New Horizons in the Ukraine-Cyprus Business Relationship
16 September 2013
The business relationship between Ukraine and Cyprus has seen rapid developments in the past 12 months. On November 8th, 2012, the new Double Tax Treaty (DTT) between Ukraine and Cyprus came into force. Despite a marginally higher withholding tax, the new DTT was widely heralded as bring a new sense of stability into the bilateral relationship.
In March 2013, the Eurogroup took the fateful decision to “bail-in” depositors in the Bank of Cyprus and Cyprus Popular Bank, leading to a catastrophic decline in confidence and deposit flight from Cyprus. Today, Cyprus Popular Bank has been liquidated and its branch network merged with that of Bank of Cyprus, and there are many questions as to whether the Bank of Cyprus can survive as a viable entity.
At the time of writing of this article, the first impacts of these changes can be measured and assessed. This article reviews the business relationship in terms of risk assessment and tax optimisation measures available to investors in Ukraine and Cyprus. It argues that the European sovereign and banking crises are far from over, and that investors in both countries must take an active risk management approach to international business transactions.
The Depositor Bail-in, Capital Controls, and Trust
The success of any bilateral relationship depends on trust. While good laws and regulations are paramount, they only serve to reinforce trust, and are only as good as the bilateral institutional commitment to respect them.
In Cyprus, it is very clear that the relationship of trust Cyprus once enjoyed with international investors has been dramatically affected. While much blame for this can be assigned to the Troika and the disastrous decision to “bail-in” depositors in Cyprus Popular Bank and Bank of Cyprus, it is clear that the underlying reasons for this bail-in have been the exclusive responsibility of the Government of Cyprus, and the political-financial elite which have managed the country for the past 30 years.
After the bail-in was completed, numerous sources of information were revealed which cast grave doubt on Cyprus’ ability to manage an international business centre. These include:
Alvarez & Marsal’s investigation into the Cypriot banking sector, which revealed that the Bank of Cyprus made executive-level decision on the purchase of Greek sovereign debt without following even basic risk management parameters or internal BOC parameters;
The decision by the Cyprus Central Bank to extend EUR 9 billion in Emergency Liquidity Assistance (ELA) to the Cyprus Popular Bank, without proper parliamentary or Ministry of Finance oversight, and ignoring fundamental banking good practises;
The current hearings in the Cyprus Parliament, which cast light on the dismal relationship between the Christofias government and the former governor of the Central Bank of Cyprus, Athanasios Orphanides, together with the apparently disastrous decisions made by the new Governor, Panicos Orphanides, who was appointed in May 2012.
The same hearings cast into stark relief the attempt by the government to “blame the banks” for the crisis, notably in the terms of reference drafted for the PIMCO/Blackrock assessments of banking sector recapitalisation needs.
Together with other factors affecting the banking sector, including such as domestic overbanking, rampant non-performing loans, high unionisation, sub-standard customer service, low productivity, and the high bureaucratisation of the country, it becomes clear to any external, disinterested observer that Cyprus’ position as an offshore centre has suffered a major blow to its reputation.
And this occurs prior to any discussion of capital controls and deposit flight. Cyprus’ attraction as a financial sector was precisely the facility with which an investor in Cyprus (or using Cyprus as a base to invest in Ukraine) could transfer money in and out of the country. For the Bank of Cyprus and the liquidated Cyprus Popular Bank, this facility is now over.
Finally, the issue of trust is measured as well in terms of how well the key institutions in Cyprus—among others the government, the Central Bank of Cyprus, and the two systemic banks (BOC/PBC)—communicated with foreign investors.
Here too, Cypriot performance leaves much to be desired. None of these parties communicated effectively with investors during or after the crisis. Perhaps the key illustration of this is the Bank of Cyprus: in the week after the first Eurogroup meeting, and at the time when the banking branches were closed, the BOC made almost no effort to communicate with its customers. The Bank’s website did not contain any information on the deposit freeze; the Bank did not send emails or make any real effort to communicate directly with its customers on what steps were being taken, and why.
The conclusion that investors large and small took from this abysmal performance is that active risk management measures were required for their business in Cyprus. Accordingly, a substantial number of the companies using Cyprus as an offshore base have now set up bank accounts for their Cypriot companies in other locations. Many have also set up new companies in other EU or international jurisdictions.
This is seen clearly in the dramatic capital flight in Cyprus, which continues despite the capital controls imposed in an effort to stem it. Between January and July 2013, total deposits by non-financial institutions in Cyprus fell from EUR 68.42 billion to EUR 49.74 billion, a decline of 27%. Euro area residents have withdrawn 45% of total deposits in this time; residents in the rest of the world have withdrawn 38% of deposits.
Table 1: Deposits by non-financial institutions in the Cypriot banking sector
Managing Risk in Cyprus: The Short-Term Perspective
Given the lack of trust in Cyprus’ ability to manage the current crisis, investors from Ukraine and other countries are re-evaluating their risk levels and risk management techniques. It is clear from discussions with Navigator Consulting Group’s clients as well as partners in various accounting, legal and financial management service providers that investor decisions are not being driven by small-scale issues such as the increase in the corporate tax from 10% to 12.5%, or the fact that in the dividend withholding tax has been increased to 5%. Instead, investors are taking decisions based on:
A fear that Cyprus can no longer guarantee the stability of its financial system, and particularly the Bank of Cyprus, and
A very real outrage at the bumbling response of the Cypriot government, the Central Bank of Cyprus and the 2 systemic banks.
