As a rule and according to Article 33 of the Cyprus Income Tax Law, which introduces the arm's length principle (using wording similar to that of article 9 of the OECD Model Tax Convention), all transactions between companies, including loan agreements/transactions by Cyprus companies, must be undertaken at arm's length terms.
The arm's length principle (ALP) is the international consensus on transfer pricing and it is a term used to describe a range of values that can be defined for purpose of selecting an appropriate arm's length price from comparable transactions. (OECD Glossary)
An arm's length transaction could be described as the condition or the fact that the parties to a transaction/agreement are independent and on an equal footing (wikipedia) and have concluded the transaction/agreement freely and independently of each other, i.e. without any of the parties being able to control the other. Such a transaction, therefore, is an "arm's-length transaction".
The Cyprus Tax Authority has the right to impose tax adjustments to make up for any deviation from the arm's length principle. Such adjustment is usually made in the form of a notional interest income.
As a long practice, the Cyprus Tax Authority treated back-to-back loans differently. It accepted such thin spreads/minimum profit margins without challenging the arm's length applicability. Due to this practice, Cyprus companies benefitted considerably from the use of back-to-back loans. Back-to-back loans are considered to be those which the Cyprus tax resident company borrows and in return lends to related and/or connected and/or associated parties leaving a small profit margin in Cyprus.
In the glossary of the OECD, a back to back loan is a method of borrowing between related and/or connected and/or associated parties where a loan is channeled through an independent third-party intermediary and arm's length principle is the standard adopted by the OECD and in many jurisdictions, which mandates that the result related parties obtain from an intercompany transaction approximates the result that uncontrolled parties would have obtained had they undertaken the same transaction under the same circumstances.
In this case, the Cyprus tax resident company, usually set up as an international financing company, is used as an intermediate company to borrow and in return lend what borrowed to a related (related to the Cyprus company) non tax resident company.
Following recent international developments and in particular the OECD/G20 BEPS Project, (which is said to equip governments with domestic and international instruments to address tax avoidance and ensure that profits are taxed where economic activities generating the profits are performed and where value is created), the Action Plan on Base Erosion and Profit Shifting ("BEPS Action Plan") identified 15 actions to address BEPS in a comprehensive manner. In October 2015, the G20 Finance Ministers endorsed the BEPS package which includes the report on Action 13: Transfer Pricing Documentation and Country-by-Country Reporting ("the 2015 Action 13 Report", OECD (2015)). Following that, the countries participating in the Project agreed to a new framework that will allow all interested countries and jurisdictions to work jointly for the implementation of the package of measures against BEPS. (https://www.oecd.org/g20/topics/taxation/beps.htm )
The Cyprus Tax Authorities, have recognized the potential for cross-border controlled transactions such as the abovementioned Cyprus back-to-back loan transactions to distort taxable income.
Following detailed studies of the existing tax regime and having reviewed and examined the existing code of conduct for the taxation of business as well as the state aid rules applicable within the EU, with the wish to become fully complied with the OECD BEPS framework and the international standards as they have developed, the Cyprus Tax Authorities have decided to proceed with the alteration of the current tax regime in relation to profit margins on loans between related and/or connected parties.
The Tax Department has already announced in February 2017 its decision to abolish the current tax practice in relation to the minimum acceptable margins on loans granted to related parties by the 30th June 2017 (inclusive).
Based on the announcement, the existing practice with the minimum acceptable margins will apply up to 30th June 2017, and from 1st July 2017 all loan transactions (and/or other financing arrangements and similar instruments) between Cyprus Tax Resident Companies and their related companies should satisfy the arm's length principle and the interest rate used should be based on current market conditions. The announcement further adds that, this will have to be supported by relevant transfer pricing studies (TPS). In other words, whether the arm's length principle will, in each time/case, be considered as satisfied and whether the interest rate used in the particular transaction under assessment will be considered as rightly having based on the market's conditions as existed at the time of the determination, will largely be based on and formed by supporting documentation, i.e. transfer pricing documentation that will need to be submitted and which, as per the announcement of the Tax Department, this is the TPS.
In fact, the current legal framework in Cyprus does not include any detailed transfer pricing rules and regulations, nor does provide for any transfer pricing studies to be submitted. For these reasons the Tax Authorities also indicated that detailed transfer pricing rules for intra-group financing transactions, based on the OECD transfer pricing guidelines, will be announced in the near future. The new rules will not only apply for the purposes of tax assessment but also for the purposes of issuing tax rulings.
