Tax deduction on capital investment

The Notional Interest Deduction (NID)

This exemption aims to encourage the financing of company business through equity (own capital), as opposed through external debt. Properly applied, Notional Interest Deduction can significantly reduce the taxable base of a Cyprus company and thus provide significant tax savings. In certain ideal cases, this deduction alone can reduce the effective tax rate of a Cyprus company down to 2.5%.

The Notional Interest Deduction (NID) is a deduction on taxable income, which is based on a Reference Interest Rate applied to New Equity (new capital). It can apply equally well to Cyprus companies that invest abroad, same as to those who do business locally in Cyprus.

“New equity” means, quite simply, the issued and fully paid share capital and share premium that is introduced in the business operations of a Cyprus company after January 1, 2015. Under certain conditions, new equity may also be introduced in-kind, at its fair market value. Capitalization of existing loans issued to the Cyprus company by its shareholders or other stakeholders will also qualify as “New equity” for the purposes of NID. This means, for example, that the company has little need to employ such techniques as back-to-back financing. In order for the Notional Interest Deduction to apply, the new equity must be directly employed for the purposes of generating the income of the Cyprus company.

As of 1st of January 2020 the Reference Interest Rate is the aggregate value of 5% plus the 10-year government bond rate of Cyprus or of that country where the New equity (new capital) got invested in the preceding year. As such, the Reference Interest Rate will fluctuate year-to-year, depending on the changes in the 10-year government bond rates of various counties, including Cyprus.

The Notional Interest Deduction is limited to 80% of taxable profit. Thus, with the right proportion of new capital versus the gross income in a Company, this deduction can reduce the effective income tax rate of a Cyprus company to as low as 2.5%.

NID will apply in perpetuity, for all subsequent tax years – for as long as the capital remains invested. However, this deduction cannot in any way apply to losses and it cannot create or increase a tax loss. If unused during any tax year, the benefits of the notional interest deduction cannot be carried-forward. The Cyprus tax laws also contain certain anti-avoidance provisions, whereby the Tax Authority may refuse the notional interest deduction where, in their opinion, Company transactions have been effected without valid economic substance or commercial reasoning, with the main purpose in mind being to claim NID. The deduction may also be denied where it is determined that arrangements have been made between related persons in such a way so as to present old equity as new equity.

A company may, in any tax year, elect to claim the whole or part of the amount of the deduction available. This may be useful if the Cyprus company needs to demonstrate that a certain (higher) amount of tax has been paid in Cyprus.

The Notional Interest Deduction described by an example

In January 2020, a Cyprus company is established. Its shareholders contribute one million euros to its paid-up capital. The company invests this capital in launching a new trading business in Cyprus. In 2020, the company earns 100’000 euros in pre-tax income.

• The 10-year Cyprus government bond rate in 2019 was 0.536%.
• This makes the Reference Interest Rate as 5.536% (0.536% + 5%).
• Based on its New Capital, the company can claim a maximum NID of 55’360 euros (1M x 5.536%).
• Based on its profits, the company could claim a maximum NID of 80’000 euros (100’000 x 80%).
• The lower of the two figures must apply.
  
  

Thus, the taxable income of 100’000 euro is reduced by Notional Interest Deduction of 55’360 euro, leaving the actual taxable income at 44’640 euro. That balance of income will be subject to the standard 12.5% tax rate. Thus the actual tax payment will be 5580 euro. That makes the rate of effective income tax in this case less than 5.58%. Mathematically, in certain conditions the effective income tax rate can be as low as 2.5%.

The Notional Interest Deduction calculation will be different in case when the New equity of the Cyprus company has been invested abroad – for example, lent to a company subsidiary in another country. In such case, that foreign country’s 10-year government bond rate will be taken as a basis for the Reference Interest Rate. If a country does not issue government bond then the reference rate of the government bond of Cyprus will be used.