Introduction

In today’s globalized business environment, building sufficient economic substance has become essential, especially for companies operating across borders. Cyprus, recognized for its strategic tax advantages such as a competitive corporate tax rate of 12.5% ​​(which can be reduced to 2.5% under IP Box Regime) and an extensive network of double tax treaties, requires compliance of economic substance for Cypriot Companies. These standards ensure that companies are not just registered in Cyprus for tax benefits, but have a real operational presence and activities within the jurisdiction.

What is Economic Substance?

Economic substance is a general principle in international tax law that in order for a company to be considered tax resident and therefore taxed in a jurisdiction, it should have a real and substantial presence in that jurisdiction. This entails proving that the company is conducting legitimate business activities, has decision-making authority and maintains an operational infrastructure within the jurisdiction. This principle, reinforced by the Organisation for Economic Co-operation and Development (OECD) Base Erosion and Profit Shifting (BEPS) Actions, particularly Action 5, aims to align tax outcomes with real economic activity.

Why is Economic Substance Important in Cyprus?

The establishment by a Cypriot Company of economic substance in Cyprus is required for said company to be taxed in Cyprus, and serves several purposes, among which:

• Securing Tax Residency: In order for companies to benefit from Cyprus tax incentives such as low corporate tax, double taxation treaties and EU Directives and Regulations, Companies must prove that their tax residence is in Cyprus. The proof that a Company has its tax residence in Cyprus is achieved through the proof that it has a economic presence in that jurisdiction.
• Compliance with EU and OECD Standards: Meeting the economic substance requirements in a jurisdiction ensures compliance with the EU Anti-Tax Avoidance Directive (ATAD) and OECD guidelines, protecting against reputational damage and penalties.
• Access to Banking Services: Banks are increasingly demanding from companies proof of economic substance before opening accounts or carrying out significant financial transactions.

Consequences of Not Meeting Economic Substance Requirements

The failure of a Cyprus Company to establish and maintain sufficient economic substance in Cyprus can lead to significant negative consequences, including:

• Loss of tax residence status in Cyprus: Companies that cannot demonstrate that they have economic substance in Cyprus (ie effective management and control in Cyprus) are at risk of losing their tax residence status in Cyprus. This could result in foreign tax authorities claiming tax jurisdiction over the company, leading to increased tax liabilities.
• Sanctions and Fines: Non-compliance with the requirements of existence of economic substance may attract sanctions to the Cyprus Company both from regulatory bodies in Cyprus and internationally. These fines can be significant and adversely affect the financial health of the company.
• Reputational Damage: Cypriot Companies that do not comply with economic substance requirements may face reputational risks, affecting their relationships with customers, partners and stakeholders. This may stand in the way of the Company’s business opportunities and growth.
• Banking Restrictions: • Banking restrictions: Without sufficient economic substance, companies may find it difficult to open or maintain corporate bank accounts with one of the local banks in Cyprus or other jurisdictions. Banks may refuse service or even terminate existing accounts for non-compliance with economic substance requirements.
• Increased tax scrutiny: Cyprus Companies that lack economic substance may be subject to increased scrutiny by tax authorities, leading to potential disputes, reassessments and protracted legal battles.

Key Elements of Economic Substance

Every Cypriot Company in order to be able to prove and maintain its economic substance in Cyprus (and therefore to be considered as a tax resident of Cyprus) should comply with some necessary elements, among which:

Physical Presence and Office Space

• Office Establishment: The company must have its registered office in Cyprus which will be dedicated to its activities. This should be a functional space equipped with the necessary business infrastructure.
• Local Employment: Employing staff registered with the Cypriot social insurance system solidifies the company’s integration into the local economy.

