By Demis Ioannou
On 30 June 2017, the Cypriot tax authorities issued the Circular 05.13.001 (“the Circular”) complying with Actions 8 to 10 under the OECD BEPS Project. The circular provides a completely new playing field for companies carrying out intra-group back to back financing activities to related companies.
This circular will substitute the so called acceptable profit margin scheme as agreed between the Institute of Certified Public Accountants in Cyprus (ICPAC) and the tax Commissioner in 2011. This article provides further interpretation of the new circular along with the transfer pricing issues.
The Circular provides for three main requirements; substance requirement, equity risk requirement and Arm’s length compensation. A group financing company not following the requirements is in breach with the Cypriot tax authorities.
(a) Substance requirement
The circular requires companies engaged in intragroup financing activities to have a real substance in Cyprus. The substance requirements (as described in the circular), provide for four main conditions which must all be met: (i) the number of board of directors members of the company that are Cyprus tax resident; (ii) the number of board of directors meetings held in Cyprus and the main management and commercial decisions taken in Cyprus; (iii) the number of shareholders’ meetings taking place in Cyprus; (iv) the availability of qualified personnel to control the transactions performed. The meaning of qualified personnel can be interpreted in different ways however it is expected to have the meaning whether a group financing company has an adequate number of employees necessary to manage the financing activities on a daily basis. The employees may be the company’s own employees, or outside staff. Therefore, the day to day management of the company may be still outsourced to well establish Cypriot service providers as long as the directors are capable to supervise the work and their decision making power is not limited.
(b) Equity at risk requirement
The circular provides for a new requirement which states that a finance company must bear the risks in relation to its intragroup financing transactions. A finance company’s equity at risk must be determined on a case by case basis, being a major change from the old back to back scheme.
Therefore, a finance company should have adequate equity level to assume risks and in particular the credit risks. The circular requires finance companies to be financed with an amount of equity to cover expected losses, should been materialized. The equity should be calculated based on the solvency criteria of regulated financial institutions or if the functional profile differs significantly (proved by the functional analysis) it allows you to refer to other methods as developed by professionals in this field. The circular does not define the term equity nor provides clarifications of how to use the funds of the equity but given that the purpose is to absorb the risk if materialized, should in principle the funds be easily available in all times.
(c) Arm’s Length Compensation
The Cypriot group financing companies should determine their arm’s length remuneration through a transfer pricing analysis and on a comparison of the conditions in a controlled transaction with the conditions in transactions between independent enterprises.
(a) Company analysis
The circular provides guidance on what a transfer pricing analysis should include. It states that the transfer pricing analysis should include an overview of the structure of the organization of the group, the role and functions performed of each entities participating in the controlled transactions and the contribution of the related entities to the value creation within the Group. In addition the circular further states that it is necessary to determine the characteristics of the controlled transaction by describing the terms and functions, assets used and the risks assumed by the related entities. This could be done through a functional analysis.
(b) Functional analysis
The circular at note 13, states that the functions performed by the finance company may be divided into those relating to the origination of the transactions and those relating to the management of the transaction. In our view, regarding the origination of the transaction functions, the most important are the negotiation (decision making whether funds should be transferred and at what terms) and the compliance functions (review agreements, checking for guarantees, resolving legal issues and transfer pricing issues etc.). In our view, regarding the managing of the transaction functions, all below should be considered important:
-managing the financing transaction (receive and pay interest, monitoring payments). The Cypriot company should be fully involved in such function.
-credit-risk monitoring; (analysing the risk of the borrower, the profitability of the loans and the return on the equity invested). This function is very important as the finance company (unlike the previous back to back scheme) will bear all the risks relative to their financial activities. Therefore finance companies should develop risk management policies and have qualified personnel.
-managing the financing for the transaction; (for example refinancing the loan, sale of the loan, terms to renew or to extend the loan agreements). The Cypriot company should be fully involved in such function.
(c) Risk analysis
It is strongly emphasised in the circular, stating that parties before engaged in granting credit should among other factors need to examine the annual accounts of the borrower, review for any guarantees, the purpose and duration of the credit. According to the circular a finance company should be in the position to manage and bear the risk and must be examined through the functional analysis.
Therefore the finance company is necessary to have the access to funding, necessary to take on or to avoid the risk, to pay the risk mitigations actions and to bear the consequences if the risk occurs. Additionally a group finance company should control its risk by having the decision making power to enter into a risks-bearing commercial relationship, if it has the ability to address the risks and if it actually performs such decision-making makings.
(d) Return on Equity
The circular provides evidence on how to determine the arms’ length remuneration. The return on equity will be one of the approaches for determining the arm’s length compensation specifically if you are a regulated financial institution. The circular specifically states that if Cypriot financing companies performing similar functions to those performed by regulated financing companies a return on equity of 10% after tax can be observed in the maker as arms’ length remuneration. For any other company, the international recognized standards could be used. Possibly the arm’s length remuneration could be found through an interest benchmarking analysis which analyses the difference between the interest expense and interest income.
(e) Simplification measure
The circular provides a simplification measure which is an option to be used which can reduce the burden of preparing a transfer pricing analysis. However, in our view is expected that in practice, most taxpayers will not opt for the simplification measure because: (i) the minimum return of 2% after tax on the assets, can be regarded as very high and may not represent the arm’s length basis of the group financing company; (ii) In the circular is stated that taxpayers opting for the simplification measure will be subjected to an exchange of information as set under the council directive 2011/16/EU. (iii) For intermediary financing companies that do not comply with the minimum substance requirements, the simplification measure is not applicable without a transfer pricing analysis.
This is a new era for financing companies in Cyprus. Most financing structures that were compliant under the old back to back scheme need to be modified in order to comply with the Circular being effective as from 01.07.2017.
The article appears in Tax Journal Issue 1, 2017.