Cyprus adopts key revisions to tax treatment of intragroup back-to-back loans

by J.P Canavan

In a move towards international cooperation in tackling aggressive tax planning, the Cypriot Tax Department has issued an important circular containing revised corporate tax treatment for intragroup back-to-back financing transactions.

This is somewhat a break from the long established favourable tax treatment Cyprus has historically promoted to the financial services industry in attempts to lure foreign direct investment to the State.

Effective from 1 July, the arm’s length principle, as set out in Article 9 of the OECD Model Tax Convention on Income and Capital, now applies in Cyprus to certain intra-group back-to-back financing transactions.

It is now necessary for the group to determine, for each covered financial transaction, if the associated remuneration complies with the arm’s length principle.

Financial transactions covered

The circular applies to Cyprus tax resident entities i.e., those companies where management and control is exercised in Cyprus and to non-Cypriot resident companies that have a permanent establishment in Cyprus which the financing arrangements are attributable to.

Intra-group financing transactions refer to any activity consisting in the granting of loans or cash advances remunerated by interest (or which should be remunerated by interest) to related companies that are financed by financial means or instruments such as debentures, private loans, cash advances, and bank loans.

Under Cypriot law, Section 33 of the Income Tax Law defines two companies as related where one participates directly or indirectly in the management, control, or capital of the other, or where the same persons participate in the management, control, or capital of both.

Old rules

Prior to the application of the circular’s new provisions,, the Cyprus Tax Department applied a minimum accepted profit margin on back-to-back loan schemes, with varying profit margin rates depending on the loan amount.

In summary, for loans up to and including €50m, a profit margin of 0.35% was applied, for loans between €50m and €200m a profit margin of 0.25% was applied, and for loans of €200m and greater the minimum profit margin was 0.125%.

As the nominal corporate tax rate for Cyprus resident entities is currently 12.5%, the effective tax rates, given the specific profit margin, ranged from 0.015625% to 0.04375%.

The actual interest rates applied on the loans was not an issue, the important factor for the Cyprus Tax Department was the margin between the two nominal interest rates.

Where the actual margin between the loans was less than the stated minimum profit margin for the applicable capital amount, a deemed interest receivable amount was added back to the company’s tax computation in order to apply the appropriate margin.

Where back-to-back loans were issued interest-free, a profit margin of 0.35% was deemed, regardless of the capital value of the loan.

New rules

The group will now be required to determine the appropriate remuneration based on transfer pricing principles rather than the historical minimum accepted profit margin scheme.

This will involve the group carrying out an appropriate comparability analysis to determine whether the resultant remuneration is comparable to transactions between independent parties under similar circumstances. This analysis should consist of two parts:

  • Identification of commercial and/or financial relationships between related entities and determination of the conditions and economically relevant circumstances attaching to those relations in order to accurately delineate the controlled transaction.
  • Comparison of the delineated conditions and economically relevant circumstances of the controlled transaction with those of comparable transactions between independent parties.

Simplification measures

The circular affords a relaxed scheme to certain Cypriot tax resident group financing companies that only participate in intermediary financing activity or grant loans or advances to related companies, which are then in turn refinanced by other related entities.

For the purposes of simplification and in consideration of the reduced transactional risks attached, where the Cypriot company receives a minimum after tax return of 2% on the assets, the relevant transaction will be deemed to comply with the arm’s length principle.

The Cyprus Tax Department has noted that this rate will be regularly reviewed and is based on relevant market analysis. To benefit from the simplified measures the company must have substance in Cyprus (discussed below) and the use of this scheme should be made clear to the Cyprus Tax Department.

These simplification measures, as with other advance pricing arrangements, are subject to the exchange of information rules.

Substance requirement

Within the circular, the Cyprus Tax Department emphasises the substance rules, requiring a group financing entity to have an actual presence in Cyprus to avail of the simplified regime.

The circular notes that the Cyprus “presence” criteria takes into account the following:

  • The number of board of director meetings held in Cyprus and the management and commercial decisions taken in Cyprus;
  • The number of board of director members that are Cyprus tax residents; and
  • The number of shareholder meetings that take place in Cyprus.

It should be noted that any variance from the minimum after tax return of 2% shall not be allowed except for in exceptional circumstances where it is justified by an appropriate transfer pricing analysis.

Furthermore the minimum return rate cannot be used for other intra-group financing transactions not covered within the circular, unless an appropriate transfer pricing analysis is presented.

Conclusions

Where Cypriot resident financing companies used the historic minimum profit margin regime in relation to financial transactions and do not qualify under the simplification regime, they will be required to undertake an appropriate transfer pricing analysis.

The circular notes the minimum requirements for a transfer pricing analysis must be submitted to the Cyprus Tax Department by a licensed auditor providing an assurance to the quality of the transfer pricing analysis.

Where a group believes they may be eligible for the simplification regime, a review will be required to ensure the financing company meets the substance criteria and that the company has appropriately qualified personnel to exercise control over the associated financing risks.

JP Canavan

JP advises on international direct tax matters. He has particular experience with pre-sale restructuring, international corporate structuring, intellectual property planning, transfer pricing, foreign direct investment proposals, tax treaties, and withholding taxes.

His experience includes work in various sectors, such as FinTech, renewable energy, media, e-commerce, technology, and pharma industries. He has significant experience in import/export and acquisition/dispatch of goods, statistical reporting, customs procedures and e-commerce services.

JP previously specialised in Irish and EU VAT within a Big Four practice, working with a wide range of clients in various industries.

JP Canavan


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