In adapting to the shifts in global standards for company establishment and taxation policies, companies face greater regulations on the demonstration of economic substance in the EU. In other words, an EU-registered company must prove that its management, business activities, and executive functions are real and in the jurisdiction of registration and tax residency.
With increased international standards to what is considered economic substance for EU companies, Cyprus is a key location to establish tax residency and substance. Benefits of Cyprus company formation include a strategic location, stable legal system, EU membership status, competitively low corporate tax rate at 12.5%, as well as several other tax incentives for individuals and businesses alike. The growing industries of Cyprus alongside an educated, professional pool of talent in the workforce make the jurisdiction a friendly locale for businesses and its employees.
The Aspen Trust Group reviews the role of economic substance for EU companies, significant economic substance legislation to know about, and the top ways your company can be sure to pass economic substance tests in Cyprus.
How Economic Substance for EU Companies is Determined
The driving force behind the establishment of economic substance for EU companies began in December 2017 with the introduction of the Code of Conduct Group by the Council of the EU. Through this group, investigations are carried out on the tax policies of EU member states as well as third countries. As a result, an EU blacklist of 13 international financial centres (IFCs) was published that presented concerning components of economic substance requirements.
In June 2018, a scoping paper issued by the EU laid out the economic substance requirements that IFCs were required to implement by 2019 regarding the real economic activities of legal entities.
The Origins of Economic Substance
Utilizing the concepts of agreed business arrangements and tax planning, analysis and regulation criteria define the nature of corporate transactions. In an effort to distinguish the appropriate balance, businesses and their financial consultants must ensure that any operational activity, including transactions and international activities, must demonstrate true economic substance. The economic substance doctrine is a newer, and quickly developing, scope of legal framework.
One of the first countries to establish an economic substance doctrine was the United States. Created out of common-law standards, the U.S. has included its merits into tax law for more than 85 years. With the first notions of the law tracing back to Gregory v. Helvering, in which taxpayers had the right to minimize their tax exposure in contention with the governmental intention of tax benefits, the past few decades have been determining the extent that these rights may be applied.
From Gregory v. Helvering and several other American court cases, the U.S. introduced its economic substance doctrine in 2010. In short, the doctrine outlined guidelines for tax benefits of transactions as long as they demonstrate economic substance or business purpose. In recent years, as with the EU’s new directives, these terms have narrowed into more specified limits, such as business purposes extending beyond simply avoiding taxation.
Other international organizations have also taken measures to create better substance requirements in conjunction with the economic substance EU measures. Mandates have also come from the OECD such as the Base Erosion and Profit Shifting (BEPS) regulation. The EU’s policy framework as well as the principles of the OECD are the new guiding policies for all financial centers worldwide, as demonstrated in the OECD’s Forum on Harmful Tax Practices.
The BEPS tax planning strategies provide multinational enterprises with healthier practices for business and tax optimization despite gaps in tax rules between jurisdictions. The OECD estimates that nearly 100-240 billion USD is lost per country annually due to tax avoidance under these gaps.
Over 140 jurisdictions have joined together to work on the OECD/G20 Inclusive Framework on BEPS to implement 15 measures on tax avoidance through fairness and tax system integrity across borders. Significantly, membership into the BEPS initiative is comprised of 70% non-OECD and non-G20 countries across all global regions. Standard-setting at the international level for all jurisdictions, including developing countries that heavily rely on corporate income tax, is a key feature of the OECD’s economic substance and tax planning agenda moving forward.
Another central element of the BEPS Package is the annual report on the progress of the implementation of tax framework and BEPS Minimum Standards, including a peer review process that not only evaluates but generates recommendations for improvement. The peer-review process specifically monitors 4 of the 15 actions.
