investmentGATEWAY

Directive (PSD) in a move to align European Union taxation policy with the Organisation for Economic Cooperation and Development (OECD) initiatives and G20/G8 countries agenda on fighting tax evasion and aggressive tax planning.

The changes proposed by EC to PSD are highly affected by the work of OECD against Base Erosion and Profit Shifting (BEPS) and the work for adopting General Anti Avoidance Rules (GAARS). The changes must be incorporated by all Member States by the 31^st of December 2014.

EC wants to close loopholes used by many companies in the EU with cross border investments in other Member States that are ‘double not taxed’, distorting the purposes of the directive which was the avoidance of double taxation for profit distributions between Parent and subsidiary companies is the Single Market. According to EC statement on 25 November 2013, that is leading to a distorting tax advantage for companies exploiting the provisions of the PSD.

The following changes will be affecting companies from 1 January 2015:

Hybrid Loan arrangements

A hybrid loan arrangement is a financial instrument that has both the characteristic of debt and equity, in one Member State is treated as loan and in another Member State is treated as equity.

This is resulting, based on EC findings, in deduction of interest in the Member State the subsidiary is located, which is the borrower, lowering the taxable profits and into a tax exempt dividend paid to the Parent company in another Member State.

In accordance to the EC amendments in case of such hybrid loans then the directive will deem the interest payment in its actual from and will be taxed under the rules of the Member State where the Parent company is located.

In effect EC has a suspended the provisions of the directive for distributions of profits which interest deducted due to the use of a hybrid instruments between the two companies.

See attached illustration 1

General Anti-Abuse Rule

Introduce an anti-abuse rule into the wording of the directive so that artificial arrangements put in place for the purpose of obtaining an improper tax advantage will not benefit from the directive.

EC identified also improper use of directive articles for avoiding taxation on profit distributions from Companies situated in Member States towards the parent companies situated in third countries and more specifically in Tax Heaven countries. Companies controlled by non EU companies in some member states that have withholding provisions, are including to their Corporate structures Companies from Member States with no withholding taxes (i.e. Cyprus holding co) provisions, with main purpose avoiding to tax profit distributions to non EU companies.

See attached illustration 2

The Cyprus effect?

At first, Cyprus as professional services destination it can be argued that would be adversely affected by the alterations to the PSD directive, however we need to consider some important facts first before drawing any final conclusions.

Examining the changed directive provisions with regards to hybrid loans in the context that interest payments from a Cyprus company towards a Parent Company in other Member States company the following must be noted:

• Cyprus has no withholding taxes with regards to interest payments.
• Cyprus has no withholding taxes with regards to dividend payments.
• Cyprus has a network of Double Taxation Treaties (DTT) with almost all the EU countries that allows interest and dividend income of receiving Companies to be taxed at destination country ranging from 0% to 15%.
• The amendment to PSD is not at all affecting hybrid arrangements between Cyprus companies and Non-EU countries.
• Many EU member states have participation exceptions for dividends received from other fellow EU companies, so in effect even if the PSD is not used, then national tax law would exclude dividends received or paid anyway.

On the contrary to the above the GAARS introduced to PSD, would in reality create some issues to group of companies that purely set up a subsidiary in Cyprus solely for avoiding withholding taxes in profit distributions to Non-EU parent companies. Directive provisions disregard that the intermediate subsidiary company has any substance and therefore any such distributions automatically would be suffering withholding tax.

Despite the above negative consequences to Cyprus as holding company destination, companies that have included Cyprus companies into their structures for that purpose can easily avoid such exposure by using the notion of tax substance.

The negative consequences can be avoided by amending the status of Cyprus resident intermediary companies from a ‘letter box company’ without any tax substance, to a fully substantiated arm of the whole group structure by creating or transferring part/parts of the management team and employees to Cyprus offices.

KTC Website: www.ktc.com.cy

Further Reading:

http://europa.eu/rapid/press-release_MEMO-13-1040_en.htm

http://ec.europa.eu/taxation_customs/taxation/company_tax/parents-subsidiary_directive/index_en.htm