International Correspondence Lawyers & Financial Experts

Cypriot holding company regime - the evolving tax framework

Date: 20-APR-2006
Presented by: Andreas Neocleous & Co.

Introduction

When one thinks about the most attractive holding company jurisdiction, Cyprus may not come immediately to mind. This article will argue that Cyprus, with its extensive double taxation treaty network as well as its stable social and economic environment will be widely recognized in the very near future as the ideal location for setting up a European holding company.

We shall focus on a Cypriot holding company regime which is evolving as a result of the recent tax reforms. After a brief explanation of the concept of a Cypriot holding company, we will elaborate on the main elements of the holding company regime as provided in the Cypriot tax laws, such as participation exemption; controlled foreign company rules; tax treatment of capital gains and interest receivable by the Cypriot holding company. Finally, some thoughts are shared on the Cypriot holding company in the context of EU law.

Cypriot holding company: the basic taxation concept

A Cypriot holding company is an ordinary company that, besides holding participation in domestic and foreign companies, may be engaged in other activities such as trading, manufacturing or financing. Upon formation a Cypriot holding company is subject to unlimited tax liability, i.e. it is taxed in Cyprus on its worldwide income, provided that its management and control is located in Cyprus.

Taxation of the Cypriot holding company is based on three pillars, namely the Income Tax Law as amended, the Special Contribution for the Defence of the Republic Law as amended and double taxation treaties.

The business profits of a Cypriot holding company are subject to a generalized corporate tax rate of 10 per cent. From 1 January 2003 dividends are not subject to Cypriot corporate tax generally; instead a 15 per cent special defence contribution tax is levied on the dividend income of a Cypriot resident company, with the participation exemption available for domestic and foreign dividends.

This regime will apply only if a holding company can be defined as a Cypriot resident company. With respect to the residence rules for companies, the tax laws adopt management and control as the key test. Registration in Cyprus alone is not sufficient to subject companies to tax in Cyprus. The law does not contain a definition of management and control but in our opinion, to ensure that a company satisfies the residence test, its decision-making processes should take place in Cyprus as far as possible. Applying this criterion to a Cypriot holding company, it means that:

- all decisions affecting a company should be made, and be shown to have been made, by its board of directors in Cyprus;
- decisions must in fact be made by the board, which must exercise its powers independently of any particular director or shareholder;
- the board should have a majority of Cypriot-resident directors.

For holding companies which traditionally require few personnel, special consideration should be given to this matter. Therefore, if the Cypriot holding company also acts as a co-ordination centre, or performs other administrative functions from Cyprus, this will help to substantiate that it is indeed resident in Cyprus.

Highlights of the Cypriot participation exemption

Cyprus applies the classical "participation privilege" to incoming dividends, i.e. if dividends are paid out of profits which have suffered tax elsewhere, they should not be taxed again in the hands of the recipient. The Cypriot participation exemption applies not only to dividends from shares in another resident company, but also to dividends received from non-resident companies as well as capital gains arising on the disposal of such shares.

Under the domestic participation exemption, dividends payable by a Cypriot resident subsidiary to its Cypriot resident parent are exempt from taxation and are not included in the taxable income of the recipient company, regardless of the extent and the holding period of the shareholding in the distributing company. No further requirements need to be met in order for the exemption to apply.

The domestic participation exemption applies to capital gains realised from a shareholding in the domestic company. However, gains from the sale of shares of companies owning immovable property in Cyprus will continue to be subject to capital gains tax.

The international participation exemption is applicable to foreign dividends provided that the Cypriot resident parent company receiving the dividends owns at least 1 per cent of the share capital of the foreign subsidiary. This requirement of 1 per cent was introduced with the intention to create a distinction between participating and investing. It should be noted that the applicability of the participation exemption is not dependent on the shareholding period in a foreign subsidiary.

Anti-abuse provisions

With regard to the international participation exemption, the Cypriot tax laws as amended provide for special anti-abuse provisions (Controlled Foreign Company or CFC provisions) which are aimed at preventing non-resident companies, over which domestic taxpayers have control or a substantial influence, from converting essentially passive income into exempt dividend income receivable by a Cypriot resident company. However, a general principle which is behind the Cypriot CFC rules is that anti-avoidance measures should be used only to maintain the equity and neutrality of national tax laws in an international environment. Therefore, Cypriot CFC rules (i) target only income that is genuinely passive, and are not extended to activities such as production, normal rendering of services or trading by companies engaged in real industrial or commercial activity; (ii) are aimed at companies benefiting from low tax regimes and are not applicable to countries in which taxation is comparable to that of the country of residence of the taxpayer; (iii) do not treat the source company as non-existent.

