Purpose and scope of DAC6

Council Directive (EU) 2018/822, also known as the 6th Directive on Administrative Cooperation (DAC6) requires tax intermediaries or taxpayers to report certain cross-border arrangements that trigger at least one of the hallmarks prescribed in the Directive, commonly known as the ‘Mandatory Disclosure Regime’ (MDR). The objective of DAC6 is to tackle the design of aggressive tax avoidance schemes.

DAC6 requires mandatory reporting of cross-border arrangements when they have an economic or tax impact covering direct taxation (i.e. corporation tax, income tax, capital gains tax, defence tax, stamp duty). In that respect, indirect taxes such as VAT, customs duties and other indirect taxes are out of scope. An arrangement is reportable if it has a cross-border element, i.e. if it concerns either more than one EU members states or a member state and a third country, and if it satisfies the main benefit test (MBT), unless we are faced with a hallmark that will by itself trigger a reporting obligation without the need to satisfy the MBT. The MBT examines whether the arrangement in question is tax driven as opposed to the tax benefit obtained from the transaction in question being just incidental.

The Cypriot DAC6/MDR Law 205(I)/2012 as amended (Annex IV), follows closely the wording of DAC 6 and was entered into force on 1 January 2021. It is therefore important to establish processes which clearly identify reportable transactions falling within the scope of DAC6 which require mandatory reporting to the Cyprus Tax Authorities.

Who shall report and when and what must be reported?

The duty to report falls on an intermediary who designs, markets, organizes, or manages the implementation of a reportable cross-border arrangement. DAC6 recognises that intermediaries should only be treated as such where they have or should have knowledge of the arrangement in question.

Lawyers operating within limits applicable to their profession benefit from a waiver of their reporting obligation due to legal professional privilege. Where this is the case, DAC6 requires intermediaries to notify any other relevant intermediaries or the relevant taxpayer himself of their reporting obligation, so the duty to report will fall on the taxpayer.

Reports need to be filed with 30 days of the reporting trigger. This would mean 30 days from the day on which the arrangement is made available or is ready for implementation or the day on which the first step in implementation is made, whichever takes place first.

The information to be reported is a detailed list containing an outline of the cross-border arrangement and transaction value, the details of all intermediaries concerned, the relevant taxpayer, the applicable hallmark and reference to the provisions of the relevant local law, i.e Law 205(I)/2012 as amended (Annex IV).

Hallmarks commonly encountered by corporate service providers

The hallmarks analysed below do not constitute an exhaustive list of all the prescribed hallmarks for the purposes of DAC6. We have attempted to identify those hallmarks that may be commonly encountered by corporate lawyers, accountants, corporate service providers and fiduciary service providers in the course of their day to day business affairs which present an indication of a potential risk of tax avoidance.

Hallmark A3:  standardised documentation

This hallmark refers to situations where we are presented with standardized documentation or a structure, which is so standard that it does not require any material tailoring to the individual circumstances of the participants implementing the arrangement. This hallmark is expressly subject to the MBT.

An indicative example of standardized documentation would be a standardised short form loan agreement, services agreement or licencing agreement which is clearly based on a template permitting the ease of replication. Such an agreement needs to be so standard in its form, that it gives the impression that it can be used by numerous clients without the need for material bespoke changes or amendments suited to the specific needs of each client.

For this reason, it is vital to search for purpose clauses in a loan agreement which make it clear for which purpose the loan is provided. In the case of services agreements, we should make sure that they refer to specific services corresponding to the commercial background of the service provider and not just generic services with no real commercial purpose clearly aimed at moving funds offshore.

An indicative example of a standardized structure would be the establishment of a new finance company abroad or a new holding company providing services. This would ofcourse catch off- the-shelf products established for the sole purpose of moving funds in the low tax jurisdiction thereby leading to a tax advantage.

Hallmark B2: conversion of income

This hallmark will trigger a reporting obligation where we are presented with the conversion of taxable income into lower or zero taxed revenue schemes, capital or gifts. This hallmark is by definition subject to the MBT since the effect of conversion of the income is taxation at a lower level or a tax exemption.

A fairly straightforward case would obviously be loan forgiveness from a creditor as it would have the effect of completely depriving the creditor of the taxable interest payments.

Another striking example potentially caught by hallmark B2 is convertible loans since by converting the loan receivable into capital in exchange for the issuance of new shares in a company, the taxable interest income that would have been received is converted into a zero taxed capital or tax-exempt dividend income.

Hallmark B3: circular transactions/ round-tripping of funds

This hallmark covers situations where the funds initially move away from one jurisdiction to another jurisdiction but subsequently return to the first jurisdiction if: (i) the transactions end up to offset/ cancel each other, and (ii) the entities concerned do not have any other primary commercial function from the circular transaction in question. This hallmark is expressly subject to the application of the MBT.

An indicative example would be a sale and subsequent leaseback transaction whereupon the leaseback transaction would effectively cancel the initial sale.

Another example would be a contribution of equity by a parent company to a subsidiary and a subsequent advancement of a loan or payment of tax exempt dividend from the subsidiary to the parent resulting in the round-tripping of funds.

The crucial question would be whether in each case there are any commercial reasons for such a circular transaction that exceed the tax advantage obtained, i.e. whether the interposed entities have any primary commercial functions justifying this transaction.

