Tax Reform in Cyprus
in View Of Accession to the European Union
By: Emily Yiolitis

The prospect of Cyprus' accession to the European Union offers wide opportunities for modernization of the Cyprus economy through revision of the outdated tax policy currently in application. This Article will deal only with alignment as far as the European Union's acquis-communautaire is concerned focusing on corporate taxation as this will apply to International Business Companies in Cyprus. This unique opportunity could be grasped for a wholesale rather than a piecemeal revision of the tax system of the island, equipping Cyprus to deal effectively and competitively with the increasing competition for taxation and investment.

Integration in the E.U.

Cyprus today is a popular international business and financial center, and one of the largest third party ship management centers worldwide. The transformation of the island's economy has taken place over the relatively short time span of 25 years and is owed largely to the incentives introduced in 1975 when the first amendment to the Income Tax Law was introduced granting the favorable tax rate of 4.25% for the companies, today known as International Business Companies. Legitimately, the prospect of accession to the European Union with the necessary harmonization which accession entails, has led to the necessity to rethink the tax policy of the Republic, whether in a wholesale or a piecemeal fashion, so as to adopt the so-called acquis-communautaire. This in turn has led to speculation that the popularity and attractiveness of the Island as far as foreign investment is concerned will diminish in view of increased regulation and higher taxes. The author will contend that this is not necessarily the case and that the prospects for the services sector of the island are far from bleak.

Undoubtedly, like all forms of integration, accession will diminish the freedom of action of the member states' policy-makers. The higher the form of integration, the greater the restrictions and loss of national competences.

At the EU level, to evaluate the degree of integration in the area of taxation, a distinction must be drawn at the very start between direct taxes which are still at an embryonic stage of harmonization and indirect taxes, which are more regulated. The field of indirect taxation creates evident obstacles to the free movement and supply of goods and services within the Union and thus a higher degree of harmonization is justified. Direct tax systems on the other hand do not justify similar harmonization and leave substantial scope for maneuvers to the national policy maker (see however the Ronald Schumacker case (Case C-279/93) which held that although direct taxation as such does not fall within the purview of the Community, the powers retained by the Member States must nevertheless be exercised consistently with Community law). Personal income taxes, for example, should not constitute matters for European-wide co-ordination, unless they entail discrimination or double taxation. Direct taxes do however have a substantial impact on the decisions of businesses and investors as far as corporate taxation is concerned and it is precisely to this matter that we shall now turn, as the low rates of corporate taxation for non-resident entities in Cyprus are the pivotal points of reference in any debate for a reformulation of tax policy on the Island.

Corporate taxation

Corporate taxation is one of the few areas where the Council can adopt legislative measures only by unanimity. This may be the reason why currently, there are only two Directives in force, the Parent-Subsidiary Directive, which eliminates double taxation on dividends paid by subsidiaries to their parent companies located in another Member State, and the Merger Directive which establishes a common system of taxation whereby any capital gains arising from mergers, divisions, transfers of assets or shares are not taxable at the time of the operation but only when the gains are actually realized. There is also a Convention in force, which outlines an arbitration procedure designed to prevent double taxation which may occur as a result of different interpretations by Member States of the transfer prices used by associated enterprises for their joint operations. As noted, none of these measures seek to harmonize corporate tax rates but to regulate direct taxation of mobile tax bases. In fact, tax competition, caused precisely because of the absence of harmonization of corporate tax rates, is a healthy, sought-after phenomenon which will induce policy-makers to offer the best possible services at the lowest possible prices. Tax competition can become harmful and create distortions only where there is a risk of "free riders" i.e. persons or businesses who benefit from low-tax jurisdictions for taxation purposes and high-tax jurisdictions for services purposes.

Cyprus' aims in the near future

So what are Cyprus' aims as far as a reformulation of its tax policy is concerned, taking into account the need to align its practices and regulations with the acquis-communautaire of the European Union (including its Code of Conduct), with the OECD in its campaign against Harmful Tax Competition and most importantly with the pressures brought on by increased global tax competition?

As a first step and as far as corporate taxation is concerned, all explicit incentives for international businesses as well as discriminatory preferential tax rates will need to be eliminated. The Code of Conduct makes it clear that tax advantages can no longer be ring-fenced from the domestic market. Various proposals have been forwarded in this context, the most popular of which advances a single corporation tax rate of approximately 10%.

Secondly, Cyprus must harmonize its VAT and excise taxes with European Union standards, abolishing all discrimination as far as excise duty is concerned against EU-imported goods. In terms of VAT, most services post revision, will be taxed at the rate of 15%, significantly increasing VAT-fostered revenues. It is expected that the increase in revenue from consumption taxes will create room for maneuvers for the policy makers in other areas of tax if wholesale revision is undertaken and one area which stands to benefit is taxation of personal income.

Thirdly, Cyprus must revisit its state aid policy which will come under scrutiny by the Commission upon accession. At least for a transitional period, it is advisable that Cyprus negotiate exemptions of the state aid prohibition with the European Commission to buy time in streamlining its revised economy. As far as the shipping and ship management sector is concerned, the regime of tonnage tax recently introduced should be kept. State aid rules are often applied by the EU to this sector and therefore Cyprus should have no particular problems in negotiating an exemption in the shipping industry.

Cyprus will further need to comply with the Parent-Subsidiary and the Merger Directives introducing a/ a revised regime for the taxation of intercompany dividends and b/ a revised regime for the taxation of capital gains. A Directive on interest and royalty payments between Companies as well as a Directive on the taxation of savings whose aim is ensuring a minimum effective taxation of savings income within the Union are in the pipeline. Cyprus is taking these into consideration while drawing up the revised taxation policy in order to avoid patching up already revised regulations to catch up with new legislation upon entry to the Union.

All things considered, the prospects for the services sector of the island are far from bleak. The unitary tax rate will remain attractively low and should not in principle deter investors. On the contrary, it is likely to increase investment if not in quantity, then arguably in quality. The elimination of the tax discrimination currently applicable will better link foreign and domestic businesses eroding the fence which has hitherto deterred co-operation and openness. The readjustment of revenues from various tax bands will create room for a "playing ground" in which policy makers can create an all-round more balanced system of taxation. In conjunction with the rest of the advantages of accession (the expected improvement of the political climate, the conditions of macroeconomic stability to be secured by adoption of the Euro and membership in the EMU, the liberalization of capital flows from and to Cyprus et cetera) all factors point towards an eventual transformation of Cyprus into a regional business center in which International Business Companies will enjoy increased demand and popularity and in which Cyprus can be better equipped for increased global tax competition.

Emily Yiolitis

For info contact: Emily Yiolitis Oxon MA, EUI LL.M
Advocate / Legal Consultant
TOTALSERVE MANAGEMENT LTD
P.O. Box 54425, 3724 Limassol, Cyprus
Tel: + 357 5 866000 Fax: + 357 5 866001
E-mail: yiolitis@totalservecy.com Website: http://www.totalservecy.com