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The Need for Substance

The Need for Substance

Establishing and maintaining adequate substance in Cyprus, is considered an important aspect in order to minimize the risk of denial of double tax treaties and of potential challenges from foreign tax authorities who might seeking to question a company's tax residency status and try to tax it locally. In view of the above, we set out some practical recommendations of several measures and actions to be implemented in order to ensure that sufficient substance is maintained.

Practical steps to enhance substance

In practice, the creation of substance in Cyprus would primarily require, amongst others:

  • acquisition or renting of office premises located in Cyprus, from where a company will or be deemed to carry out its activities;
  • employment of person(s) who shall be working out of the company’s office premises in Cyprus and who will possess the necessary characteristics and qualifications to perform the necessary tasks;
  • account for social insurance and other mandatory deductions of such employed person(s) in Cyprus;
  • the setting up of a functional telephone line and utilities (electricity, water, internet etc) in the name of the company, and showing use thereof depending on the size of the company’s staff;
  • appoint persons to the board who shall be tax residents in Cyprus (if not all of them, at least the majority shall be local tax residents) and who must help and assist towards to the running of the business, taking part of the decision making process and of course deciding on independent management decisions (and strategic matters) in Cyprus; and
  • maintain proper and accurate corporate records and books in Cyprus.

The test

As noted, a company is regarded to be a “tax resident” in Cyprus if it is effectively managed and controlled from Cyprus. The terms “management and control” are not defined under applicable tax law; however, in determining the same, Cyprus tax authorities commonly looked in the previous years, for guidance at, inter alia, the following factors: 

  • whether the majority of the board of directors of the company are Cyprus tax residents;
  • whether board meetings of the company are held and important strategic decisions are taken in Cyprus; and
  • whether Cyprus is the place where the discussion and approval of the financial statements takes place, and other antecedent matters such as employment of local employees, etc.

Challenges and risks

It must be noted that the possibility to eliminate all associated risks for a potential challenge of a company’s tax residency by any foreign authority, does not exist. The abovementioned non-exhaustive steps are recommended to be in place in order to be well-equipped and have strong grounds to defend (if such need arises) successfully any potential challenges in future. It is worth noting that such challenges are evidenced more frequently in the recent years, as a result of systematic effort, on an EU level, to minimise tax evasion, tax avoidance and aggressive tax planning.

Furthermore, and in order to highlight the importance, the European Commission announced on 22/12/2021 the intention of issuing a new directive to fight against the misuse with regards to tax purposes of “shell entities”. As per the proposal, the companies that are presumed to be “shell companies”, would not be able to access tax relief and the benefits of the tax treaty network of its Member State and/or to qualify for the treatment under the Parent-Subsidiary Directive and Interest and Royalties Directive. Based on the proposal, it is expected that minimum substance for tax purposes will be introduced for EU companies in terms of income, staff and premises in order to be able to claim the tax benefits/tax reliefs derived from the tax treaty network and the EU Directive. The Directive is expected to come into force in January 2024.

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