By Christopher OwenWhen 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
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
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
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
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
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.