Abolition of the back-to-back minimum margin scheme and introduction of transfer pricing rules In Cyprus

On 8 February 2017 the Cyprus Tax Department wrote to the tax committee of the Institute of Certified Public Accountants of Cyprus announcing its intention to abolish the so called “minimum margin scheme” which applies on related party loans (so called “back to back” financing arrangements), with effect from 1 July 2017.

This development is in line with global initiatives in the international tax sector (particularly the OECD/G20 Initiative and the BEPS Action Plan) and follows detailed studies by the tax department of the existing tax regime, including a detailed review and examination of the existing Code of Conduct for the taxation of businesses and the state aid rules applicable within the EU.

The minimum margin scheme, which was introduced in 2011, will continue to apply until 1 July 2017 in respect of loans between group companies in which the borrowed funds are on-lent, either on an interest-bearing basis or interest-free, within 6 months from the time the intermediary Cypriot borrower received them. In order for the scheme to apply there needs to be a clear connection between the borrowed and the on-lent funds, clearly evidenced by documentary proof.  If part of the funds lent by the intermediary was derived from internal sources rather than from intra-group borrowings, then only the part of the loaned funds which was derived from intra-group borrowings will fall within the “back to back” scheme; normal market rates will apply on the balance. The minimum profit margins accepted by the tax department range from 0.125% for loans of more than EUR 200 million to 0.35% for loans of less than EUR 50 million.

The current legal framework in Cyprus does not include any detailed transfer pricing rules and regulations, and the only provision regarding transfer pricing is article 33 of the Income Tax Law, which introduces the arm’s length principle using wording similar to that of article 9 of the OECD Model Tax Convention.

In its letter dated 8 February 2017 the tax department also indicated that detailed transfer pricing legislation for intra-group financing transactions, based on the OECD transfer pricing guidelines, is to be announced shortly. The new rules will apply with effect from 1 July 2017 both for the purposes of issuing tax rulings as well as for the purposes of tax assessments. The rationale behind this development is to reduce base erosion and profit shifting by ensuring that transfer prices are based on real economic activity and valuation.

Therefore with effect from 1 July 2017 pricing of intra-group financing transactions will need to be fully substantiated and supported by transfer pricing studies, preferably prepared by independent professionals.

Taxable profits for intra-group financing schemes which have already been executed and put in place prior to 1 July 2017 will have to be re-calculated based on two different set of rules. The “back-to-back” rules under the minimum margin scheme will apply for the first six months of 2017 and the new transfer pricing rules will apply for the second six months. Any tax rulings already obtained in relation to such arrangements will no longer apply from 1 July 2017.

While the tax department’s letter relates only to financing transactions between related parties, it is expected that comprehensive transfer pricing rules will be developed in the near future, given Cyprus’s commitment to implementing the OECD BEPS Initiative.

It is advisable to undertake a full review of the financing and other commercial arrangements between related entities and structures in order to be prepared to assess the impact of the changes as soon the new provisions are announced, allowing corrective actions to be taken in good time in order to ensure conformity with the new framework and optimize the structure from a tax viewpoint.