New rules for intra-group back-to-back financing arrangements
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On 30 June 2017, the Cyprus Tax Department (CTD) issued a Circular with regards to the new rules for intra-group back-to-back financing arrangements, with effect as from 1 July 2017. The Circular requires that arm’s length principle must be applied in all intra-group back-to-back financing arrangements in accordance with the OECD  Transfer Pricing Guidelines.

The main provisions of the Circular are analyzed below:

Application of new back-to-back rules
The new rules apply to any entity that carries out intra-group financing transactions and is a Cyprus tax resident entity (i.e. the management and control is exercised in Cyprus) or to a Cyprus permanent establishment of a non-tax resident entity.

Intra-group financing transactions refers to any activity of granting loans or cash advances remunerated (or should be remunerated) by interest to related companies financed by financial means and instruments such as debentures, private loans, cash advances and bank loans. Two companies are considered to be related if they fall within the scope of Section 33 of the Cyprus Income Tax Law.

Application of arm’s length principle
The Circular specifies that the remuneration of all intra-group financing transactions should comply with the arm’s length principle i.e. corresponds to the price which would have been accepted by independent entities in comparable circumstances taking into account the economic nature of the transaction.

A comparability analysis must be carried out in order to:

  1. Delineate the controlled transaction
    Identify the commercial or financial relationship between related entities and determine the conditions and economically relevant circumstances attaching to those relations in order to accurately delineate the controlled transaction and,
  2. Determine the arm’s length remuneration
    Compare the conditions and economically relevant circumstances of the controlled transaction with those of comparable transactions between independent entities to determine arm’s length remuneration.

A. Delineation of a controlled transaction
In order to accurately delineate the financing transaction, it is necessary to determine its characteristics, such as its terms and functions, the assets used and the risks assumed by the related entities.

  1. Contractual Terms
    In order to delineating the transaction, the actual conduct of the parties should be taken into account and not what was contractually agreed between the parties (substance over form).
  2. Functional Analysis
    A functional analysis should be performed in order to identify the economically significant activities, responsibilities and functions, the assets used and the risks assumed by the parties in the context of the transaction. The functional analysis focuses on actual activity of the parties and on the competences they deploy.

    Identification of functions performed and assets used is necessary in order to identify the risks related to the financing transactions.
  3. Analysis of Risks
    A group financing entity is considered to assume the risk if it has the financial capacity to manage the risk and to bear its financial consequences if the risk materializes. The financial capacity to assume the risk can be defined as the access to funding necessary in order to take on or avoid the risk, to pay for the risk mitigation actions, and finally to bear its consequences if the risks materializes.

    A financing entity controls the risk if it (a) has the decision making power to enter into a risk bearing commercial relationship, (b) has the ability to address such risks and (c) actually performs such decision making functions.

    In order a group financing entity be able to justify the risk of control and validate that its management and control is exercised in Cyprus, it is necessary to have actual presence in Cyprus. Actual presence takes into account (but is not limited) to the following:
  1. The number of Cyprus tax resident Directors;
  2. The number of Board meetings held in Cyprus and whether the main management and commercial decisions are taken in Cyprus (corporate policy);
  3. The number of shareholders’ meetings taking place in Cyprus;

In addition, the group financing entity must have the qualified personnel to control the transactions performed. Any functions that may not have a significant impact on risk control can be outsourced provided that the financing entity maintains control and adequately supervises the risk and function outsourced.

B. Determination of arm’s length remuneration
In order to be able to determine the arm’s length remuneration of the delineated transaction, it is necessary to compare the transaction with comparable transactions in the open market.

The Circular mentions that in the case of entities performing functions similar to those performed by regulated financing and treasury entities, a return on equity of 10% after tax can be observed in the market and can be considered as reflecting arm’s length remuneration. This percentage will be regularly reviewed by the CTD based on relevant market analyses.
Transactions without commercial rationale
Intra-group financing transactions that cannot be observed in the open market and are also devoid of any commercial rationale must be disregarded to ensure full compliance with the arm’s length principle.

Simplification measures
A group financing entity which has actual presence in Cyprus as described above and conducts a purely intermediary activity, grants loans or advances to related entities which are refinanced by loans or advances granted by related entities, is considered for simplification purposes that the transactions are deemed to comply with the arm’s length principle if the analyzed entity receives in relation to its controlled transactions a minimum return of 2% after tax on assets. This percentage will be regularly reviewed by the CTD based on relevant market analyses.

A deviation from the minimum return of 2% is only allowed if duly justified by an appropriate transfer pricing analysis.

In order to benefit from the simplification measures, entities should disclose the use of such measures to the CTD through their tax return in the corresponding fiscal year.

Minimum requirements for a transfer pricing analysis
A transfer pricing analysis should be:

  1. Prepared by a Transfer Pricing expert;
  2. Submitted to the CTD by a person who has a license to act as an auditor of a company according to the Cyprus Company Law and is required to carry an assurance control confirming the quality of the transfer pricing analysis;
  3. Include the minimum requirements as specified in the Circular.

Exchange of information
The issuance of tax rulings or Advanced Pricing Arrangements as well as the use of the simplification measures are subject to the exchange of information rules set under the Directive on Administrative Cooperation.

Entering into force
The new rules apply with effect as from 1 July 2017 for all existing and future transactions, irrespective of the date of entering into the relevant transactions. Tax rulings issued prior to 30 June 2017 will no longer be valid.

All content prepared by KPMG Cyprus.