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Much has changed since July 2012, when, in reaching out for a European Union (EU)-funded bailout, the Cypriot Government resolutely denied the possibility of a hike to its prized 10% corporate income tax rate. Cypriot authorities' obstinate refusal to accept an earlier bailout, when the stakes were lower, led to a rude awakening for Cypriot taxpayers Saturday morning (March 16) with news not only of a symbolic hike to the island's corporate tax to 12.5%, but of Cypriot authorities' plans to purloin their savings with a shock smash-and-grab tax on bank deposits.
Shortly after the announcement in the early hours of March 16 that a deal had been hammered out with the International Monetary Fund, the European Central Bank and the EU, Cypriot lawmakers were assembled to rush through legislation in an attempt to install the levy before Tuesday, March 19, 2013, when Cypriot banks were to reopen their doors after a three-day public holiday. The banks' closure enabled authorities to prevent a full-blown bank run with cashpoint withdrawals being capped at EUR400.
After the parliament roundly rejected the proposed deal on Tuesday, Finance Minister Michalis Sarris flew to Moscow to negotiate Russia's involvement in an alternative package and the bank closures were extended to the full week.
The highly controversial levy, which would have to have been approved by Cyprus's hung parliament and EU member states, had been drawn up to raise revenues worth EUR5.8bn (USD7.6bn) overnight. The tax features a one-time levy of 9.9% on deposits over EUR100,000, and a lesser 6.75% tax on deposits below that value. Analysts have warned that the levy would set a dangerous precedent that could have a destabilizing impact on the European banking system, prompting concern from taxpayers in other nations that have yet to implement comprehensive austerity measures — such as the United Kingdom — that the measure could be replicated.
From one perspective, the levy is the worst possible measure that could have been drawn up to fund the recapitalization of Cyprus's two largest banks; ironically, it would inevitably cause substantial capital outflows and reputational damage to the Cypriot banking sector internationally that may take decades to rebuild. However, from another perspective — the one being argued by Cypriot authorities — the levy forces foreigners, predominantly wealthy Russian depositors, whose funds account for almost half of all deposits, and who are generally non-resident, to shoulder the burden of recapitalizing the banking system. In addition to the bank deposit levy, a new withholding tax on bank interest is to be introduced with a rate yet to be announced.
Unlike Ireland — the recipient of the EU's second bailout in November 2010 — Cyprus has bowed to demands that the nation hike its headline corporate income tax rate, from 10% to 12.5%. Just days before the bailout package's announcement, presidential advisor, Christopher Pissarides admitted that the island would resign itself to a higher corporate income tax rate — despite earlier hard lining on the matter — but underscored that the territory would only do so on the pre-condition that the rate be guaranteed for at least a decade to provide certainty for businesses and investors.
Compared with the revenues that the harmful banking deposit levy would generate, the contribution of a higher corporate tax rate to consolidation efforts is expected to be minimal. It has been estimated that a 1% hike to Cyprus's corporate tax rate would generate just EUR80m, and therefore the concession has likely been crow-barred into the deal as a trade-off to appease Europe's higher tax nations. In return for its 2010 bailout, Ireland fought off incessant calls — mainly from France and Germany — for it to hike its cornerstone 12.5% rate, which had been chided as predatory.
Critically, in another blow to Cyprus's international competitiveness, Cypriot authorities have also agreed to expand the scope of the territory's capital gains tax. The absence of a capital gains tax, other than on the sale of immovable property, has been a key driver in Cyprus's rise to prominence as a leading EU holding company domicile. Cyprus is expected to retain the withholding tax exemption for non-residents on dividend income, however.
In return for the austerity measures, Cypriot authorities would have secured bailout funds worth just EUR10bn; significantly less than previously expected. Earlier, Cyprus was expected to receive funds totaling EUR17bn but European Union negotiators aired concerns that Cyprus's national debt to gross domestic product (GDP) would have risen to 120% — a level they argued would be unsustainable.
Confirming the deal, the European Union stated: "The Eurogroup is confident that these initiatives ... will allow Cyprus's public debt, which is projected to reach 100% of GDP in 2020, to remain on a sustainable path and enhance the economy's growth potential. The current fragile situation of the Cypriot financial sector linked to its very large size relative to the country's GDP will be addressed through an appropriate downsizing, with the domestic banking sector reaching the EU average by 2018, thereby ensuring its long-term viability and safeguarding deposits."
According to a Troika document leaked months ahead of the concluded deal, Cyprus's bailout package will likely be rounded off with comprehensive public sector retrenchment, which could involve more than 2,000 public sector redundancies, a 15% cut in public sector wages and the divestment of public sector enterprises. Cyprus has already agreed a third consecutive hike to its value-added tax rate, from 18% — last increased in January 2013 — to 19% in January 2014, bringing it closer to the EU median rate of 20%.
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