Cyprus: International Tax Aspects Of The Cypriot Holding Company

Holding companies exist for legal, commercial and tax reasons. For years it was accepted that the alternatives were either the Luxembourg company established under the 1929 legislation or the Netherlands company enjoying the participation exemption. However, during the last decade various European countries have introduced holding company regimes and many multinationals now face the problem of selecting the right jurisdiction in which to establish their holding company.¹

A multinational group requires three things from a holding company. First, the holding company must be able to take dividends out of the operating company free of withholding tax or at a lower rate of withholding tax by virtue of a tax treaty or under the EU Parent/Subsidiary Directive, and to dispose of its investment in the operating company without any liability to capital gains tax or its equivalent in the operating country. Secondly, some provisions in the domestic laws of the holding company jurisdiction should wholly or largely exempt such dividends and capital gains from local tax. Thirdly, the multinational should have the ability (and this, traditionally, has been the most difficult step) to take dividends out of the holding company without giving rise to any charge to tax in the holding company jurisdiction. ² Additional tax considerations may include the existence of controlled foreign company (CFC) rules, thin capitalization and the ability to obtain interest deduction in full, corporate and local tax rates in respect of other income and any other taxes, e.g. capital gains tax and stamp duty. Certainly, no single location has all the attributes of the best holding company location; which location is most suitable in a specific case ultimately depends on the particular circumstances and on individual tax and non-tax objectives, as the establishment of a holding company is usually not just a tax driven decision.

With the introduction of the new tax legislation on 1 January 2003 Cyprus joined the race to be a major contender for the location of a holding company. This article will describe the recent developments, advantages and challenges of the new Cypriot holding company regime.

The main features of the regime are as follows:-

Like most European countries, Cypriot tax rules, subject to certain conditions, provide full exemption from local taxation in respect of dividends received by a holding company from its local and foreign subsidiaries.

The exemption from tax of trading and capital gains made by a Cypriot holding company from the sale of shares in foreign subsidiaries creates a level playing field with the traditional European holding company regimes such as the Netherlands, Denmark, Luxembourg and Switzerland.

Outgoing dividends remitted by a Cypriot holding company to the ultimate parent company do not suffer any withholding taxes in Cyprus.

In view of the fact that Cyprus has a large number of double tax treaties, incoming dividends received by a Cypriot holding company from its foreign subsidiary are either exempt from or subject to low withholding taxes in the subsidiary’s jurisdiction.

The EU Interest/Royalty Directive has been transposed into Cypriot domestic legislation and therefore the tax laws provide for exemption at source of interest where the beneficial owner is a non-resident.

It is important for an investor to obtain a tax deduction in respect of borrowing costs incurred in relation to investments in subsidiaries. In general, interest expenses payable by a Cypriot company are fully deductible.

Thin capitalization may be a critical issue. If a company is thinly capitalized under the rules of the country in which the company is tax resident, part of the interest deduction may be disallowed and treated as a dividend distribution. ³

Cypriot tax legislation does not contain specific rules concerning thin capitalization of companies. Therefore a Cypriot holding company may be capitalized with loans without any risk that interest paid at arm’s length to the parent company will not be deductible.

Cypriot CFC legislation targets low tax and/or tax haven countries, and then narrows its scope further by targeting only certain types of income which are not derived from genuine business activities.

• Cypriot corporate tax rate for business profits is 10%;
• Cyprus does not have any rules stating that holding companies cannot perform operating activities;
• Group relief;
• Cypriot tax regime permits losses to be carried forward indefinitely;
• Attractive permanent establishment rules;
• Treatment of foreign taxes as expenses;
• Modern reorganization and merger rules
• Unilateral tax relief may be available;
• UK Company Law heritage/common law tradition.

A Cypriot holding company is an ordinary company which, besides having a participation in domestic and/or foreign companies, may also be engaged in other activities such as trading, manufacturing or financing. The company is liable to be taxed in Cyprus on its worldwide income, provided that it is managed and controlled in Cyprus.