Hallmark C1 (b.i) – (c) – (d) : payment to an associated enterprise not subject to tax or subject to zero tax or a preferential tax regime

The first limb of hallmark C1 concerns payment to an associated enterprise not subject to tax or subject to zero tax or a preferential tax regime. Where the law requires the jurisdiction of the receiver of the payment to be subject to zero tax or a preferential tax regime, this makes the cross-border payment subject to the MBT.

A typical example would cover the situation where an offshore company shareholder of a Cypriot company provides an interest-bearing loan to its Cypriot subsidiary which would result in cross border interest payments made from the Cypriot company to its offshore parent. Where the country of the offshore parent receiving the interest is not subject to tax or is a preferential tax regime compared to the country of the Cypriot borrower, this would trigger a reporting obligation.

Another example would be cross-border deductible license payments to an associated enterprise in cases where the jurisdiction of the receiver benefits from an IP box regime.

Hallmark C1 (a) – (b.ii) : payment to an associated stateless enterprise or an associated enterprise in a blacklisted jurisdiction

The second limb of hallmark C1 is straightforward since what is required is payment to an associated enterprise which is either not tax resident anywhere or is in a blacklisted or non-compliant jurisdiction.

This is not subject to the MBT and the payment does not need to not result in a tax benefit obtained by the recipient associated entity.  The only requirement is that the associated entity should be either not tax resident anywhere or in a blacklisted country. In that respect, any type of payment to an offshore subsidiary in a jurisdiction concerned would trigger a reporting obligation. In that respect, where the country of the offshore parent being the recipient of a payment is not a tax resident anywhere, this would automatically trigger a reporting obligation without the need to prove that a tax benefit was obtained for the purposes of satisfying the MBT.

For the purposes of determining a blacklisted or non-compliant jurisdiction, we take into account the OECD list of non-compliant jurisdictions (currently four countries, i.e., Anguilla, Antigua & Barbuda, Nicaragua, Guatemala) and of course the EU list of non-cooperative jurisdictions (currently sixteen countries). Notably, Russia, BVI, Marshall Islands, Panama and Bahamas are some of the countries among EU’s list of non-cooperative jurisdictions. Where the payments concerned are made to an enterprise which is in a blacklisted jurisdiction, it goes without saying that this will trigger a reporting obligation without the need to show that the country of the receiver benefits from any preferential tax regime.

Hallmark E3: profit shifts following an intragroup reorganisation

This hallmark refers to cross-border transfer of functions/ risks/ assets where the transferor is deprived of its main assets i.e., such a transfer is projected to result in a more than 50% decrease in profit before tax (EBIT) during the next three years, regardless of whether the transferee will gain a main benefit. Therefore, the MBT does not apply to this hallmark. Rather the real question is whether the profitability of the transferor shall be impacted by the transaction in question.

This covers a large number of typical restructuring transactions including, mergers, de-mergers, transfers of subsidiaries and liquidations.

If we take the example of a voluntary liquidation of a foreign subsidiary whereby as a result of the distribution of assets in the course of the liquidation all of the assets of the subsidiary in liquidation are transferred to its Cypriot holding company, it is clear that the projected EBIT of the transferor (company in liquidation) would be reduced to zero since all its assets in their entirety would move to its parent company.

Similarly, in the case of a cross-border merger whereby a Cypriot holding company absorbs its foreign subsidiary, all the assets of the subsidiary would be transferred to the Cypriot holding company thereby reducing its profits to zero.

Notably, dividend income should not be taken into account for the purposes of calculation of the projected 3-year EBIT of the transferor. In that respect, we need to make sure that the asset base of the company being absorbed or liquidated, as the case may be, consists of other types of assets in addition to shares. This is actually an important point to note, as we need to evaluate the asset base of the company transferring its assets in order to determine whether a reporting obligation under hallmark E3 should be triggered.

Penalties – consequences of failure to report to the tax authorities

Cyprus imposes administrative fineS between €10,000 and €20,000 per reporting failure. In particular an administrative fine between €1,000 and €5,000 is imposed where there is a delay in reporting of up to 90 calendar days by an intermediary or taxpayer. Where such a delay exceeds 90 calendar days, the administrative fine can raise from €5,000 up to €20,000. Also, the administrative fine imposed in cases of failure of the intermediary to notify the relevant taxpayer about his/her duty to report due to the intermediary’s legal professional privilege ranges from €10,000 up to €20,000.

Is there any way to circumvent the reporting obligations?

Even though there is no way to circumvent the reporting obligations, the application or not of a specific cross-border payment or arrangement to one of the hallmarks will mostly depend on the application of the MBT, save for those hallmarks that are not subject to the MBT (hallmark C1 (a) – (b.ii) and hallmark E3). The real question would be whether there is a primary commercial rationale behind a certain transaction that would render any tax benefit gained as a result of the transaction incidental. Where, on the other hand, it is pretty obvious that the parties entered into a specific transaction for the sole purpose to gain a tax advantage and for no other commercial reason, there is a clear duty to report.

Compliance with DAC6 is a challenging task, when it comes to identifying applicable hallmarks and ensuring that the reporting obligations will be complied with going forward. Intermediaries should actively monitor cross-border arrangements or structures potentially affected as an ongoing process and should raise awareness within the members of staff with a view to ensuring efficient compliance with the DAC6 reporting obligations.