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Cyprus & The EU - Taxation Trends

Author: Paul Mallis, International tax partner, Deloitte Limited, Nicosia, Email: pmallis@deloitte.com

Cyprus's competitive tax system and membership of the EU have helped the Island become a leading centre of international business. Low tax rates are one thing, but how does Cyprus compare to the rest of the EU when it comes to tax revenues as a proportion of actual income? Paul Mallis of Deloitte comments on the recent Eurostat findings.

Last month Eurostat, the Statistical Office of the European Communities, issued its annual report on Taxation Trends in the European Union based on taxation data for 2007 . The report stated that the overall tax-to-GDP ratio in the EU27 in 2007 was 39.8%. This is a measure of the total tax revenues of the government as a proportion of gross domestic product, being the market value of all final goods and services made within a country in a year.

One would imagine that with a 10% company tax rate (together with Bulgaria, the lowest in the EU) and a low top personal income tax rate of 30%, Cyprus's overall tax-to-GDP ratio would be significantly below the EU average. At 41.6% in 2007, it is actually higher. Not only did Cyprus have the 8th highest tax-to-GDP ratio in the EU27 in 2007, in the same year only one non-EU country in the OECD had a rate above 35%.

One must look at the detailed findings released in the Eurostat report to help explain the trends. The report provides the 2007 implicit tax rates on labour, consumption and capital for the EU27. Implicit tax rates are a historical looking measure, taking actual tax revenues of a country and comparing it to the total income of persons from that country.

2007 implicit tax rates: EU average & Cyprus 

 

Tax Revenue
% of GDP

ITR – labour

ITR – consumption

ITR - capital

EU27 average

39.8%

34.4%

22.2%

28.7%

Cyprus

41.6%

24.0%

21.4%

50.5%

Highest

Denmark 48.7%

Italy 44.0%

Denmark 33.7%

Cyprus 50.5%

Lowest

Romania & Slovakia 29.4%

Malta 20.1%

Greece 15.4%

Estonia 10.3%

 

Labour

For the average Cypriot, the inherent tax rate on labour is a crucial statistic to be aware of. It is a broad measure of the tax burden falling on employment income. It looks at total employment taxes and compulsory social insurance contributions compared to total compensation of employees. In 2007, Cyprus had a rate of only 24%, the second lowest in the EU after Malta. The low rate reflects the comparatively low top personal tax rate on employment income of 30% (compared to Denmark 59% and Sweden 56.4%), as well as the generous tax free allowance in Cyprus where the first €19,500 of a individual's annual taxable income is tax free. The level of labour taxation in Cyprus is similar to that in the USA and Japan. Cypriots should be happy they are not living in one of the eight other EU countries with inherent tax rates on income of over 40%.

Consumption

When it comes to the tax burden on consumption, inherent tax rates among the EU27 vary much less than with labour, ranging from a low of 15.4% in Greece to a high of 33.7% in Denmark, with most countries recording a rate in the twenties. Cyprus is near the middle of the range with 21.4%.

Although Cyprus has the lowest VAT rate in the EU of 15%, the inherent tax rate on consumption looks at all taxes on discretionary consumer spending including excise duties on fuel, alcohol and cigarettes, which assists to raise the rate above 15%. Although Cypriot duties on alcohol and cigarettes are low compared to other European countries, the total magnitude of consumption of these goods means total duties are significant as compared to total discretionary consumer spending on all goods and services. Also, although the distances travelled are short, with Cypriots having a high car to person ratio and with little alternative transport, petrol consumption, and so duties collected on petrol, are comparatively high.

Capital

At first it would appear incredible that Cyprus could have the highest of any measure of tax in the entire EU. The reality is that it does - an inherent tax rate of 50.5% on capital.

To understand this, we need to examine what this measure actually is. First, the rate looks at all taxes on savings and investments which, for Cyprus includes defence contribution payable on interest, dividends and rents as well as capital gains tax and transfer fees on sales of immovable property. The total revenue from these taxes is then compared to all income from capital and business activities.

It is clear that the property boom in Cyprus has had a profound effect on the inherent tax rate on capital, contributing to the high rate. The pattern within the EU is clear, with other countries experiencing similarly high rates, such as the UK (42.7%) and Spain (42.4%), having had equally buoyant property markets in recent years.

It will be interesting to see how this rate will compare when statistics are released for future years as the dampening of property prices in Cyprus and elsewhere in Europe only began subsequent to 2007. It is already clear that there will be a big impact on the Cypriot rate with the Cyprus Inland Revenue's own statistics showing a reduction in receipts of capital gains tax of 81% in the five months to 31 May 2009 as compared to the same period in 2008 .