These same rules will also provide for the transfer pricing studies requirement (TPS), as abovementioned, which, as the announcement indicates, will have to be prepared by independent experts and be based on the OECD principles, procedures and standards. The announcement does not give any further details nor it provides information on the specific transfer pricing rules to be enacted. It does not mention anything about the content and timing of the required TPS either.
In fact, the TPS forms part of the first attempt by Cyprus to enact a national transfer pricing framework and the use of transfer pricing documentation. Based on the latest OCED transfer pricing guidelines an important consideration in developing such rules is to balance the usefulness of the data to tax administrations for transfer pricing risk assessment and other purposes with any increased compliance burdens placed on the taxpayers. (http://www.keepeek.com/Digital-Asset-Management/oecd/taxation/guidance-on-transfer-pricing-documentation-and-country-by-country-reporting_9789264219236-en#page16 )
According to the 2014 OECD guidance on Transfer Pricing Documentation and Country by Country (CbC) Reporting, the following objectives should be considered in designing appropriate domestic transfer pricing documentation requirements:
- to ensure that tax payers give appropriate consideration to transfer pricing requirements in establishing prices and other conditions for transactions between associated enterprises and in reporting the income derived from such transactions in their tax returns;
- to provide tax administrations with the information necessary to conduct an informed transfer pricing risk assessment; and
- to provide tax administrations with useful information to employ in conducting an appropriately thorough audit of the transfer pricing practices of entities subject to tax in their jurisdiction, although it may be necessary to supplement the documentation with additional information as the audit progresses. (http://www.keepeek.com/Digital-Asset-Management/oecd/taxation/guidance-on-transfer-pricing-documentation-and-country-by-country-reporting_9789264219236-en#page16 )
Taxpayers themselves, therefore, first would need to evaluate their own compliance with the newly applicable transfer pricing rules. And in fact a well-prepared transfer pricing study will provide tax administrations with a solid indication that the particular taxpayer has indeed analysed the positions it reports on tax return, has considered the available comparable data and has reached consistent transfer pricing positions. On the other hand, tax administrations would need to be able to access sufficient, relevant and reliable information when conducting a transfer pricing risk assessment to decide whether to perform an audit or when assessing an enquiry for a ruling and obviously the TPS may be considered a critical source of information for such risk assessment.
The TPS, therefore, should be able of consistently demonstrating that the results of transactions with related and/or connected and/or associated parties are determined for tax purposes according to arm's length principle. For this purpose the TPS should provide adequate accounting records and adjustment records (i.e. records identifying adjustments made on account of tax rules to move from profits in account to taxable profits). It should, further, identify specific transactions to which the transfer pricing rules apply and provide relevant evidence capable of proving that the result of these transactions is indeed arm's length for purposes of the transfer pricing rules.
The TPS, in this way, actually forms an inherent part of the taxpayer strategic tax risk management.
It is expected that the Cyprus Tax Authorities might not require independent Transfer Pricing studies if the interest on loans between related parties is not below certain market averages.
Furthermore, the Tax Authority announced that, any tax rulings relevant to the minimum acceptable profit margins which have been already issued (up to 30th June 2017) are rendered void and will be treated as inapplicable.
Any relevant transactions still in place after 30 June 2017 will have to be supported by the said Transfer Pricing Studies after that date.
This new rule will affect all the financial transactions between related companies for both tax assessment purposes and for the issuance of tax rulings.
In addition, all tax rulings which have been issued up to 30th June 2017 in relation to this subject will become void.
A large number of taxpayers will most probably be affected by the abovementioned changes. We, therefore, strongly recommended that taxpayers and other interested parties undertake a review of their current group structures and existing financing arrangements, monitor the developments around the implementation of the new transfer pricing regime, identify and assess possible and sensitive gaps in order to assess the potential impact of the upcoming changes and re-evaluate their strategies timely take corrective actions (possibly including the restructuring of their loans by taking advantage of the Notional Interest Deduction (NID) provisions giving out a loan through own funds that were introduced in the share capital of the company) in an attempt to ensure their conformity with the new tax pricing framework.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.