Its taxation is based on three pillars, namely the Income Tax Law, the Special Contribution for the Defence of the Republic Law, and the double taxation treaties.

The business profits of a Cypriot holding company are subject to a corporation tax rate of 10%. Since 1 January 2003, dividends have not been subject to Cypriot income tax generally: instead a 15% special defence contribution tax is levied on the dividend income of a company resident in Cyprus, with the participation exemption available for domestic and foreign dividends.

The international participation exemption is provided by domestic law and grants relief from international double taxation by exempting foreign dividends received by Cypriot companies from any taxation, provided that the Cypriot company’s holding in the foreign company exceeds 1% of the shares. The legislation also exempts from taxation the dividends that the Cypriot holding company pays to its parent. The law does not distinguish between shareholdings in companies in EU and in non-EU countries.

Individuals not resident in Cyprus⁴ are also exempt from dividend taxation whereas residents are liable to a 15% special defence contribution which is a final tax withheld at source.

The holding company régime applies only if the company can be defined as a Cypriot-resident company. Under the residence rules for companies, management and control is the key test. Registration in Cyprus alone is not sufficient to subject companies to tax in Cyprus. Although the law does not contain a definition of management and control, in our opinion, to ensure that a company satisfies the residence test, its decision-making processes should take place in Cyprus as far as possible. Applying this criterion to a holding company, this means that:

• All decisions affecting a company should be made, and be shown to have been made, by its board of directors in Cyprus;
• Decisions must be made by the board, exercising its powers independently of any particular director or shareholder; and
• The board should have a majority of Cypriot-resident directors.

For holding companies which traditionally require few personnel, particular consideration should be given to these matters. If the company also acts as a co-ordination centre or performs other administrative functions from Cyprus, this will help to substantiate its residence. In this respect it should be noted that holding companies qualify as profit-orientated establishments for the purposes of protection under the fundamental freedoms of the EC Treaty. Furthermore, ‘substance over form’ issues should be considered carefully to avoid any possible attacks by the Inland Revenue using the general anti-abuse legislation. In other words, substance requirements will have to be satisfied by a Cypriot holding company to qualify as a resident of Cyprus for tax purposes.

These requirements prevent companies without any significant substance in Cyprus, i.e. mere letterbox or brass-plate companies from obtaining benefits from the Cypriot legal and tax systems simply by incorporation.

Cyprus applies a classic participation exemption privilege to incoming dividends, i.e. if dividends are paid out of profits which have suffered tax elsewhere, they are not taxed again in the hands of the corporate recipient. The participation exemption applies not only to dividends from shares in another resident company but also to dividends received from non-resident companies (subject to certain conditions, see below) and capital gains arising on the disposal of the shares.

Under the domestic participation exemption, dividends payable by a Cypriot-resident subsidiary to its Cypriot-resident parent are exempt from taxation and are not included in the taxable income of the parent company, regardless of the extent and the holding period of the shareholding in the subsidiary company. No further requirements need to be met in order for the exemption to apply.

The domestic participation exemption also applies to capital gains realized from a shareholding in a local company. Gains from the sale of shares of companies owning immovable property in Cyprus, however, will continue to be subject to capital gains tax.

The international participation exemption is applicable to foreign dividends, provided that the Cypriot-resident company receiving the dividends owns at least 1% of the share capital of the foreign subsidiary. This 1% requirement was introduced to create a distinction between participating and investing. It should be noted that the applicability of the participation exemption is not dependent on the shareholding period in a foreign subsidiary.

With regard to the international participation exemption, the Cypriot tax laws provide special anti-abuse provisions, known as the ‘controlled foreign company’ (CFC) provisions. These are aimed at preventing non-resident companies over which domestic taxpayers have a controlling or substantial influence from converting essentially passive income (tainted income) into exempt dividend income receivable by a Cypriot-resident company.