One other influence that should be noted is that of the divergence of the company tax rate from personal income tax rates. As at 1 January 2000 the combined tax rate on company profits was 29% and the top personal income tax rate was 40%. In 2007 (and now), the company tax rate is 10% and the top personal income tax rate is 30%. The divergence in rates together with other tax advantages has led to increasing incorporations of businesses where personal incomes of sole traders and partners are converted into corporate returns such as company profits and dividends, boosting corporate tax and defence contribution revenues at the expense of personal income tax revenues.

And how does Cyprus compare to "the good old days"?

The table below shows the inherent tax rates in 2007 and also in 2000, showing that all rates have increased over time. The latest statistics are for 2007 and so we cannot point to the old chestnut that adoption of the Euro in Cyprus has lead to the increases that they show.

2007 versus 2000: Cypriot implicit tax rates

 

Tax Revenue
% of GDP

ITR – labour

ITR – consumption

ITR - capital

2007

41.6%

24.0%

21.4%

50.5%

2000

30.0%

21.5%

12.7%

23.8%

 

The rates above again show the astounding increase in the inherent tax rate on capital between 2000 and 2007. The probable reasons have already been commented on above. The most direct reason for the 68% increase from 12.7% to 21.4% in the inherent tax rate on consumption is the increase in the standard VAT rate from 8% as at 1 January 2000 to 15% as at 1 January 2007 (and now). The inherent tax rate on labour has increased by a relatively lower 11% from 21.5% to 24.0%.

The hidden influence

What cannot be derived from the numbers stated in the Eurostat report is the influence of international business and investment on the tax rates.

Clearly the burden of tax on the Cypriot citizen has increased since 2000, particularly on consumption expenditure. However how much of the total tax revenue is being suffered by actual Cypriot citizens and business?

Many investors in the Cypriot real estate market are non- Cypriots or non-Cypriot businesses. These foreign investors have contributed significantly to Cypriot tax revenues when paying capital gains tax on sales of these properties.

Also, the increase in international business through Cyprus has contributed to total tax revenues while, most probably not contributing to an increase in actual GDP in the same proportion. A simple example is an international business that incorporates a Cypriot finance company with large financial receivables and payables. The company probably pays tax at 10% on net interest earned while the financial assets are not included in the calculation of GDP. Such companies therefore add to the tax revenue of the country without necessarily increasing GDP, meaning that the overall tax-to-GDP ratio goes up. As Cyprus becomes more and more an international financial hub, it is expected that there will be a continuing increase in the existence of such companies in Cyprus and upward pressure on the tax-to-GDP ratio.

At the same time, if the assumption is made that the total budget of the Republic is fixed, then a further conclusion can be made that these ultimately foreign sourced tax revenues avoid a need to increase tax revenue from the Cypriot citizen, influencing the continued relatively low inherent tax rate on labour.

Conclusion

The Eurostat report enforces a number of aspects we already know.

We know that the general burden of taxation in Cyprus has been increasing over recent years. What the report shows is that this increased burden is suffered through consumer spending and the increased taxes on consumption and is a trend throughout the EU.

We know that a person selling real estate in Cyprus incurs significant taxes - both capital gains tax and transfer fees. What the report shows is that this tax burden has contributed to a massive increase in total taxes on capital and the resulting total tax revenue of the government.

What the report does not show is how much of this tax burden has been truly suffered by the Cypriot people and how much is driven by the immense growth in our international economy, being contributions of tax revenue to the government tax purse without actually burdening Cypriots. This is an unavailable, but key statistic that would be of great interest to everyone.

Paul Mallis

Deloitte
STADYL Building
Corner Themistocli Dervis and Florinis
P.O.Box 21675
CY-1512, Nicosia
Cyprus

Tel: +357 22 360 300
Fax: +357 22 679 006
Email: pmallis@deloitte.com

Paul Mallis is a tax partner of Deloitte, Cyprus.  He leads the international tax group of the Nicosia office and specialises in cross border structuring and transactions, mergers and acquisitions.  He joined the Cyprus practice of Deloitte in 2007 after 8 years at the London office of Deloitte, including 5 years in the M&A tax group. 

Originally from New Zealand, Paul is a member of the New Zealand Institute of Chartered Accountants and holds a Bachelor of Commerce and Administration from Victoria University of Wellington.  He is also a member of the Institute of Certified Public Accountants of Cyprus and serves on its Tax Committee.

 

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