Management and Control

• Local Directors: Appointing a qualified director who is a tax resident in Cyprus and actively participates in the company’s decision-making process is crucial.
• Board of Directors Meetings: Regular board meetings should be held in Cyprus, with key strategic decisions taken during these meetings. Documentation such as minutes and Resolutions should reflect that significant management takes place within Cyprus.
• Record Maintenance: Important documents, including minutes, decisions, agreements and corporate records, should be archived at the Company’s registered office in Cyprus.

Administrative Functions

• Dedicated Communication Channels: Special communication channels: The Cyprus Company should maintain local contact details, including a telephone line, an email domain and a website registered at its address in Cyprus.
• Operational Activities: Business operations should be conducted in Cyprus, with local personnel involved in day-to-day activities.

Financial and Compliance Operations

• Bank Accounts: Opening a corporate bank account in one of the banks in Cyprus and with local signatories is a key indicator of economic substance.
• Accounting and Auditing: Bookkeeping, invoicing, and payroll should be managed in Cyprus, with financial statements prepared according to International Financial Reporting Standards (IFRS). Annual audits must be performed by a local auditor.

Practical Steps for Establishing Economic Substance in Cyprus

To ensure compliance and enhance the company’s credibility, the following measures are recommended:

• Office Space: Secure a dedicated office for business operations.
• Appoint Local Directors: Directors should be qualified tax residents of Cyprus, capable of making autonomous decisions.
• Hold Board of Directors Meetings Locally: Ensure that key decisions for the operation of the Company are made in Cyprus and are properly documented.
• Employ Local Staff: Register employees with social insurance and maintain payroll records.
• Open a Local Bank Account: Use this account for company operations, with transactions initiated from Cyprus.
• Maintain Comprehensive Records: Store essential minutes, resolutions and corporate documents at the Company’s registered office in Cyprus.
• Comply with Reporting Standards: Prepare and audit financial statements in Cyprus.

How Our Firm Can Assist

At Polycarpos Philippou & Associates LLC, we offer a comprehensive suite of services to ensure your Cypriot Company meets the economic substance requirements effectively and efficiently:

• Legal Advisory: Our experienced team provides thorough guidance on navigating and complying with Cyprus and EU regulations.
• Company Incorporation: We handle the full incorporation process, ensuring all necessary legal and administrative steps are completed seamlessly.
• Office Solutions: We assist with securing suitable office space.
• Director and Personnel Services: We provide qualified tax resident directors who actively engage in the company’s strategic management. We also support the recruitment and employment of local staff, preparing employment contracts, registering with social insurance, and managing payroll.
• Board of Directors Meeting: Our Law Firm arranges, documents, and oversees Board of Directors meetings held in Cyprus, ensuring that minutes and resolutions are meticulously recorded to demonstrate local decision-making.
• Document and Record Keeping: We manage and archive essential minutes, resolutions and corporate documents, ensuring all records are securely stored and accessible at the Company’s registered office in Cyprus.
• Accounting and Financial Services: Through our in-house accounting experts, we provide comprehensive bookkeeping, preparation of financial statements in line with IFRS, and coordination of audit processes by qualified Cypriot auditors.
• Banking Support: We facilitate the opening and administration of local corporate bank accounts, assisting with compliance and ensuring smooth banking operations.
• Continuous Compliance Monitoring: Our team offers ongoing support to help your company maintain its substance, stay updated with regulatory changes, and meet all post-incorporation requirements.

Conclusion

The establishment and maintenance of economic substance in Cyprus is no longer optional, but a necessity for Cypriot Companies that wish to be considered tax residents of Cyprus and benefit from the tax privileges offered by Cyprus. By meeting the necessary standards, businesses not only protect their Cyprus tax status but also enhance their credibility and operational integrity. Our Law Firm, with extensive experience and knowledge in the registration and operation of Cyprus Companies, is here to provide comprehensive assistance to help you navigate this key aspect of corporate governance, ensuring that your business complies with all legal and practical substance requirements.

For advice and personalized support, contact us at Polycarpos Philippou & Associates LLC, where we turn compliance into strategic advantage.