In our interconnected global economy, tax transparency and the fight against tax avoidance are top priorities for tax authorities worldwide. Cyprus, as a member state of the European Union with a favorable tax regime, has adopted Controlled Foreign Company (CFC) rules in compliance with Council Directive (EU) 2016/1164, known as the Anti-Tax Avoidance Directive (ATAD). These rules came into force on January 1, 2019, in an attempt to prevent the shifting of profits to low-tax jurisdictions through foreign subsidiaries.
The introduction of CFC legislation marks a significant shift in the international tax landscape, encouraging substance-based structuring and discouraging artificial arrangements lacking genuine economic activity. For companies based in Cyprus that operate internationally, the CFC rules require a proactive and well-documented approach to tax planning. It’s essential to grasp their scope, limitations, and potential effects to ensure full compliance and steer clear of any unexpected tax liabilities.
Understanding Controlled Foreign Corporation (CFC) Rules
CFC rules aim to stop companies from shifting profits to low-tax countries by linking the income of foreign subsidiaries back to their parent companies in their home country. In Cyprus, these rules apply to Cyprus tax-resident companies and non-Cyprus tax-resident companies with a permanent establishment in Cyprus. The main goal is to discourage the artificial movement of income to entities located in places with lower or no taxes.
Legislative Framework in Cyprus
The CFC rules in Cyprus were incorporated into national law through Article 36A of the Income Tax Law of 2002 (Law 118(I)/2002). This article introduces provisions for Controlled Foreign Companies, explaining the circumstances in which the income from foreign entities can be counted as part of the taxable income for a company that’s a tax resident in Cyprus. The full text of Article 36A is available on the Cyprus Legal Information System (CYLAW) website.
Definition of a Controlled Foreign Company (CFC)
According to Article 36A, a foreign entity will be classified as a Controlled Foreign Company when the following conditions are met:
- Control Threshold: The Cyprus tax-resident company, either on its own or in conjunction with associated enterprises, holds more than 50% of the voting rights, capital, or profit rights of the foreign entity, whether directly or indirectly.
- Low Taxation: The foreign entity or its permanent establishment pays less than 50% of the corporate tax that would be due in Cyprus under similar conditions. Since Cyprus has a corporate tax rate of 12.5%, this means the foreign tax rate must be below 6.25%.
Inclusion of CFC Income
Where an entity qualifies as a CFC, the Cyprus tax-resident company has to bring into its taxable base the …non-distributed income of the CFC resulting from non-genuine arrangements that have been put in place for the essential purpose of obtaining a tax advantage.. Non-distributed income refers to the accounting profits after taxation of the CFC not distributed among the controlling Cyprus company within the same tax year in which they were earned or within seven months thereafter.
Non-Genuine Arrangements
An arrangement is deemed non-genuine if the Controlled Foreign Corporation (CFC) wouldn’t have obtained the assets or taken on the risks that lead to its income without being under the control of a company that resides in Cyprus for tax purposes. This evaluation zeroes in on the key functions carried out by the controlling company, which are essential for producing the CFC’s income. In practice, the Cyprus Tax Department applies a functional analysis approach, in accordance with the OECD Transfer Pricing Guidelines, to determine whether the income-generating activities can be attributed to the controlling Cyprus-resident entity.
Exemptions from CFC Rules
Article 36A outlines certain exemptions from the application of CFC rules:
- De Minimis Exception: This applies when the CFC’s accounting profits are below €750,000 and its non-trading income is under €75,000.
- Low Profit Margin: This applies when the CFC’s accounting profits are less than 10% of its operating expenses for the tax period.
Avoidance of Double Taxation
In order to mitigate the risk of double taxation, the Cypriot law gives relief by way of credit against Cyprus corporation tax for certain taxes paid abroad on the CFC income. Double taxation avoidance provisions are also provided in case the income hitherto subject to the CFC provisions is subsequently distributed or realized through the disposal of the investment.
Practical Implications and Compliance Strategies
Cyprus companies with foreign subsidiaries must conduct thorough reviews of their structures to ensure compliance with CFC rules. Key considerations include:
- Substance Evaluation: Assessing the tax residency and economic substance of foreign subsidiaries to substantiate genuine business operations. This involves ensuring that the foreign entity has adequate physical presence, personnel, and activities in its jurisdiction of residence. The assessment of economic substance should be based on the identification of Significant People Functions (SPFs) or Key Decision-Making Functions, in line with the OECD Transfer Pricing Guidelines.
- Control Analysis: Evaluating the level of control and participation in foreign entities to determine potential CFC classification. Understanding the ownership structure and rights to profits is crucial in this assessment.
- Tax Treatment Review: Analyzing the tax treatment of subsidiaries’ income in their respective jurisdictions to identify low-tax scenarios. This includes reviewing the effective tax rates and any preferential tax regimes applicable to the foreign entity.
Failure to comply with CFC regulations can result in significant tax liabilities and penalties. Therefore, it is imperative for Cyprus-resident companies to maintain robust documentation and seek professional advice to navigate the complexities of these regulations effectively.
Impact on International Tax Planning
The introduction of CFC rules in Cyprus has significant implications for international tax planning. Companies can no longer rely solely on low-tax jurisdictions to minimize their tax liabilities without considering the substance and control aspects of their foreign subsidiaries. This shift necessitates a reevaluation of existing structures and the development of strategies that align with the new regulatory environment.
Conclusion
At Polycarpos Philippou & Associates LLC, we understand the increasing complexity of international tax law and the critical importance of compliance with CFC regulations. Our experienced legal and tax advisors are well-positioned to assist Cyprus-resident companies in navigating the challenges posed by the CFC regime.
We offer strategic, tailored advice to ensure that your structures are not only compliant with current legislation but also aligned with your broader commercial objectives. For a consultation on how the CFC rules may affect your business, please contact our team.