However, the general principle behind the Cypriot CFC rules is that anti-avoidance measures should be used only to maintain the equity and neutrality of national tax laws in the international environment. Therefore, the Cypriot CFC rules only target income that is genuinely passive and do not extend to active income such as income from production, normal rendering of services or trading by companies engaged in real industrial or commercial activity. Further, the CFC rules are aimed at companies benefiting from low tax régimes and are not applicable to countries whose taxation is comparable to that of Cyprus. Finally, Cypriot counteracting measures do not (unlike the US Subpart F rules) treat the source company as non-existent.

The CFC provisions will only be triggered if more than 50% of the non-resident company’s activities result directly or indirectly in investment income, and the foreign tax burden on the income of the non-resident company paying the dividend is substantially lower than the tax burden of the company which is tax-resident in Cyprus. Both conditions must apply for the CFC provisions to be triggered; if not, the exemption is available.

Although the law compares the actual overseas tax burden with the tax burden of the Cypriot-resident company, no reference is made to the corporation tax rate. The law is also silent as to whether the tax must actually have been suffered or not. With respect to the term ‘substantially lower’, the law provides neither a definition nor official interpretation or guidance. However, bearing in mind that the CFC provisions target the low tax and tax haven countries, the term ‘substantially lower’ might well be interpreted as meaning an effective corporation tax rate of 5% or less.

It is interesting to note that the CFC regulations in Sweden will be triggered when the income of the foreign legal entity is considered to be subject to low taxation, namely below 15.4%, calculated in accordance with Swedish tax laws. However, if the foreign legal entity is tax resident in a country listed in an appendix called "The White List", the Swedish shareholder will not be subject to CFC taxation. In this respect many of the problems of interpretation of the Cypriot CFC rules could arguably be resolved if the Cypriot tax authorities were to produce such a list as well.

The law defines ‘investment income’ as any income which is not derived or arising from any business, employment, pension or annuity paid by reason of or in connection with past employment. Passive or ‘tainted’ income invariably includes dividends, rents, royalties and interest.

Generally, the Cypriot CFC provisions do not adversely affect holding companies resident in Cyprus, since the Cypriot CFC provisions, unlike the US Subpart F rules, are triggered only when there is an actual distribution of dividends.

As regards the compatibility of the Cypriot CFC legislation with the EC Treaty, there is a view that all the CFC rules of EU Member States are of doubtful compatibility with the EC Treaty. ⁵ The European Court of Justice (ECJ) has consistently rejected a number of arguments traditionally made in support of CFC rules. The ECJ issue here is that the taxation on the parent company of the profits of a subsidiary established in another EU Member State, compared with the absence of such taxation for a domestic subsidiary, is contrary to the freedom of establishment enshrined in Articles 43 and 48 of the EC Treaty. The ECJ held in the Baars⁶ and Verkooijen⁷ cases that discrimination against a domestic shareholder is not justifiable on the basis of the low tax burden of the foreign country.

The justification of the CFC rules on the ground that there is a need to prevent abuse of the tax system would appear to be reasonable only if the relevant legislation has the specific purpose of preventing wholly artificial arrangements. ⁸

There may be instances where the effects of the CFC regulations could be eased by diligent planning, such as changing the subject of the business by distribution or "dividend stripping", since capital gains from the sale of any shares that are not connected to real property in Cyprus are exempt from tax. However, ‘substance over form’ considerations will have to be taken into account in such cases because of the commitment of Cyprus to OECD standards and the EU Code of Conduct.

‘Substance over form’

Cyprus follows the ‘substance over form’ and ‘business purpose test’ doctrines which allow the Cypriot tax authorities to recategorize an artificial or fictitious transaction. At the same time Cyprus, like many other countries, recognises the right of a taxpayer to arrange his affairs in a way which attracts minimum tax liability, and therefore to choose legal forms which are in his view the most suitable for the disposition of his affairs. However, under the ‘substance over form’ doctrine a taxpayer may be restricted in the reduction of his liability to pay tax in circumstances where his business arrangements are carried forward with the object or intent of tax avoidance and substantially without a bona fide purpose. ⁹

General anti-avoidance rules are maintained in the Assessment and Collection of Taxes Law, which was amended to transpose the EU Mutual Assistance Directive 77/799/EEC into domestic legislation. Under the anti-avoidance provisions, the Commissioner of Inland Revenue may disregard artificial or fictitious transactions and assess the person concerned on the proper object of tax. The provisions apply to local or international transactions, and to residents and non-residents.

