As a candidate for EU membership and as an international business centre Cyprus has been under much scrutiny for the past few years. The reports and observations resulting from that scrutiny have been quite encouraging but they have all stressed the need for reform, especially in relation to the tax system. To that end Cyprus has made several commitments at the international level. In order to remain true to those commitments fundamental reform is essential.
In the report of the Organization for Economic Cooperation and Development, Progress in Identifying and Eliminating Harmful Tax Practices, published in June 2000, Cyprus was conspicuous by its absence from the black list. But this was achieved only after Cyprus made a commitment, along with another 6 countries, to eliminate harmful tax practices by the end of 2005, and to embrace international standards of transparency, exchange of information and tax competition.
As an aspiring EU member Cyprus must amend its legal framework and make it compatible with the acquis communautaire. The modifications needed to complete this process include changing the tax system so as to conform to the EU Code of Conduct and the rules on business taxation.
The process of tax reform is already well under way. A bill was approved by the Council of Ministers on November 5th. All that remains now is to secure approval by the House of Representatives. The bill will be presented there within the week.
In this article we shall look first at the tax provisions in force at the present time and then at the proposed reforms and the possible consequences of their implementation.
Present Tax Regime
Under the current regime individuals are taxed on the basis of a progressive scale on their aggregate net income. Personal allowances and deductions may be claimed. In addition to direct taxation individuals have to contribute to the Defence Fund and the Social Security Fund.
The taxation scale for the income of individuals is as follows:
Up to CYP 6,000
From CYP 6,001–9,000
From CYP 9,001–12,000
Above CYP 12,001
Corporation tax is levied on all companies. It applies to any company incorporated or registered under Cypriot law as well as any foreign company which has an office or place of business in Cyprus or conducts business here. The tax is assessed on taxable trading profits and levied on local companies at a rate of 20% on profits up to the first 40,000 CYP and 25% on profits above this amount.
The tax regime in Cyprus is especially favourable to international business entities. Any company which is exclusively owned by non-residents and whose income is generated from activities outside Cyprus is taxed at a flat rate of 4.25% and its dividends do not attract any withholding tax. This also applies to offshore branches of foreign companies whose management and control is situated in Cyprus. Where management and control of the branch is outside Cyprus then the branch is wholly exempt from tax on profits.
Expatriate employees of international business entities enjoy a more privileged position inasmuch as their emoluments are either taxed at a reduced rate or not at all. The definition of emoluments includes the salary as well as other allowances, e.g. housing, cost of living, school fees etc.
If such employees work in Cyprus they are taxed at 50% of the normal rates and are entitled to personal allowances. If they work abroad they are charged at 10% of the normal rates unless the remuneration is received in or through Cyprus, in which case it is exempt from tax. They are not entitled to personal allowances.
The government has developed some radical tax proposals which were approved by the Council of Ministers on 5th November. The general thrust of the reform bill is the reduction of income and corporation taxes in exchange for a gradual increase in VAT and other indirect taxes. The proposals take the following form.
The VAT increase will take place in two stages, from 10% to 13% in the first stage and then to 15% by the end of 2002. Taxes on luxury items and on vehicles will also be raised gradually. The road and registration taxes for vehicles (except diesel saloons) will be increased and some custom and excise tax reliefs will be abolished.
The tax-free income of individuals will be raised and the tax rate lowered proportionally in each band.
The new taxation scale for the income of individuals will be as follows:
Up to CYP 9,000
From CYP 9,001–12,000
From CYP 12,001–15,000
Above CYP 15,001
Personal allowances and deductions will be abolished with the exception of the discounts allowed for contributions to the Social Security Fund, Welfare Fund and the discounts allowed for life insurance. The Government’s contribution to the Social Security Fund for private employees will fall from 4% to 2%.
Expatriate personnel of international business companies will be subject to income tax in the same way as Cypriot citizens and they will be expected to contribute to the Social Security Fund. Various options are being considered to provide further relief to such personnel, such as overseas allowances, housing allowances and hardship allowances, provided that the reliefs comply with the acquis communautaire and with the Code of Conduct. Duty-free facilities for expatriate personnel will be abolished from April 2003.
A single corporation tax will be levied on all companies, whether international or local, at a flat rate of 10%. From 1st February 2002 all companies will be subject to VAT.
Dividends paid to individuals will be taxed at source at 15%. The tax will be paid on the deemed distributed dividends, i.e. on 70% of 90% of the profits of the company after the 10% tax has been subtracted. There is to be a special provision for 2002, which suggests that during that year the tax will be 10%. Foreign shareholders will not pay tax on dividends irrespective of residence. Dividends paid to legal persons will be subject to a 20% tax.
Within the context of the EU accession negotiations the government is attempting to secure a transition period during which the system will remain as it is. It will be achieved by putting into effect the “grandfather clause”. This is not very difficult to do, especially in relation to the advantages enjoyed by expatriate employees, as most of the laws and regulations which provide for the advantages enjoyed by such employees have an expiry date and will cease to apply when that date is reached.
The defence levy will be abolished, with the 2% levy on salaries and pensions eliminated immediately and the 3% charge on rents and dividends removed in 2003. The defence levy on interest will rise to 10% though it should be noted that interest will no longer be subject to tax.
The government also proposes some measures to assist groups of people that will not benefit from the tax reforms like retired persons and low income families. It is expected that 88 million CYP will be utilised so as to raise the basic pension, public assistance and the child allowance.
The government’s aims in formulating the tax reform package are to harmonise the present legislation with the acquis communautaire, to ensure the stability of both the economy and society, to conform with the EU Code of Conduct and the rules on business taxation, to honour its commitment to the OECD, to preserve and improve the position of Cyprus in international tax competition and to simplify the tax system.
The likely rise in the tax rate of corporation tax on the net profits of international business companies is not expected to have a critical impact on the presence and operation of such companies in Cyprus. In formulating the tax change the Ministry of Finance has worked closely with international businesses to secure their approval of the new 10% levy. The Cyprus International Business Association publicly declared its support for the proposed rate on 5th November.
The Employers and Industrialists Federation also expressed its approval of the proposed reforms. The lower corporation tax rate is deemed especially welcome at the present time when the economy is facing a slowdown.
The move towards indirect taxation is expected to minimise the mischief done to government funds by widespread tax evasion. The system will become fairer, more effective and easier to manage.
The government’s aims appear to have been realised though only time will tell whether that is true. All in all, the proposed reforms seem to be taking Cyprus down the right road towards fulfilling all its obligations.