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What is Economic Substance?
Economic Substance is the international tax law principle that mandates that for a transaction to be considered valid, it must have an economic purpose other than the reduction of tax liability. An EU company can prove economic substance if its management, business operations and executive functions are real and in the jurisdiction of registration and tax residency. That being said, each company has different requirements to prove Economic Substance in a jurisdiction. For example, a holding company will require satisfaction of a lesser test of substance than a trading or investment company.
Brief history
December 2017: Introduction of the Code of Conduct Group by the Council of the EU. Through various investigations of the CCGC, an EU blacklist of 13 international financial centres (IFCs) was published that presented concerning components of economic substance requirements.
June 2018: A scoping paper was issued by the EU laying out the economic substance requirements that IFCs had to implement by 2019 regarding the real economic activities of legal entities.
Other international organizations, such as the OECD, have also taken measures to create better substance requirements.
EU Economic Substance Tests
In order to establish economic substance in the EU, a company must pass specific tests:
1. The “Directed and Managed” Test
The company must prove that it is directed and managed in the jurisdiction of tax residency. This includes the following:
· Having frequent board meetings in the jurisdiction
· Quorum of directors being physically present at board meetings
· Decision making events to take place in the jurisdiction
· Meeting minutes to be kept in the jurisdiction
Etc.
2. The “Core Income Generating Activities (CIGA)” Test
The company must be in the position to prove that the relevant CIGAs meet certain thresholds within the jurisdiction of tax residency. Outsourcing CIGAs is acceptable, provided that they will be monitored and controlled by the board of the company. In this case, the relevant resources of the service providers will be taken into consideration to determine whether the CIGA test is satisfied.
3. The “Adequate” Test
To satisfy this test, the company needs to prove that it has:
· Adequate number of qualified employees in the jurisdiction
· Adequate expenditure in the jurisdiction
· Adequate physical presence in the jurisdiction
For the purpose of this test, adequacy is dependent to the particular facts and circumstances of the company and its activities.
How to establish substance in Cyprus
1. Headquarters or Office Requirements
It is crucial for a company that needs to prove economic substance in Cyprus to maintain formal physical offices or headquarters on the island. This is a first step to demonstrate real economic activity that occurs in the jurisdiction and prove the company’s tax residency in Cyprus.
2. In- Country Management
A company is considered resident in a jurisdiction where the central management and control actually abides. In the case of a Cyprus company, proving that the management of the entity has substance in the jurisdiction means that all or majority of the directors are resident in Cyprus. This can be achieved by either hiring locals or relocating foreign nationals who are part of the management team.
3. In-Country Control
The location of the decision-making process, should be in the company’s headquarters in Cyprus to ensure that the company’s tax residency is never in question. This can be achieved by the following:
· Decisions are taken and seen to be taken in Cyprus (recorded minutes)
· All actions consequent upon the decisions are implemented in Cyprus (i.e. signing of agreements)
· Regular board meetings (at least 3 meetings annually and maybe more if the activity of the company merits it) at which decisions are taken and implemented are held in Cyprus. Any foreign director should be physically present to such meetings.
4. In-Country Employees
It is important for a company to complete normal business operations in Cyprus by hiring enough employees and meet certain employment requirements (i.e. social insurance and GHS contributions).
Outsourcing is also an option, but a business should not rely on outsourced services for all its functions when measures are taken to establish the economic substance. Outsourcing will be discussed in the following paragraph.
5. Outsourcing Evaluation
Despite the fact that outsourcing is not prohibited by any regulations, companies should be very careful with the impact that reliance on too much outsourcing might have on their overall substance status. It is imperative to maintain control and management within the company with clear and regular communication with the outsourcing partners to ensure that substance remains in Cyprus.
6. Documents to be retained locally
All documents and company-related paperwork should be physically maintained in the company’s office in Cyprus or be accessible in the Cyprus office at any time. This includes all certificates, registers, accounting and reporting documents, resolutions and decisions and any other corporate or tax related document that will serve to prove that core income generating activities are occurring within jurisdiction.
7. Local Presence
Any Cyprus company should participate within the local ecosystem of businesses. This includes, among others:
· Establishing a local domain
· Company and employee profiles
· Local contact information
How we can assist you
Flexi 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.
*DISCLAIMER: This article and its publication are intended to provide a brief introduction and act as a general guide. This is provided for information purposes only and cannot be utilized as a substitute for professional advice. This document does not represent a legal opinion and one must not rely on it without receiving independent advice based on the particular facts of its own case. No responsibility is accepted by the author or the publishers for any loss suffered from acting or refraining from acting based on the contents of this publication.
Start a conversation with us today to find out how you can benefit from a relationship with Flexi Group.
Please get in contact with our Head of Business Development:
Mrs Daniella May / Head of Business Development
Tel.: + 357 7000 2 5555 / + 357 22 87 57 55
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