Overview of Cyprus’s Tax Mechanisms: From Legacy Systems to Proposed Reforms
In Cyprus, two longstanding tax mechanisms, Special Defence Contribution (‘SDC’) and Deemed Dividend Distribution (‘DDD’), have served as key tools in shaping the country’s fiscal landscape. Both were introduced to counter tax avoidance and ensure equitable tax collection, especially from passive income. Yet, over the years, they have also given rise to serious debate, especially on their compatibility with principles of fairness, equality, and EU law. Now, with the Cypriot government proposing long-awaited reforms, through this article we aim at analysing the current regime, the legal and policy arguments on both sides, and how the proposed amendments may bring overdue balance to the system.
Understanding the Two Pillars
A. Special Defence Contribution (SDC)
SDC is a tax applied on certain types of passive income (dividends, interest, and rental income), payable by Cyprus tax residents who are also domiciled in the Republic. The current rates are:
- 17% on dividends,
- 17% on passive interest (with limited exceptions),
- 3% on gross rental income (after a 25% deemed deduction).
A significant exception exists: Cyprus tax residents who are not domiciled in Cyprus (so-called “non-doms”) are exempt from SDC entirely. This has made Cyprus a magnet for HNWIs and expatriates, particularly given its 17-year “non-dom” tax planning window. But is it fair, for the citizens-by-birth of the Republic?
B. Deemed Divided Distribution (DDD)
Introduced in 2003, DDD is a unique Cyprus mechanism targeting retained corporate earnings. Where a Cyprus tax-resident company fails to distribute at least 70% of its after-tax profits within two years from the end of the relevant tax year, those profits are “deemed” to have been distributed to the shareholders, and SDC (plus National Health Contribution, known as GESY) becomes payable accordingly, provided those shareholders are Cyprus tax-resident and domiciled. And again, is it fair for the citizens-by-birth of the Republic?
No actual dividend need be paid. The tax is applied on a notional basis, and future real distributions trigger tax only on the excess beyond the amount already deemed distributed.
The Case in Favour of the Current Regime
Targeting Passive Wealth Accumulation
The SDC regime seeks to ensure that individuals who accumulate wealth through passive income (rather than through active employment or trading) contribute their fair share. By taxing dividends and interest, it closes the loophole that allows wealth to grow untaxed through corporate covers.
Anti-Deferral and Anti-Avoidance
Deemed distribution addresses the classic deferral problem: shareholders, particularly in closely-held companies, might indefinitely retain profits in the company to avoid dividend taxation. DDD pre-empts this by imposing taxation after a two-year window.
Fiscal Stability
These mechanisms contribute significantly to national revenue and discourage excessive profit retention. They also reflect a policy of protecting public finance in the face of aggressive international tax planning.
The Criticisms and Legal Controversies
Unequal Treatment and Discrimination
The SDC regime’s domicile distinction means two tax residents in Cyprus, living and earning in the same jurisdiction, even doing the same business, may have vastly different tax obligations. While this is arguably a domestic matter, some consider it a form of indirect discrimination against nationals or long-term residents, especially where “non-dom” status is more accessible to foreigners.
This raises questions under:
- Article 14 of the European Convention on Human Rights, prohibiting discrimination,
- Articles 20 and 21 of the EU Charter of Fundamental Rights, which guarantee equality before the law and non-discrimination.
This concern is not merely academic: the European Parliament, in a 2022 policy report (Harmful Practices and Competition in the Area of Personal Income and Wealth Taxation, Jan. 2022), highlighted Cyprus’ non-dom regime as a “preferential tax arrangement aimed at wealthy foreigners”, implicitly confirming the regime’s discriminatory effect within the EU internal market framework.
Taxing the Shareholder Without Income
Deemed dividend distribution taxes shareholders on income they never received. This challenges two legal fundamentals:
- Ability to pay principle: individuals are taxed without liquidity.
- Right to property:arguably undermined under Article 17 of the EU Charter and Article 1 Protocol 1 of the ECHR, as shareholders lose value through tax without corresponding economic benefit.
Detrimental to Business Growth
For companies, especially SMEs or start-ups, being penalised for reinvesting profits rather than distributing them undermines growth. Forced deemed distributions may discourage prudent capital retention, affecting long-term development.
The Long-Awaited Reform Proposal
In early 2025, the Cyprus Ministry of Finance announced a major tax reform package, expected to modernise and rationalise the tax system. Key proposed changes include:
A. Abolition of Deemed Dividend Distribution
- Full repeal of the deemed distribution mechanism is on the table, recognising its growing incompatibility with modern business realities and investment logic.
- This signals a shift towards taxing actual economic benefit, not hypothetical distributions.
B. Reduction of SDC on Dividends
- SDC on dividends for domiciled individuals is proposed to be cut from 17% to 5%.
- Rental income SDC may be abolished entirely.
These proposals, if implemented, would:
- Level the playing field between domiciled and non-domiciled residents business owners (at least partially),
- Eliminate the anomaly of taxing undistributed profits,
- Enhance the attractiveness of Cyprus for local entrepreneurs, not just foreign investors.
A Reform That Strikes Balance
The proposed amendments reflect a conscious evolution of Cyprus tax policy, from defensive mechanisms rooted in a 2003 framework to a more modern, business-friendly and rights-respecting model.
By abolishing DDD, Cyprus removes the compulsion to distribute. At the same time, the reduced SDC rate provides an incentive for real distributions, allowing the tax system to align with actual economic activity.
The reforms bring the system more in line with EU legal principles of proportionality, legal certainty, and non-discrimination. They also reduce the risk of Cyprus facing legal challenges before EU or ECHR courts.
Conclusion
Cyprus’ Special Defence Contribution and Deemed Dividend Distribution rules served a purpose in an earlier tax era. But today, they increasingly appear as legal and discriminatory anomalies. The government’s reform proposal, long demanded by tax professionals, business men and investors alike, signals a turning point. By replacing rigid mechanisms with balanced and proportionate rules, Cyprus reaffirms its position as a competitive and compliant jurisdiction for both local and international business.
The reform is not only a matter of tax policy. It is a recalibration of the system!
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