Cyprus faces heat over tax treaty

Business Standard

India’s action is a significant step for compliance with international transparency standards on exchange of information

Last week, India took a tough stance exercising its legislative powers for promoting transparency and preventing harmful tax competition. Its first axe fell on Cyprus with the Department of Revenue notifying it as a non-cooperative tax jurisdiction with immediate effect. Implications of this administrative circular has deep-rooted consequences and is indicative of India’s position in Organisation for Economic Co-operation and Development (OECD)’s global transparency forum, currently chaired by a senior Indian Revenue Service officer.

Cyprus – a case of chequered history
From Cyprus’ standpoint, being classified as non-cooperative is not the first brush with foreign governments/treaty partner, as Russia had taken to a similar exceptional measure in 2008 despite Cyprus emerging as a leading financial centre for inbound and outbound foreign investments from and into Russia. Cyprus, though, did yield to continued pressure to conform to the Information Exchange protocol in 2013 and was subsequently taken off the list of non-cooperative jurisdictions. In yet another instance, Cyprus was listed as a ‘tax haven’ by Italy for outbound investment in 2000 and was forced to amend its tax treaty with Italy to incorporate the information exchange framework. India’s action, though unprecedented, is a significant step to its commitment for ensuring compliance with international transparency standards on exchange of information.

Section 94A of the income tax law (I-T Act) inserted by the Finance Act of 2012 empowers the government to classify any jurisdiction as non-cooperating on failure of such country to implement exchange of information. In 2007, India made a formal request to the governments of UAE and Cyprus to amend their respective tax treaties to incorporate a limitation of benefits (LoB) clause, a vexed issue with Mauritius in the recent years. Though UAE agreed to amend the treaty to include LoB clause followed by a comprehensive article on exchange of information, negotiations with Cyprus have not progressed. This exceptional step doesn’t surprise me given Cyprus’ continued silence and global focus in ensuring transparency standards via work carried out by the OECD on BEPS action plan, widely endorsed by OECD and non-OECD countries as part of the recent G-20 summits.

Immediate repercussions
India’s decision entails four directly visible consequences each of which are viewed from macro-economic and fiscal standpoint :

a) First and foremost, transactions between Indian entities and unrelated/third party Cyprus entities will be deemed as transactions between Associated Enterprises (AEs) and subject to the rigors of Indian transfer pricing regulations. Besides, the requirement to maintain documentation to demonstrate ALP test, the change shall cause discomfort and add to the administrative burden of doing transaction with Cyprus residents.

b) All transactions will be subject to higher penal withholding tax of 30 per cent (unless a higher rate applies) in relation to all payments liable to tax. Besides, Cyprus investors would be mandatorily required to lodge Indian tax return to pursue refund of excess tax withholding relying on a beneficial tax regime under the treaty.

c) PE funds and FII investors routing investments through Cyprus-based funds/investment vehicles could be made liable to tax on investments as deemed income (of Indian investee company) unless the source of funds and details of beneficial ownership areproved to satisfaction of tax administration. Onus to explain the source and beneficial ownership shall rest with the Indian company. This anti-abuse tool could lead to taxing foreign direct investments (FDI) and cause wider implications for investors choosing Cyprus as a preferred financial centre.

d) Lastly, for shifting of tax base to a lower tax jurisdiction (Cyprus in the present context), the I-T Act mandates that inadequate explanation for expenses incurred towards payments to Cyprus entity could lead to disallowance of expenditure, thus increasing the transaction costs.

Viewed cumulatively, all the above will operate as a significant deterrent to investors investing through a Cyprus financial centre and in particular, real estate funds. Lack of grandfathering for existing investment structures could make investors think of migrating to a preferred tax jurisdiction with robust a tax treaty.

The very intent of legislating penal consequences for non-cooperation underlines India’s respect for international convention of ‘treaty override over domestic law’. An unbiased way to decipher this development is to take it as India’s stringent warning to delinquent treaty partners and investors who choose to invest using such jurisdictions. Late on Friday, the Cyprus government getting into damage control mode, issued a press release in its righteous intention affirming its intention to abide by bilateral convention and to enter into direct negotiations for long pending treaty negotiations with India. It would then be interesting to see if India reciprocates by withdrawing Cyprus from the non-cooperation list.