The international participation exemption applies to capital gains realized by a Cypriot-resident company on shares in a foreign subsidiary. In contrast to the foreign dividend exemption rule, the minimum 1% participation threshold and the CFC rules are not applicable to the participation exemption of capital gains.

It should also be noted that, under the new tax rules, trading gains realised by a Cypriot resident company through the disposal of securities are exempt from taxation. This exemption may be of particular benefit to Cypriot financial services providers operating under the Financial Services Firm Law which is in line with the EU legislation in this regard.

Since 1 January 2003, dividends have not been subject to Cypriot income tax. Instead, the 15% special defence contribution tax is levied on dividend income. Companies resident in Cyprus are entitled to the above-mentioned participation exemption for foreign and domestic dividends, provided that in the latter case the "deemed distribution regime" does not apply. Individual taxpayers who are residents of Cyprus must include any foreign dividends received in their tax return for the purpose of the assessment of the 15% special defence contribution.

Inter-company dividends of Cypriot-resident companies do not attract any withholding taxes. However, a Cypriot-resident company which has not declared a dividend is deemed to have distributed 70% of its profits arising or accruing in the year of assessment, after their reduction by transfers to reserves as legally required and by corporation tax paid or payable on such profits, in the form of dividends to its shareholders, as at the end of a 2-year period from the end of the year of assessment to which the profits relate. Where a dividend has been paid within the 2 year period in relation to the particular year of assessment, the deemed distribution is reduced by the actual dividend paid. Resident corporate shareholders which at a later stage receive dividends from a company which has been subject to a deemed distribution are entitled to reclaim the underlying defence contribution tax.

Foreign corporate as well as foreign individual shareholders will receive a refund upon subsequent actual distribution by the company assessed under the deemed distribution rules.

The actual distribution of dividends to a Cypriot-resident corporate shareholder will not attract any form of taxation in Cyprus, either in the hands of the payer or in the hands of the recipient, and will not trigger the imposition of the special defence contribution on the dividend distribution.

Shareholders who are not residents of Cyprus are not subject to the special defence contribution tax, and therefore dividends payable by a Cypriot-resident company to its foreign shareholder (whether a company or an individual) will not attract any withholding taxes in Cyprus. This absence of withholding tax differentiates Cyprus from many other régimes in the EU in respect of dividends paid within the EU. Intra-EU dividends are usually paid within groups without withholding tax under the EU Parent/Subsidiary Directive, provided that the 25% holding requirement that the other EU jurisdictions have imposed is fulfilled (see below), but this will not protect a non-EU parent from withholding tax on dividends paid by an EU-resident subsidiary company.

As a result, a non-EU parent of most EU- based companies will have to rely on the terms of an applicable double taxation treaty to reduce withholding taxes. Thus, for example, the domestic Netherlands withholding tax of 25% is generally reduced to 5% under most of the double taxation treaties. By contrast, Cyprus provides a full exemption from withholding tax on outward dividend payments and therefore has a real advantage over other European holding company régimes.

If a Cypriot holding company is liquidated, all the profits of the last five years which have not been distributed or been deemed to have been distributed are deemed to have been distributed and the shareholders are deemed to have received these dividends. As mentioned above, deemed dividends are subject to the 15% special defence contribution. This does not apply, however, where a company is liquidated in the context of a reorganization arrangement. As in any other case of deemed distribution the proportion attributable to foreign shareholders is not taxable.

Cypriot tax legislation does not contain any thin capitalization rules, i.e. a debt:equity ratio requirement. However, there are certain indirect debt:equity restrictions.

