Tax treatment of intra-group back-to-back financing arrangementsnconstantinou
It should be noted that the application of the pre-agreed minimum profit margins of 0.125% and 0.35% for back-to-back loans will be terminated as at 30 June 2017.
As from 1 July 2017, the new framework will apply to these and certain other financing arrangements.
On 30 June 2017, the Tax Department has issued a circular regarding the new framework. The Circular applies to intra-group financing activities where loans are granted by a company (“financing company”) to related parties (definition under the Income Tax Law art. 33), financed by financial means and instruments such as private loans, cash advances, bank loans etc.
A financing company will be required to determine its remuneration on the basis of transfer pricing principles. This means that the company will need to identify each commercial and financial relationship with the related parties (“controlled transactions”) and to determine the economical and significant conditions and circumstances relating to such transactions.
An analysis is required of the functions performed, assets used and risks assumed 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 bear the financial consequences id the risks assumed actually materialise. Therefore, the company is expected to determine the appropriate level of equity that would be needed to assume the risks. In case the financing company is a credit/financial institution or an investment firm, it is deemed to have a sufficient level of equity to bear the financial consequences of its risks.
In addition, an appropriate comparability analysis must be carried out in order to determine whether the remuneration resulting from the transactions between the related parties are comparable to transactions between independent parties under similar circumstances in the open market. The Circular indicates that in the case of companies performing functions similar to those of regulated financing and treasury companies, a return on equity of 10% after tax can be considered as reflecting an arm’s length remuneration. This percentage will be regularly reviewed by the Tax Department based on relevant market analyses.
The Circular indicates that financing companies must have an actual presence in Cyprus and qualified personnel to control the risks and transactions entered into. The financing company is considered to control the risk if:
- it has the decision making power to enter into a risk-bearing commercial relationship
- it has the ability to address such risks
- it actually performs such decision-making functions
The actual presence criteria taken into account are:
- the number of directors that are Cyprus tax residents
- the number of board of directors meetings held in Cyprus
- the number of shareholders meetings held in Cyprus
The daily activities of risk mitigation can be outsourced to third parties as long as the company has the capability to take, and actually make, the key decisions with respect to the outsourcing.
Transactions without commercial rationale
Transactions that cannot be observed on the open market and do not have any commercial rationale must be disregarded to ensure full compliance with the arm’s length principle.
The minimum requirements for the transfer pricing analysis are:
- a description of the computation of equity allocation required to assume the risks
- a description of the group and the inter-linkages between the functions performed by the entities participating in the controlled transactions and the rest of the group, together with a description of the value creation within the group by the entities participating in the transactions
- the precise scope of the transactions analysed
- 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
A financing company which meets the substance requirements and is engaged in purely intermediary financing activities, borrowing from related entities and lending to related entities, will be deemed for the sake of simplification to comply with the arm’s length principle if it receives in relation to its controlled transactions a minimum return of 2% after tax on assets.
An entity which meets the criteria and does not intend to prepare transfer pricing documentation may choose to benchmark its remuneration based on this minimum return on assets approach. The 2% will be regularly reviewed by the Tax Department.
Submission of transfer pricing analysis
The Tax Department expects that the transfer pricing analysis will be submitted to the Tax Department by auditors, who are required to carry out an assurance quality control in order to confirm the quality of the transfer pricing analysis.