NOTIONAL INTEREST DEDUCTION
During the recent years there has been a lot of developments around the world on the application of the double tax treaties. These changes were mainly driven by OECD through the BEPS initiative, local legislation (i.e. Russia de offshorisation law) as well as case law which set, a precedence as to when a benefit under a double tax treaty can be granted.
For financing transactions there was significant attention given on back to back loans and after the introduction of the above-mentioned developments companies involved in such transactions were denied treaty benefits.
The Government of Cyprus in an attempt to address the risk that heavily leveraged Cyprus companies were facing, introduced in 2015 the Notional Interest Deduction (“NID”). The main purpose of introduction of NID was to assist Cyprus companies to de-leverage the and provide a tax efficient alternative to debt financing.
In this brochure, we shall examine the main features of NID and identify the benefits that NID offers and how NID interacts to the tax developments.
A. WHAT IS NID
The NID is a theoretical interest expense calculated on New Equity introduced into a Cyprus company. NID is calculated for tax purposes only and has the same tax treatment of interest expense. In effect, the NID encourages equity finance in corporate structures by granting the notional interest deduction, substituting the interest from the debt finance which was preferable for tax purposes.
B. WHO CAN CLAIM NID
Eligible for NID are the Cyprus tax resident companies and Cyprus permanent establishments (PEs) of non-tax resident companies provided that:
1. “New equity” is introduced into the business, which will be used by such business for the purpose of generation of taxable income.
2. Paid either in cash or in kind, and
3. The relevant tax declaration in relation to the claim of NID is duly completed and submitted to the Tax Authorities, and in case that the TAX Authorities require particulars in relation to the computation of the NID, such particulars should be duly completed and submitted in due time to the TAX Authorities.
Eligible for NID are also companies that relocate their tax residency in Cyprus on or after the 1st of January of 2015, subject to conditions.
C. BENEFITS USING THE NID
Despite the obvious tax benefit of having an expense for tax purposes without incurring an actual expense, the equity financed companies can address the constraints imposed by the recent tax developments.
In summary, the current tax environment constrains companies’ strategies by enforcing the following:
1. Introduction of Transfer Pricing Study on intra group transactions;
2. Introduction of Anti -Tax Avoidance Directive and EU Directive on Mandatory Disclosure;
3. Beneficial Owner of the income concept for avoiding abuse of double tax treaties;
In this respect, the application of the NID in combination with the equity finance may overcome the above-mentioned obstacles. In particular, these issues may be addressed though the equity financed as follows:
1. Transfer Pricing Report Issue:
In Cyprus the Transfer Pricing requirements currently relate to “intra group finance transactions” (defined as any activity by way of granting of loans or cash advances to related parties) which are financed by financial means and/or instruments (loans, bank loans, promissory notes, etc.)
Therefore, by substituting the debt finance to equity finance for the purpose of granting intra group loans, the company’s obligation for the Transfer Pricing requirement is eliminated.
2. Anti - Tax Avoidance Directive Provisions:
The General Anti-Abuse Rule aims to eliminate artificial arrangements whose main purposes is the tax benefit that defeats the object or purpose of the tax laws. Back to back arrangements have been considered in many cases by authorities or court cases as artificial arrangements with the main purpose to benefit from a tax treaty thus the treaty benefits were denied.
Therefore, the current tax environment emanates shifting from such arrangements. The NID is a useful scheme that can reduce the tax burden and substantially reduce the risk of falling within the general anti abuse rules.
3. Beneficial Ownership Issue:
The purpose of the Beneficial Ownership Issue is to attack aggressive tax planning structures by refusing the granting treaty benefits to the entities that are not beneficial owners of the income.
An important factor to consider whether the company is the beneficial owner of the income or not is the power of the company to dispose the income and whether all or almost all of the income is transferred to another entity.
One of the measures that may assist in addressing the Beneficial Ownership Issue is the conversion of debt into equity since through the equity finance the company’s obligation for further transferring the funds into another entity is eliminated, implying that the control of the economic destiny of the income is retained by the company.
D. HOW TO CALCULATE NID
The NID is calculated by multiplying the amount of the “New Equity” introduced into the company, with the “Reference Interest Rate”.
