What is economic substance
Economic substance is a doctrine in the international tax law under which a transaction must have an economic purpose aside from reduction of tax liability in order to be considered valid. A company must be able to show physical presence and actual activity of the independent management within the jurisdiction of incorporation and/or tax residence of the corporate structure. In simple words a company must demonstrate that it manages, executes and oversees its business activities in a specific country to establish its economic substance.
Why have economic substance in Cyprus
Cyprus is a well-respected and experienced tax incentive country and currently enjoys double tax treaties with 66 countries. Among them are Canada, China, Czech Republic, France, Germany, Greece, Hungary, UAE, UK and USA. This range of double tax treaties strengthens the country’s popularity as an investment funds destination. Cyprus tax residents can take advantage of reliefs other benefits emanating from tax treaties signed by Cyprus and other countries. Such benefits will not be available to Cypriot citizens or Cyprus incorporated companies that are not Cyprus tax residents.
Creating sufficient substance in Cyprus, is a key element in order to minimize the risk of denial of double tax treaties and of a foreign tax authority seeking to challenge a company’s tax residency status and try to tax it under its own legislation. For a Cyprus incorporated company, adequate measures will need to be taken proving that the company is managed and controlled in Cyprus and that substantive business operations are carried out in Cyprus. Also, a Cyprus company claiming double tax treaty benefits and having access to EU directives needs to have sufficient substance in order to be able to benefit from those.
How to establish economic substance in Cyprus
In addition to registering with tax authorities, companies need to prove their economic presence in Cyprus. There is no standard approach to achieve substance. Each company and its corporate structure should be reviewed on a case-by-case basis and each jurisdiction has multiple interpretations to take into account. As a general rule, companies in Cyprus are urged to proceed with the following governance procedures and indicators of substance in order to support the tax residency of their company and achieve economic substance.
- Rent/buy an office space in Cyprus intended for business activity (not residential premises);
- Appoint a qualified director, resident of Cyprus who will make independent decisions on the companies activities;
- Have a functioning telephone line, domain email address and website;
- Open a bank account with local bank;
- Hire employees in the company and arrange for the payment of the relevant payroll taxes;
- Registration of the company and other employees with social insurance requirements;
- Have effective management and control of the company in Cyprus (make decisions concerning the company in Cyprus); and
- Ensure proper physical storage of the company’s documents (agreements, statements, invoices etc.) in the office located in Cyprus.
Having the majority of the directors to be Cyprus tax residents is quintessential to Cyprus tax residency and substance. The Cyprus resident directors should be the top managers of the company and should be in a position to exercise the management of the company. This should be also reflected in the effective documentation of business transactions and by the fact that they form a quorum in a board meeting.
Board meetings should be held in Cyprus. Being able to show that the management of the company is performed from Cyprus is an important substance component. Significant decisions should be taken in Cyprus and this should be also reflected in effective documentation. At least one board meeting should be held every year at which all directors (resident and non-resident) should be physically present. Directors of a Cyprus company must also have sufficient knowledge to make decisions and be able to demonstrate that they are the decision-makers. A Cyprus-registered company is not considered to have Cyprus business substance if its decisions are controlled or dictated by outsiders.
Memorandum and Articles of Association
The company’s memorandum and articles of association should include the necessary provisions to eliminate the risk of being viewed as having a taxable presence in another jurisdiction. For example, they should contain the requirement that all board meetings should be held in Cyprus or that the majority of the directors should be Cyprus tax residents.
Record Keeping –Archiving
Agreements, resolutions, minutes, company seal and share register should be kept in the Cyprus office.
All financial transactions and operations of the company should be prepared and kept in Cyprus. This includes the issue of invoices and receipts, the execution of documents, and the carrying out of statutory requirements. Bookkeeping, preparation of management accounts, financial reports and financial statements in line with the IFRS should be performed in Cyprus. The accounts should be audited in Cyprus and their discussion and approval should also take place in Cyprus.
Personnel and Office
Personnel should be physically present in the office performing their duties. They should also be registered in social insurance. Directors and other management officers should be situated in Cyprus. A full-fleshed office should also be maintained for the operations of the company.
Power of attorney
General powers of attorney granted to non-tax residents of Cyprus should be avoided since there is a danger for the management and control of the company to be shifted in another jurisdiction. In case such power of attorney is granted, the attorney should inform the director of any actions immediately so that the director is aware of any activity concerning the company.
Maintaining a local bank account
Any company can have various bank accounts in the different jurisdictions in which it operates, a corporate bank account must be kept in Cyprus as key evidence of substance in the jurisdiction of its tax residency. Bank signatories and banking transactions from this account should also be based in Cyprus.
Establish a Cyprus International Trust
Setting up a Cyprus International Trust for the shares of a Cyprus company is a step further in securing beneficial ownership.
Lack of substance means increased tax risks, tax-disputes and higher tax burden often exceeding the advantages of foreign corporate structures. On the other hand, the existing of substance will allow to manage tax risks effectively while conducting international business
While the above are form the conception of establishing substance, it is important to go beyond just demonstrating the initial reasons for forming a Cyprus company. The economic substance should be continuously demonstrated throughout the company’s lifetime.
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