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Tax treatment of related party financing transactions – Guidance issued by Cyprus Tax Authorities
As we have reported before the fixed profit spreads applied on related party financing transactions adopted by the Cyprus Tax Authorities were set to be abolished on 1 July 2017. On 30 June 2017 the Cyprus Tax Authorities issued a Circular in relation to the new rules to apply on this area from 1 July 2017 onwards.
The methodology to be applied is the one of Transfer Pricing, which is to be applied based on the arm’s length principle, in accordance with the relevant provisions of the OECD Base Erosion and Profit Shifting (BEPS) project.
The main provisions of the Circular are as follows.
The Circular applies to loans granted by a company (“financing company”) to related parties, financed by financial means and instruments, such as private loans, cash advances, bank loans and debentures.
Two companies are considered to be related if they fall within the scope of Section 33 of the Income Tax Law.
- Transfer pricing requirements
The remuneration of a financing company will need to be determined based on the transfer pricing principle. This would entailthe identification of each commercial and financial relationship with related parties (“controlled transactions”) and determining the economically significant conditions and circumstances relating to such transactions. This means that an assessment needs to be made on whether each intragroup financing transaction corresponds to the price which would have been accepted by independent entities in comparable circumstances, taking into account the economic nature of the transaction. It should be stressed that it is the actual conduct of the parties, which should be taken into account if this differs from what was contractually agreed.
As mentioned above the relevant provisions in Cyprus tax legislation are those included in Section 33 of the Income Tax Law. This section provides for the adjustment of reported profits in case the transfer prices differ from prices that would have been agreed between independent entities.
- Functional Analysis
An analysis is required of the functions performed, the assets used as well as the risks borne by the financing company. An underlying principle of the risk analysis is that a financing company bearing risks must have the financial capacity to manage those risks and to face the financial consequences if the risks assumed actually materialize. To this respect, the financing company is required to determine, using relevant methodology, the appropriate level of equity that would be needed to assume the risks.
As an example, where the financing company is comparable to entities subject to the EU regulation on prudential requirements for credit institutions and investment firms, and it has an equity level that complies with the solvency criteria laid out in this regulation, it is deemed to have a sufficient level of equity to bear the financial consequences of its risks.
The following functions can be associated with companies conducting intra-group financing transactions:
(a) Origination of the transaction including the following:
(i) commercialization of a transaction;
(iii) identification of the refinancing structure related to the financing activity;
(iv) evaluation of compliance with contractual commitments prior to the final closing.
(b) Managing the transaction, such as:
(i) managing the financing transaction;
(ii) credit risk monitoring;
(iii) managing the financing of the transaction.
- Comparability Analysis
Furthermore, an appropriate comparability analysis must be carried out in order to determine whether the remuneration resulting from the transactions between the related parties is comparable to the one on transactions between independent parties under similar circumstances on the open market.
The comparability analysis includes the identification of comparable transactions in a transparent, systematic and verifiable manner using appropriate sources of information.
Following the same example cited above, the Circular states that that in the case of financing companies performing functions similar to those of regulated companies, a return on equity of 10% after-tax can be observed in the market and can be considered as reflecting an arm’s length remuneration at the time of publication of the Circular. This percentage will be regularly reviewed by the Tax Department based on relevant market analyses.
The Circular provides that financing companies must have an actual presence in Cyprus, including members of the board of Directors who are Cyprus tax residents, the number of meetings of the Directors as well as the shareholders in Cyprus and also the existence of qualified personnel to control the risks and transactions entered into. A financing company is considered to control the risk if it has the decision making power to enter into a risk-bearing commercial relationship, if it has the ability to address such risks, and it actually performs such decision-making functions.
The daily activities of risk mitigation may be outsourced as long as the company has the capability to take, and does take in practice, the key decisions with respect to the outsourcing.
Transactions that cannot be observed on the open market and are devoid of any commercial rationale must be disregarded to ensure full compliance with the arm’s length principle.
- Simplified Approach
A financing company meeting the substance requirements mentioned above and engaging in purely intermediary intra-group financing activities will be deemed to comply with the arm’s length principle if it receives a minimum return of 2% after-tax on assets. This percentage mentioned above will be regularly reviewed by the Tax Department based on relevant market analyses.
Thus, an entity which fits the profile mentioned above and does not intend to prepare a transfer pricing study for the relevant operations can opt instead for this minimum return on assets approach.
Corporation Tax Returns will be amended to include a relevant field to be filled in by such entities who will choose to apply this simplification measure.
Deviation from the minimum return is permitted only in exceptional cases, where it is duly justified by an appropriate transfer pricing analysis.
The simplified approach cannot be used to determine an arm’s length remuneration for intra-group financing transactions different from those covered by the relevant Circular.
- Minimum Requirements
The Circular provides for some minimum requirements for a transfer pricing analysis, which include, among other, the following:
- a description of the computation of equity allocation required to assume the risks,
- a list of the searched potentially comparable transactions,
- a rejection matrix for rejected potentially comparable transactions with justifications,
- the final list of comparable transactions which have been selected and used to determine the arm’s length price applied to the intra-group transactions accurately delineated,
- a general description of market conditions,
- a list of all previous agreements on transfer pricing concluded with other countries in relation to the transactions in question,
- a list of all the previous agreements concluded with entities under analysis which are still in effect at the time of the submission of the request,
- a projection of the income statements for the years covered by the request.
It is expected that the transfer pricing analysis will be submitted by persons entitled to act as auditors of a company in Cyprus in order to carry out an assurance control of the transfer pricing analysis.
- Exchange of Information
The issuance of tax rulings related to intra-group finance arrangements or Advanced Pricing Arrangements, as well as the use by a taxpayer of the simplified approach, will be subject to the exchange of information rules set under the Directive on Administrative Cooperation.
- Entry into force
The Circular applies from the 1st of July 2017, for all existing and future transactions. Any rulings issued prior to this date will no longer be valid for periods from 1st of July 2017 onwards.
If the intra-group financing transactions had been supported by a Transfer Pricing study and are still ongoing after the above date, the study will need to comply with the provisions of the Circular.
- How we can assist
We are at your entire disposal to assist with makinga relate party financingassessment, formulating the way forward, arranging for Transfer Pricing studies, building-up and maintaining substance and in any other way needed.