Cyprus: Practical Application Of The New Cyprus Notional Interest Deduction

As reported in a July 2015 issue of Global Tax Weekly,¹ Law 116(I) of 2015 amending the Income Tax Law of 2002 introduced a notional interest deduction ("NID") on new equity capital (paid-up share capital and share premium) injected into companies and permanent establishments of foreign companies on or after January 1, 2015, for the purpose of financing business assets and operations.

The Fundamentals Of The NID

The NID is a deduction from taxable profit, calculated by applying a reference rate to the new equity. The reference rate is the higher of the ten-year government bond yield of Cyprus or the country in which the assets funded by the new equity are employed, with an uplift of three percentage points. The bond yield rates to be used are those applying on December 31 of the year preceding the year of assessment.

The NID is limited to 80 percent of the taxable profit before deducting the NID. No NID is available unless there is a taxable profit and unutilized NID cannot be carried forward to be offset against future years' profits.

The NID is a continuing deduction. It is available not only in the year the capital injection is made, but also for all subsequent tax years as long as the new capital remains in place.

New equity may be contributed in cash or in the form of other assets, in which case the amount of new equity will be the market value of the assets agreed with the tax authorities. No NID is available in respect of capitalization of reserves, revaluation of assets, or for companies benefiting from the reorganization exemptions included in the tax laws, and NID may be refused if the tax authorities deem that the transaction concerned has no economic or business purpose.

NID Rates For 2015 And 2016

Earlier this year the tax authorities announced the ten-year government bond rates at December 31, 2014, on which the NID for the 2015 tax year will be based, for Cyprus, Germany, India, Romania, and Russia. They subsequently announced the corresponding rates at December 31, 2015, on which the notional interest deduction on capital introduced in 2016 will be based, for these countries and for the Czech Republic, Latvia, Poland, Ukraine, and the United Arab Emirates. After applying the three percentage points uplift, the NID rates for capital introduced in 2015 range from 3.54 percent for Germany, to 16.73 percent for Russia. Including the uplift, the NID rate for capital used to finance assets in Cyprus (and in any country with a lower rate) is 8.037 percent.

With the tax return deadline for 2015 on the horizon, the tax department has issued a circular explaining how the provisions for NID are to be applied in practice. The guidance sets out the legal basis for the NID, explains the underlying concepts, definitions and basic principles of calculating NID, and their application in practice, and provides worked examples illustrating various hypothetical scenarios.

Sample Calculations

A simple example will help illustrate the principles. Assume that a new company is established on March 31, 2015, with an initial capital of EUR20m (USD22.3m), fully paid in cash. Its pre-tax profit for the nine months ended December 31, 2015, is EUR400,000, and for the year 2016 it is EUR2m.

For 2015, the maximum NID is nine-twelfths (because the capital was in place for only nine months of the year) of 8.037 percent (the NID rate for Cyprus) applied to the new capital of EUR20m, giving a result of EUR1,205,550. It is then necessary to consider whether the 80 percent ceiling on profits applies. As profits for the period are only EUR400,000, the NID is limited to 80 percent of this, namely EUR320,000, and the company's taxable profit is reduced to EUR80,000.

For 2016, there is no time-apportionment because the capital is in place throughout the year. The maximum NID is 6.685 percent (the Cyprus rate for 2016) of EUR20m, namely EUR1,337,000. This is less than 80 percent of the pre-tax profit, so there is no cap on NID. The unused NID from 2015 cannot be used to bring the NID up to 80 percent of pre-tax profit. NID is therefore EUR1,337,000, reducing taxable profit for the year to EUR663,000. Assuming that the company remains profitable, and the capital is not reduced, NID will continue to be available at the ruling rates for the years concerned.

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