Tax Treatment of Intra-Group back-to-back Financing Arrangements
Due to the global initiatives in the international tax sector, particularly the OECD/G20 initiative and the base erosion and profit shifting (BEPS) action plan, the profit margins (0.35% or lower) that used to be applicable for tax purposes on back to back financing arrangements, have ceased to be acceptable as from 1st of July 2017.
The term “intra-group financing transaction”, refers to any activity consisting in the granting of loans or cash advances to related entities, remunerated (or that should be remunerated) by interest to related companies, financed by financial means and instruments, such as debentures, private loans, cash advances and bank loans.
In view of the above, for companies involved in such intra-group financing transactions, two separate tax computations should be submitted for the accounting period of 2017. One for the period 01/01/2017-30/06/2017 and one for the period 01/07/2017-31/12/2017.
For the first semester of 2017, companies engaged in back to back loans (loans receivables and loans payables with group companies) will be taxed as per the below minimum profit margins which were effective until 30.06.2017:
Loan receivable amounts Profit margin
<50 million 0.35
50m-200 million 0.25
>200 million 0.125
For example, for loans receivable of €3 million, the minimum taxable profit for the period 01/01/17-30/06/17 will be €5,250 (€3mX0.35%x6/12) with tax payable equal to €656.25 (12.5%).
However, from the 1st of July 2017 onwards, the tax computation will be based on the arm’s length principle, being the international standard adopted by OECD member states.
This means that for each intra-group financing transaction conducted (for example a loan agreement) the Company has to determine through a transfer pricing study, that the agreed remuneration (for example interest) complies with the arm’s length principle i.e. corresponds to the price which would have been accepted by independent entities in comparable circumstances. If according to the transfer pricing study, a higher interest rate should be imposed on the loan agreement, the tax computation will be adjusted accordingly.
The transfer pricing study must be submitted to the Cyprus Tax Department by a Transfer Pricing Expert (auditors or other licenced companies).
According to the relevant circular sent by the Cyprus Tax Department, the revised tax treatment of intra-group back to back financing arrangements, is applicable to companies that meet the below criteria:
- They carry out group financing transactions (activities related to investment holdings are not taken into consideration);
- They are Cyprus tax residents (management and control is exercised in Cyprus) or have a permanent establishment in Cyprus which performs the financing activities.
The Cyprus tax system remains one of the most attractive tax systems in Europe (tax rate remains 12.5%). The following solutions are available, which enable the corporate tax structure of entities performing intra-group transactions to remain tax efficient.
1. NOTIONAL INTEREST DEDUCTION (NID)
Notional interest deduction is allowed on new equity funds introduced into a Cyprus tax resident company which are used to finance taxable operations of the company.
New equity includes shares of any class, including ordinary, preference, redeemable and convertible shares, paid either in cash or in kind.
Also the following may qualify as new equity:
- Loans payable and other debt instruments converted into issued share capital;
- Shareholders’ credit balances converted into issued share capital;
- Non-refundable capital contribution converted into issued share capital;
- Realized reserves created after 1 January 2015 converted into issued share capital.
The reference interest rate is the higher between the yield on the 10-year government bond plus 3% of the country where the new funds will be/are invested and the 10-year government bond of Cyprus (currently 3.489%) plus 3%.
Consequently, the minimum notional interest deduction of 2017 will be around 6.489%.
However, the notional interest to be deducted, cannot exceed 80% of the taxable income (at least 20% of income must be taxed at 12.5%).
This results to an effective tax rate of 2.5% (20%X12.5%) on Income (interest received).
For example, loans receivables of €3 million with interest rate 7%, result to interest income of €210,000. As per NID principles, the minimum tax payable accepted is €5,250 (210,000×2.5%).
Advantages of this method:
- The notional interest deduction is recurring (can be utilised every year);
- The companies can also convert loans payables/credit balances of shareholders to equity and get the notional interest deduction.
- The transfer pricing studies for any intra-group agreements may not be avoided (apart from the costs of transfer pricing studies that must be prepared by experts there is risk of tax computation adjustments, if the rates in the agreements are not following the market rates/arm’s length principles).
2. SIMPLIFICATION MEASURES (section 4 of Tax Circular)
If a group financing company pursues a purely intermediary activity (intercompany loans receivables and payables) and it has an actual presence in Cyprus , then the transactions are deemed to comply with the arm’s length principle and the minimum return accepted is 2% after-tax on assets (profit after tax) which effectively means a minimum taxable profit of 2,2857% on assets.
So for example for loans receivable of €3 million, the minimum taxable income is €68,571 and so tax payable will be €8571 (12.5%).
Actual substance is achieved if both economic and physical substance exist as per the below criteria (and according to paragraph 19 in section 18.104.22.168 of the circular):
1. Economic substance (effective management and control is performed in Cyprus)
- Majority of the directors are Cyprus tax residents;
- Directors’ and shareholders’ meetings are held in Cyprus;
- Management decisions are taken in Cyprus.
2. Physical substance
- The company has employees, an office and telephone facilities in Cyprus.
What is of importance in relation to substance is that the relevant company actually performs the functions it purports to perform in Cyprus. Therefore it is essential that the ‘mind’ of the company is located in Cyprus i.e. the persons that actually have the capacity and expertise to take the important decisions.
Advantages of simplification measure
- Transfer pricing studies are avoided;
- A minimum profit margin of 2,2857% on assets is achieved.
Disadvantages of simplification measure
- The Company must establish a physical substance (office and employees). Having said that, the Cyprus labour and tax laws provide a number of incentive for staff relocating in Cyprus;
- The minimum profit margin may be adjusted by the Tax Department;
- Use of the simplification measure will be indicated on tax return. The Company will be subject to exchange of information rules and this may increase the withholding tax from other jurisdictions;
- It weakens the beneficial ownership position as a company will be indicating that it is a pure intermediary with no significant risks (and no significant equity at risk).
3. Proceed to a transfer pricing study for every related party agreement
- The results of the transfer pricing study may show that the interest rates used are indeed at market rate and so the taxes payable will be in line with previous years;
- The Company avoids exposure in exchange of information rules.
- A risk exists that the results of the transfer pricing study will be unfavourable, imposing a higher interest rate on the agreement under review;
- The cost of the transfer pricing study and the fact that it can only be done by Transfer Pricing Experts (audit firms);
- An additional transfer pricing study will be required if the parties of the agreement change (if for example the agreement is assigned to a new borrower). Also it has not yet been clarified how often a transfer Study will have to be updated.