However, the following restrictions apply which limit the amount of the NID granted to the lower of the:
1. 80% of the taxable profit that each asset or activity or group of assets or activities separately has generated.
2. 80% of the taxable profit that the assets or activities collectively have generated.
The terms “New Equity” and “Reference Interest Rate” are defined below.
In order to obtain a clear understanding of the NID equation, the following terms are defined:
1. New Equity:
New Equity is defined as the “capital introduced” into the company, which is represented by “shares”.
Capital introduced comprises the following:
• Issuance of shares as from 01/01/2015;
• Conversion of loans payable, payables and other debt instruments into issued share capital, after 01/01/2015;
• Conversion of non-refundable capital contribution into issued share capital, after 01/01/2015;
• Conversion of realized reserves created after 1 January 2015 into issued share capital;
• Conversion of realized reserves existing on 31 December 2014 into issued share capital, provided that upon the conversion the capital is employed in new assets which generate taxable income.
In accordance to the Cyprus Income Tax Law, Non-Refundable Financial Assistance, and Shares in Partnerships or other transparent entities, explicitly disqualify for the “capital introduced” definition.
The term shares include shares of any class and type. More specifically the type of shares may be:
• Share premium;
Unpaid share capital shall be considered as paid-up capital and qualifying as “New Equity” for NID purposes however a corresponding claim will be recognized which will give rise or is deemed to give rise to interest subject to income tax.
2. Old Equity:
Old equity is defined as the share capital and share premium which is issued and settled prior to 31/12/2014.
3. Reference Interest Rate:
Reference Interest Rate is the 10-year government bond yield of the country in which the funds raised from the new equity are invested, increased by 3%.
The 10-year government bond yield used for the calculation of the NID is the rate as at 31st of December of the previous year, of the year in which the NID is claimed.
The 10-year government bond yield is obtained from the official site of the Tax Department in Cyprus, in which the 10-year government bond yields for selected countries on an annual basis is issued.
II. Basic Principles/Limitations:
In order to calculate the NID, the following basic principles should be taken into account.
1. Time apportion of NID:
The NID deduction is granted proportionally for the months for which the company is eligible to the new equity (the capital introduced is both issued and paid) provided that taxable income is generated from the use/investment of such new equity.
NID is subject to an option which can be exercised in each year of assessment in respect of total or part of the NID (for indefinite period).
For better understanding, please refer to the example in Section F, Appendix A.
2. Matching Concept:
The matching concept is used by allocating the New Equity to the assets or activities of the business that were financed. The NID is calculated for each asset/activity/group thereof separately.
Therefore, on calculating the NID of each asset/activity, the value of the new equity contributed together with the reference interest rate for each asset/activity/group should be identified. Further on applying the 80% restriction of NID the taxable profit of each asset/activity should be identified.
For better understanding, please refer to the example in Section F, Appendix B.
3. Method of finance of the new equity:
The method of finance of the new equity by the shareholder varies. However, this impacts the calculation of the NID, since different treatments apply in each case as analysed below:
1. Financed from new equity of another Cyprus company:
NID may be claimed only by one company, unless the reinvestment of the new equity generates different taxable income.
2. Financed directly or indirectly from loans:
NID is reduced by the amount of the interest expense claimed for tax purposes by the shareholder if the shareholder is Cyprus Tax Resident.
For better understanding, please refer to the example in Section F, Appendix C.
3. If the new equity is a result of conversion of loans payable into capital:
NID is calculated on the taxable income generated by the assets or activities that the loans payable were financing.
4. If the new equity contributed by the shareholder is paid in kind:
The value of the new equity is the market value of the assets contributed at the date of the injection of the assets into the company, provided that such value is accepted by the Tax Authorities.
The NID is claimed provided that the injected assets contributed by the shareholder produce taxable profits to the company.
4. Restrictions on the grouping of the assets/activities subject to NID:
NID is calculated separately on each asset or activity, unless the assets or activities qualify for grouping.
Therefore, unless the assets/activities form part of a group, the income and expenses of each asset/activity needs to be clearly defined and documented, since the 80% restriction will apply on the taxable profit generated from such asset/activity respectively.
5. If the new equity is a result of reorganisation:
NID is claimed by the surviving company on the new equity that results from the reorganisation, subject to conditions.