Based on the above principle, Cypriot anti-avoidance legislation targets low tax and/or tax haven countries, and then narrows its scope further by targeting only certain types of income, or a certain type i.e. income which is not derived from a genuine business activity.

The CFC provisions will be triggered only if more than 50 per cent of a non-resident company's activities results directly or indirectly in investment income, and the foreign tax burden on the income of the non-resident company paying the dividend is substantially lower than the tax burden on the company which is tax-resident in Cyprus. Both of these conditions must apply for the CFC provisions to be triggered and, if not, the exemption is available.

Analysing these two elements of the CFC provisions, it should be noted that the law compares the actual overseas charge with the tax burden of a Cypriot resident company. However, no reference is made to the actual corporate tax rate. The law is also silent on whether the tax must be actually suffered or not. As regards the term "substantially lower", the law does not provide any definition and no official interpretation or guidance has been released so far. However, taking into consideration that the CFC provisions target the low tax and tax haven countries, the term "substantially lower" may be interpreted as a corporate tax rate of effectively 5 per cent or less. The law defines "investment income" as any income which is not derived or arising from any business, employment, pension or annuity paid by reason of or in connection with a past employment. Broadly speaking passive or so-called "tainted" income invariably includes dividends, rents, royalties and interest.

Generally, Cypriot CFC provisions do not affect adversely holding companies based in Cyprus, as Cypriot holding companies are not taxed on income derived from their foreign shareholdings until the subsidiaries start to distribute dividends, in which case the exemption is available under the aforesaid conditions.

Tax treatment of capital gains

The international participation exemption applies to capital gains realised by a Cypriot resident company on shares in a foreign subsidiary. In contrast to the foreign dividend exemption rule, the minimum 1 per cent participation threshold and the CFC rules are not applicable for the participation exemption on capital gains.

Tax treatment of resident shareholders

As mentioned above, inter-company dividends of Cypriot resident companies do not attract any withholding taxes. However, from 2003 a Cypriot resident company is deemed to have distributed 70 per cent of its profits arising or accruing in the year of assessment, after their reduction by the corporation tax paid or payable on such profits, in the form of dividends to its shareholders (company or individual) as at the end of a period of two years from the end of the year of assessment to which the profits relate. Shareholders concerned shall be assessed accordingly to the special defence contribution tax on such dividends. A 15 per cent special defence contribution tax payable by a shareholder concerned in consequence of a deemed distribution shall in the first instance be paid by the company which will debit such contribution to the shareholder. It should be noted that the real distribution of dividends to a Cypriot resident company shareholder will not attract any form of taxation in Cyprus either on the payer or on the recipient of the dividend and will avoid the imposition of the special defence contribution tax on the deemed distribution.

Tax treatment of non-resident shareholders

Non-residents of Cyprus are not subject to the special defence contribution tax, and therefore dividends payable by a Cypriot resident company to its foreign shareholder (company or individual) do not attract any withholding taxes in Cyprus. This absence of withholding tax does not make Cyprus different from many other regimes in the EU in respect of dividends paid within the EU. Intra-EU dividends are usually paid within groups without withholding tax under the EU Parent/Subsidiary Directive, but the latter will not protect a non-EU parent from withholding tax on dividends paid by an EU-resident subsidiary company. As a result, a non-EU parent of most EU based companies will have to rely on the terms of the applicable double taxation treaty to reduce withholding taxes. Cyprus provides for the full exemption from withholding taxes on the outward dividend payments and therefore has a potential advantage over the other European holding company regimes. As regards the special defence contribution tax imposed on a deemed distribution, it is refunded upon subsequent payment of dividends to non-resident shareholders of a Cypriot resident company.

Liquidation of a Cypriot holding company

In the event of the liquidation of a Cypriot holding company, the total of the profits of the last five years before the liquidation which have not been distributed or have not been deemed to have been distributed are deemed to be distributed and the shareholders shall be deemed to receive such profits as dividends. As mentioned above, deemed dividends are subject to 15 per cent special defence contribution tax.

Thin capitalization rules

Cypriot tax legislation does not contain any thin capitalization rules (a debt:equity ratio requirement). However, there is certain indirect debt: equity restrictions.

