The relationship between Cyprus and Russia is well known. For many years, Russian individuals have registered and maintained their businesses in Cyprus, whilst many have also become Cypriots taking advantage of the Cyprus citizenship programs.
Recent developments however have shown that this relationship may be coming to an end, and it is therefore important for Russian business owners to decide on whether this is a relationship worth fighting for, or if they are going towards a divorce, in which case it is always important to do everything correctly so as to avoid any future surprises.
There are a number of facts and recent developments one needs to take into consideration as to whether to decide to maintain their business in Cyprus or not.
1. The Cyprus banking system and the famous circular issued
2. Beneficial ownership issues and consideration of Cyprus as a destination for conduit companies
3. Overall substance required both for the Cyprus and Russian Tax authorities
Taking a look at the wider picture, one will notice that in the structures that were frequently used, BVI companies are usually also included. Such offshore jurisdictions are by nature disliked by tax authorities and it is often the case that just the existence of an offshore company in a structure will be a ‘red flag’ for tax authorities.
There are also a number of factors that need to also be taken into consideration for these BVI entities.
1. CFC rules and how these impact your BVI company
2. The BVI Economic Substance Act
The Cyprus banking situation
In June 2018, the Central Bank of Cyprus issued a ‘circular’ addressed to all Cyprus credit institutions whereby they were required to avoid entering into and renewing business relations with entities that met the criteria of a ‘shell company’ or ‘letter-box company’. The definition of such companies was revised in an additional circular issued in November 2018, whereby it was clarified that a shell company or letter box company is defined to be one that:
a) Has no physical presence or operations in its country of incorporation/registration (other than a mailing address). Physical presence includes having a place of business or operations as well having meaningful mind and management. The presence of a third person providing nominee services does not constitute on its own physical presence.
b) It has no established economic activity in its country of incorporation/registration, little to no independent economic value, and no documentary proof to the contrary
The Central Bank has further clarified that the following types of companies are excluded from being defined as ‘shell companies’:
a) Companies that hold shares (or other equity instruments) of another business entity or entities engaged in legitimate business with identifiable ultimate beneficial owners;
b) Companies which hold intangible or other assets including real estate, ship, aircraft, portfolio of investments, debt and financial instruments;
c) Companies established to facilitate currency trades and asset transfers, corporate mergers, as well as carrying out asset management activities and trading of shares;
d) Companies that act as a treasurer of companies, recognized as a group or manages the activities of a group.
e) Any other case where convincing evidence can be provided that the company is engaged in legitimate business with identifiable ultimate beneficial owner(s).
In addition to the above definitions, credit institutions are to avoid engaging in a business relationship with offshore entities which are registered in a jurisdiction which does not require from them to submit to the authorities audited financial statements nor do they voluntarily prepare audited financial statements, or companies that have a tax residence in a jurisdiction included in the EU list or the OECD list of non-cooperative jurisdictions for tax purposes.
It is indeed the case that Cyprus banks have already closed the bank accounts of many such shell companies, whilst opening a bank account in Cyprus has become very difficult for businesses.
Conduit companies/ beneficial ownership issues and apportionment of profits
In the post BEPS (base erosion and profit shifting), post MLI (multilateral instrument) era, in an era where cases are frequently presented at the Russian courts, it is important to understand how conduit companies and beneficial ownership of income issues impact your structures.
Conduit companies and beneficial ownership of income are interlinked matters and can be easily explained through the use of an example.
A typical structure, one which you hopefully do not currently maintain, is one where a Russian individual owns a BVI entity, which in its turn owns a Cyprus entity, which then has a Russian subsidiary. The Russian subsidiary would normally be the entity where all operations where maintained, whilst profits would be shifted to the Cyprus or the BVI company in the form of royalties, commissions, management fees etc. The Cyprus entity would of course also be receiving dividends from its subsidiary which it would then in its turn pay to the BVI parent company. Frequently these structures would also encompass the provision of loans and the subsequent payment of interest from the Russian entity to Cyprus and then to BVI (note that such back to back loan transactions are now subject to transfer pricing in Cyprus).
In these structures, it was further usually the case, that the Cyprus entity had no employees, just nominee directors and a registered office. And this is where the issue kicks in. The Cyprus entity was enjoying high profits without actually having the means to explain the reason of these profits. Further, these profits were not used in any way by the Cypriot entity, and were merely transferred to the BVI parent company. By doing so it was evidencing that it was not the beneficial owner of this income and it was acting as a mere conduit through which profits were shifted from the Russian company to the Russian individuals whilst minimizing the taxes they were paying.
This is something which was of course has been picked up by the Russian tax authorities, and cases with such structures are frequently presented at Russian Courts. Common grounds in cases which are won by the Russian tax authorities is the lack of a ‘substance over form’ approach to beneficial ownership, lack of administrative costs, lack of assets, employees, equipped office, sham directors serving as directors in many other entities etc. These all link in to the substance requirements discussed in the next section.
