There is no profit but there are taxes

Accounting profit is arguably one of the main indicators of financial position of an organization. However, information about it does not make it possible to get an idea of the amount of income tax. Accounting profit includes all income and expenses of a company without exception, not taking into account any peculiarities of tax laws of the country of incorporation of the company.

Tax profit shall be understood to mean the difference between income and expenses which forms the tax base. Tax profit can be fundamentally different from accounting profit. A simple example for a Cyprus company is dividends received or profit from sales of securities which make it into accounting profit but not into tax profit.

In this article, we will consider situations that are not so obvious but occur quite often, like when a company incorporated in Cyprus has differences between accounting profit and tax profit.

1.As in many other jurisdictions, Cyprus has a rule under which expenses not related to generating income (note: taxable income) are not taken into account in calculation of corporate income tax. Such expenses particularly include rental costs for premises/equipment the use of which is not related to activities of a company. Another example is broker’s fee for transactions on sale and purchase of securities. Since profit from sales of securities is exempt from taxation, expenses will not be taken into account when calculating the tax base.

2.The next difference that occurs in activities of virtually any company concerns exchange differences. They are realized and unrealized.

Realized exchange difference is exchange difference arising as a result of changes in exchange rates in the course of a certain transaction (currency conversion, repayment of debts/credits/loans/interest on loan obligations denominated in foreign currency, etc.).

Unrealized exchange difference is exchange difference arising in revaluation of funds in foreign currency accounts, assets and liabilities under contracts entered into in foreign currency at the end of the reporting period.

All unrealized exchange differences, both positive and negative, are excluded from the tax base in tax calculation.

3. Differences in calculation of accounting and tax income are also caused by transactions concerning forgiveness of debts and loans in full or in part, both granted and received. These transactions usually arise between related parties.

Accrual of so-called notional interest is associated with adherence to the arm’s length principle set forth in Article 33 of the Income Tax Law 2002.

In the event of financing/provision of loans to related parties, transactions must be made at arm’s length. Otherwise, Cyprus tax authorities reserve the right to introduce tax adjustments to reflect deviations from this principle. This is usually done in the form of notional interest and/or waiver of certain interest expenses.

That is, when the conditions of two related companies in their commercial or financial relations differ from those of independent parties, any profit that should have been accrued (provided that the same conditions are applied as those of independent parties) can be included into the company’s profit and be taxed with corporate tax at the rate of 12.5% accordingly.

For companies whose primary activities are receipt and provision of loans, the fact of excess of interest expenses over interest income would be considered suspicious. It is worth mentioning the loan interest limitation rule (exceeding borrowing costs, EBC). On April 25, 2019, the Law 63(I)/2019 on implementation of the EU Anti-Tax Avoidance Directive (ATAD) 2016/1164 came into force in Cyprus. Under this rule, excessive borrowing costs are deductible in the amount of up to 30% of EBITDA (Earnings before interest, taxes, depreciation and amortization). The said rule has a number of exceptions, namely:

  • A minimum threshold has been set (excessive borrowing costs of up to 3 million euros can be deducted);
  • The rule does not apply to loans issued before June 17, 2016 and other loans.

4. Receivables that remain outstanding for several reporting periods often lead to additional tax charge.

According to IFRS (International Financial Reporting Standards), it is important to adhere to the concept of time value of money. Obviously, 5 million rubles now and 5 million rubles in 3 years’ time is not quite the same amount. Therefore, if a company has receivables and takes no action get its money back for several years, it is not about the receivables but about financing received, most likely, from a related party, i.e. an interest-free loan.

In this case, it would be right to discount 5 million rubles, that is, calculate the equivalent amount at the time being and reflect financial income each year in the same manner as if an interest loan were issued. In this case, there is no difference between accounting profit and tax profit.

However, this approach is unpopular in practice. Company management cites a lack of information on maturities and professional judgment. Still, there is no way to avoid recognition of income in Cyprus. In the event of an audit, the auditor or tax authorities accrue notional earnings. That is, financial income will not be recognized in accounting profit but will be included into tax profit based on the same arm’s length principle.

It is possible to avoid the accrual of notional interest if evidence is provided that the debt is defaulted (not recoverable) according to the classification from IFRS 9 Financial Instruments.

It is mentioned in the standard that accountants can use their professional judgment, however, in practice, the auditor and tax authorities request a court ruling or other documents confirming bankruptcy/liquidation of the debtor in English or in Greek.

Until the asset is recognized as defaulted, it is necessary to accrue financial income whether it is a “hung” receivable or a loan. If there are no supporting documents, bad debt provision which reduces accounting profit but does not affect the tax base shall be recognized in accounting.

Thus, the lack of profit in accounting does not guarantee that a company will not have tax liabilities, and vice versa. The company may have both large accounting profit and tax loss. To avoid any unpleasant surprises in preparation of financial statements, it is very important to understand the impact of a business transaction on taxable profit in view of nuances of tax legislation.


*- according to audit and judicial practice, not fixed at the legislative level

Julia Vints

Director

IFRS Practice

Korpus Prava

Other Articles on Topics
See Also Articles from the Issue
The National International Private Law Development: Resolution of the Plenum of the Supreme Court of the Russian Federation on the Application of International Private Law

2019 was full of events in the legislative and enforcement spheres. Novation has affected particularly the scope of international private law.

March 13, 2020

What Has The Year of the Rat Prepared for Accountants?

From January 01, 2020, tax authorities will maintain the State Information Resource of Accounting Statements (GIRBO). The Law No. 247-ФЗ dated 26.07.2019 establishes the procedure for submission of the accounting statements (including amended statements) to the GIRBO.

March 13, 2020

Review of Russian Legislative Changes in 2020

In the traditional annual review article devoted to innovations in the legislation of the Russian Federation, we have collected for you the most interesting short stories of the Russian legislator that will come out in 2020.

March 13, 2020

New Year – New Rules

One of the innovations that completely changed the current practice was the introduction of liability for illegal currency transactions in the form of a fine amounting to 75 to 100 % of the amount of the currency transaction.

March 13, 2020

FAQ on Cyprus

In this article you will find answers to many questions regarding residency,controlled foreign companies, and transfer pricing in Cyprus.

March 12, 2020

Ongoing Search for a Beneficial Owner of Income: Overview of Recent Court Decisions for 2019

The past year of 2019 was quite rich in tax disputes concerning the issues of determining and qualifying a beneficial owner of income. In this article, we offer a review of key court decisions made in 2019. At the same time, in this article we will only pay attention to the arguments made by regulatory authorities and courts.

March 12, 2020

Special Instance, Professional Representation, Continuous Cassation and Other Changes in the Process

In 2019, major changes for the recent years — the so-called procedural revolution — took place. On October 1, three key laws that reform the system of general jurisdiction courts and change the rules of court procedure came into force.

March 12, 2020

AML 5, or Nice to Meet You

Rumors regarding the introduction of an electronic register of beneficiaries in European jurisdictions have been around for a long time and finally, they have become real. On May 30, 2018, the European Union issued Directive 2018/843 amending EU Directive 2015/849 dated 20.05.2015.

March 12, 2020

Subsribe to the Journal

Your subscription to our journal will definitely boost the efficiency of your specialists and downsize your expenses for consultants.

The journal is available free of charge in the electronic version.

Free Download