- Action 5 – Harmful tax practices: assessment of preferential tax regimes that accommodate base erosion and profit shifting; framework on transparency; and requirements on substantial activities for a level playing field
- Action 6 – Prevention of Tax Treaty Abuse: observing bilateral tax treaties so that they do not encourage abuse or “treaty-shopping” in which individuals may access benefits of a tax treaty without residency in one of the jurisdiction
- Action 13 – Country-by-Country Reporting: Ensuring quality data on corporate taxation is gathered for the purposes of authorities to determine transfer pricing and risk assessment; public consultation process (2020) to allow stakeholders input onto data collection
- Action 14 – Mutual Agreement Protocols: Improvements on timeliness and efficiency when reviewing and monitoring peers in the resolution of tax-related disputes, namely double taxation
Member jurisdictions have access to several tools core to the Inclusive Framework, including e-learning and training seminars, a consultancy with tax auditors for audit capacity building, toolkits specifically for low capacity countries, as well as induction and bilateral programmes for BEPS implementation.
Tests for Economic Substance
Economic substance in the EU is established through two tests – The Directed and Managed Test and The Core Income Generating Activities Test. These two tests check that business management is done within the jurisdiction of tax residency, including decision-making events and the inclusion of the minutes of meetings, and that income derived from the relevant business activities meet certain thresholds within the jurisdiction of tax residency as well.
An additional test, The Adequate Test, serves to remind companies that a physical presence and a reasonable number of in-jurisdiction employees to perform business operations are required to establish a true business presence in Cyprus.
New Directives and Cyprus Law
In April 2019, Cyprus law adopted the principles of the Anti-Tax Avoidance Directive (ATAD) under the recommendations of the OECD’s BEPS Action Plan and the Economic Substance EU Directive. The goal of ATAD is to guarantee that tax is paid when profits or values are generated. The law went into effect in January 2019 and comprised three major areas of measures:
- Controlled Foreign Company (CFC) rules: Under the new directives, international corporate entities are discouraged from shifting profits from high-tax jurisdictions to low-tax ones in an effort to avoid paying taxes. Both Cypriot tax resident and non-tax resident companies that have a permanent establishment in Cyprus must abide by the rules.
- Interest limitation rule: The rule restricts borrowing costs deductibles in the tax period that is more than 30% of earnings before interest, tax, depreciation, and amortization to prevent borrowing from companies in low-tax jurisdictions by high-tax jurisdiction companies.
- General anti-abuse rule: Significant for upholding the concept of economic substance for EU companies for tax-related process, Cyprus Income Tax Law may disregard any arrangement, or series of, if the expressed purpose it to garner a tax advantage that ignores applicable tax law purposes or cannot display adequate economic substance. Exit taxation and hybrid mismatch rules were provisions applied as of January 2020.
The latest Directive by the European Commission in December 2021 focuses on the misuse of shell entities in relation to tax avoidance. Known as ATAD 3, EU-based shell entities failing to meet a minimum economic substance of EU companies’ level would lose certain tax benefits. In effect, the initiative aims to produce a common minimum substance test for all EU member states to improve transparency and enhanced information exchange protocols.
Using “gateway” tests, an entity in the EU must pass three criteria or be reported to relevant tax authorities for economic substance analysis. The tests examine for:
- mobile or passive income that accounts for more than 75% of earnings
- cross-border activities that either demonstrate more than 60% of assets outside the member state or more than 60% of income earned or paid from cross-border transactions
- outsourcing of significant daily administration or decision-making functions
How Multinational Enterprises Can Test for Substance
An international structure can also work from within to organize an appropriate level of substance to not only meet the requirements of new economic substance requirements but also achieve tax optimization. One method to do this is to approach the organization of economic substance for EU companies by objective and subjective criteria.
First, objective economic substance deals with the level of economic activity and international corporate formation. Some valuable questions include:
- Is the staff of the entity its own and considered in-house?
- Are the staff and equipment located in the jurisdiction of registration?
- Is there an office space or headquarters in the jurisdiction of registration?
- To what extent are the costs of operation locally incurred?
- Do real business operations occur in the jurisdiction of registration?
- Does decision-making at both the upper management levels and the independent staff levels occur locally?
- How much of the daily operations occur through outsourcing or in other jurisdictions?
