EU grey list: Cayman issues draft economic substance legislation

The Cayman Islands has published a Bill which will require certain businesses in the Cayman Islands to show that they have sufficient economic substance in the Cayman Islands. The International Tax Co-operation (Economic Substance) Bill 2018 has been published against the background of Cayman’s inclusion in the EU grey list of countries.

Affected businesses will include those in the financial services sector, including fund management businesses. Guidance is to be issued by the Cayman tax authorities and this will be particularly important in determining the extent to which affected businesses are compliant, especially in the context of outsourced activities, for example where a Cayman manager delegates investment management and fund distribution services to a UK or other onshore investment manager.

Background

In December 2017, following work of the EU Code of Conduct Group on Business Taxation, the EU Council adopted an EU list of non-cooperative jurisdictions for tax purposes, which were set out in an Annex to its conclusions. The Annex contained a black list of non-co-operative jurisdictions but also a grey list containing a number of different lists of jurisdictions in relation to which the EU Code of Conduct Group identified concerns during its screening process. The jurisdictions identified on the grey list all committed to address these concerns by introducing relevant changes in their tax legislation in order to comply with the EU criteria. It was expected that most “grey list” jurisdictions would implement the necessary changes by the end of 2018.

The Cayman Islands, along with Jersey, Guernsey and the Isle of Man, was one of those jurisdictions on the original grey list on the basis of the existence of “tax regimes that facilitate offshore structures which attract profits without real economic activity” (the so-called “2.2 jurisdictions”). The publication of the Cayman International Tax Co-operation (Economic Substance) Bill 2018 is in response to this situation and follows 18 months of engagement with the EU on this issue.

Proposed measures

The Bill provides that certain entities that carry on “relevant activities” are required to satisfy an “economic substance” test in relation to those activities.

Entities covered by the new regime will include local companies and local LLPs (unless, in either case, centrally managed and controlled and tax resident abroad) and foreign companies that are centrally managed and controlled and tax resident in the Cayman Islands.

Activities that are covered by the Bill include banking, financing and leasing, fund management, insurance, holding companies and headquarter activities, IP businesses and shipping and distribution services. However, the business of operating as an investment fund is excluded.

The Bill contains annual reporting obligations on relevant entities to inform the Cayman tax authorities as to whether they are carrying on relevant activities and whether income from that activity is subject to tax in another jurisdiction. In addition, where an entity is subject to the requirement to meet the “economic substance test”, it must submit a detailed report to the Cayman tax authorities setting out the information required by section 7(4) of the Bill.

Economic substance

The economic substance test will be satisfied if the entity conducts “Cayman core income generating activities”, is directed and managed in an appropriate manner from Cayman and has adequate operating expenditure incurred in or from Cayman, has adequate physical presence (including plant, property and equipment) in Cayman and has an adequate number of full-time employees or other appropriately qualified personnel in Cayman.

Cayman core income generating activities generally means “activities that are of central importance to a relevant entity in terms of generating income and that are being carried out from within Cayman”. However, the Bill goes on to provide more detailed descriptions in relation to different business types. For example, in relation to fund management it means taking decisions on holding and selling investments, calculating risks and reserves, taking decisions on currency or interest fluctuations and hedging positions and preparing reports or returns for investors or the Cayman Islands Monetary Authority.

However, the Bill goes on to provide that an entity may satisfy the economic substance requirements where its Cayman core income generating activities are conducted by another person provided that the entity is “able to monitor and control” the carrying out of those activities.

There are detailed provisions in relation to appropriate management regarding the status and role of the entity’s board of directors and conduct of board meetings. For example, meetings of the board of directors need to be held in the Cayman Islands at adequate frequencies and with a quorum of directors present in the Islands.

Lower requirements apply to a pure holding company, whilst there are specific provisions dealing with IP holding companies, which in practice will be challenging to satisfy.

The Cayman tax authorities are required to issue guidance on satisfying the economic substance test, following private sector consultation.

Penalties

Where an entity fails to meet the economic substance test, the Cayman tax authorities may impose a penalty of $10,000 on that entity. If the failure continues in a subsequent period, then the Cayman tax authorities may impose of penalty of $100,000. The Bill also gives the Cayman tax authorities power to apply to the Grand Court for an order requiring the relevant entity to take such action as specified in the order for the purpose of satisfying the economic substance test or otherwise strike off the entity.

The Bill also provides for criminal sanctions where any person knowingly or willfully supplies false or misleading information to the Cayman authorities under these provisions. The offence carries a penalty of a fine of $10,000 or imprisonment for a term of five years or both. A director, manager, secretary or other officer of a body corporate which commits an offence under these provisions is equally guilty of that offence where the corporate offence was committed “with the consent or connivance of, or to be attributable to any neglect” of that person. It is also an offence for a person to fail to provide information specifically requested under these provisions by the Cayman tax authorities, which may result in a fine of $10,000 or to imprisonment for a term of two years or both.

The Bill also provides for the Cayman tax authorities to share any information provided under this law in relation to a company which fails the economic substance test with the jurisdiction of the company’s parent company or beneficial owner and the jurisdiction of incorporation of the company under any relevant international or bilateral agreements.

Comment

The Bill is expected to come into force from 01 January 2019. However, it is unclear from which date relevant entities need to meet the economic substance test and therefore what kind of lead time affected businesses will have to prepare. In addition, details of when notifications will need to be made by affected businesses and the form and manner of notifications are yet to be issued by the Cayman tax authorities. These details are expected to be prescribed by regulations or set out in guidance expected to be released in the next few days.

Obviously, the guidance to be issued by the Cayman tax authorities will be most important in setting the boundaries for compliant businesses. In particular, guidance on the circumstances in which oversight of outsourced activities will be compliant is awaited and affected business should ensure that they take part in the industry consultation that the Cayman tax authorities are obliged to conduct.

The EU is expected to review the legislation passed by the Cayman Islands, as well as other similarly affected jurisdictions, in early 2019. The EU is then expected to announce an updated list of non-cooperative tax jurisdictions by March 2019. It is possible that further changes may be required to the Cayman legislation following the EU review.