights to provide cross border services across all other EU member states, while 78 credit institutions from 13 other member states have notified the Central Bank of Cyprus of their intention to exercise the freedom to provide services in Cyprus. Two credit institutions, one from the UK and one from Greece, have also opted to exercise the right of establishment of a branch in Cyprus.
“The full impact which the above liberalisation will have on Cyprus’s banking system is still early to assess,” said Sarris. “In the light of enhanced competition from EU and other foreign banks, domestic banks have already started to introduce new systems in order to improve their operational efficiency, the diversification as well as the strengthening of their risk management procedures and controls.”
Maintaining the factors that have made Cyprus an attractive location for international financial and commercial business is a major challenge for the Government of Cyprus. “It is incumbent to maintain and, if possible, enhance those factors, especially for the banking and financial systems, which are undergoing an unprecedented volume of international regulatory changes,” said Sarris. “Although Cyprus will face competition form other jurisdictions, we believe that not only the government but also the financial and banking regulatory authorities of Cyprus, are aware of international and EU developments and are shaping our domestic legislation and regulation accordingly.”
“Awareness of international developments helps to improve the high regulatory standards which already exist, as well as promote a more efficient and profitable economy which will be able to cope successfully with the competition which Cyprus, unavoidably, is facing. It is only fair to state that the financial system may also benefit from the increased competition, since the whole system must find ways of reducing costs, become more competitive, offer better services and, generally, find ways of going beyond the small and rather saturated domestic market,” he said.