Christos Theophilou and Demis Ioannou of Taxatelier present a case study of how the Cypriot tax authorities use safe harbour rules in determining arm’s-length interest rates. The article appears in International Tax Review, published by Euromoney PLC.

1. www.itrinsight.com November 2020 1
Local insights | Europe, Middle East & Africa
CYPRUS
Taxatelier
Christos Theophilou and Demis Ioannou
A look at intra-group loans
and safe harbour rules in
Cyprus
Christos Theophilou and Demis Ioannou of
Taxatelier present a case study of how the Cypriot
tax authorities use safe harbour rules in
determining arm’s-length interest rates.
Transfer pricing has always been a chal-
lenging exercise, in particular in regard
to intra-group financial transactions. It was
not until February 2020 that the OECD
eventually published specific guidance on
financial transactions, namely the
“Transfer Pricing Guidance on Financial
Transactions: Inclusive Framework on
BEPS Actions 4, 8-10”.1
In the context of intra-group loans, to
provide administrative simplicity for both
the taxpayers and the tax authorities, safe
harbour (or safe haven) rules are often
used by tax authorities in determining
arm’s-length interest rates. Such rules are
usually optional (i.e. the taxpayer can elect
to either apply the safe harbour rule or
follow the country’s domestic transfer
pricing guidelines).
For example, in the context of intra-
group loans, a safe harbour rule could be a
pre-determined rate that is typically pub-
lished by the tax authorities and such a
rate may be amended from time to time.
However, certain tax risks may arise, on
both domestic tax law and at tax treaty
level.
Safe harbour rules and intra-group loans:
Cyprus as a case study
As noted above, tax policy-makers are
inclined to introduce safe harbour rules to
provide (for both tax administrators and
taxpayers):
• Increased administrative simplicity;
• Lower tax compliance burden;
• Minimised transfer pricing disputes; and
• Certainty for taxpayers.
Presumably, with all these merits in
mind, in mid-2017 the Cypriot tax
authorities (CTA) introduced a safe har-
bour rule with respect to intra-group
loans. In brief, taxpayers that entered into
intra-group loans (specifically back-to-
back loans) have the option to either pre-
pare a transfer pricing study and therefore
apply the arm’s-length interest rates or
apply a pre-determined rate that is 2%
profit margin (i.e. the difference between
loan payable and loan receivable).
Practical application and planning points
Despite the above advantages, in practice,
several issues have arisen. To begin with,
the outcome of using the safe harbour rule
(i.e. 2% profit margin) may be contrary
with the arm’s-length principle (i.e. the
guidelines provided in the FT Report).
For example, assume that a Cyprus tax res-
ident company borrowed funds from its
parent at 2% and on-lend such funds to its
wholly-owned foreign subsidiary bearing
interest at 4%.
Assume further that the arm’s-length
interest rate is 3.2 %. As a result, the tax-
payer is found to report income above
arm’s-length level. It is worth mentioning
that tax authorities would not provide for
a downward adjustment, that is to refund
the difference of 0.8%. On the other hand,
the foreign tax authorities would be
inclined to challenge the high safe harbour
rule as it may lead to less taxable income
reported by the foreign subsidiary.
Furthermore, the foreign tax authori-
ties – where the subsidiary is considered to
be tax resident – may challenge the
amount of interest expenses paid. In such
a case, provided that the foreign tax
authorities follow the OECD TPG (i.e.
the FT Report), in order to accurately
delineate the intra-group loan, they must
take into consideration the commercial
rationality of the transaction from both
perspectives, that is the Cyprus company
as a lender and the foreign subsidiary as a
borrower.
At least two tax risks may arise. In case
the Cyprus company is found to be a lim-
ited risk financing entity, typically earning
a handling fee (i.e. the functional analysis
concludes that the company performs lim-
ited functions and has limited risks) and
not a fully-fledged financing entity.
First, according to the FT report on
paragraph 10.8, in case the transaction is
found to be commercially irrational then
the foreign tax authorities may disregard
the transaction and therefore disallow the
interest expense. The same result would be
achieved in case the foreign tax authorities
decide to re-characterise the
transaction/payments thereunder, normal-
ly from interest to dividends.
Second, the Cyprus company would
typically not be entitled to tax treaty bene-
fits. This is because a handling fee earning
type of entity may, depending on the facts
of the case, also not be considered as the
beneficial owner of the income nor fulfil
the requirements of the principal purposes
test. As a result, the generally lower tax
treaty rate for interest income (i.e. Article
11 of the OECD Model) would not apply,
and therefore the source country will have
an unlimited taxing right to apply its
domestic withholding tax rate imposed on
interest paid to non-residents.
In light of the above, taxpayers entering
in cross-border intra-group loans, when
following the safe harbour rule in Cyprus
would not be in a position to analyse their
capital structure (i.e. the balance of debt
and equity funding), in order to ensure
that they comply with the FT Report.
However, by performing a transfer pricing
study, the taxpayer will be able to identify
any tax risks and therefore be in a position
to minimise such risks by planning their
cross-border activities depending on their
capital structure, and their specific set of
facts and circumstances.
1 There were brief country notes on financial
transactions relevant to transfer pricing in the Transfer
Pricing and Multinational Enterprises Report of 1979,
repealed by the OECD’s Council in 1995, and in the
Thin Capitalization Report of 1987.
Taxatelier
T: +357 22 875 720
E: ctheophilou@taxatelier.com;
dioannou@taxatelier.com