Under the Income Tax Law, any interest paid in the course of a company’s normal trading activities is an allowable deduction, including any amount in relation to the acquisition of assets used in the business.

However, if a Cypriot company that pays interest makes advances at a zero rate of interest or at a rate lower than the one paid to related parties, interest equal to 9% p.a. on those advances, or the difference between the actual interest paid and received will have to be added back, because such advances are not considered as ‘expenses incurred for the purpose of the production of income’¹⁰.

In this respect the Cypriot legislation is consistent with the EU law. In the ECJ decision in Lankhorst-Hohorst ¹¹ it was held that the German thin capitalization system (before the abolition of imputation as from 1^st January 2001) infringed the freedom of establishment under the EC Treaty and could not be justified. ¹² It is worth noting that under Articles 4 and 5 of the EU Interest/Royalty Directive an interest payment may be re-characterized as a dividend payment in cases where there is abuse or fraud or the like. The issue would then be whether thin capitalization rules constitute an anti-avoidance measure and this would very much depend on the facts of each case.

Cypriot holding companies are liable to the 10% special defence contribution tax on interest income from any source, whether in Cyprus or abroad. The deduction is made at source if received from Cyprus, otherwise by assessment on the basis of returns.

However, the special defence contribution tax does not apply to interest earned by a company in the ordinary course of its business or to interest closely related to that ordinary carrying on of the business, both of which are subject to income tax with no exemption available.

Any interest received by a Cypriot holding company which is deemed not to be from or closely related to its ordinary business activities will be subject to 10% income tax on 50% of the interest received and to a special defence contribution tax at 10% on the whole amount of the interest received, thus giving an effective total tax burden of 15%.

According to the Income Tax Office Circular 003-8, interest earned in the ordinary course of business includes banking and finance, hire-purchase and leasing. Interest closely related to the ordinary course of business includes:

• Interest received from trade debtors by companies engaged in the trading and/or development of land, and by traders of new or old cars or of any other vehicles or machines;
• Interest earned by insurance companies;
• Interest earned by banks on current accounts; and
• Interest earned by a company acting as a vehicle to finance other group companies.

Interest earned from loans by a company to third parties and interest from savings and deposits are taxed under the special defence contribution provisions, unless these fall within one of the above categories.

Considering the absence of explicit thin capitalisation rules (see above) and the tax treatment of interest, it should be noted that a Cypriot holding company can be financed primarily by debt to capitalize foreign subsidiaries by way of loans rather than equity capital. This entails the following advantages:

• There is less likelihood that the external borrowings can be challenged under thin capitalization rules;
• Cyprus’ extensive network of double taxation treaties either protects interest receipts entirely from, or at least substantially limits, any exposure to withholding taxes applicable in the country of source; and
• There is no withholding tax on interest payable to non-Cypriot tax residents.

The Income Tax Law provides relief from double taxation in relation to income tax and any tax of a similar character imposed by the laws of another country. The Law distinguishes between situations where there is a double taxation treaty in force between Cyprus and another country and where there is not. All the Cypriot double taxation treaties provide relief from double taxation by applying the credit method regarding the taxation of dividends and interest. It should of course be noted that EU Law prevails over tax treaties which cannot be used to justify its violation. ¹³

The relief is provided by allowing tax payable in respect of any income in the other treaty country as a credit against tax payable in Cyprus in respect of that income; the tax charge will be reduced by the amount of the credit. The Special Contribution for the Defence of the Republic Law (which, as mentioned above, imposes the payment of a special defence contribution on dividends, interest and rents) specifically states that the provisions relating to the application of double taxation treaties and the granting of credits will also apply to any contribution payable under it.

