Establishing Economic Substance in Cyprus

In the current landscape of heightened scrutiny on tax practices and anti-avoidance initiatives, creating sufficient economic substance has become a cornerstone for companies wishing to achieve favourable tax treatment and compliance credibility. Although there is no specific legal requirement under Cyprus law that mandates companies to establish substance within the jurisdiction, the benefits of doing so extend beyond just tax planning. Economic substance serves as a protective measure against challenges from both domestic and international authorities and is essential for accessing the benefits of double tax treaties and EU directives.

This article will explore the concept of economic substance, the rationale behind establishing it in Cyprus, and a practical guide to achieving sufficient substance through recommended actions.

What is Economic Substance?

Economic substance is a principle under international tax law and the Organisation for Economic Co-operation and Development (OECD) guidelines that requires a company to have a real and tangible presence in the jurisdiction where it claims tax residency. The doctrine of economic substance dictates that a company must have a genuine business purpose aside from mere tax avoidance. This concept gained significant importance with the introduction of the OECD’s Base Erosion and Profit Shifting (BEPS) Actions, especially BEPS Action 5, which focuses on countering harmful tax practices and aligning tax outcomes with economic activity.

In practical terms, economic substance implies that a company must manage, execute, and oversee its business activities within the jurisdiction it claims as its primary base. To achieve this, the company must show actual presence and significant business operations, including decision-making, employment, and physical infrastructure, within that jurisdiction.

Why Establish Economic Substance in Cyprus?

Establishing economic substance in Cyprus is instrumental in securing tax residency status and benefiting from double tax treaties and EU Directives. A Cyprus-based company with adequate substance can reduce the risk of a foreign tax authority reclassifying its tax residency and subjecting it to taxation outside Cyprus. Furthermore, substance in Cyprus strengthens a company’s ability to access the benefits of EU Directives such as:

The Parent-Subsidiary Directive – facilitating dividend flows within the EU by eliminating withholding taxes on dividends.
The Interest and Royalties Directive – eliminating withholding taxes on interest and royalty payments between associated companies within the EU.
The Merger Directive – enabling cross-border mergers within the EU without immediate tax implications.

In addition to treaty benefits, the presence of substance in Cyprus helps mitigate risks associated with Controlled Foreign Company (CFC) rules and anti-abuse provisions outlined in the EU Anti-Tax Avoidance Directive (ATAD). CFC rules, aimed at preventing profit-shifting to low-tax jurisdictions, target entities that lack sufficient economic substance. For a Cyprus-incorporated company, adhering to the principles of economic substance strengthens its tax residency claim and shields it from reputational risks associated with allegations of tax avoidance or abuse.

Establishing Economic Substance in Cyprus

Each company is unique, and there is no standardised approach to creating substance in Cyprus. However, the following key actions can serve as a guide to meet the economic substance requirements effectively.

a. Physical Presence and Office Space

Rent or Purchase of Office Space: The company should establish a dedicated office space in Cyprus. This office should be intended for business activities, excluding residential premises, and should house relevant infrastructure for the company’s operations.
Local Employment: Hiring local employees and registering them with Cyprus social insurance is crucial. This move not only contributes to the company’s physical presence but also demonstrates its integration within the Cypriot economic landscape.

b. Management and Control

Local Directors: It is essential to appoint a qualified Cyprus-resident director who possesses the expertise to make autonomous business decisions on behalf of the company. This director should be actively involved in the company’s management and not merely a figurehead.
Board Meetings in Cyprus: Board meetings should be held physically in Cyprus, and major decisions should be taken locally to establish that the control and management of the company take place in Cyprus.
Record of Meetings: Keeping detailed records of board meetings and decisions taken within Cyprus further evidences that the company’s strategic and operational decisions are made locally.

c. Administrative Presence

Corporate Records: Important corporate documents, such as agreements, resolutions, and minutes, should be archived in Cyprus. These documents may be stored physically at the company’s Cyprus office to substantiate the presence of the company’s administrative functions.
Dedicated Communication Channels: The company should establish a functional telephone line, an email domain, and a website registered under its Cyprus address. This enhances the company’s accessibility and local identity.

d. Financial and Compliance Functions

Bank Account: Opening a bank account with a Cyprus financial institution is another indicator of the company’s substantial connection to Cyprus. Local bank accounts not only support the company’s operational requirements but also facilitate compliance with Cypriot banking regulations.
Accounting and Bookkeeping: All accounting functions, including bookkeeping, invoicing, and payroll, should be conducted in Cyprus. Financial statements and management accounts should also be prepared locally, in accordance with International Financial Reporting Standards (IFRS), which Cyprus mandates.
Annual Audits: The company’s accounts should be audited by a Cypriot audit firm, and the approval of these accounts should occur in Cyprus. This ensures transparency and accountability in line with Cypriot regulatory standards.

e. Personnel and Office Maintenance

Local Personnel: Having employees physically present in Cyprus, carrying out substantive roles for the company, is essential. This not only supports tax residency but also reflects the actual economic activity of the company.
Full-fledged Office Maintenance: The company should maintain an operational office in Cyprus equipped with the necessary resources and infrastructure to facilitate its business operations.

Legislative Framework Supporting Economic Substance in Cyprus

The obligation to establish economic substance aligns with various international and EU standards targeting tax avoidance and aggressive tax planning. These include:

OECD BEPS Actions: Particularly Action 5, which focuses on countering harmful tax practices through substance requirements.
The EU Anti-Tax Avoidance Directive (ATAD): Specifically, Article 7 of ATAD introduces CFC rules, requiring substance to prevent tax base erosion.
Cypriot Tax Residency Law: According to Cyprus Income Tax Law, Article 2 defines tax residency based on the “management and control” test, which implicitly requires that significant decisions and management activities occur in Cyprus.
Double Tax Treaty Network: Cyprus’s extensive network of double tax treaties necessitates that entities claiming treaty benefits substantiate their Cyprus residency by demonstrating effective management and control within Cyprus.

Conclusion

Economic substance has become indispensable in the current global tax environment. Companies operating in Cyprus are encouraged to take proactive steps to establish their presence and activities within the country to meet the OECD, EU, and local substance requirements. By doing so, companies not only safeguard their tax residency status and access to tax treaties but also reinforce their reputation and standing with tax authorities. Cyprus offers an attractive environment for companies seeking to establish substance, but each company must assess its specific needs and tailor its approach to meet the substance requirements effectively.

Services Provided by Chambers & Co for Establishing Economic Substance in Cyprus

At Chambers & Co, we offer comprehensive services tailored to assist companies in achieving and maintaining economic substance in Cyprus. Our services include legal advisory for compliance with Cyprus and EU legislation, Cyprus company incorporation, assistance with setting up physical office spaces, and the appointment of qualified, resident directors. We provide support in meeting corporate governance requirements, conducting board meetings locally, and handling administrative tasks such as record-keeping and archiving. Additionally, our firm offers accounting, bookkeeping, and auditing services aligned with IFRS standards, employee hiring and payroll services, registration with tax and social insurance authorities, and continuous legal guidance to ensure effective management and control of operations within Cyprus.