While there are few clear-cut international guidelines to the amount at which these questions must be positively answered, the EU is placing greater emphasis on establishing the majority of business operations and decision-making scenarios occurring in the registration and tax residency of the corporation. In essence, cementing that a business has a physical presence and real operational outputs in the country it claims for formation and tax residency.
On the other side is subjective economic substance, which refers to the activities of foreign corporate entities in relation to the legal frameworks of the jurisdictions it operates within. This may be one framework if the company is a domestic-only function or several frameworks if it operates cross-border. These can include IP protections and rights, holding structures, and international financial transactions.
When determining the correct level of economic substance for EU companies under the subjective criteria, the EU requirements under the new directives as well as the OECD’s BEPS progress must be met.
The Role of Headquartering for Legal Entities
Headquartering in the tax residency of Cyprus is the foundation for meeting economic substance EU criteria. Having a physical presence, with local or tax resident employees, and participating within the local business community are the key takeaways in the path towards passing the substance tests. In this article, we will cover more areas of business operations that stem from the headquarters of a business that are fundamental to establishing true economic substance and enjoying the benefits of Cyprus’s favorable tax regime.
Creating Economic Substance for EU Entities
There are seven areas of business activities that can affect the economic substance in company assessment. Focusing on and improving upon these vital operations can ensure that your company never has to worry about substance and related tax penalties.
Office Real Estate
One of the most important aspects of economic substance by EU standards is creating a formal office or headquarter in Cyprus. A P.O. Box puts the company at risk by skirting around an actual presence in the country. Purchasing and utilizing office real estate in the tax jurisdiction is an essential base step towards demonstrating real economic activity that occurs in Cyprus.
Once a real location is established, internal operations must be conducted to pass an economic substance test. Hiring locals or relocating foreign nationals who are part of the management team allows for transparency and proof of in-country activities, especially if these individuals qualify to be tax residents of Cyprus.
Decision-Making in Headquarters
Another important focus for companies should be the location of the decision-making process. Even if shareholders or management often go overseas, the company should take initiative to encourage decisions to be made in person in Cyprus. This ensures that the company’s tax residency is never in question.
Company formation in Cyprus requires certain thresholds for employee registration (right qualifications and adequate experience) depending on the structure. It is important to not only meet these requirements but also to hire enough employees to complete normal business operations.
Outsourcing, which we will also discuss, can be a useful tool in the business process, but it should not be relied upon for all business functions when measures must be taken to establish the economic substance in the EU.
There are no regulations that prohibit outsourcing, however, companies should be aware of the impact that reliance on too much outsourcing can have on the overall substance of the company.
Crucial management functions should remain within the company and clear, regular communication should be established between the company and outsourcing partners throughout the entire length of the process to ensure that substance remains mostly in Cyprus.
Retain Documents In-House
All legal documents and company-related paperwork should remain in the Cyprus office or be accessible in the office at any time if they are uploaded to cloud data systems. Accounting and reporting documents should be included and management must approve each of these to assert that vital business operations and core income-generating activities are indeed occurring within the jurisdiction.
Finally, Cyprus companies should focus on improving participation within the local ecosystem of businesses. Establishing a local domain, company and employee profiles, and local contact information are significant components of establishing a business presence in Cyprus. Moreover, participation and networking within the local business community offer many rewards beyond just meeting economic substance EU requirements, such as beneficial partnerships and stronger, healthier business practices.
Pass the Economic Substance Test with The Aspen Trust Group
Cyprus presents international companies with one of the most advantageous tax and business environments anywhere in the world, but to qualify for these benefits companies need to establish and maintain economic substance by EU standards.
Further, businesses can utilize the aspects of economic substance requirements for tax purposes but also to gain more credibility and worthwhile business partnerships at large. The global community is increasingly turning its attention towards eliminating offshore structures and other legal entities that do not contribute positive and relevant activities to their tax jurisdictions.
The Aspen Trust Group has a team of international professionals ready to assist your business with Cyprus company formation, employee relocation, and other risk assessment services to ensure that your company avoids EU blacklisting under recent economic substance legislation. Let us help you meet economic substance EU requirements for rewarding business practices in Cyprus’s ideal tax jurisdiction.