As a practical example, the following tax situation will arise when dividends from a Russian subsidiary are paid to a Cypriot holding company. Dividend income from the Russian subsidiary is neither subject to Cypriot income tax nor to the special defence contribution, provided that the Cypriot holding company receiving the dividend owns at least 1% of its Russian subsidiary. However, the exemption from the special defence contribution will not be granted if the CFC provisions apply, i.e. if more than 50% of the paying subsidiary’s activities result in investment income and the foreign tax burden is significantly lower than the tax payable in Cyprus.

As the Russian corporation tax rate is not lower than the Cypriot one, the CFC provisions will not be triggered. Assuming, however, that the dividend income of the Cypriot holding company from its Russian subsidiary does not constitute exempt income but is subject to the 15% special defence contribution in Cyprus (e.g. if the holding in the Russian company is less than 1%), then any withholding tax suffered abroad would be credited against the special defence contribution. In accordance with the double taxation treaty between Russia and Cyprus, the credit would take into account both the Russian withholding tax and the underlying tax (i.e. the Russian corporation tax on the profits out of which the dividend is paid).

This should mean, therefore, that all dividend income received from Russia is unlikely to suffer any tax in Cyprus. The only tax suffered would be the Russian 5% withholding tax on dividends, provided that the capital investment in the Russian company is more than US$100,000, or 10% in all other cases pursuant to the terms of the Russia/Cyprus double tax treaty. Assuming that the shareholders of the Cypriot holding company are non-residents of Cyprus, then the total tax on dividends distributed from Russia via the Cypriot company to the ultimate shareholder would be a mere 5%, as dividends payable by a Cypriot-resident company to a foreign shareholder (company or individual) do not attract any withholding taxes in Cyprus.

The EU Parent/Subsidiary Directive (with its recent amendments) was transposed into Cypriot law in the form of the Income Tax Law and the Special Contribution for the Defence of the Republic Law. These laws establish a liberal system of double taxation avoidance. Moreover, as already mentioned above, the application of the new tax régime extends to non-EU countries, as the tax laws provide merely for a distinction between residents and non-residents of Cyprus.

With respect to the taxation of dividends, the domestic tax laws are even more liberal than the Directive. Exemption of foreign dividends is available when a Cypriot resident company holds at least 1% of the share capital of a foreign subsidiary. For holdings below this threshold there is usually relief from double taxation in the form of a foreign tax credit to be claimed under the double taxation treaties. Where no treaty exists, relief may be granted unilaterally at the discretion of the Commissioner of Inland Revenue .

As regards the holding period, the Cypriot legislation does not mention a minimum requirement either for domestic or foreign subsidiaries. In this connection, the second derogation of the Directive allows a Member State not to apply the Directive to companies of that Member State that do not maintain for an uninterrupted period of at least two years a holding qualifying them as parent companies or to those of their companies in which a company of another Member State does not maintain such a holding for an uninterrupted period of at least two years. It seems that Cyprus has not exercised this opportunity to restrict the applicability of the Directive in relation either to dividends received from companies of other Member States or to dividends paid to overseas companies. However, the derogation may impact on Cypriot companies holding an interest in the share capital of a company in another Member State; there can be a pitfall in the event that the other Member State then exercises the restriction and forces the two year qualifying period requirement to be satisfied before applying the Directive.

Article 3 (1) of the Directive provides that the status of a parent company shall be attributed to any company in a Member State which is holding a minimum of 25% of the capital of a company in another Member State. This means, in our opinion, that the Directive gives a discretionary power to the Member States to choose an even lower threshold than 25%. Once a State has opted to do so, e.g. Cyprus which has introduced a 1% threshold, it will be bound by it and may not contravene it by introducing CFC legislation.

As mentioned above, the Cypriot anti-avoidance rules concern holdings where the controlled foreign company is predominantly earning passive income. In this respect there is a likelihood that after 1 May 2004 the Directive may negate the Cypriot CFC provisions. The Directive generally prohibits the taxation of dividends from direct investment. Therefore, if a CFC distribution qualifies as a distribution under the Directive, the Directive generally hinders the taxation of CFC income in a direct investment relationship. As the CFC regimes are especially designed to deal with controlled foreign companies, in many cases a direct investment relationship does indeed exist. ¹⁴

Article 1(2) of the Directive expressly states that it ‘shall not preclude the application of domestic or agreement-based provisions required for the prevention of fraud or abuse’.

