1. THE ROLE OF ECONOMIC SUBSTANCE IN INTERNATIONAL TAX PLANNING
“Substance” is a well-known tax concept used in cross-border tax structuring. The term “substance” does not appear in the actual text of double tax treaties (DTTs).
DTTs contain other type of tests such as residency, beneficial ownership, and a general anti-avoidance rule (GAAR).
However, there is a connection between the formal tax treaty tests used to ensure tax payers qualify to deduct foreign withholding taxes and the informal substance test which is commonly adopted by many tax jurisdictions.
The absence of economic substance is likely to be considered as indicator of abusive tax avoidance in various jurisdictions.
The drivers behind this trend of sharply increased scrutiny, which are summarised below:
- In a competitive economic environment emphasis in some cases was given to tax mitigation strategies.
- Tax administrations are turning their attention to corporate tax revenues.
- The broader public is scrutinising the tax practices of the companies.
- Companies such as Google and Starbucks have been in the press for using tax loopholes to avoid payment of taxes. A reputation damage of the companies involved and increased scrutiny by the relevant tax authorities may be caused by these articles.
- Decisive action by the OECD to combat the problem of tax evasion through an automatic exchange of information standard (Common Reporting Standard).
1.1 GLOBAL FIGHT AGAINST TREATY SHOPPING
The international tax landscape is changing globally. It is crystal clear that it is not a matter of moving from one jurisdiction to another. Taxpayers are challenged to demonstrate that their foreign operations are genuine subsidiaries being managed overseas.
In other words, companies must show that the management, control and day-to-day decisions relating to the company’s business activity are taken in the country where the subsidiary company is based.
OECD transfer pricing guidelines refer to the following substance parameters:
- What roles and responsibilities are specifically assigned to what person in what jurisdiction?
- Does that person have sufficient equity and insurance coverage given the business risks he is exposed to?
- Is there enough skilled staff to carry out a local core business?
Inter alia, based on previous experience, we are in position to know that tax authorities also tend to look at the following:
- Are there any local directors and an active bank account?
- Are local compliance formalities duly satisfied?
- Are meetings physically held locally?
- Are the company’s operating expenses recorded in the P&L?
2. RELEVANT CYPRUS TAX PROVISIONS
2.1 Substance Requirements
A company is tax resident of Cyprus if its “management and control” is exercised in the Republic. There is no specific definition in the Cyprus tax legislation of the term “management and control”, but in practice and based on UK Common Law, it is considered that management and control is exercised where:
- the majority of the directors reside;
- the majority of the board meetings are held; and
- The majority of significant decisions are taken.
2.2 The role of substance in international tax planning/tax treaty requirements
The concept of substance in tax avoidance cases is an evolving and important subject area in the global economy. The absence of economic substance is an alarm for abusive tax avoidance in a number of jurisdictions.
Under the OECD model convention, a company may qualify for tax treaty benefits, if the following criteria (normally contained in tax treaties) are met:
- The company is a tax resident of the State it is registered in; and
- The company is the “beneficial owner” of the income distribution (i.e. dividends, interest, royalties).
For example, consider the case of a multinational group that incorporates a subsidiary under the national laws of Cyprus (or other commonly used investments holding jurisdictions, such as Luxembourg, Malta, the Netherlands, etc.). If that entity is effectively managed from abroad (for example by the parent company of the group) or by a foreign beneficial owner, tax residency in the country of incorporation of the company claiming treaty benefits (i.e. in Cyprus) may be at jeopardy. The tax authorities of the source countries or the country of residence of the shareholders, in such case, could take the position that the Cyprus company is not a resident of Cyprus due to the fact it is effectively managed and controlled from another jurisdiction.
“Effective management” is directly related to substance. If the company in the aforementioned example does not have directors who are the actual decision makers (i.e they are the ones who decide what to do with the income earned by the subsidiary), it may find itself being challenged in terms of substance by the foreign tax authority, the result of which may well be the loss of fiscal residency in the country of residence (i.e Cyprus) and loss of double tax treaty rights.
Things get even more complicated in applying the beneficial ownership test found in almost all tax treaties. All this test is trying to determine is whether the receiving legal entity, even if it is a tax resident of the other treaty country, earns the income for itself and not for someone else (i.e. it is not a conduit company). The receiving entity should not, either directly or indirectly, (for example, through provisions contained in Shareholders’/ Joint Venture agreements) have an obligation to pay the dividends, capital gains, interest or royalties it receives onwards to a party outside its country of tax residency.
A summary of the main UK case law on tax residency considerations is as follows:
• De Beers Consolidated Mines Ltd vs. Howe (1906)
A company resides where its real business is carried out, i.e. where the central management and control actuallytakes place (and not where the trading operations are taking place).
• Bullock vs. Unit Construction Co Ltd (1959)
Corporate residence is related to the central management and control of the business of the company, which is exercised by the directors from the place where they meet (and not the control of the company itself, which is exercised by its shareholders).
• R vs. Dimsey (1999)
Central management and control of the business must be distinguished from (and need not be in the same place as) the place of business, where the actual trading and business operations of the company are conducted. Identify where the decisions of fundamental policy are made as opposed to the place where the day-to-day activities are undertaken.
• R vs. Holden (2005)
Directors must apply their mind and decide on their own discretion, and not simply follow instructions of shareholders or third persons.
Following from the R vs. Holden case, the directors of Grid Essence Holdings Ltd, should be able to prove (upon challenge of the Cypriot tax residency of the company by foreign tax authorities) that they do apply their mind and decide on their own discretion and to do so one would expect that they are adequately and regularly informed about the operations and financial position of the Cyprus company.
How HLB Cyprus can assist you?
Enhancing substance becomes of paramount importance. HLB Cyprus can help you to analyse substance requirements and implement solutions tailored to your needs.
Our tax specialists can assist you with the following services:
- Diagnostics of the tax risks arising in the existing structure
- Recommendations on the actions required to deal with these risks including
- Assistance in the implementation of substance recommendations following the diagnostic review
- Assistance in preparing a comprehensive corporate governance framework
- Setting-up an office and hiring employees in Cyprus (including assistance in drafting employment contracts, obtaining work permits and optimization of taxation and social security liabilities with respect to the employees)
- Providing support in relation to administrative issues (assistance in accounting functions, tax compliance, audit) of the Cypriot companies