Recent developments in Cyprus have brought under scrutiny the need for businesses to have real substance in order to operate in Cyprus and to benefit from Cyprus tax residency. It is crucial to note that a lack of proper substance may lead to the denial of benefits as put forth in Double Tax Treaties or EU Directives. It may also means that the company concerned is unable to operate a bank account in Cyprus.

The Central Bank of Cyprus issued a circular on June 14th 2018, instructing credit institutions it regulates not to open new bank accounts or continue existing accounts with companies that are regarded as "shell" or "letter box" companies. These guidelines are to be incorporated into the Central Bank's anti-money laundering directive in the near future.

A "shell" or "letter box" company is defined in the circular as an entity which is not publicly traded and which meets any of the following criteria:

• It has no physical presence in its country of domicile apart from a mailing address;
• It has no established economic activity, little to no independent economic value, and no documentary evidence to the contrary;
• It is registered in a jurisdiction where companies are not required to file independently audited financial statements;
• It has a tax residence in a jurisdiction recognized as a tax haven or no tax residence whatsoever.

What is required of a company in order to prove a solid physical presence within a country / jurisdiction?

1. First and foremost, having real management located within a country, carried out by individuals possessing the knowledge and experience needed to run the business.
2. Secondly, the existence of employees is another factor indicating physical presence. It is also very important to note that while it may be necessary and useful for other reasons, representation by means of nominee services provided by agents such as lawyers or corporate service providers does not constitute physical presence.

With regards to trading companies, it has been stipulated that companies of this type with no effective place of business and management, and hence no substance, will not be permitted to maintain bank accounts in Cyprus, and that trading companies incorporated in jurisdictions recognized as tax havens will have to become tax resident in a non-tax haven jurisdiction in order to continue banking in Cyprus.

It is important to note however that these restrictions do not apply to holding companies which own investments in shares, intangible or other assets (including real estate or ships), companies undertaking group financing activities or acting as group treasurer, or companies established to facilitate currency trades, asset transfers or corporate mergers, provided that their beneficial ownership is identifiable and they demonstrate that they are engaged in legitimate business.

When it comes to banks, they may opt to engage in a business relationship with a "shell" company client but will have to be able to justify their decision and record this justification in the client file. When it comes to dealing with such clients, banks will need to follow a risk-based approach and they are also required to carry out a review of their customers to identify such companies. The deadline to inform the Central Bank of Cyprus of the results of the review and whether they intend to continue their business relationship with the entities concerned was July 31st, 2018.

Tax Authorities Around the World: 
In addition to pressures from the banking authorities, tax authorities around the world are becoming increasingly assertive and sophisticated, and ready to challenge what they perceive to be abusive structures and arrangements. With increased transparency and automatic exchange of information, Cyprus companies which are not deemed to have real substance within the country, run tax risks, including the risk of having their Cyprus tax residency status being put into question, losing the benefits of Cyprus tax residency, and becoming liable to tax elsewhere.

What is important to note is that a company lacking sufficient management and capital may be entirely disregarded by foreign tax authorities, running the risk that, in addition to any taxes payable by the company in Cyprus, its income is charged to the beneficial owners in their own country and taxed there. The availability of a notional interest deduction in Cyprus provides an incentive to increase the company's capital and economic substance and benefit from reduced taxation on new equity.

Companies with transactions with related parties increasingly face transfer pricing challenges, making transfer pricing a compliance priority for entities carrying out cross-border transactions. Under the detailed transfer pricing rules introduced in Cyprus in 2017, companies need to demonstrate real substance in Cyprus in the form of adequate management and capital.

The Key Characteristics of Substance and Methods of Enhancing it:

The two foremost cornerstones of substance are the following:

1. Sufficiency of Management: i.e. having adequate corporate governance arrangements and directors with the skills, knowledge and experience to run the business, who make the important business decisions in Cyprus. They need to spend adequate time on the business of the company and they must have real decision-making powers. They must not be directed by the shareholders but should always act independently in the interests of the company.

Depending on the size of the business, the existence of an office in Cyprus, as well as facilities and employees, can be important in enhancing substance. The operation of bank accounts, the accounting and human resource functions should preferably take place in Cyprus. The company might also actively take part in the local business community by joining the Chamber of Commerce, the Cyprus International Businesses Association and other similar bodies.

Clearly, the optimum degree of presence will be determined by the needs of the business. If, for example, a holding company holds just one investment and the only decision is to declare a dividend once a year, or if a financing company has just one loan which is assessed only once a year, the physical presence required will be much less than for a larger business.

2. Sufficiency of Capital: It is required of a company to have enough of a capital buffer to assume the risks of its operations. It is not, therefore, a mere conduit or proxy, and the profits or losses from the operations evidently belong to it alone.

Last but not least, it is important to note that any decisions made to enhance substance in Cyprus may well have an effect within other jurisdictions as well. Consequently, these issues should always be considered in a more holistic context of the entity or of the group of which they are a part.

Our team of professional advisors would be happy to assist you. For any query please contact Charles Savva at c.savva@savvacyprus.com.