Cyprus: The importance of Transfer Pricing rules

The need for establishing a set of Transfer Pricing rules is based on the "Arm’s Length principle" and is perhaps the most important tax issue from an economic point of view over the past 20 years. It is estimated that a percentage of 60%-70% of the economic and commercial activity internationally is carried out between companies of the same group or between related companies. The primary goal of Transfer Pricing rules is to ensure that income generated within the same group and related companies, is taxed in the same place where economic value is created. 

Simply put, Transfer Pricing rules aim to regulate the pricing of transactions undertaken between related companies and ensure that the same market conditions that apply for transactions undertaken between unrelated companies (de-facto regarded as being carried out at arm’s length) are reflected and apply to transactions carried out between companies that are related to each other.

Ensuring that transactional value creation is fully aligned with a properly documented transfer pricing outcome has been a fundamental principle in the direction in which the international tax rules have been moving in recent years, especially after the publication  and immediate implementation at a global level of the OECD/G20 plan targeting the erosion of the taxable base and the shifting of profits to jurisdictions with low or even zero tax rates (BEPS Actions 8,9,10).

The case of Cyprus

It is a well-known fact that Cyprus has a relatively low corporate tax rate (12.5%), so it is very important for the Cyprus Tax authorities to be able to prove to foreign Tax authorities that the income received by Cypriot companies is in line with the international pricing standards (OECD’s Transfer Pricing Guidelines) that regulate transactions undertaken between related companies. 

As a result, the need to adopt specific rules regulating transactions undertaken between related companies, in order to avoid overpricing the value of transactions, thus shifting  profits towards jurisdictions with low or zero tax rates, or vice versa, of underpricing  transactions carried out between related parties with an aim to lower the level of profit subject to tax in jurisdictions that feature high tax rates, was a necessity which needed to be addressed in today’s highly digitalized and interconnected global economy.

Statutorily requiring documenting transactions carried out between related parties and by extension, documenting the level of income received or expenses paid by the Cypriot companies will also provide certainty to taxpayers and prospective investors regarding the level of their tax obligations, while strengthening at the same time the negotiating position of the Cyprus Tax Authorities in cases of disputes by foreign Tax authorities. 

It is important to note that the new Transfer Pricing rules capture all types of transactions (goods, services, financial services, transactions involving intellectual property etc) carried out between related companies, if such transactions exceed (or should have exceeded, if priced based on market conditions) the annual threshold of €750,000 per category of income. Each transaction should be assessed separately as well as cumulatively with other transactions within the same category of income, to assess whether the annual threshold is met.  For companies that meet the threshold, there is a statutory obligation to prepare a “Local” file which must be updated annually.  The content of the local file should provide among others, a background of the company, a description of the controlled transactions undertaken, a functional profile analysis, a benchmarking study, as well as the reasoning for the transfer pricing methodology selected.  In addition to the local file, all Cyprus companies that engage in controlled transactions must prepare and submit a table of summarized information (TSI) listing all controlled transactions that the company concluded with its related parties, irrespective of the value of each transaction. 

The benefits for Cyprus

The benefits for Cyprus from opting to adopt transfer pricing rules will be realised on multiple fronts (monetary and non-monetary) and in several stages.  First and foremost, regulating transactions carried out between related parties will help strengthen the Cyprus brand as a reputable financial center and clearly and practically demonstrate its commitment to the highest standards of transparency and substance.  Monetary gains in the medium- and long-term horizon will also be realised since reputable investors are always looking for such qualitative characteristics in a jurisdiction in combination with a friendly tax system, before they decide to invest or set up their business.  The new rules are also expected to act as a stimulant for existing companies to enhance their physical and economic substance in Cyprus with a spillover effect on other sectors of economic activity such as services, commerce and construction.

The statutory requirement for documenting controlled transactions by Cyprus companies is certainly a step in the right direction.  It is also aligned with the officially asserted transparency and substance appetite that Cyprus has consciously strived to demonstrate in recent years.