The benefits of the Directive will not be granted in circumstances of tax avoidance through Directive shopping. There is a view that if an intermediary entity is used solely for the purposes of enjoying Directive benefits which the taxpayer would not enjoy in the absence of such an arrangement, and there is no valid commercial reason for the interposing of the entity, Directive benefits may be denied. ¹⁵

It is also widely thought that the anti-abuse clause of Article 1(2) has no existence of its own and that therefore governments may not use this provision alone to justify further control of foreign operations (such as CFC rules). ¹⁶ Any refusal to grant a favourable tax regime must be supported by a specific proviso within the Directive, following the ruling of the ECJ in the Denkavit case¹⁷. Therefore the requirement by many Member States that the subsidiary’s state must have a normal tax level may be lacking a legal basis¹⁸.

In the light of ECJ decisions on the interpretation of the anti-abuse provisions of the Directive, it could arguably be stated that a narrow interpretation is required (Denkavit case), the principle of proportionality must be applied (Futura/Singer¹⁹ and Leur-Bloem²⁰ cases), and there is a strict prohibition of general presumptions (Leur-Bloem case). ²¹

It should be mentioned that Cyprus did not have the initial intention to introduce any CFC legislation while drafting its tax reform, but was called upon to do so by the European Commission during the accession talks.

The Cyprus tax reform has introduced, in Part VI of the Income Tax Law, extensive rules on company reorganizations, which follow the EC Merger Directive Rules strictly.

No taxation consequences, either of an income or capital nature, will arise for a Cypriot holding company in a reorganization. The absence of any taxation liability flows from a combination of the recent Capital Gains Tax (Amendment) Law and the current reorganisation rules applicable to mergers, division and transfer of assets and exchange of shares.

The Merger Directive contains a general anti-avoidance clause by virtue of which any Member State may decline to apply the relief under the Directive where any transaction has as one of its principal objectives tax evasion or tax avoidance. For some reason this clause of the Directive has not been transposed into Cypriot law but the domestic general anti-avoidance provisions²² will be applicable in the absence of any specific provision in the law.

In order to obtain exempt treatment for the reorganization, the Commissioner of Inland Revenue will have to certify that the merger or other type of reorganization as provided in the law is made under the scope of the reorganization rules. In this respect general anti-avoidance provisions (‘substance over form’) may be triggered and the business purpose doctrine may be applied by the Inland Revenue to disallow purported corporate reorganizations where the principal or sole motive is to avoid Cypriot taxes. However, no single test has been clearly articulated in this regard. As one would expect, the focus will be on transactions that fit structurally within the scope of tax-free reorganizations but have no independent business significance and valid commercial reasons. The ECJ decision in the Leur-Bloem case contains a number of statements made by the ECJ on the interpretation of the anti-abuse clause of the Merger Directive in general and may, therefore, also affect the application of the Parent/Subsidiary Directive in practice. It could arguably be concluded from the Leur-Bloem decision that neither of the two Directives permits an automatic exclusion of certain companies and transactions on the basis of predetermined presumptions of the implementation laws of the Member States. ²³ The ECJ stated in this case that certain tax advantages provided by the Merger Directive apply irrespective of the reasons, whether financial, economic or simply fiscal, for those operations. Furthermore the ECJ held that ‘the fact that those operations were not carried out for valid commercial reasons constitutes a presumption of tax evasion or tax avoidance. However, in order to determine whether the planned operation has such an objective, the competent national authorities cannot confine themselves to applying predetermined general criteria but must subject each particular case to a general examination’. ²⁴

