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 many jurisdictions.
The attitude of many foreign tax authorities and public perception has hardened against tax avoidance in the last five years. That has implications both for the authorities' willingness to bring charges and the benefit of the doubt Courts are prepared to give to taxpayers and professionals. There is a heightened risk that tax avoidance schemes that fail for artificiality, poor implementation or lack of commerciality will be perceived as tax abuse or worse, evasion.
Recent developments from both a domestic law perspective as well as from an EU perspective have given substance a great importance, pointing out that international cooperation is the only way to tackle the challenge of tax avoidance.
Under the OECD model convention, a company may qualify for tax treaty benefits if the following criteria (normally contained in tax treaties) are met:
For example, consider the case of a multinational group that incorporates a subsidiary under the national laws of Cyprus (or other commonly used investment 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. This test attempts to determine 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/flow-through 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.
In 2012, the Governments of the G20 decided to take action in order to attack and prevail over aggressive tax planning. The OECD’s Report dated 12 February 2013 addresses Base Erosion and Profit Shifting (“BEPS”), as the latest international tax planning, and the use of offshore instruments to avoid paying tax, has become a massive threat to the economy as a whole. The main reason for introducing the BEPS Action plan is to attack this trend, particularly double non-taxation structures and to address situations where profits are perceived as geographically divorced from activities.
Also in 2012, the European Commission began a similar initiative, adopting an Action Plan to attack tax fraud and tax evasion, including a proposal to address any deficiencies within the EU Parent-Subsidiary Directive which were used by some companies to avoid taxation. Accordingly, in November of 2013, the European Commission adopted a proposal to amend the Directive by introducing a uniform anti-avoidance rule which would deny the benefits of the Directive to artificial tax structures (i.e. lacking substance).
In regards to Cypriot tax, a company is tax resident of Cyprus if its “management and control” is exercised in the Republic. Although no other substance requirements are formally imposed, recent international court cases and the global trend of tax jurisdictions demonstrate the necessity to ensure there is no discrepancy between the form and substance of arrangements and the importance of companies being managed and controlled from where they claim to be. Cyprus also follows the “substance over form” and “business purpose test” doctrines, which allow the Cyprus tax authorities to re-categorize an artificial or fictitious transaction or structure. The Assessment and Collection of Taxes Law, includes a general anti-avoidance rule under which the Commissioner of Income Tax may disregard a structure/transaction (on the grounds that it represents an artificial or fictitious transaction) and assess the person concerned on the proper object of tax. The provisions apply to local or international transactions, and to residents and non-residents.
When analysing substance requirements, the starting point, and by far the most important issue to be considered, is the make-up/composition of the management of the company, which is typically reflected within the Board of Directors. The appointment of directors requires thorough planning to ensure that the aforementioned risks are addressed. Physical presence of the directors of a company claiming to be a Cyprus tax resident company in the Republic, as well as evidence the major decisions have been taken out from Cyprus, would serve as a safeguard against future challenges.
In determining whether the effective management and control of a company is indeed within a specific country, a foreign tax administration or court (depending of course on the specific case and the nature of the business of the company in question), would in general consider the following:
Deficiencies with respect to the above conditions may result in potential challenges by a foreign tax authority on the grounds that the directors in question were merely acting as “nominee” directors while the actual decisions were made by a third party.
Meeting Substance Requirements in Cyprus: The Savva & Associates approach
In light of the above developments, it has come as no surprise that the rate of tax investigations initiated by foreign tax authorities has recently been increasing significantly. Through the Cypriot Inland Revenue Department, foreign tax authorities are now asking Cypriot service providers the following specific questions in connection to foreign residents with interests in a Cyprus entity (“CypCo”):
It is evident the above questions are used by the foreign tax authorities to extract information which will refute that management and control of a Cyprus company is being exercised within Cyprus. More precisely, the aim is to demonstrate that actual management and control is being exercised in a foreign jurisdiction.
As a result of these local and international developments, we are now strongly urging all clients to consider adding substance at the level of their Cypriot structures.
The unfortunate reality in Cyprus is there are serious abuses by service providers in regards to substance. The few providers that claim or advertise the provision of substance services do not actually offer solutions which add value to their clients’ business, but are essentially overpriced services that do not in any way mitigate the tax risks currently being faced. We have seen many examples of this.
Savva & Associates have significant expertise providing bespoke substance solutions to international clients setting up Cypriot structures. We make it a priority to advise all clients of the importance of economic substance and ensure we clearly communicate all risks associated with setting up a legal structure which is designed to achieve specific tax related objectives.
Our substance related services are specifically the following:
We would like to make clear however, any service provider promoting packaged substance solutions should raise red flags. Each structure is unique, and so are the substance requirements of each client- this is the simple approach we take. With this in mind, we have developed a proposal merely outlining the numerous possibilities available for creating substance in Cyprus. Our proposal serves as a solid starting point for the wealth of options open to clients wishing to build and maintain a strong presence in Cyprus.
Overall, it is evident that the present environment which sees tax authorities around the world becoming increasingly aggressive, it is prudent to guard against challenges that a structure is in place merely to obtain treaty benefits. One way of doing this is to ensure that any holding or finance structure has as much economic substance as possible – for example, by giving a holding company an additional function, such as that of a regional administrative and marketing headquarters.
In recent years a number of companies have not only strengthened their claim to Cyprus tax residence, but also enjoyed operational and economic benefits by locating regional administrative and headquarters functions in Cyprus, taking advantage of Cyprus's strategic location, EU membership, low costs and high quality of life.