Under Section 9 (1) of the Income Tax Law (as amended) any interest paid in the course of a company's normal trading activities is an allowable deduction, including any amount in relation to the acquisition of business assets used in the business.

However, it should be pointed out that in situations where a Cypriot company that suffers interest makes advances (i.e. on-lending funds) to related parties/companies, interest equal to 9 per cent p.a. on the advances, or the actual interest suffered if lower, will have to be added back, because such advances are not considered as expenses incurred for the purpose of the production of income.

Tax treatment of interest income

Cypriot holding companies are liable to the special defence contribution tax at 10 per cent on interest income from any source, Cyprus or abroad. Deduction is made at source if received from Cyprus, otherwise by assessment on the basis of returns.

The special defence contribution tax does not apply to interest earned by a company in the ordinary course of business or to interest closely related to the ordinary carrying on of the business, both of which are subject to income tax with no exemption available.

Any 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 income tax and special defence contribution tax with an effective total tax burden of 15 per cent.

In accordance with the Income Tax Office Circular 2003-8 dated 19 May 2003 interest earned in the ordinary course of business includes banking and financing, hire purchase and leasing.

Interest closely related to the ordinary course of business includes:

- Interest received from trade debtors by companies engaged in trade and/or land development, and by traders of new or old cars or other vehicles or machines;
- Interest earned by insurance companies;
- Interest earned by banks on current accounts;
- Interest earned by companies acting as a vehicle through which a group of companies is financed.

Unless it comes under these four categories, interest earned from loans of companies to third parties and interest from savings and deposits is taxed under the special defence contribution.

Having considered thin capitalization rules and the tax treatment of interest, it should be pointed out that a Cypriot holding company could be primarily financed by debt to capitalize foreign subsidiaries by way of loans rather than equity capital because of the following advantages:
- There is less likelihood that the external borrowings could be challenged under the thin capitalization rules;
- Cyprus' extensive network of double tax treaties either protects interest receipts entirely from, or at least limits substantially, any withholding taxes applicable in the country of source;
- There is no withholding tax on interest payable to non-Cypriot tax residents.

Implementation of the EU Parent/Subsidiary Directive

The EU Parent/Subsidiary Directive ("the Directive") was implemented in the Cypriot legislation in the form of the Income Tax Law, as amended, and the Special Contribution for Defence of the Republic Law, as amended, which came into force on 1 January 2003. On the basis of the foregoing analysis it appears that the above tax laws establish quite a liberal system to avoid double economic taxation which is fully in line with the Directive. Moreover, the application of the new tax rule has also been extended also to non-EU countries, as the tax laws provide for a distinction only between residents and non-residents of Cyprus.

With respect to taxation of dividends, conditions in the domestic tax laws are even more liberal than conditions in the Directive. Exemption of foreign dividends is available when the parent company holds at least 1 per cent of the share capital of a foreign subsidiary. For a holding below this threshold there is relief in the form of a foreign tax credit.

As regards the holding period, the Cypriot legislation does not provide any reference to a minimum holding period requirement for either domestic or foreign subsidiaries. In this connection it is worth mentioning the second derogation of the Directive, which allows a Member State not to apply the Directive to companies of that Member State which do not maintain for an uninterrupted period of at least two years a holding qualifying them as parent companies or to those of their companies in which a company of another Member State does not maintain such a holding for an uninterrupted period of at least two years. It seems that Cyprus has not exercised this opportunity to restrict the availability of the Directive in relation to either dividends received from companies of other Member States or dividends paid to overseas companies. The derogation may, however, impact on Cypriot companies holding an interest in the share capital of a company in another Member State, as there can be a pitfall in the event that the other Member State then exercises the restriction and forces the two year qualifying period requirement to be satisfied before applying the Directive.

Conclusions

The legislators of Cyprus, in their effort to harmonize its national laws with the acquits communautaire, have revised the tax system as a whole and have created a unique tax framework for holding companies. In general, the Cypriot legislature followed in the footsteps of many EU countries, taking advantages, however, of the new tax rules available to EU residents. The Cypriot holding company regime is evolving tax wise and it is very desirable that, in the absence of domestic judicial interpretation, the Cypriot tax authorities should facilitate the application of the general tax rules by adequate regulations and guidance.

Source: Andreas Neocleous & Co.
Elias Neocleous & Olga Michailova