The growing opposition from the EU and the OECD to international tax evasion raises questions about the future of holding company regimes. Both the 1997 EU Code of Conduct on harmful tax competition among EU Member States and the 1998 OECD Report "Harmful Tax Competition: As Emerging Global Issue" focus on tax evasion in international situations. Since then the focus of the EU and OECD campaigns has shifted towards transparency and exchange of information, so that what has become harmful is lack of transparency and willingness to exchange information. ²⁵

The EU has not decided whether the holding company regimes are acceptable or not. ²⁶ As most EU countries and many of the OECD non-EU countries have introduced holding company regimes it is becoming harder to say that these regimes might be unacceptable. For example, participation exemptions are now so widely available that it is hard to see those as being harmful regimes in any way. The exemption method is so widely practiced that it is also unlikely that it would ever be regarded as harmful and absence of tax on capital gains can be perceived as part of the general tax system. ²⁷

Within the EU tax environment, ECJ compatibility should also be considered, in view of the ECJ’s efforts to bring the tax legislation of EU Member States in line with the freedoms of the EC Treaty. This is viewed by Member States as an interference with their right to enact tax legislation autonomously.

As far as the Cypriot holding company regime is concerned, the key factors, i.e. effective exchange of information and transparency are clearly present and the regime cannot be faulted in this respect. The Assessment and Collection of Taxes Law has been amended to implement the EU Mutual Assistance Directive which will lead to extensive cooperation in respect of exchange of information and enforcement of taxation. The European Commission in its latest report on Cyprus accession²⁸ stated that on administrative cooperation and mutual assistance Cyprus was taking the necessary steps to transpose the acquis communautaire and to implement it by the time of accession.

A main criterion of harmfulness for the EU Code of Conduct and an ancillary factor for the OECD Report is the departure from generally accepted international principles in the determination of profits derived from the internal activities of a multinational group. In relation to internationally accepted principles, the text refers in particular to the Transfer Pricing Guidelines which determine arm’s length terms of business between related entities. ²⁹ This principle is enshrined in Article 9 of the OECD Model Tax Treaty. Section 33 of the Income Tax Law transposes the basic rules into Cypriot law and the same transfer pricing rules as operate in most EU Member States will apply in Cyprus.

Finally, it can be argued that the Cypriot holding company regime is based on the EU Parent/Subsidiary Directive and therefore cannot give rise to harmful tax competition.

In the case of an international structure that includes non-EU companies, tax evasion will be negated by the general anti-sham and avoidance rules maintained in the Cypriot legislation and the CFC provisions.

It is puzzling that harmful tax competition is now subject to closer scrutiny than ever before, while at the same time tax incentives for holding companies proliferate everywhere at a rapid pace. The question remains unanswered, whether the status quo will be challenged or tax competition should be allowed to develop. Although uncertainty prevails, one thing is definite – exchange of information and transparency are the key elements of a non-harmful tax regime. Cyprus, in joining the European Union, has recognized the crucial importance of these elements and the Cypriot legislators having transposed them into the new tax legislation have strengthened Cyprus’ ability to act as an attractive holding company platform.

The global tax environment is changing and one might imagine that, in the light of the recent enlargement of the European Union to 25 Member States, there will be a European Union with different speeds of tax reform, dependent on each individual state.³⁰ Given the above, it is very desirable that, in the absence of domestic judicial interpretation, the Cypriot tax authorities should facilitate the implementation of the new tax rules by adequate regulations and guidance which should be in full compliance with international tax principles. In this respect, to be in line with the principles set out by the OECD and the EU, the advanced ruling practice should be developed in Cyprus as much as it can be so that the Cypriot Inland Revenue will give binding advance decisions to taxpayers on the tax consequences of proposed transactions. Consistency with international tax principles will definitely enhance the legal certainty and uniformity of the Cypriot tax reform.

In its effort to harmonize the national laws of Cyprus with the EU acquis communautaire, the legislature has revised the tax system to create a unique environment for holding companies. Whilst the Cypriot legislature has followed in the footsteps of many EU countries, it has also made the advantages available to non-EU residents, thus securing Cyprus’ attractiveness to international businesses.