The adoption of the multilateral instrument (MLI) as part of the OECD's BEPS project by many jurisdictions worldwide forces them to put measures to prevent the misuse of their existing bilateral tax treaties.
Many developments in international taxation have occurred in recent years, mostly as a result of the OECD/G20 Base Erosion and Profit Shifting initiative, also known as BEPS Project.
In relation to the above, the Multilateral Convention might be viewed as a global mechanism for updating bilateral double tax treaties.
Since the convention's wording was decided in November 2016, 99 jurisdictions have signed it, with more governments indicating their wish to do so.
The MLI has already begun to have an impact on the bilateral treaties of the 70 countries that have ratified it until February 2022. It is likely to have an impact on over 880 treaties signed between those 70 jurisdictions, with an additional 940 treaties whose application will be modified after the MLI is adopted by all Signatories, affecting over 1800 treaties worldwide.
Cyprus signed the agreement during the first high-level signing ceremony, which was held in Paris in June 2017, demonstrating its commitment to implement the BEPS project recommendations. In addition, on the 22nd of January 2020, it published its instrument of ratification in the Official Gazette, which was submitted with the OECD the next day.
The Republic of Cyprus approved the integration of the actions of the framework for the 'Erosion of the Tax Base and the Shifting of Profits' concerning Action 6 (Prevention of Tax Treaty Abuse) and Action 14 (Mutual Agreement Procedure) by decision of the Council of Ministers dated 5/4/2017 in order to ensure our country's required compliance with the minimum standards. Cyprus has stated that it will cover all of its current conventions, with the exception of those where the adoption of minimum standards have already been bilaterally agreed.
Principal Purpose Test
The "Principal Purpose Test" is expected to have the most significant impact on the Cyprus DTT as a result of adopting the Action 6 of the BEPS.
Given the extensive use of treaty shopping schemes on a global scale, Action 6 of the BEPS Action Plan, and Article 7 of the Convention, target those tax abusive schemes seeking tax advantage by using shell or conduit companies in various jurisdictions.
Principal Purpose Test (PPT) essentially comes into place to act effectively to deny treaty benefits in unintended circumstances.
The PPT will apply to deny treaty benefits if the tax administrations can reasonably conclude that obtaining the treaty benefit was one of the principal purposes of an arrangement or transaction. On the other hand, the burden of proof is set over the taxpayers in cases they were denied treaty benefits under certain circumstances.
The purpose of a person putting a scheme or a transaction in place, can only be determined if an objective analysis is undertaken. In all respects, based on previous experiences, the purpose of a structure or a transaction, cannot alone prove to be the obtaining of a tax benefit. Of course, it can be one of the key drivers, but to pass the Principal Purpose Test, a scheme or a transaction must be driven by commercial considerations. Whether obtaining a tax benefit comes together, it should be considered as an additional benefit.
The impact on the Cyprus tax resident entities
The extensive network of Tax Treaties of Cyprus gives the country the possibility to attract the incorporation of legal entities that are used as a medium to effective tax planning.
In addition, the domestic tax legislation, allows Cyprus to be characterised as one of the most favourable tax jurisdictions in Europe and on a global level. However, the implementation of the MLI has made it clear, that schemes structured without economic reasoning and that have been established to exploit tax advantages through the treaty networks of the signing parties to MLI (including Cyprus), are not expected to be granted the treaty benefits.
It is therefore concluded that treaty benefits can be awarded to arrangements or transactions that are undertaken as part of a core commercial activity and not being designed to exploit tax advantages.
It is anticipated that any person to whom the treaty benefits are denied as part of failing to the PPT, may still be able to claim to enjoy the treaty benefits if they establish that obtaining this benefit was in line with the object and purpose of the treaty provision.
It is also expected that the above developments will have a significant impact on the Cyprus tax resident entities and the Cyprus economy in general.
Multinational corporations have long regarded Cyprus' DTT network as optimal, and it has been frequently utilised. These multinational corporations must examine their current arrangements in light of the new developments and comply with the so called "substance requirements" to their Cyprus-based organisations. They must provide a clear reason for their existence supported by commercial considerations. This varies by entity, primarily according to their activities and business nature.
Failure to comply with the minimum substance requirements, as these are expected to come into play to tackle shell companies, and the Principal Purpose Test as already described, may lead to unwilling recharacterisation or disregarding of incomes, higher taxes, possible double taxation and given the extent of the incompliance, interests and monetary penalties may also arise.
After all, entities failing the PPT, may be at risk to prove their tax residence. In some cases, we may see that certain entities are completely disregarded as being part of a larger multinational organisation, due to lack of substance and proper functions in their jurisdiction of incorporation. It might also be the case that such entities, will not either be able to benefit from other EU Directives, apart from the treaty benefits themselves.
It is reasonable that following the implementation of the provisions, there would be a risk of increased controversies. To ensure that controversies are minimised, we believe that the companies that already have some extent of substance in the jurisdiction of incorporation, must ensure that documentation is in place to justify that they do have proper substance and their operations are backed by economic rationale to minimise controversies.
It may be necessary for organisations to consider restructuring their operations in jurisdictions where they maintain legal structures, to ensure that their operations are supported by people's functions and to subsequently prove that they do have a real business purpose in the jurisdictions of incorporation.
Author: George Themistocleous, FAIA, Managing Partner, CEO
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