6. Cessation of NID:
NID ceases to be granted if the new equity is withdrawn via a capital reduction, or in the instance that the company purchases its own capital, or in the instance the company stops using the new equity for the generation of taxable income.
In the instance of reduction of capital, then the capital is matched to the assets/activities in order to result to the amount of new equity subject to the capital reduction and consequently the restriction of the NID.
7. Capital Increase:
Where there is capital increase from the capitalisation of reserves that cannot be matched to assets/activities, then the capitalisation of reserves is conducted in a predetermined order. The order will be analysed on a case by case basis.
8. Profit/Loss generated from the disposal of the asset or from the activities subject to NID and reinvestment into same type of assets/activities:
Where there is a disposal of an asset generating taxable income and a further reinvestment of the proceeds into another taxable income generating asset then the profit/loss on disposal is not taken into consideration when calculating the amount of the New Equity for NID purposes.
9. Conversion of debt:
Where there is conversion of debt that financed non-taxable income generating assets/activities, into equity, then NID may be claimed if the assets are disposed and the proceeds are used for the acquisition of new taxable income generating assets/activities. However, unless the disposal of the assets and purchase of new assets is incurred after the capitalisation of debt, NID is not granted.
For better understanding, please refer to the example in Section F, Appendix D.
10. Limitation of the taxable loss:
Any brought forward loss that an asset or activity or group thereof may produce is not included in the calculation of arriving to the taxable profit of that asset or activity or group thereof subject to NID.
For better understanding, please refer to the example in Section F, Appendix E.
A collective restriction applies by which the 80% of the total taxable profit of all assets or activities is calculated. In order to arrive to the total taxable profit of all assets or activities, both the taxable profits and taxable losses generated by each asset or activity is taken into consideration.
For better understanding, please refer to the example in Section F, Appendix E.
The NID cannot create or increase taxable losses.
11. Limitation on Reference Interest rate:
The 10-year government bond yield to be used should be higher or equal to the 10-year government bond yield of Cyprus, as at 31st of December of the previous year of the year in which the NID is claimed, increased by 3%.
For better understanding, please refer to the example in Section F, Appendix D.
In the instance that the subject country has issued 10-year government bond yields for various currencies, then the 10-year government bond yield of the transactions’ currency is used. If the subject country has not issued a 10-year government bond yield of the transactions’ currency, then the 10-year government bond yield of the country’s currency is used.
III. NID Anti-Abuse Rules:
1. Capital Reduction and Reissuance of New Equity
If there is a capital reduction and increase of capital in relatively short time, then the grant of NID is not allowed.
2. General Anti abuse Provisions
The Tax Authorities do not have to grant the NID where the company is entering into certain transactions or arrangements having no commercial or economical rational, as main purpose is to obtain the tax benefit through the NID scheme.
Also, the Tax Authorities do not have to grant the NID where the origin of the new equity of the company is from equity existed as at 31/12/2014 and through transactions or arrangements between related parties whose main purpose was is to obtain the tax benefit through the NID scheme.
3. Value of New Equity:
Where the capital is introduced in the form of assets, the value of the assets should be determined through a report of an external independent expert, unless certain conditions apply.
The tax developments applied universally necessitates the companies to reconsider their business structures, and consider whether it would be more beneficial to shift from debt finance to equity finance.
As analysed, the equity finance assists in conformance of the globally applied regulations and also offers a notional interest deduction of up to 80% of the taxable income, leading to an effective taxation of only 2.5%, through the application of the NID.
Our Tax Department is able to prepare a diagnostic review and propose possible solutions to your structure.
Partner – Tax Department
Associate – Tax Department
SCHEDULE 1 – REFERENCE INTEREST RATES
The following table gives a summary of the 10-year government bond yield of EACH country since 2014 as issued in the official site of the Tax Department in Cyprus, forming the reference interest rates:
SCHEDULE 2 –NID CALCULATION EXAMPLES
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Disclaimer: This publication has been prepared as a general guide and for information purposes only. It is not a substitution for professional advice. One must not rely on it without receiving independent advice based on the particular facts of his/her own case. No responsibility can be accepted by the authors or the publishers for any loss occasioned by acting or refraining from acting on the basis of this publication.