Logic Behind Substance:
A Case Study from Russia

Working in the field of personal and business relocation to Cyprus, as well as citizenship by investment, I closely watch the trends and cases related to our area of professional interest. Those who have faced the need to relocate their business and/or assets to Cyprus, or those who have researched this issue, already know that proper substance is essential for tax planning and running the business.

Still the topic of substance is surrounded by a number of misconceptions: there is a lot of confusion how substance works, what criteria are essential and how much shall it cost for the business and for individuals. Sometimes I receive questions even from my colleagues that offer such services to the market.

Let me share my view on the topic of substance and the logic behind it – I hope it will bring clarity to both companies that are already using these services and to those who are just considering them now as an option.

Historically, many companies relocating their business and assets to Cyprus preferred to take an “easy way” in terms of substance, setting a formal business entity without real or with minimal business activity in the country.

Lately I was reading a court case from Russia that clearly shows the scope of consequences such an approach can lead to. Here is the full story for those interested in full details (Case number A11-6159/2018 dd 28.06.2019), but let me share the essence of this case study with you here.

The case describes the situation, when the court decided that the 5% reduced income tax as per Double tax treaty between the Russian Federation and the Republic of Cyprus from 05.12.1998 was applied incorrectly. It is not the purpose of this article to discuss the whole case, I just want to highlight how court have examined the substance and to what level of details they have paid attention to.

The company insisted that the business was established and managed in line with Cyprus law, that they had expenses for company management, courier, accounting and audit, that they paid levy and paid taxes as per Cyprus law (in this specific case no tax in Cyprus on dividends – note by authorities).

Nevertheless, Russian Tax department and court saw the following:

  • Cyprus companies were represented in the court by locals (Russians) on basis of Power of Attorney,
  • Dividends were the only source of income for the companies in Cyprus,
  • Shares of Russian company were bought by means of borrowed funds from affiliated parties (in fact, Cyprus companies experienced financial losses due to the loans and interest payments as per financial statements),
  • Cyprus companies did not possess any real estate or any other assets, there were no employees and expenses related to asset ownership, companies did not report real management expenses.

The court has concluded that Cyprus companies (the actual shareholders of a Russian company) were performing only a technical function by transferring income to other legal entities. The court held that they are just theoretical owners not beneficiaries and Cyprus companies have performed only tax agent functions, while dividends received from Russia by Cyprus companies were transferred in whole amount to BVI (converted in USD dollars).

The court held that the declared substance in Cyprus (company incorporation and renewal expenses, auditor’s remuneration, levy, bank commissions and percent payments regarding loans) shall be treated as expenses for formal presence.

Authorities also pointed out that small proportion of expenses cannot be treated as a substantial evidence for real substance. From the court’s point of view, there were no evidence that directors actually managed company and took decisions on usage of the received dividends. In addition to that, two Cyprus companies were incorporated at the same date with minimum share capital (only 1000 euro) and serviced by the same law office.

The case contains detailed description how managers of Russian company were connected through other companies, including Cyprus and BVI companies – the court held that those individuals shall be considered affiliated persons.

When you plan the substance for your business, REMEMBER there are open registries to check, information is available from banks and from other ongoing court cases. Consider even to whom the Power of Attorney was issued and what addresses and other contact details were declared and DO NOT IGNORE human factor (if the court sees uncertainties/lack of clarity, they will be looking for arguments supported by evidence).

Moreover, in the case described above the court have discovered the evidence, that some of Cyprus company bank accounts were managed by one of the directors of a Russian company (please note that courts are authorized to request information from banks). It was discovered that bank accounts of Cyprus and BVI companies were opened in the same bank in Russia.

To conclude the story, the court had ordered that financial operations of shareholders of a Russian company were organized by the group of affiliated companies in the interest of these shareholders, while Cyprus companies in their Financial statements did not show affiliated persons as per international audit standards. That evidences the formal status of the company instead of showing real substance.

Fact that The company ignored local taxes and was demanding international benefits it was not entitled to does not help at all. It is not good idea to claim some tax benefits, without paying other taxes.

The court decision remained unchanged even after appeals.

Always here to give you a professional advice on the subject of substance,

Liene Vitola - Evele
Business and Investment Migration Advisor | IMCM