Another important area, which will be soon become an issue, is the apportionment of profits. Profits will be apportioned and taxed in each country depending on what that country offers to a structure. By default, a holding company will not be entitled to any apportionment of profits other than dividends if it has no other substance to explain why higher profits should be apportioned to it. As such this is something many companies will be faced with in the near future.
Substance requirements as we knew them are a thing of the past. Maintaining a company with just nominee directors and a registered office in Cyprus is simply not substance, and to be honest it never should have been.
A general definition of substance is not adequate as substance requirements are different for each entity depending on the business they are involved in.
The simplest form of substance is having physical presence in your country of residence. A registered office shared by hundreds, if not thousands, other entities can of course not be considered as having physical presence. Whether a small office is adequate substance or whether a whole building is required will depend on the business you are in.
Another simple example is personnel. A company’s personnel must represent its real needs. Again personnel should correspond to the line of business a company is in. This does not just refer to the volume but also to the skills and qualifications the personnel should have.
A company should have in place everything required for it to be able to prove that it performs from Cyprus the operations which correspond to the profits it claims are being earned in Cyprus.
Finally, why not take it a step further? Companies can list on the Cyprus Stock Exchange which would by itself add to the substance of an entity. The Cyprus Stock Exchange offers also the option of the emerging companies market which is a multilateral trading facility.
The above examples are just some ideas and not an exhaustive list.
OFFSHORE JURISDICTIONS - BVI
CFC rules and their impact on BVI entities
In accordance with Controlled Foreign Corporation (CFC) rules, companies located in offshore jurisdictions need to prepare financial statements under either International Financial Reporting Standards (IFRS) or under local accounting standards. Further, many jurisdictions, will require that these financial statements are also audited by external auditors.
Even if not required by law, it might still be beneficial for offshore entities to voluntarily audit their financial statements. The reasoning behind this is that these offshore jurisdictions do not have a double tax treaty in place with Russia, nor do they exchange information with Russia (full list of such jurisdictions are published in the Russian Official Gazette). As a result, if audited financial statements are voluntarily prepared for such entities, these financial statements will be used for calculating tax on CFC profits, instead of using arbitrary estimations of the Russian Tax Authorities. It should be noted that such financial statements should be prepared in accordance with IFRS or any other international standards and should have an unmodified audit opinion.
The BVI Economic Substance Act
It is also important to note that in accordance with the BVI Economic Substance Act, as of 1 January 2019, BVI legal entities have a requirement to demonstrate adequate economic substance. Specifically, companies which carry on the below listed activities are required to demonstrate adequate economic substance:
· Fund Management
· Finance and leasing
· Intellectual Property
· Distribution and service centers
Under the Act, economic substance will be measured by reference to reporting periods which are not longer than one year. Once it has been determined that an entity carries out a relevant activity, it will need to conduct core income-generating activity in the BVI (core income-generating activities of each relevant activity is defined in the Act). Further, adequate level of employees, expenditure, physic offices etc., must exist in the BVI.
In the case of pure holding companies, which carry no relevant activity other than holding equity participation and earning dividends, will be deemed be deemed to have adequate substance if it complies with its statutory obligations and has adequate employees and premises for holding and managing the said participation.
If all changes are too much for you, or if the added cost does not make your investment in Cyprus profitable, it might be the case that dissolving your operations in Cyprus is your best action. It should be noted that a Company in Cyprus can either proceed with a strike-off from the Registrar of Companies or with an official liquidation. In both cases, the reporting requirements of the Company being dissolved will have to be up to date. This translates into both audited financial statements having been submitted to the Registrar of Companies and annual tax returns having been submitted to the tax department.
In a recent letter released by the Cyprus Tax department, it was announced that it had been noted that many companies have applied to the Registrar of Companies for strike off. However, these companies were not up to date with their tax obligations and thus the Tax Department could not consent to the strike off. As a result of this, the Cyprus Tax Department requested auditors through this letter to complete and submit a specific form for client with whom they have lost contact as well as for clients who are dormant. Further auditors have been requested to submit the tax returns of such clients, to the extent possible. Once this is done they would evaluate whether or not to consent with the strike-off. If you fall within this category of clients, it is advisable that you discuss this option with your auditor.
Whether or not the Cyprus-Russia relationship is one worth fighting for or one which should result in a divorce is up to the Russian individual. Cyprus is of course still a very appealing option, with many benefits. However, it is an option which should only be chosen with caution and by having in mind that like all relationships it needs commitment and effort. Business in Cyprus must have real substance in Cyprus for the relationship to survive. Real substance comes of course at a cost, but the benefits of Cyprus would by far exceed that cost. If this is not an option you are interested in you should take the hard decision of leaving Cyprus, but as already explained this should be done again in a correct manner to avoid any surprises in the future.
How ELSAVCO can help
Whether you decide to commit to your relationship or proceed with a divorce, our team of experienced and skilled professionals can assist you all steps. Our tax and financial advisors as well as our certified auditors can assist you in reviewing your structures and explaining to you all steps necessary in making your structures solid or dissolving your structures in an efficient manner.
Contact us to discuss your needs: firstname.lastname@example.org