Economic substance is a doctrine in international tax law.

It states that economic transactions are valid only if they have a purpose apart from reduction of tax liability. To put it simply, a company must show that it is carrying out activities in a specific country to set up an economic substance.

The company must be able to show two things to establish an economic substance in any country of its choice. These include the physical presence of its members and the on-ground activity of its higher-ups within the tax residence or the jurisdiction in the targeted country.

In this article, we’ll discuss:

  • What is economic substance
  • Why set up economic substance in Cyprus
  • A step-by-step guide on setting up economic substance in Cyprus

Why Set Up Economic Substance In Cyprus In 2024?

Cyprus is considered one of the top 15 tax havens around the world for a reason. Mainly because it has signed double tax treaties with more than 60 countries worldwide. Among them are economic powerhouses such as the USA, China, France, Germany, and the UK.

Residents of these countries will get two major benefits from creating substance in Cyprus.

The first is that they will get to enjoy the benefits of double tax treaties. Secondly, any foreign tax authority, trying to tax their company under the legislation of their parent country, will find it hard to challenge their company’s tax status.

How to Set Up Economic Substance in Cyprus?

Setting up economic substance in Cyprus isn’t easy, especially for a Cyprus-incorporated company. The must carry out an overwhelming number of measures to prove that a) it is managed in Cyprus and b) substantive business operations are carried out in the country.

Here is a step-by-step approach to establishing economic substance in Cyprus:

Step 1: Preliminary Steps

  1. Register your company with Cyprian tax authorities;
  2. Buy/rent an office in Cyprus for business activities (residential premises do not count);
  3. Appoint a resident of Cyprus as a qualified director of the company. They should make independent decisions regarding the activities of the company;
  4. Have a working website, telephone number, and email address;
  5. Open a local bank account;
  6. Hire locals in the company and undertake the necessary arrangement for the payment of payroll taxes;
  7. Register your company as well as the people working for it with social insurance requirements;
  8. Make sure that the decisions concerning the company are made inside Cyprus (the effective management and control of the company must be in Cyprus);
  9. Ensure that all the company’s documents (agreements, invoices, statements) are properly stored in the company’s Cyprus office
  10. All the agreements, share register, minutes of meetings, and resolutions should be property stored in the Cyprus office.

Step 2: Board Composition

Making sure that most of your company’s directors are Cyprus tax residents is crucial to establishing economic substance in the country. The company directors residing in the country must not only have a say in its management. They should also be among the company’s top hierarchy and must form a quorum in the company’s board meetings.

All of this should be reflected in the company’s business transactions documents.

Step 3: Board Procedures

Holding board meetings in Cyprus is one of the most essential substance components. Crucial decisions regarding the company must be taken in the country – a fact that should reflect in the relevant documentation. Any company whose decisions are made by outsiders won’t be considered to have economic substance in Cyprus.

Furthermore, the company must hold at least one board meeting every 12 months. In the meeting, all the directors (resident as well as non-resident) should be physically present. Resident directors of the company must demonstrate they have enough say in managing the company’s affairs.

Step 4: Memorandum and Articles of Association

The company’s articles of association and memorandum mustn’t have anything to show its taxable presence in another jurisdiction. One way to do that is by ensuring that the majority of the company’s directors are Cyprus tax residents.

Step 5: Accounting, Bookkeeping and Auditing

For a company to have sufficient economic substance, all its financial transactions and operations should be kept and prepared in the country. This encompasses the execution of documents, issuance of invoices, and exercising statutory requirements.

The same goes for bookkeeping – all the financial reports, management accounts and financial statements must be prepared in line with the IFRS inside Cyprus. Audits, as well as their discussion and approval, should also be conducted inside the country.

Step 6: Office and Personnel

Company personnel should be carrying out their duties in the physical office in Cyprus. They must have valid social insurance numbers. The same goes for directors and other management officers. Operations related to the company must be carried out in a fully-furnished office.

Step 7: Power of Attorney

Transferring the general powers of attorney to non-tax residents should be avoided as much as possible. That is because it leads to the risk of the company’s management and control going outside its jurisdiction. However, in scenarios where there is no choice but to transfer the power of attorney, the directors should be immediately made aware of this decision by none other than the attorney.

Step 8: Local Bank Account

Opening and maintaining a local bank account in Cyprus is key evidence of substance in the country. Bank signatories should also be based in the country. Furthermore, the banking transactions should also originate from within Cyprus.

Conclusion

In this article we answered what is economic substance and we explained its importance.

The presence of economic substance allows companies to manage tax risks while conducting international economic transactions. On the other hand, lack of substance may give rise to tax disputes and a tax burden that may outweigh the benefits of foreign corporate structures.

Keep in mind that the above mentioned steps will only come in handy to set up substance in Cyprus. They are no guarantee that the substance will be maintained throughout the company’s lifetime. Only by its repeated actions could a company demonstrate its substance.