Substance is not expressly defined. However, it is broadly referred as a tax concept, especially in international taxation and cross border tax, that allows the tax authorities of various jurisdictions to assess whether foreign entities are taxed in the correct jurisdiction and whether the entities are eligible for the various tax treaty benefits.
Substance is vital when it comes to the tax residency of companies and their management and control aspect.
The idea of substance is becoming more and more important when it comes to tax treaty or EU directive shopping. Substance is also relevant from a transfer pricing perspective and applicable to general, specific and local anti-abuse legislation.
- Recent International Trends
The aim of the European Union and the OECD is to establish basic standards on good governance, tax transparency and fair taxation. EU is issuing a list of non-cooperative jurisdictions, which is being updated and revised on a constant basis.
From an EU viewpoint, it is important that anti-abuse provisions be in place and relevant guidance be issued by the CJEU.
Court of Justice of the European Union (hereinafter the "CJEU") judgements ruled as follows:
- The notion of "Beneficial Ownership" should be in accordance with the OECD principles and needs to be considered not only under the legalistic perception but also under the economic reality in order to prevent international tax evasion and avoidance.
- Anti-abuse provisions can apply to the EU directives.
- Each member state is required to consider and determine what constitutes abuse as the evidence of abusive practices needs to be a mixture of objective circumstances and subjective elements.
Another important implication of the CJEU's judgement is that it requires sound commercial and business rationale.
In addition to the above, it has become increasingly common for foreign tax authorities to send requests under the Double Tax Treaties in place. Such requests include questions about whether the Cyprus Company carries out any business activity, where the directors meet, details of employees (including copies of their employment contracts), details of the office maintained in Cyprus, etc.
- Important Substance Risk Factors and Economic Substance
In accordance with Cyprus tax practice, there are some important points that have been identified and need to be considered – these are known as the "Red Flags":
- A Cyprus Company does not have any employees located in Cyprus.
- There are foreign directors who usually attend meetings through telephone.
- There is no office or their office is disproportional to the Company's activities and/or income.
- The Company's profits are transferred to other related Companies without any valid reasoning.
- Transactions are either being executed by the foreign directors or with the use of Powers of Attorney.
Therefore, the key indicators for economic substance are:
- Physical presence in terms of premises, employees and equipment, reflecting the economic reality.
- Carrying on genuine economic activity and not just a "letter box" or "shell" company.
- Effective management and real business risk assessment.
Physical presence, i.e. "substance", may not be sufficient if it does not take into consideration the actual volume and complexity of the transactions as well as the actual turnovers of a company.
- Cyprus Tax Residency Rules
Cyprus tax residency is based on the management and control principle. However, there is no specific definition of management and control under the Cypriot tax legislation. In accordance with the tax practices and international tax principles, the following need to be considered:
- The majority of the directors are Cyprus tax residents.
- An office is maintained in Cyprus.
- All strategic/ important decisions are taken in Cyprus by the directors, and those directors are exercising their duties and responsibilities in Cyprus.
- No General Power of Attorneys are provided to persons outside Cyprus.
Having considered all the above aspects, we note below a globally accepted table that may be used as guidance in relation to substance features:
- Adequate number of skilled employees;
- Residency of the directors;
- Corporate Bank account;
- Books and records to be kept at the registered office of the Company;
- Transactions (e.g. tax, accounting, legal, administrative).
The required level of substance for holding companies need to be considered taking into consideration the relevant activities, their complexity and volume.
- Raising of funds and managing risks are carried out by the Company;
- Management and control by the board of the Company;
- Adequate number of knowledgeable and experienced employees.
The required level of substance for financing companies need to be considered taking into consideration the relevant activities, their complexity and volume.
Intellectual Property/ Trading Companies:
- Strategic decisions are made and management (including considering risks) is carried out by the Company;
- Adequate number of knowledgeable and experienced employees;
- Control over the developing, exploitation, enhancement, maintaining and protection of intellectual properties;
- Office maintained in Cyprus.
The required level of substance for Intellectual Property and Trading companies need to be considered taking into consideration the relevant activities, their complexity and volume.
IMPORTANT: Each case should be considered separately, taking into account its merits, before a decision about the level of substance required is made.
Savva & Associates aims to work with clients to ensure their Cyprus, international and personal structures are established and administered at the highest level of international standards. Our highly experienced and qualified team will ensure the correct structuring of your Companies and provide comprehensive advice on all VAT and Tax matters.