To be perfectly honest, many Russian and Ukrainian investors feel that they have been duped by the assurances made by the government, the Ministry of Finance, the Central Bank and the 2 banks prior to the crisis. Following the crisis, they have been outraged at the fact that they are often seen as a cash cow by the Cypriot “system”. This is nowhere more apparent that in the very convoluted efforts made by the Bank of Cyprus to prevent Russian shareholders from nominating members of the Board of Directors.
At the same time, investors accept that Cyprus retains certain strategic advantages:
A highly favourable tax system, including low or zero income and dividend taxes on non-residents
A favourable network of double taxation treaties
A business system where Russian and English are widely accepted languages
The presence of international banks in Cyprus, including Russian Commercial Bank
The potential of concealing the ultimate beneficial shareholder of Cypriot companies, either via nominee shareholders, or interlocking shareholding by Trusts or foreign companies (notably British Virgin Islands).
The following general steps are being taken in the short term to manage risks:
Moving deposit accounts abroad: Nearly all Russian and Ukrainian investors we are in contact with have opened secondary accounts in jurisdictions such as Malta, Latvia, Jersey, Denmark, or further afield. Financial transactions have been separated from the corporate domicile.
Opening new corporate subsidiaries: Many investors have opened subsidiary or new companies in Malta, Latvia, Luxembourg, Switzerland, Ireland and a range of other jurisdictions. A substantial number are “idling” their Cypriot operations in favour of the new jurisdictions until the situation settles.
Increasing the “ecosystem” of related companies and/or bank accounts: Many investors have increased the number of related companies in Cyprus and internationally. This is primarily an attempt to come under the EUR 100,000 deposit level; in other cases, the financial “velocity” of transfers between companies in the same ecosystem has simply increased in an effort to manage risk. Many companies are now implementing a daily or weekly cash “sweep”: sending all deposits over EUR 100,000 from Cyprus to a third country location to avoid further bail-ins or seizures.
These are obvious and largely superficial measures. Over the longer term, Ukrainian and Russian companies should review how to strategically restructure their international operations, using Cyprus as a European foothold, but diversifying risk and improving operations systematically.
Managing Risk in Cyprus: The Future Perspective
A future, longer-term perspective for Ukrainian investors in Cyprus (and Cypriot investors in Ukraine) must take the more comprehensive risk weighting and business potential analysis into account. This is obviously specific from sector-to-sector, and investor-to-investor, but a few salient options stand out:
a. Ukraine and Russia
Political and commercial relations between Ukraine and Russia remain marked by high risk. While Russia remains a major export market for Ukrainian manufacturers, Russia’s selective use of trade, tariff and administrative barriers to Ukrainian exports remains a present threat. To counteract this, many Ukrainian manufacturers have invested in factories in Russia, thus avoiding or minimising the threat of Russian barriers. A key priority is therefore to establish third-party sites and corporate identities to avoid or mitigate Russian barriers. This can increasingly be done via Poland or Lithuania.
b. Ukraine and Lithuania
Ukrainian / Cypriot investments in Lithuania can play an active role in managing this risk absent a direct investment in Russia. In Lithuania, Navigator is working with a free trade zone which offers a 0% income tax for FTZ residents for the first 7 years, followed by a 14% income tax for the next 10 years. Setting up a subsidiary of a Cypriot firm in the FTZ, together with a “round trip” export of manufactured goods, gives Ukrainian manufacturers the advantage of an EU-Baltic business identity with a double tax advantage within the EU. The FTZ also provides 0% import / export tariffs, providing that the origin and final destination of goods is outside the EU. Managed correctly, registration here avoids the threat of further Russian tariff barriers against Ukrainian products.
c. Ukraine and Poland
Poland is also increasingly becoming a strategic market for Ukraine. Its low debt-to-GDP, high population, stable currency and growing consumer incomes mean that many Ukrainian firms are increasingly targeting sales in Poland. Numerous Ukrainian companies are also choosing to list shares on the Warsaw Stock Exchange. Setting up a Polish subsidiary or listing on the Warsaw Stock Exchange via Cyprus gives relief from dividend taxes in Poland, while maintaining a common border with Ukraine and the advantage of an EU identity. Cyprus remains the most effective country for investing in Poland in terms of its Double Tax Treaty. Poland will also be a major beneficiary of EU Structural Funds, with over EUR 70 billion anticipated between 2014-2020.
d. Ukraine and the United Kingdom
Although not widely recognised as a fiscal “paradise”, registering a non-resident company in the United Kingdom offers important tax advantages. As long as the shareholders are not resident in the UK, and the income does not originate from the UK, there is no tax payable in the UK. (The shareholder is taxed in their country of fiscal residence). Thus, a Cypriot company owned by a Ukrainian investor can set up a subsidiary in the UK. This gives the advantages of a UK corporate identity with Cypriot taxation.
The four options provided here are only a few of the hundreds of options open to a Ukrainian investor in Cyprus. It is incumbent upon investors and their professional advisors to develop the most optimal solution for managing future risks and developing strategic business expansion.
The future trend is clear: rather than relying on a single EU jurisdiction (Cyprus), with a “second step” offshore (outside the EU), the emerging risk environment means that an ecosystem of onshore and offshore locations will be necessary in the future.
Moreover, the fact that the sovereign debt and banking crises have not abated in Europe, while the OECD and G-20 are making increasing efforts to reduce tax havens, means that Russian, Ukrainian and Cypriot investors need to make continual efforts to monitor the international tax and operating environment. The next five years will remain extremely turbulent in Europe, and stability cannot be assured. In such an environment, the lessons learned in the 2013 Cyprus crisis may well function as a useful template for future emergencies.
(c) Philip Ammerman, Navigator Consulting Group